convertibility - IMF eLibrary - International Monetary Fund

CURRENCYCONVERTIBILITYAND THEEXCHANGE HATESYSTEM

The author explains some of the factors involved in extending the free-dom of currency convertibility, one of the Fund's principal policy aims.

Pieter Lieftinch

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What do we mean when we talk about currency con-vertibility? In absolute terms currency convertibilitymeans that every person, physical or juridical, residentor nonresident of the country involved, is free toobtain, convert, and transfer balances in the currencyof that country or balances in another currency forwhatever purposes he may desire. This enables thosepersons to use their money (own or foreign) for pur-chases, payments for other purposes, and capital trans-fers wherever they consider this to be most beneficial tothem, for buying in the cheapest markets or investingin the most profitable opportunities. In order to meetthis criterion, currency convertibility has to be comple-mented by the absence of major import and exportrestrictions on foreign trade, discriminatory practices,and bilateralism. Currency convertibility, that is to saythe absence of foreign payments restrictions, withoutadequate trade liberalization, makes in fact no sense.

In actual practice no such absolute or full converti-bility as I have just described exists. It is not requiredto enjoy the major part of the benefits of a multilat-eral system of payments that allows a country to inte-grate its economy to a very large extent into the sur-rounding world. Our present world is composed ofcountries with various degrees of convertibility and cer-tain limitations to it are generally accepted. The crite-ria by which the existence of convertibility is judgedare relative rather than absolute. What then are thepossible limitations which still are consistent with con-vertibility in a practical sense, taking account of exist-ing systems and the rules and practices of the Interna-tional Monetary Fund which champions the principleof convertibility by all its members?

A first limitation that is generally accepted excludesfrom monetary convertibility the freedom of interna-

tional capital transfers, thus limiting convertibility tofreedom of payments and transfers for current interna-tional transactions only. This narrower concept is theone adopted by the Fund, which does not forbid in anyway restrictions on capital movements irrespective ofwhether these are of a long-term or a short-term non-commercial nature. In order to avoid uncertainties withrespect to this distinction between current and capitaltransfers the Fund's Articles of Agreement spell out inconsiderable detail what is included under currenttransactions, namely, (1) all payments due in connec-tion with foreign trade, other current business (includ-ing services) and normal short-term banking and creditfacilities; (2) payments due as interest on loans and asnet income from other investments; (3) payments ofmoderate amounts for amortization of loans or fordepreciation of direct investments; and (4) moderateremittances for family living expenses. Inasmuch as acountry abstains from restrictions on these transactionsits currency meets the Fund's test of convertibility.1

In spite of the usefulness of this distinction betweencurrent and capital transfers, experience tends to showthat some practical difficulties arise when currenttransactions are fully liberalized and capital transac-tions are kept under control. There have been numer-ous instances of large-scale capital movements that havetaken place in the guise of commercial transactions,when exports of capital or speculative capital move-ments were effectuated through dealings in goods or bydeferring payment dates. This risk has often led toreluctance to abolish all administrative control over cur-rent payments; a number of countries have, however,accepted such loopholes as a price to be paid for theadvantages of administrative simplification and a con-siderable reduction of their bureaucracies.

1 See also "Current and Capital Transactions: How the FundDefines Them," Finance and Development, September 1968.

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Residents and NonresidentsA second possible limitation is connected with the

distinction between convertibility for residents and fornonresidents. A country might well restrict the right ofits residents to use their local or foreign currency bal-ances for current spending on imports, tourism, studyremittances, and so forth, while granting nonresidentowners of such balances complete freedom to convertthem into other currencies, provided that such conver-sion is required for the settlement of current transac-tions with other countries. From an international pointof view the crucial step in the direction of multilateraltrade and payments is clearly the establishment of ex-ternal, nonresident convertibility. All trading partnersof a country taking this step are thereby enabled to useelsewhere the balances earned in that country.

