Notes on Currency Convertibility

Due to government restrictions, a significant number of currencies are not freely convertible into other
currencies. A country's currency is said to be freely convertible when the country's government
allows both residents and non-residents to purchase unlimited amounts of a foreign currency with it.
A currency is said to be externally convertible when only non-residents may convert it into a foreign
currency without any limitations. A currency is nonconvertible when neither residents nor non-
residents are allowed to convert it into a foreign currency.
Free convertibility is the exception rather than the rule. Many countries place some restrictions on
their residents' ability to convert the domestic currency into a foreign currency (a policy of external
convertibility). Restrictions range from the relatively minor (such as restricting the amount of foreign
currency they may take with them out of the country on trips) to the major (such as restricting
domestic businesses' ability to take foreign currency out of the country). External convertibility
restrictions can limit domestic companies' ability to invest abroad, but they present few problems for
foreign companies wishing to do business in that country. For example, even if the Japanese
government tightly controlled the ability of its residents to convert the yen into US dollars, all US
businesses with deposits in Japanese banks may at any time convert all their yen into dollars and take
them out of the country. Thus, a US company with a subsidiary in Japan is assured that it will be able
to convert the profits from its Japanese operation into dollars and take them out of the country.
Advantages
Encourages export: - Exporters are motivated to increase their exports since there is possibility of making
more profits under currency convertibility conditions. As a result of convertibility on current account,
higher profits will be earned since market exchange rate will give higher returns as compared to the
officially fixed exchange rate. From the given exports, they earn more foreign exchange.
Encourage Import Substitution: - since the market determined exchange rate is higher than the officially
fixed exchange rate, imports become more expensive. This makes countries to go in for import
substitution.
Incentives to Send Remittances from Abroad:- Indian workers employed abroad & NRIs find it
convenient to send remittances of foreign exchange without hassle. This also encouraged illegal
remittances like hawala money & smuggling.
Countries are Enabled to specialize in the Production of Goods for which they have a Comparative
Advantage:- each country will be able to engage in the production of goods in accordance with their
comparative advantage & resource endowments. When there is currency convertibility, market exchange
rate truly reflects the purchasing power of their currencies which is based on the prices & costs of goods
in different countries. In a competitive environment, lower prices of goods which reflect the comparative
advantage will enable countries to increase exports. Thus currency convertibility will lead to
specialization & international trade on the basis of comparative advantage. This will be beneficial for all
countries in trade.
Integration of World Economy:- currency convertibility enables better integration of the world economy.
The easy availability of foreign exchange helps in the growth of trade & increased capital flows between
countries. This will enables the growth of all countries which is important in the context of globalization.

Disadvantages
Currency convertibility can give rise to problems of inflation in domestic economy. The market
determined exchange rate is generally higher than the officially fixed exchange rate. This leads to a rise
in prices of essential imports which can results in a situation of cost push inflation in an economy.
Under capital account convertibility, a country is given the freedom to transact in financial assets with
foreign countries without restrictions. Such an arrangement is to enable increased investment activities.
But there are risks attached to it. A very likely possibility is that of capital flight at the first sign of an
internal economic problem.
Speculative activities may increase under free convertibility, making the exchange rates highly volatile.
Speculation can lead to depreciation of currencies & flight of capital. This is proved by the experience of
the South East Asian countries like Thailand, Malaysia, in the year 1997-199, which experienced severe
depreciation of currency & capital flight.
Counter-trade Example
In 2000, India and Iraq agreed on an "oil for wheat and rice" barter deal, subject to United
Nations approval under Article 50 of the UN Persian Gulf War sanctions, that would facilitate 300,000
barrels of oil delivered daily to India at a price of $6.85 a barrel while Iraq oil sales into Asia were
valued at about $22 a barrel.