Quote:

---

Convertibility and foreign-exchange controls

A currency's usefulness as a medium of exchange depends on its convertibility. Convertibility means that the currency can buy domestic and foreign goods and services, including foreign currencies. Without a convertible currency, people cannot easily make the decentralized exchanges using money that make a market economy work efficiently.

Convertibility has three gradations corresponding to the extent to which a government allows a currency to function as a medium of exchange. The most basic type of convertibility is cash convertibility--the ability to exchange a unit (say, a dollar) of bank deposits for a unit of notes and coins on demand. Cash convertibility is so much taken for granted in developed countries that it is seldom discussed, except when bank runs occur. Nevertheless, it does not exist in a few developing countries, such as the remaining centrally planned economies.

The second type of convertibility is commodity convertibility--the ability to buy domestic goods and services. It too is so much taken for granted in developed countries that it is seldom discussed. Nevertheless, it too does not exist in some developing countries. In countries with commodity convertibility, all that is usually required to buy domestic goods and services is cash or credit to pay a domestic seller; domestic trade is little restricted compared to a centrally planned economy. The exchange of goods and services is much more extensive, rapid, and efficient where commodity convertibility exists than where it does not.

The third type of convertibility is foreign-exchange convertibility--the ability to buy foreign goods and services, including foreign currencies. If no restrictions exist on buying foreign goods and services, including foreign currencies, at market rates of exchange, a currency is said to have full foreign-exchange convertibility. A currency with cash, commodity, and full foreign-exchange convertibility has full convertibility. Foreign-exchange convertibility almost always implies cash and commodity convertibility, so henceforth full convertibility will be synonymous with unrestricted foreign-exchange. The currencies of most developed countries are fully convertible, but the currencies of most developing countries are partly convertible or inconvertible. For example, many currencies are convertible for most current-account purchases, in which residents use domestic currency to buy foreign goods and services for import, but inconvertible for many capital-account purchases, in which residents use domestic currency to buy foreign financial assets such as foreign currencies and securities, and certain nonfinancial assets such as real estate. (12) Restrictions on capital-account transactions are called capital controls.

Current-account convertibility exposes domestic producers to foreign competition if trade quotas and tariffs are low. Current-account convertibility tends to introduce into the domestic economy the structure of prices that prevails in world markets. World prices are signals that help people determine which areas of production to specialize in. By specializing in the goods they produce most efficiently, then trading those goods for other goods, wealth increases globally.

Current-account convertibility is helpful for foreign trade, but is insufficient for attracting substantial foreign investment; for that, capital-account convertibility is necessary. Unless foreigners can repatriate some profits, they will usually be reluctant to make large investments.

Almost universal agreement exists that cash and commodity convertibility are desirable in most countries immediately. However, many economists have advised developing countries to delay full foreign-exchange convertibility (for example, Greene and Isard 1991: 12-13, 16; McKinnon 1991: 156; Williamson 1991: 379). One argument against immediate full convertibility is that it would worsen capital flight, that is, domestic investment would leave on a large scale. Another argument, inconsistent with the first, is that immediate full convertibility would allow excessive foreign investment and would thereby make export goods uncompetitive. Foreign investment increases the prices of land, labor, and other nontraded goods. Prices of exported goods would then increase because they are made partly from nontraded goods. A large, sudden appreciation of the real exchange rate could make exports uncompetitive, causing a depression (as Ronald McKinnon argues in Hanke and Walters 1991: 187-9). A third argument against immediate full convertibility is that it would create problems of moral hazard. Chile, Argentina, and Uruguay suffered banking crises in the 1980s after they abolished some restrictions on convertibility. Many companies and banks borrowed heavily abroad. Their liabilities were payable in foreign currency but their income was mainly in domestic currency. As real exchange rates appreciated, political pressure from export industries and economic pressure from currency speculators induced the central banks of those countries to devalue. Devaluation steeply increased the burden of debt repayment for companies and commercial banks that had borrowed in foreign currency, and bankrupted many. Their governments or central banks rescued them and assumed responsibility for repaying their debts.

The arguments against full convertibility, although perhaps valid for a typical central banking system, are not applicable to a typical currency board system. Immediate full convertibility in a typical currency board system is credible, so it tends to encourage a net inflow of capital rather than capital flight. Although foreign investment increases the prices of labor, land, and other nontraded goods, but if the investment is used productively, the new higher prices reflect the increased productivity of nontraded goods (Schmieding 1992: 196). The experience of currency board systems has been that foreign investment does not cause large, sudden appreciations of the real exchange rate that make exports uncompetitive and cause depressions. International capital movements, like domestic interregional capital movements, tend to be self-correcting if they overreact to opportunities for arbitrage. Immediate full convertibility tends not to create problems of moral hazard in a typical currency board system because a typical currency board is not a lender of last resort. The unhappy experience of Chile, Argentina, and Uruguay with full or nearly full convertibility illustrates the moral hazard created when a central bank is implicitly a lender of last resort to commercial banks, and to private and state enterprises; it does not illustrate inherent problems of convertibility (Corbo and others 1986: 620-30).

The historical experience of currency boards supports the view that problems with full convertibility in a typical central banking system are caused by central banking rather than by full convertibility. The currency board devised by John Maynard Keynes that existed in Northern Russian from 1918 to 1920 maintained full convertibility from the day it opened, even though Russia was in the midst of civil war (Hanke and Schuler 1991a). The Burmese currency board also maintained full convertibility during a civil war (Schuler 1992b: 69-70). The currency boards of Hong Kong, Malaya, and the Philippines resumed convertibility into their reserve currencies soon after Japanese occupation during the Second World War ended (King 1957: 23, 109). No mass flight from local currencies into reserve currencies occurred; instead, convertibility encouraged foreign investment. The postwar experience of Hong Kong has been that large, uncontrolled increases in foreign investment have not hurt export industries; rather, they have equipped export industries with the tools necessary to grow (Schuler 1992b: 159-61).

The experience of these currency board systems, and the contrast with the typical experience of central banking systems, is part of a pattern. The International Monetary Fund'sAnnual Report on Exchange Arrangements and Exchange Restrictions, published since 1950, describes restrictions on convertibility in its member countries and some of their colonies. Never have the majority of central banking systems reporting to it had full convertibility. Almost all developed countries with central banks now have full convertibility, but only a minority of developing countries do. Among currency board and currency board-like systems, only that of Bermuda had foreign-exchange controls. Bermuda limits the amount of funds that Bermudians may invest abroad without special permission to US$30,000 per person per year. It is apparently the only currency board system that has ever restricted convertibility into its reserve currency, though some currency board-like systems have restricted convertibility initially.

---