III Effects of Current and Capital Account Convertibility
- Joshua Greene, and Peter Isard
- Published Date:
- March 1991
Establishing convertibility for international transactions has a variety of implications for an economy. By exposing the economy to the pressures of foreign competition, current account convertibility, along with the removal of trade restrictions, offers substantial benefits for a country’s supply side. It also poses certain risks, particularly in the short run, for domestic employment and real income levels, and for macroeconomic instability resulting from the possibility of greater or more frequent current account imbalances or exchange rate pressures. Creating convertibility for capital transactions can likewise have both good and bad repercussions for a country’s external capital flows, inviting inflows of long-term investment capital while opening the doors for capital flight. Both current and capital account convertibility also have implications for a country’s balance of payments, requiring more attention in the development and implementation of monetary, fiscal, and exchange rate policies.
Convertibility and the Supply Side of the Economy
Current Account Convertibility
Establishing current account convertibility within an environment of liberal trade regulations can introduce a new degree of freedom into the economy, particularly in countries that have been characterized by central planning. In the absence of prohibitive quantitative restrictions on imports, current account convertibility can allow individuals a much greater choice of consumption items by simplifying and expanding the opportunity to purchase goods and services from abroad. This can lead to significant increases in consumption and consumer satisfaction in the short run, particularly where the output of domestic industries has in the past been unable to satisfy consumer demands. It may also promote domestic output by improving access to production inputs and modern technology.
These direct benefits, however, have traditionally been considered less important than the indirect benefits that current account convertibility can provide by creating a more competitive environment and promoting production and investment decisions consistent with the country’s comparative advantage. The transformation of centrally planned into market-oriented economies involves substantial decentralization of production and investment decisions and reliance on market prices to coordinate the behavior of many separate economic units. Success depends on the quality of information that guides decision makers, and on how well the price-adjustment mechanism functions in equilibrating supply and demand. From this perspective, it is important for domestic producers to operate in a competitive environment.
Current account convertibility can help create such an environment, insofar as it exposes domestic producers to competition from abroad and helps introduce the relative prices for different goods prevailing on world markets. The strength of this competition depends not only on whether domestic currency is convertible for current account transactions but, more broadly, on the overall scope and nature of trade restrictions.
A competitive environment provides strong incentives for producers to use resources efficiently, thereby enabling them to produce additional output. Exposing the economy to international competition also reduces the market power of domestic monopolies and oligopolies, which have been a common feature in many centrally planned economies. In small economies, such as those in Eastern Europe, domestic markets in many industries may be too thin to support a large number of producers. Imports may thus be a particularly important source of competitive pressure. The opportunity to export, which expands the size of the market that domestic producers can reach, also promotes competition by strengthening the incentives for more enterprises to produce any particular good or service.
Over the longer run, import competition is likely to promote innovation and quality improvements in domestic industry. Domestic enterprises will need to adjust product lines and styles, and to introduce new technologies, to keep their products competitive with goods available from abroad. More generally, an environment of international competition induces domestic producers, whose objectives are to maximize their own financial performance, to allocate resources in ways that tend to exploit the country’s comparative advantage. This is particularly true to the extent that greater international competition, fostered by current account convertibility and a liberal trade environment, helps domestic firms adjust to the relative prices prevailing on world markets. In such an environment, investment tends to take place in activities that offer relatively attractive prospects for expanding domestic production and exports and for raising living standards over time.
While the beneficial effects from increased competition argue strongly for current account convertibility, there are also risks involved. Substantial unemployment and idle capacity can result in the short run if the products of domestic enterprises are extensively abandoned in favor of imported goods and services. Alternatively, substantial reductions in real wages (after adjustment for exchange rate changes) may be required to keep domestic products competitive if imports become readily available, particularly if the quality of domestic output is much poorer than that of competing foreign products. In either case, the purchasing power of domestic incomes can decline substantially,6 with reinforcing multiplier effects on domestic output. If the environment for domestic enterprises grows too harsh, the strains imposed on the population can become unsustainable, thereby undermining political support for a reform program.
