g Concepts and Degrees of Currency Convertibility Manuel Guitian* urrency convertibility has always been a fundamental notion in inter- Cnational economic relations. Yet, since the abandonment of the Bretton Woods par value regime, a remarkable degree of silence has until recently surrounded the subject. Possibly this silence is related to the advent and prevalence of flexible exchange rate arrangements that fol- lowed the Bretton Woods order. The reason could be that, in theory, flexible exchange rates would make exchange and other restrictions unnecessary or redundant; and, therefore, under such exchange rate arrangements currencies would be convertible by definition, so to speak. But as is often the case, what can be expected in principle does not always materialize in practice; exchange, payments, and other international restrictions have continued to prevail in the period of flexible exchange rates and, therefore, questions of currency convertibility have remained open. Recently, though, the silence has been broken and numerous writings on the subject of convertibility have begun to appear. Two different sets of factors account for the renewed interest. One has been the widespread * Director, Monetary and Exchange Affairs Department, International Monetary Fund. The views expressed in the paper are those of the author and should not be attributed to the International Monetary Fund. For the preparation of the paper, I have relied extensiv- ely on the work on convertibility of several of my colleagues or ex-colleagues in the Fund. I would like to mention, in particular, Gold (1971), Polak (1991), Gilman (1990), Greene and Isard (1991), and Mathieson and Rojas-Suarez (1993). 21 ©International Monetary Fund. Not for Redistribution Currency Convertibility in the Middle East and North Africa process of reform currently under way in the ex-collectivist economies of central and eastern Europe, as well as of the former Soviet Union, that began in the late 1980s. The other has been the process of domestic financial sector deregulation and capital market liberalization that either de jure or de facto has been carried out during the last decade in the industrial world at large and in many developing countries. From the standpoint of the societies in transition from central plan- ning to a market-based system of economic organization, the issue of cur- rency convertibility has become important in that it constitutes a key component of their reform efforts. In this context, it has been pointed out that the concept of convertibility transcends the boundaries of a nar- row monetary question and that it embodies central elements of the strat- egy to transform economic regimes radically and comprehensively. Developments in domestic financial markets in industrial economies and in many developing countries and the consequent globalization of international capital markets, in turn, have also stimulated interest in cur- rency convertibility issues. The interest here has focused on the degree, rather than the concept, of convertibility. In this regard, the issues brought to the fore have been those concerning currency convertibility for capital account transactions, more commonly referred to as capital account convertibility.1 This paper discusses the concept of convertibility in its various modal- ities and degrees. Convertibility, like other related economic concepts, such as liquidity and restrictiveness, is not always amenable to precise def- initions and, therefore, it is worth stating explicitly what it entails, its scope, which is not invariant in time or in economic usage. Concept of Convertibility Traditionally, that is, until early in this century, convertibility generally referred to the right to unrestrictedly convert a currency into gold at a given rate of exchange. This right was an essential component in the func- tioning of the gold standard that prevailed at the end of the nineteenth and the beginning of the twentieth centuries. In this sense, no currency is convertible today. At present, gold no longer plays a significant monetary role and therefore convertibility into it is no longer a relevant concept. Instead, convertibility now refers to the right to convert freely a national currency at the going exchange rate into any other currency. Clearly, the 1See Mathieson and Rojas-Suarez (1993) and Guitian (1992a). 22 ©International Monetary Fund. Not for Redistribution Concepts and Degrees of Currency Convertibility going exchange rate can be either fixed or flexible, in principle, and con- vertibility is a concept that would apply to a currency under either regime. Yet, as hinted in the introduction, the strength of the concept of convert- ibility is not invariant with regard to the existing exchange system. To the extent that flexibility in exchange rates replaces the need for restrictions on exchange transactions, it is clear that such flexibility and currency convertibility go hand in hand. Deviations between the two concepts arise whenever a flexible exchange rate coexists with exchange restrictions, as is often the case in practice. In theory, though, flexible exchange rates render such restrictions (and international reserves) unnecessary, or in any event less necessary than otherwise. Convertibility in this context is a corollary of exchange rate flexibility. A soft concept of convertibility, therefore, would be embodied in the ability to engage in unrestricted exchange of currencies at market-determined exchange rates. Most discussions of convertibility, however, do not envisage such an unconstrained notion. In fact, the general understanding of convertibili- ty is rather the right to engage in unrestricted exchange of currencies at a given exchange rate. This is a hard concept of convertibility and the one associated with fixed exchange regimes. To the extent, though, that exchange restrictions accompany fixed exchange rate systems, the scope of convertibility is thereby limited. So far, the discussion has been conducted on the basis that convertibili- ty is a financial, a currency, concept. And it has been argued that the con- cept depends on the nature of the exchange regime, both in terms of the exchange rate system and of the presence or absence of exchange restric- tions. But even when exchange restrictions do not exist, convertibility in a fundamental sense is very much affected by restrictions other than those on exchange transactions. This is particularly true with controls on the under- lying transactions, such as those on imports of goods and services and of capital exports. That is to say, a currency that is convertible at a given exchange rate (the hard concept discussed above), because there are no exchange restrictions, can be made practically inconvertible through trade and capital controls. These interconnections between financial and real transactions are the basis for the distinction between real or commodity convertibility (prevailing when there are no exchange and trade controls) and financial convertibility (requiring only absence of exchange controls). Degrees of Convertibility Apart from the various definitions of convertibility just discussed, there are a number of other meanings given to the term that, rather than 23 ©International Monetary Fund. Not for Redistribution Currency Convertibility in the Middle East and North Africa reflect additional variations of the concept itself, represent differences in degree. These degrees are derived from various perspectives from which the question of convertibility of a currency can be examined. The most common angles have been (a) the holders of the currency balances; (b) the purposes for which convertibility is sought; and (c) the geo- graphical scope of convertibility. From the standpoint of the holders of currency balances, distinctions have been made between external convertibility and internal convertibil- ity. External convertibility typically refers to extending to foreign holders of currency the right to convert their balances into foreign exchange. This form of restricted convertibility becomes relevant in settings where promotion of foreign capital inflows is a relevant consideration. More generally, external convertibility will provide incentives for foreigners to engage in economic transactions in the countries that provide this free dom to their currency. Internal convertibility, in turn, typically relates to the right given to domestic (resident) holders of currency to convert their balances into foreign exchange. This modality of restricted convertibility, although it is not inconsistent with the promotion of foreign investment, focuses more on other aspects of an economy's performance. Apart from providing incentives to residents to hold domestic cash balances, internal convertibility exposes domestic economic policies to external competi- tion. As such, it poses risks to the policymaker, but it also contributes to making domestic policies internationally competitive. These two forms of restricted convertibility are also often referred to as nonresident versus resident convertibility. From the standpoint of the purposes for which convertibility is sought, the criterion to define its scope is the nature of the transaction for which the foreign exchange is required. The traditional distinction here is between current account convertibility and capital account con- vertibility. Current account convertibility is the most common concept and is defined as the right to convert currency balances into foreign ex- change for making payments