Heading for Convertibility As the current experience in Eastern Europe shows, sound macroeconomic policies are a crucial prerequisite Martin G. Gilman with the rapialy unfolding developments background, highlighting the rules of the IMF in Eastern Europe, there have been resur- on convertibility, before moving on to detail gent calls for moves toward currency con- the necessary preconditions for the success- vertibility—essentially, the unrestricted use ful introduction and maintenance of converti- of a country's currency for international bility. Finally, some observations concerning transactions, allowing it to be freely ex- the convertibility of Eastern European cur- changed for foreign —as a part of rencies are presented, ones that pertain in the process of integration into the world varying degrees to policy dilemmas faced by market economy. The virtues of convertibil- economic decision makers in other regions. ity appear to be widely accepted: offering The main point that emerges is that if greater freedom of choice between foreign governments wish to avoid resorting to and domestic goods, services, and assets, restrictions on the use of domestic currency when combined with the liberalization of those for foreign transactions, then sound economic transactions; and enhancing efficiency through policies must be pursued. the elimination of price distortions. Less clear, however, is whether countries with The concept of convertibility previously highly protected economies equally Convertibility—traditionally defined as the accept the inevitable costs inherent in the unrestricted exchange of paper money into wrenching adjustment entailed in moving at a predetermined rate—has long played toward greater currency convertibility. This a central role in international economic has given rise to divergent views on the relations. Until 1914, the United Kingdom desirable pace toward convertibility. Some maintained full convertibility of sterling into are opting for a gradual approach, while gold at a fixed rate. But in 1925, and again, others, such as Poland and Yugoslavia, in 1947, it failed in its attempts to restore launched bold initiatives in early 1990. convertibility, not only to gold but also to the To understand what is involved in the move US dollar, because of high underlying rates to convertibility and why some countries opt of inflation and inappropriate supporting poli- for approaches that are faster than others, it cies. It took until 1958 for the major Western is helpful to place the concept of convertibility European nations to re-establish currency in perspective. This article briefly recaps this convertibility—following the breakdown of

32 Finance & Development I September 1990

©International Monetary Fund. Not for Redistribution the world financial system between the two tions—accommodated the switch to floating nominal exchange rate are to be avoided. world wars and the move from a exchange rates by incorporating them into the • Exchange rates must be realistic. to a modified gold/dollar standard—although Second Amendment to its Articles of Agree- Whatever type of exchange arrangement is the financial discipline imposed by the con- ment in 1978. This flexibility implied that put in place, the real exchange rate must be vertibility requirements at pre-established there would no longer be any impediments, compatible with a sustainable balance of par values eventually proved unacceptable to in principle, to the adoption of full convertibil- payments over the medium term—that is, certain major industrial countries. In 1973, ity of members' currencies. relative prices must be roughly aligned. This the par value system, which had been adopted , The fundamental notion of convertibility will usually entail movement from an overval- with the founding of the IMF at Bretton fostered by the IMF is that countries should ued official exchange rate and a substantially Woods in 1944, collapsed, and the era of allow an unrestricted and nondiscriminatory more depreciated parallel market rate toward floating rates was ushered in. In theory, this right to residents to use domestic currency a unified, market-clearing nominal rate. This should have allowed most countries to move to effect payments and transfers for current could involve, at least initially, floating the toward full convertibility, since there would international transactions. But it should be rate in an auction market through which an be no need to impose restrictions to support noted that the Fund's concept of convertibil- increasing proportion of external transactions a particular exchange rate. ity, as defined in its Articles of Agreement (including those of the official sector) are In practice, a large number of governments (Article VIII), is a limited one, related channeled. The goal would be to narrow, and were not willing to give total freedom to their pragmatically to the economic circumstances then eliminate, any difference with the parallel currencies' movements, preferring fixed ex- of members. Fund members are obliged to market rate. The maintenance of a realistic change rates, or at least targets for the maintain financial convertibility (the absence exchange rate (one that is perceived as being exchange value of their currencies. Many of government limitations on the making of credible in terms of market expectations), is resorted to restrictions on trade and pay- payments and transfers), but not commodity a sine qua non for the sustainable convertibil- ments rather than monetary and fiscal disci- convertibility. Moreover, the Fund's concept ity of a currency. pline to support their exchange rate policies, applies only to current transactions (in a few • Macroeconomic policies must be correspondingly reducing the degree of con- instances, transactions of a capital nature are appropriate. At the same time, stable real vertibility of their currencies. As a result, included, such as amortization of loans or exchange rates, whether in fixed or floating even where tight government controls on depreciation of direct investments), and is regimes, can only be maintained without currency convertibility existed, there