VII Summary and Conclusions

Joshua Greene, and Peter Isard
Published Date:
March 1991
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This paper has analyzed the establishment of currency convertibility in transforming centrally planned economies, focusing mainly on current account convertibility, with some discussion of capital account convertibility and internal convertibility. It has addressed current account convertibility in the context of the systemic reforms under way in these countries and as part of the larger issue of removing restrictions on current account transactions generally. In view of the widespread agreement that convertibility is desirable as a long-run objective, the paper has focused on the speed with which it should be introduced.

Current account convertibility in a liberal trade environment can bring both benefits and risks to an economy. Among the benefits are the direct gains in consumer welfare that result from easing the import process and broadening the array of imported goods and services. However, the major benefits are indirect, resulting from the effects of import competition on the efficiency of domestic production and the guidance that relative prices on world markets can provide for the allocation of investment.

Convertibility also poses two notable risks. First, a rapid move to convertibility is likely to require the real exchange rate in the short run to be more depreciated than its longer-term equilibrium level. This raises the relative price of imports, including important inputs to production and capital goods, and can have distorting effects on resource allocation if investors do not accurately anticipate movements in the real exchange rate over time. Second, maintaining current account balance, once convertibility is established, implies either greater exchange rate instability or greater pressure on the authorities to direct policy instruments toward external rather than internal stability. Historically, most countries have moved gradually to establish current account convertibility and have restricted convertibility for many types of capital flows until later in their development.

The analysis of when to introduce current account convertibility indicates that the success of convertibility will generally require macroeconomic stability and appropriate microeconomic incentives, implying that certain conditions must be established before, or at the time that, convertibility is introduced. The paper has identified four such preconditions: (1) an appropriate exchange rate; (2) adequate international liquidity (meaning reserves and foreign financing); (3) sound macro-economic policies, including the elimination of any monetary overhang; and (4) an environment in which economic agents have both the incentive and the ability to respond to market prices. The first three preconditions are required to limit the risks of severe macroeconomic instability, while the fourth is needed to ensure that current account convertibility delivers its principal benefits. For countries undertaking the transformation from centrally planned economies to market-oriented systems, the third and fourth preconditions require major institutional reforms.

The feasibility of moving quickly and firmly to establish the preconditions for current account convertibility may depend on the depth and breadth of popular discontent with the initial macroeconomic situation. Where discontent is not strong, the population may be reluctant to accept the degree of initial austerity implied by highly restrictive policies and enterprise reforms. Thus, for centrally planned economies that are not starting from a position of severe macroeconomic instability, a rapid move to convertibility may lack strong popular support. However, if such countries choose to move gradually toward current account convertibility, they risk prolonging the period in which there is no efficient guide for production and investment decisions. Moving gradually can also make it hard to maintain sound macroeconomic policies.

However long it takes for countries to establish full current account convertibility—that is, to eliminate all exchange restrictions on current account transactions—there is broad agreement that they should move as quickly as possible to unify the exchange rate for current transactions and to liberalize trade policies by removing quantitative restrictions and rationalizing the system of import tariffs. Moreover, once they have established the preconditions for current account convertibility, countries should move rapidly to secure the key benefits of convertibility, namely, introducing import competition and the relative price signals that world markets provide.

History provides few examples of countries that have eliminated all restrictions on current account transactions in a single stroke. Some countries have found it attractive to introduce transitional arrangements in which controls are placed on the total volume of resources available for imports through official channels while still allowing households and enterprises to bid openly for these resources. This approach permits considerable import competition and effectively permits a market allocation of foreign exchange while limiting imports financed by private borrowing abroad. At the same time, it enables the authorities to maintain close control over the current account balance or, alternatively, to stabilize the exchange rate. It should be recognized, however, that such arrangements involve inherent multiple currency practices that are unlikely to lead to successful macroeconomic performance, or be acceptable to the IMF, unless they are accompanied by appropriate macroeconomic policies that will prevent significant divergence between the exchange rates on the official and parallel markets.

Another set of transitional arrangements involves eliminating all exchange restrictions on current account transactions while relying on temporary import tariffs to stabilize the current account. Although this approach protects domestic output and employment in the short run, limiting the strength of import competition also undercuts one of the key benefits that convertibility is intended to provide. Moreover, to the extent that this approach relies on differential tariffs, it prevents domestic relative prices from adjusting all the way to world levels and can thereby distort domestic production and investment decisions. It also tends to keep the foreign exchange value of domestic currency above the level that would otherwise prevail in the short run, thus providing less stimulus to exports.

While history suggests that few countries have moved quickly to eliminate all restrictions on current account transactions, it also illustrates the dangers of allowing such restrictions to persist. In the absence of a well-defined and credible timetable for phasing out restrictions, the process of economic transformation and growth may be seriously weakened or undermined.

On issues relating to capital account convertibility, many economists and policymakers have traditionally argued that, apart from moving to promote investment-related inflows (which may require channels for certain types of capital outflows), countries should not rush to liberalize restrictions on international capital movements. From this perspective, efforts in the short run should focus on fostering long-term capital inflows while limiting the possibilities for capital flight and volatile, short-term capital inflows. At the same time, however, the authorities should recognize that controls on capital outflows may not be effective in the absence of sound macroeconomic policies and attractive economic prospects.

As regards internal convertibility, allowing citizens to hold foreign-currency-denominated assets can help to channel existing but hidden private holdings of foreign exchange into the banking system, although this risks substitution out of domestic currency holdings into foreign currency. Accordingly, internal convertibility should be introduced only in the context of an appropriate exchange rate, adequate international liquidity, and sound macroeconomic policies.

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