But as long as restrictions on current payments byresidents, and trade restrictions, particularly those of aquantitative nature such as import quotas, are main-tained, importers in that country are denied the advan-tage of buying in the cheapest market. Nevertheless, anumber of countries have introduced nonresident con-vertibility while maintaining a rather restrictive systemin respect of current payments and imports by resi-dents. Generally, the amounts involved in resident con-vertibility are much larger and the impact of unre-stricted imports on the economy is much more pro-nounced than in nonresident convertibility. On theother hand, it should be noted that the introduction ofnonresident convertibility does not allow for muchgradualism or an easy retreat—although such retreatshave occasionally occurred—whereas resident converti-bility, and particularly import liberalization, can beachieved step by step in relation to the progress acountry makes in strengthening its internal and externalposition.

The Fund's Articles of Agreement make the dis-tinction between currency convertibility for residentsand for nonresidents, but make it an obligation in prin-ciple to avoid restrictions on current payments of bothcategories. However, in recognition of the fact that inthe postwar period this obligation could be too burden-some because conditions might not permit membercountries to accept full convertibility in either sense, itwas provided that during a transitional period membersare allowed to maintain and adapt to changing circum-stances restrictions on payments and transfers for cur-rent international transactions. Nevertheless, it wasexplicitly stated that members shall have continuousregard in their foreign exchange policies to the purposesof the Fund, and, as soon as conditions permit, theshall take all possible measures to develop such com-mercial and financial arrangements with other mem-bers as will facilitate international payments and themaintenance of exchange stability. In particular, mem-

bers shall withdraw restrictions as soon as they aresatisfied that they will be able, in the absence of suchrestrictions, to settle their balance of payments in a man-ner which will not unduly encumber their access to theresources of the Fund. In fact, at present out of a totalof 118 member countries, 35, representing 75 per centof world trade, have formally accepted the obligationsconcerning nonresident and resident convertibility; themajority of the Fund member countries are still avail-ing themselves of the transitional facility, althoughmany of them have reduced their restrictions and someare maintaining restrictions only on payments andtransactions by residents. For those that have formallyaccepted the convertibility obligations but find it toodifficult to comply fully with these, the possibility ofexceptions has been opened, subject to the approval ofthe Fund (such approval is not required for countriesthat adapt or continue to maintain restrictions duringthe transitional period), and the instances are not in-frequent where the Fund has approved, always on atemporary basis, the maintenance of some remainingrestrictions, and even some new ones introduced bymembers with currencies that are regarded as con-vertible under Article VIII. All members still retainingany restrictions on current payments, approved or not,have to consult annually with the Fund as to theirfurther retention, and the Fund is entitled, in principle,to take certain actions aiming at their withdrawal.

Nonmember CountriesA third possible limitation with respect to currency

convertibility consists of differential treatment of pay-ments and transfers for current transactions with indi-vidual countries or territorial areas. A Fund member'sconvertibility obligations exist only with respect tofinancial transactions with other members. The FundAgreement clearly states that nothing in this Agree-ment shall affect the right of any member to imposerestrictions on exchange transactions with nonmembersor with persons in their territories unless the Fundfinds that such restrictions prejudice the interests ofmembers and are contrary to the purposes of the Fund.With the notable exception of Switzerland, most non-members of the Fund have centrally controlled econ-omies with rather rigid trade and payments restric-tions. They constitute a nonconvertible area of theworld. Many members of the Fund have entered intobilateral trade and payments agreements with the coun-tries in that area. Although such bilateral arrangementsexclude, by definition, free convertibility, the bilateralpartners may have arranged between them that certainnet balances accruing on either side can mutually beconverted into a convertible currency. Such arrange-ments are certainly useful as far as they go, but theydo not solve the problem of breaking down the barrier

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between countries with centrally controlled trade andpayments practices and those that have eliminated orare trying to eliminate their restrictive system in favorof a market economy.