was limited mostly to relations with other Fund recourse to restrictions when appropriate usually a parallel, and often illegal, market members. Deviations from the Fund's con- macroeconomic policies—essentially mone- where currency could be exchanged at some vertibility objectives are permitted, although tary and fiscal policies—are in place. Such price. members are expected to remove restric- policies would help restrain overall demand Currency convertibility is, in principle, a tions as soon as circumstances permit. in line with a country's productive and simple concept. It applies to the ability of debt-servicing capacities. Internal financial residents and nonresidents to exchange do- Preconditions to convertibility stability, in the form of relatively low inflation, mestic currency for foreign currency without Over the years, many countries have is essential to the success of convertibility. limit. There are, however, many degrees of found that the twin goals of relative exchange A major burden will fall on monetary policies, convertibility, with each denoting the extent rate stability and convertibility cannot be especially where there has been suppressed to which governments impose limitations on achieved simultaneously in an inflationary inflation and thus excess liquidity in the the use of currency, which can take the form environment or where inflation is repressed system. Steps could also be taken to absorb of prohibitions, taxes, special deposits, nomi- via price controls and rationing. More pre- excess liquidity directly through the large- nal ceilings (such as for travel allowances), cisely, if a country's price level rises faster scale sale by the state of tangible assets (e.g., or procedures for allocating foreign exchange. than its trading partners—and abstracting housing, businesses) and financial assets. But even in cases where currencies are fully from terms of trade, institutional, technologi- • Price controls should be elimi- convertible, the practical scope depends not cal, and climatic changes—it cannot hope to nated. In countries where resource allocation only on the extent of governmental limitations maintain equilibrium in its balance of pay- has been distorted through the use of price on foreign exchange and payments but also ments without either introducing ad hoc controls, the use of a market-clearing price on restrictions applied to the underlying restrictions on imports or payments, or for foreign exchange will facilitate the deter- transactions, such as imports, services, or letting its currency depreciate; in other mination of appropriate domestic market investing abroad. To free one without the words, without abandoning either convertibil- prices in the nontradable sectors. The longer other is to effectively limit the use of a given ity or the nominal stability of its currency. the domestic price structure has been dis- currency in a practical sense, by reducing the Clearly, within this trade-off (at least since torted, and the greater the degree of extent to which it can be used to carry out the time of the Second Amendment), con- distortion, the greater the transitional costs transactions and make purchases. Thus, vertibility—accompanied by increasing trade of adjustment; conversely, the greater the convertibility—a financial concept—should be liberalization—has been the more desirable benefits in the removal of distortions. The accompanied by liberalization of trade and objective. The goal of a stable system of heated nature of the current debate on the other international transactions, implying that exchange rates is to be achieved by the appropriate degree of gradualism in adjust- the benefits of full convertibility are derived adoption of mutually consistent and appropri- ment programs being implemented by coun- from both "financial" and "commodity" con- ate macroeconomic policies. tries under these conditions—along with the vertibility. In moving toward convertibility—while emphasis on the need for a social safety net The IMF—one of whose founding pur- taking into account the size of the underlying to cushion the adverse impact of adjustment poses was to seek a multilateral, nondiscrimi- macroeconomic imbalances and the degree on the poor—stem from these considera- natory system of payments and transfers for of cost/price distortion in the economy—a tions. current international transactions, and to country would need to establish certain • Adequate foreign exchange re- eliminate foreign exchange restric- preconditions if extreme fluctuations in its serves are needed. Substantial foreign

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©International Monetary Fund. Not for Redistribution exchange reserves or external credit lines establishing convertibility discussed earlier convertible currency settlement in 1991. may be necessary to bolster market credibil- apply to all countries. Indeed, these condi- While Poland and Yugoslavia have already ity in an initial period of adjustment, if tions constitute the core of much of the established foreign exchange markets, the convertibility is to be introduced while main- Fund's policy advice to members within the other Eastern European countries have taining a particular nominal exchange rate, or context of annual consultations or Fund- started to nudge their currencies closer to within a specified range. Balance of payments supported programs. The details need to be market-clearing levels. In addition, other support may also be needed in subsequent examined on a case-by-case basis, depending critical steps are being taken: Hungary allows periods of external pressure. For members upon the initial degree of convertibility, the enterprises to trade excess transferable ruble of the IMF, use of Fund resources could be state of economic development, structural proceeds among themselves; Czechoslovakia temporarily made available for this purpose. and market features, confidence factors (such and the Soviet Union have held foreign The removal or reduction of the above as the public's faith in the government's ability currency auctions; and in Hungary, Poland obstacles should permit a country's