The nature of the environment facing domestic enterprises, and their ability to compete with imported goods and services, depends critically on the level of the exchange rate. The adverse effects on employment and real wages (measured in domestic terms) can be limited if current account convertibility and other measures to expose the economy to international competition are introduced at an exchange rate that makes imports sufficiently expensive.7 However, an exchange rate sufficiently depreciated to allow domestic producers to survive the early stages of reform can make all imports appear costly for consumers and producers, including imports of essential intermediate goods and investment goods critical for the country’s development efforts. This can bias production and investment decisions against the technologies and products that are most efficient over the medium term. Countries may thus be inclined to set their foreign exchange policies to meet objectives other than the early introduction of current account convertibility. Historically, countries with uncompetitive industries and foreign exchange shortages have generally sought to restrict the convertibility of their currencies, or to maintain other forms of import restrictions, rather than to rely on a heavily depreciated exchange rate for attaining a sustainable current account position. Such an approach, however, tends to maintain distortions and imbalances in the economy.
Capital Account Convertibility
One of the key issues faced by reforming economies is how to attract capital and other productive resources from abroad. To the extent that official grants, loans, and technical assistance are limited, the success of these countries’ transformations may depend crucially on their ability to attract inflows of private capital and expertise.
The introduction of capital account convertibility—or, at least, convertibility for certain types of capital flows—can help attract resources from abroad.8 The willingness of foreigners to move capital into a country depends heavily on whether interest, after-tax profits, and initial capital investments (investment principal) can be repatriated, and on the attractiveness of individual projects. This is true for virtually all forms of direct investment flows and portfolio capital flows.9
Where foreign investors assume large ownership positions in domestic enterprises, capital inflows can lead to new and possibly better management, with more complete information about production techniques used and marketing opportunities available outside the country. Direct investment may also contribute in other ways to expanding the country’s access to technology from abroad and to foreign markets, thereby leading to more efficient production methods.
The effectiveness of convertibility in attracting private capital inflows will depend crucially on the country’s current and prospective economic and legal environment. Whether macroeconomic stability can be achieved and maintained is a central consideration in evaluating whether specific domestic investment opportunities compare favorably with investment opportunities elsewhere. As emphasized by Corbo and Fischer (1990, p. 27), “investment requires an appropriate and credible economic environment …. [and] does not respond well when investors, foreign and domestic, doubt that the government will sustain its reforms….” Other important considerations include the legal system and the nature of the investment code; the quality of the physical and electronic infrastructure, including the transportation system and the communications network; human capital and natural resources; perceived political stability; and the size of the markets to which there is access domestically and in neighboring countries. Although the success of economic transformation may hinge crucially on attracting capital inflows, a country that establishes capital account convertibility also runs the risk of capital flight and greater volatility in exchange rates, external reserves, or interest rates.10 Greater ability to send savings abroad could, on balance, reduce the country’s funds available for domestic investment, particularly where the reform process has not progressed enough to dampen uncertainties about macroeconomic stability and the competitiveness of domestic enterprises. Until there is widespread confidence that a country’s reform program will succeed, changes in the perceived likelihood of success could, under capital account convertibility, generate strong pressure on the exchange rate, which, in turn, could greatly complicate the task of macroeconomic stabilization.
Perhaps because of these risks, most countries have maintained restrictions on various types of capital flows until their economies were well advanced, usually some time after the introduction of current account convertibility. Delaying the introduction of capital account convertibility implies a judgment that the risks associated with full capital account convertibility outweigh the distortions introduced when convertibility is limited to the current account (plus selected types of capital flows). In assessing this trade-off, however, authorities should recognize that current account convertibility without capital account convertibility is essentially equivalent to a dual exchange rate system (Adams and Greenwood (1985) and Kiguel and Lizondo (1990)), and that restrictions on external capital transfers have become harder to enforce as advances in information and transactions technologies have increased the integration of international capital markets. Thus, capital flight has sometimes occurred on a large scale even in the absence of capital account convertibility. This issue is discussed further in Section V.
Convertibility and Macroeconomic Stability
Both current account convertibility and capital account convertibility can complicate the task of macroeconomic policymaking, largely because convertibility allows greater movements—including trends—in the current or capital accounts of the balance of payments. Under a fixed exchange rate system, persistent external imbalances can drain a country’s international reserve holdings, thereby creating pressure to adjust either its exchange rate or the settings of other policy instruments. Adjustments may also be needed when international reserves are accumulating, to avoid the adverse consequences of failing to slow the domestic money creation that typically accompanies reserve inflows. Under a flexible exchange rate system, incipient trends in the balance of payments typically lead either to exchange rate movements or to adjustments in the settings of other policy instruments. These changes, in turn, affect domestic prices and incomes and may compromise the ability of policymakers to achieve the ultimate objective of sustained, noninflationary growth.