No difference in the treatment of current transac-tions is allowed, at least in principle, between a mem-ber and other members of the Fund. This is the rule ofnondiscrimination and the avoidance of multiple cur-rency practices. Member countries that still availthemselves of the facilities under the provisions of thetransitional period are exempt from this rule insofar asthe maintenance and adoption of these practices, andthose that have accepted to undertake the convertibilityobligations may only engage in such practices on atemporary basis with the authorization of the Fund.But the Fund is rather severe in this respect, particu-larly in its insistence on nondiscrimination and theavoidance of bilateral payments arrangements betweenmembers, because multilateralism is one of the Fund'scredos.

An Administrative LimitationA possible limitation that is generally accepted is a

purely administrative one, namely to forbid or restrictpayments and transfers for international transactionsby individuals and to channel all or most exchangetransactions through recognized financial institutions.Many countries have made it obligatory for the publicto surrender all foreign exchange they receive (withminor exceptions) to the banks, the greater part goingto the central bank, while the commercial banks mayretain what is considered to be adequate as workingbalances. A corollary of this proposition is to bring inthe banks whenever currency or other payments instru-ments are internationally needed. Such measures, thepurpose of which is to enable full registration of inter-national payments and to better enforce remaining re-strictions, do not by themselves militate against theprinciple of currency convertibility provided that theyare administered efficiently and without causing restric-tions or undue delays in transfer.

So much for some of the main limitations on cur-rency convertibility. This is not an absolute concept. Itallows for the maintenance of controls on internationalcapital movements. It requires convertibility of nonresi-dent balances but does not necessarily demand fullconvertibility of resident balances, provided that the re-maining restrictions are approved by the Fund. Inorder to make sense, it should be accompanied by theabolition of quantitative import restrictions and evenexcessive tariff restrictions. Generally speaking it ex-cludes discrimination and bilateralism, at least be-tween Fund members. Finally, channeling all exchangeoperations through the banking system is compatiblewith convertibility.

CONDITIONS FOR CONVERTIBILITYLet us now turn to the next question that should be

discussed. What are the conditions for convertibility?First, the country concerned should have a realistic ex-change rate reflecting, and appropriate to maintain, abalance between incoming and outgoing paymentsunder a free international trade and payments regime.In other words the exchange rate should be such as toenable the country to participate in the world economywith a balance of payments tending toward equilib-rium. This requires that at the existing exchange ratethe country should be able to face international compe-tition in its domestic and in foreign markets, and toearn by its exports of goods and services what isneeded to pay its import bill, taking into account apossible net inflow of long-term and medium-term cap-ital on the one side of the balance and the servicing ofits foreign debt on the other side. This means that thecost and price level in the country which makes itscurrency convertible at the existing rate of exchangeshould not be out of line with the cost and price levelof its trading partners, at least for commodities andservices that enter into international trade.

Adequate ReservesSecond, the country concerned should have at its

disposal sufficient reserves of gold, foreign exchange,special drawing rights issued by the Fund, and reservepositions in the Fund to enable it to stand the strain ofa certain excess of outgoing payments over incomingpayments for a limited period. An unfavorable crop, apeak in investments, a speculative outflow of funds—togive some examples—may cause a temporary balanceof payments deficit for which covering reserve holdingsshould be sufficient to gain time for automatic redressor for measures designed to restore a proper externalbalance to become effective. How large an amount ofreserves is needed to allow a country to accept the ob-ligations of convertibility without assuming an unduerisk is a question not easily answered. It depends onseveral factors: on the vulnerability of a country's bal-ance of payments position; and on a country's capacityto raise foreign loans for the purpose of bridging tem-porary liquidity gaps—which in turn is dependent onits international credit standing. Generally speaking, re-serve holdings equal to the value of several months'imports should be considered a minimum, at least tosupport the transition to convertibility, which is boundto be associated with uncertainties.

its House in OrderThird, the country concerned should have put and

should keep its house in order financially, so that noserious balance of payments difficulties can arise froman excess of national spending. In other words, the

