I Introduction

Joshua Greene, and Peter Isard
Published Date:
March 1991
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Many countries that have had centrally planned economies are now undergoing a dramatic transformation aimed at making their economies more market oriented. Far-reaching reforms are contemplated or under way, including an extensive overhaul of the institutions and mechanisms for implementing monetary and fiscal objectives. At the policy level, the reforms include the restoration of macroeconomic stability, major price liberalization, the restructuring of firms and industries, the creation of new tax and budgetary systems, and the establishment of commercial banking activities.

Among the reforms attracting major attention is the establishment of currency convertibility—the freedom to buy or sell foreign exchange, generally for payments related to international flows of goods, services, and financial assets. Long dismissed in centrally planned economies as unnecessary or a threat to the availability of foreign reserves for industrialization and development targets, convertibility has acquired new significance in the context of economic transformation. Convertibility for current account transactions, along with measures to liberalize trade and payments generally, is now advocated as a source of competitive discipline and appropriate price signals that can play a vital role in guiding domestic enterprises toward efficient production and investment decisions. Convertibility for certain types of capital account transactions is seen as helping to attract foreign investment inflows and associated managerial resources and transfers of technology, which can significantly affect the transformation process. Internal convertibility is viewed as a way of making domestic holdings of foreign currencies available to banks or other intermediaries, thereby easing a country’s foreign exchange constraint. In general, establishing convertibility is seen as a way of reducing the costs associated with the administrative allocation of foreign exchange. Convertibility has also become a key symbol of openness and economic freedom that may be important in gaining acceptance for difficult reform programs.

Questions still remain, however, about the risks of establishing convertibility, particularly early in the transformation process, when economic incentives and legal provisions may not yet be in place to enable markets and macroeconomic stabilization mechanisms to function properly. Domestic industries may not yet be internationally competitive, and foreign exchange reserves may be limited.

This paper addresses the main issues relating to currency convertibility, with special regard to the problems of establishing convertibility in countries undergoing the transformation to market-oriented economies. Limitations on currency convertibility have traditionally been analyzed separately from restrictions on trade and capital flows, perhaps because they have often evolved independently and for different reasons. Economically, however, the two types of restrictions have similar effects. Moreover, the role of the payments system in influencing the expansion of world trade is recognized explicitly in Article I(iv) of the IMF’s Articles of Agreement, which states that one of the purposes of the Fund is 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.”

In recognition of the links between the payments system and the system of trade and capital flows, this paper analyzes the case for eliminating restrictions on currency convertibility as part of the larger issue of removing restrictions on international transactions generally. Complete liberalization of current and capital account flows requires currency convertibility, and restrictions on trade and capital flows can dilute its benefits. Because most economists agree that convertibility is desirable as a long-run objective, along with the general liberalization of trade and capital flows, much of the analysis concerns how rapidly convertibility should be established during the transformation process.

The paper is organized as follows. Section II defines several different aspects of convertibility, distinguishing, in particular, among current account, capital account, and internal convertibility. Section III then analyzes how current and capital account convertibility affect a country’s production sector and macroeconomic stability. Section IV discusses when a country should introduce current account convertibility, emphasizing that success depends on establishing several preconditions at or before the move to current account convertibility. This section also discusses transitional arrangements countries may wish to consider in establishing convertibility. Sections V and VI discuss issues related to capital account convertibility and internal convertibility, respectively. Section VII provides a summary and conclusions. The Appendix reviews some historical experiences with establishing convertibility, focusing on two groups of countries: the Western European countries that were members of the European Payments Union during the 1950s; and the newly industrializing economies of Eastern Asia.

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