Convertibility

A currency is convertible when it can be exchanged freely for other currencies (or, in the past, gold). Restrictions on convertibility act as a barrier to international trade and capital flows; similarly, for convertibility to be meaningful, other barriers to trade must come down. Since the 1980s, convertibility has spread rapidly, as a large number of countries reduced or eliminated these barriers.

Since countries can impose several levels of currency controls, economists distinguish between different kinds of convertibility. The main distinctions are between current and capital account convertibility, and external and internal convertibility. Current account convertibility refers to the use of a currency for current account transactions, i.e., international payments for goods and services, interest and dividend payments, and remittances or gifts. Capital account convertibility means the absence of restrictions on international capital flows. External convertibility refers to transactions between residents of a country and nonresidents, while internal convertibility is the right of residents to hold assets denominated in foreign currency and to carry out transactions with them.

During the international gold standard, the major economies of the world maintained convertibility between their national currencies and gold at fixed [Page 388]ratios, and permitted international movements of gold with little interference. The U.S. dollar, for example, was defined as equivalent to 23.22 grains of gold. Issuers of these currencies were obligated to convert them to gold on demand at the defined rate (“par value”), and therefore the currencies were convertible to each other. The beginning of the period is not clearly defined, as various countries adopted the gold standard at different times (Great Britain in 1821, Germany in 1871, France and Switzerland in 1878, the United States in 1879, Japan in 1897).

Before that, these countries had followed either a silver or bimetallic standard, and in principle their currencies were convertible, but convertibility was frequently suspended during wars or financial crises. At the end of the 19th century, however, convertibility at the par value was considered to be a prime goal of monetary policy. The stability and confidence this provided helped the great expansion of international trade and investment during this period, sometimes regarded as the first age of globalization.

The outbreak of World War I in 1914 saw the belligerent countries impose strict trade and currency controls, and the gold standard and convertibility were suspended. During the inter-war period (191839) attempts were made to restore convertibility, but economic instability, high unemployment, and competitive devaluations led to these attempts being less than successful. During World War II, international transactions again came under severe controls, and currencies became inconvertible.

At the end of World War II, the International Monetary Fund (IMF) was established to promote the smooth functioning of the international monetary system. One of its principal objectives was “to assist in the establishment of a multilateral system of payments in respect of current transactions between members and in the elimination of foreign exchange restrictions which hamper the growth of world trade” (Article 1). Specifically, under Article 8 of the IMF charter, members were to remove restrictions on current account transactions (though such restrictions could be maintained on a temporary basis). Article 6, however, allowed members to regulate international capital movements, since they could be disruptive to the fragile macroeconomic stability of most economies in the immediate postwar period.

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