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country should maintain what is called internal balance;it must take care that its national spending on con-sumption and investment does not exceed its resourcesin the sense of its national product augmented, if any,by net capital imports. This implies that the volume ofmoney and commercial credit increases only pari passuwith the expansion of the need for monetary balancesresulting from the productive expansion of the eco-nomic system. For this purpose a policy of "dirigism" isnot required, except perhaps for checking the dangerof cost inflation through excessive increases of wagesor profit margins, resulting from unrestrained pressuresfor higher personal incomes or from monopolistic con-ditions. What should be adequately ensured is that nei-ther the public authorities nor the socialized or privatesector of the economy live above their own available in-comes, supplemented by the savings of others that canbe attracted by borrowing; and further that the crea-tion of money through bank lending should be limitedto the extent needed for the financing of expandingtransactions at the given level of prices and incomes.Such monetary equilibrium need not be precisely real-ized at all times: variations in it may result, for in-stance, from shifts in demand and supply or changes inthe terms of trade. But as long as inflationary pressuresare contained, or if they arise are expeditiously coun-teracted, a country's balance of payments shouldremain in reasonable equilibrium without restrictionsthat are incompatible with convertibility. The require-ment of internal financial stability should, however, beunderstood in a comparative sense. The fact is that welive in an inflationary world. Therefore, a certain rateof domestic inflation is tolerable, provided that it doesnot exceed the rate of inflation prevailing in the coun-try's partners in international trade. In a system of in-tegrated economies national price levels, especially inthe international sectors, tend to equalize automati-cally. This means that in an inflationary environmentindividual countries do not need to create inflation de-liberately to become exposed to it. On the other hand,it should be recognized that the ill effects of inflationhit especially hard the smaller and weaker countrieswhen the days of readjustment dawn.

Trading PartnersA fourth and last condition which also could be

called a prerequisite for convertibility of the currencyof a country with the concomitant avoidance of traderestrictions is the observance of a similar regime by itsmain trading partners. Unilateral convertibility is a lux-ury which in the postwar years only the United States(and some economically less powerful countries in theWestern Hemisphere) could afford. The introductionof convertibility by a number of Western Europeancountries in the late 1950s took place simultaneouslyafter a period of progressive liberalization of trade and

payments among themselves under the European Pay-ments Union. Convertibility as an international conceptpresumes multilateral acceptance of the obligations in-volved, not necessarily by all nations but by a suffi-ciently large number of them to be meaningful and toyield the connected advantages of expanding interna-tional trade and monetary transactions. It implies inter-national cooperation among the countries involved topromote exchange stability, and, in the event, orderlyexchange rate adjustments. It requires international ar-rangements aiming at the provision of adequate inter-national reserves to cushion temporary balance of pay-ments disequilibria. It demands a reasonable degree ofinternal discipline and flexibility to be maintained bythe countries individually in order to avoid persistentdeficits or surpluses in their international payments. Allthese requirements are expressed or implied in the In-ternational Monetary Fund Agreement and, despite thefact that they are not yet fully observed, progress isbeing made over the years toward their practical imple-mentation.

A FLEXIBLE EXCHANGE RATE?Now I come to the final question whether a flexible

exchange rate could be helpful to the introduction andmaintenance of convertibility by a country that consid-ers this step. It is generally agreed that a countrywhich has established internal stability can operatewith a stable exchange rate, provided that rate reflectscorrectly the balance of incoming and outgoing pay-ments resulting from a given structure and perform-ance of its economy and from the pattern of net long-term capital inflows that it has become accustomed to.It should be recognized, however, that the introductionof convertibility is likely to cause rather significantchanges in the country's economy since it has to adjustitself to freer international competition. Enterprisessupplying the domestic market under the protection oftrade and payments restrictions have to face a largerinflow of competing goods from abroad. Export indus-tries will have to expand their production and marketsin order to earn sufficiently more to cover a highertotal import bill. This reorientation and restructuring ofvital sectors of the economy to meet the new challengeof convertibility is not only a time-consuming processbut it requires considerable capital investments andoften a relocation and retraining of labor and manage-ment.