Whether current account convertibility leads to persistent external imbalances in a fixed exchange rate system or to more direct pressures for adjustment in a flexible rate system depends on the exchange rate at which convertibility is established, together with the stance of fiscal and monetary policy. For economies undertaking substantial reforms of the environment in which domestic producers must operate, the real exchange rate at which domestic enterprises are competitive in the short run may differ considerably from the rate at which they are competitive over the longer run. The establishment of current account convertibility may thus imply a need for real exchange rates to adjust over time if large external imbalances are to be avoided.
Whether this rate adjustment can be achieved smoothly over time once current account convertibility has been established is an open question in today’s environment. Historical experience before 1973, by which point most industrial countries had established current account convertibility, is not a useful guide for two reasons: the international environment has since become much more conducive to transmitting speculative pressures; and policies before 1973 were oriented toward keeping exchange rates fixed, with occasional discrete realignments, rather than toward achieving smooth adjustment over time. Most of the countries that have maintained current account convertibility throughout the past two decades have also imposed few, if any, restrictions on capital flows. Experience suggests that, in a world of highly integrated capital markets and technologies for making financial transactions rapidly, once convertibility is extended to the capital account, strong pressures on exchange rates are likely to develop periodically in response to changes in the economic or political outlook. In the absence of adjustments in interest rates or other policy instruments in response to these changes in outlook, full convertibility can allow large swings in exchange rates. The accepted wisdom regarding this situation is that a country cannot simultaneously enjoy a stable exchange rate, unrestricted capital mobility, and independent control over interest rates or other instruments of monetary policy.
Even with convertibility limited to the current account, speculative pressures can be transmitted to exchange rates through advanced and postponed shipments of durable goods, and through leads and lags in payments and currency conversions. Thus, a country may not be able to enjoy both exchange rate stability and the absence of current account restrictions without limiting its ability to focus macroeconomic policy instruments on domestic economic performance.11
Countries must therefore weigh the benefits of removing current account restrictions against the advantages of exchange rate stability and greater monetary independence. The relative importance of these three objectives may change as countries move through different stages of economic development and transformation. In the early stages of reform, some countries may consider it particularly important to keep interest rates and credit policies stable and to avoid sharp fluctuations in exchange rates. They might thus find it desirable to retain some current account restrictions temporarily (along with certain restrictions on capital account transactions), in addition to pursuing appropriately tight macroeconomic policies, as a way of controlling external payments imbalances. As is discussed later, transitional arrangements that enable the authorities to control the total resources available for imports, while allowing market participants to bid openly for those resources in an environment of liberal trade regulations, may be particularly attractive in this context. Such arrangements may not be very effective, however, in the absence of sound macroeconomic policies and attractive economic prospects, without which the incentives to evade controls are likely to be strong.
As Lipton and Sachs (1990a) emphasize, however, the reduction in real incomes, as traditionally measured, may well overstate the fall in living standards in an economy characterized initially by extensive shortages and rapid inflation.
Of course, if at world prices the value of a firm’s output is less than the cost of its inputs of tradable goods, no exchange rate will make the firm competitive (in the absence of trade restrictions). Similarly, if the costs of labor and other nontradable inputs cannot be prevented from rising in parallel with the prices of tradable goods, exchange rate depreciation cannot raise the value of a firm’s output relative to the cost of its inputs.
Capital account convertibility may also enable residents to obtain higher risk-adjusted rates of return in the short run and to hold internationally diversified investment portfolios, thereby cushioning the real value of their savings against various shocks to the domestic economy.
Capital account convertibility is not the only way to attract private capital from abroad. Provided that foreigners have reasons to believe they will eventually be able to repatriate earnings, various tax concessions and subsidies may serve as an inducement for private capital inflows. Such inducements, however, are likely to be considered inequitable, because they discriminate between foreign and domestic investors. In addition, they may have adverse fiscal implications and often prove inefficient in terms of the new income generated relative to the revenues forgone and expenditures involved. Accordingly, economists generally caution against using such measures to encourage foreign investment.
There is also the risk that lack of oversight and coordination at the macroeconomic level may allow capital inflows to exceed the socially optimum level, resulting in an excessive debt burden if the inflows represent mostly borrowed funds. See Aizenman and Isard (1990).
This limitation is not necessarily undesirable. Some have argued that sacrificing policy flexibility may have benefits for a country embarking on a comprehensive reform program, by imposing discipline and thereby enhancing the credibility and effectiveness of the program. However, credibility can easily be lost when policymakers tie their hands in ways that generate more austerity or volatility than the populace is willing to accept.