Heading for Currency 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 currencies—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 gold 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 gold standard 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