The argument in favor of adopting a flexible ratesystem under such circumstances is that it would facili-tate the transition. Allowing the exchange rate to de-preciate—for that is the only realistic expectation—when pressures on the balance of payments build upwould mitigate the impact of convertibility, because itwould permit the country to follow more autonomousdomestic financial and social policies than otherwise

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would be possible. At the same time exports wouldbecome more attractive and imports more costly, whichwould work in the right direction from a balance ofpayments point of view. But what would be the otherside of the coin? The very consideration that a flexibleexchange rate enables a country to pursue autonomousfinancial and social policies creating more inflation—forthat is what it means—having less regard to the devel-opments in other countries, does itself involve a strongargument against flexible rates. All the familiar disad-vantages of inflation, which intensify as the rate in-creases, militate against it. It should also be observedthat if the uncertainties resulting from a flexible rate arecompounded with the impact of convertibility with itsadjustment requirements, the strain on the economicand social system may become quite excessive.

Apart from these specific objections, the general dis-advantages of a flexible rate system, especially in theform of a freely floating rate, deserve to be kept inmind. I quote from a recent report of the ExecutiveDirectors of the International Monetary Fund: "An es-sential drawback of such a system is that national au-thorities could not be expected in modern conditions toadopt a policy of neutrality with respect to movementsin an economic variable of such importance to the do-mestic economy as the rate of exchange, with its effectson prices, incomes, employment, and the structure ofindustry as between domestic and foreign sectors."

The point I have tried to make is a rather simpleone. The introduction of currency convertibility with thetrade liberalization that makes it effective is a delicateprocess involving far-reaching changes in a country'seconomic structure with widely spread social conse-quences. It should be implemented in steps and not becomplicated and precipitated by the introduction of ex-

change rate flexibility which would expose the countrysimultaneously to the impact of freer foreign competi-tion, currency depreciation, and a strong tendency to-ward internal inflation with the economic distortionsand social inequities that accompany it.

However, once convertibilty has been established, thegreatest possible effort should be made to preserve it.The road of return means defeat, is demoralizing, cre-ates uncertainty, and results in the loss of hard-wongains. Appropriate policies to avoid overspendingshould be systematically and vigorously applied. If in-ternal or external developments, after convertibility hasbeen established, show that reasonable balance of pay-ments equilibrium cannot be maintained at the existingexchange rate, the rate should be courageously ad-justed, and the sooner the better. In their report fromwhich I quoted, the Executive Directors of the Fundhave drawn the attention of the prevalence of toomuch reluctance to adjust exchange rates that have be-come unrealistic or do not allow countries to followtheir legitimate economic policy preferences. They havefound that smaller and more frequent exchange rateadjustments than have been customary in the past areacceptable under the Fund's Articles of Agreement.Such adjustments are certainly preferable to renewedreliance on trade and payments restrictions, which re-duce the degree of currency convertibility and free-dom of international trade that has been achieved andshould be promoted further. This does not meanpreaching laxity in the defense of carefully chosen ex-change rates. Stable exchange rates are a precious assetof the international monetary system and most usefulfor domestic financial discipline. But they should beadjustable and be adjusted in an orderly manner if andwhen there is sufficient justification.

Pieter Lieftinck was Professor of Eco-nomics at Rotterdam in the prewarperiod and Finance Minister of theNetherlands for seven years in the imme-diate postwar period. After three yearsof service with the World Bank as Spe-cial Representative in Turkey and Mis-sion Chief in Syria and Jordan, he be-

came an Executive Director for theNetherlands, Yugoslavia, Israel, andCyprus of both the World Bank andthe International Monetary Fund. OnApril 1, 1971 he retired from the Boardof the World Bank; he is still an Exec-utive Director of the Fund.

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