Currency Convertibility is the ability to exchange money for gold or other currencies. Currency is considered to be convertible when the concerned country formally accepts the obligations of Article VIII, Sections 2, 3 and 4 of the Articles of Agreement of the IMF.
An international monetary system has been in existence since monies have been traded, its analysis have been traditionally started from the late 19th century when the gold standard began.
The Gold Standard
Exact date for the commencement of the gold standard is not known however the 1880-90 period is important. Currencies are valued in terms of a gold equivalent known as the mint parity price (an ounce of gold was worth $ 20.67 in terms of the U.S. dollar over the gold standard period) in gold standard. Each currency is defined in terms of its gold value hence all currencies are linked together in a system of fixed exchange rates. Gold was used as a monetary standard because it is an internationally-recognized homogeneous commodity that is easily storable, portable, and divisible into standardized units, such as ounces. Since gold is costly to produce, it possesses another important attribute governments cannot easily increase its supply.
The Gold Exchange Standard
An international conference at Bretton Woods, New Hampshire, in 1944 at the close of World War II transformed the international monetary system into one based on cooperation and freely convertible currencies. By this each country had to fix the value of its currency in terms of gold. This established the “par” value of each currency. The U.S. $ was the main currency in the system and $1 was equated in value to 1/35 oz. of gold. By this all currencies were linked in a system of fixed exchange rates.
The members were committed to maintaining the value of the currency within +/-1% of parity. Various central banks were to achieve this goal by buying and selling their currencies (usually against the dollar) on the foreign-exchange market. When a country experienced difficulty maintaining its parity value due to balance-of-payments disequilibria, it could turn to the International Monetary Fund (IMF), which was created to monitor the provision of short-term loans to countries experiencing temporary balance-of-payment difficulties.
External and Internal Convertibility
When all holdings of the currency by non-residents are freely exchangeable into any foreign (non- resident) currency at exchange rates within the official margins, then that currency is said to be externally convertible. All payments that residents of the country are authorized to make to non-residents, may be made in any externally convertible currency that residents can buy in foreign exchange markets. And if there are no restrictions on the ability of a country to use their holdings of domestic currency to acquire any foreign currency and hold it, or transfer it to any nonresident for any purpose, that country’s currency is said to be internally convertible. Thus external convertibility is the partial convertibility and total convertibility is the sum of external and internal convertibility.
Externally inconvertible currencies may be of rather limited value to their holder. An exported item from a developing country to the USSR, for example, may be paid for in rubles or the currency of a country that has ratified Article VIII. The proceeds may be used to purchase goods anywhere.
In considering possible import suppliers, a developing country will have some interest in directing its importers to those countries, whose inconvertible currencies are in large supply.
This is, of course, a case of trade discrimination that is condemned by traditional theory. This means that goods are not being purchased from the cheapest source. Recent economic writing has, however, reopened the question in view of the continued existence of inconvertible currencies. Where it is profitable on the export side to trade with countries maintaining inconvertible currencies, as well as the government wishes to encourage imports from such countries to offset its credit balances, it will utilize its exchange distribution mechanism to limit the availability of convertible exchange, where there are alternative suppliers of the same type of goods in inconvertible currency countries.
Current Account Convertibility
Current account is defined as including the value of trade in merchandise, services, investment, income and unilateral transfers. Being essential to the development of multilateral trade, three approaches to current account convertibility has been adapted by developing countries. These are the pre-announcement, by-product, and front-loading approaches. Each approach is distinguished by the importance it attaches to convertibility relative to other economic objectives.
Capital Account Convertibility
Capital account includes transactions of financial assets. Its convertibility refers to the freedom to convert local financial assets into foreign assets in any form and vice versa at market-determined rates of exchange.
Capital controls normally restrict or prohibit cross-border movement of capital. Thus, controls on capital movements include prohibitions: need for prior approval; authorization and notification; multiple currency practices; discriminatory taxes; and reserve requirements or interest penalties imposed by the authorities that regulate the conclusion or execution of transactions. The coverage of the regulations would apply to receipts as well as payments and to actions initiated by non-residents and residents.