authori- to pursue the necessary policies), and the and Yugoslavia, foreign currency deposits are ties to move toward currency convertibility extent to which appropriate economic policies freely held and constitute a significant portion by eliminating various restrictions on pay- have been carried out in the past. of the total . ments and transfers—including the use of For countries wishing to profit from partici- Since the beginning of 1990, Poland and bilateral payments agreements, import de- pation in the world economy, inconvertibility Yugoslavia have undertaken bold experi- posits, and export subsidies. Moreover, is no longer an option. Modern communica- ments, which will also set examples for other liberalization of the underlying transactions, tions, the ease of travel, the size and countries in Eastern Europe and elsewhere. beginning with trade and services, should be sophistication of international capital markets, The first step has been the introduction of pursued. Any remaining trade and payments and the importance of trade for even formerly "resident" convertibility for their currencies restrictions in the transitional period should autarkic economies mean that countries have at fixed exchange rates, the appropriateness be included in "negative lists," meaning that relatively limited margins for insulating them- of which will be kept under review. (This anything not explicitly restricted is permitted. selves from the discipline of the market. And means that residents can freely convert Partner countries should reciprocate these it should be stressed that attempts to do so domestic currency at a given exchange rate efforts by opening up their trade and pay- also exact enormous economic costs because and use those funds to spend abroad on most ments systems, if they have not already done draconian restrictions are required. More- current transactions, but nonresidents—for so. After all, the true efficiency gains from over, partial convertibility, except as a the moment—cannot do so.) In both coun- convertibility can only come about with the transitional mechanism, will not work. Re- tries, the necessary preconditions had been opening of an economy to international trade, strictions will be evaded and parallel markets met: realistic exchange rates had been services, and capital markets. It has to be will emerge. Not surprisingly, therefore, introduced, supported by appropriate poli- recognized, however, that for countries with more and more countries are dismantling cies. Over time, the structures of domestic highly protected economies, these moves can restrictions, introducing market-determined prices and resource allocation, assisted by involve considerable dislocation of firms and exchange rates, and adopting appropriate legal reform and privatization, should align entire economic sectors, entailing high social macroeconomic policies, often in the context themselves, but perseverance in the face of costs, as economic agents will inevitably alter of Fund-supported programs. significant transitional costs will be required. their spending and saving decisions when When considering calls for convertibility of An alternative sequence involving completion offered greater, and undistorted, freedom of Eastern European countries, it is important of structural reforms, as a precondition for choice. These costs, at least in the short run, to keep in mind that they are starting from the move to opening up the economy, also will be higher, the more artificially insulated diverse economic situations in terms of the entails costs. the country has been from the world econ- degrees of central planning, use of the price In the sequencing of reform measures, a omy. mechanism, and privatization. Moreover, in rapid move to convertibility can play an many ways, events have overtaken the initial especially important role in Eastern European Meanwhile in Eastern Europe cautious calls for gradualism. For example, countries, all of which have been character- Inconvertibility is hardly limited to East- the likelihood of organizing economic relations ized by highly monopolized sectors of the ern Europe, or even to centrally planned or through the Council for Mutual Economic economy. Introducing convertibility would socialized economies, in general, as many Assistance, or other regional arrangements, facilitate foreign trade, so that foreign compe- countries have overvalued exchange rates, diminishes as country after coun- tition could substitute to some extent for the administered prices, distorted resource allo- try—Hungary, the Soviet Union, and Yugo- initial lack of a competitive domestic market cation, and extensive restrictions on trade slavia—announces its intention to move to structure. It would also eliminate the need for and payments. While all six Eastern European regulation and bureaucracy, which could countries that either are Fund members facilitate the inflow of foreign private capital (Hungary, Poland, Romania, and Yugoslavia) Martin G. Gilman and send a signal to the international commu- or applied for membership in 1990 (Bulgaria a US citizen, is a Senior nity that a serious commitment to trade and Czechoslovakia) maintain bilateral pay- Economist in the Fund's liberalization and reform was in place. In ments arrangements with other Fund mem- Exchange and Trade Rela- addition, convertibility—when combined with bers and with nonmembers as of the end of tions Department. He holds anchoring the exchange rate to a reserve 1989, there are another 39 Fund members a PhD from the London currency—would enable governments to in- who also maintained such arrangements School of Economics. crease the credibility of their commitment to among themselves. fight inflation. This allows them to take In essence, therefore, the convertibility advantage of the established credibility of a issue faced by the countries of Eastern foreign central bank, possibly alleviating the Europe is similar to that confronting other degree of severity of the monetary shock Fund members, and the preconditions for needed to establish their own credibility. •

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