As the name suggests, currency convertibility is all about the ease with which the currency of a country can be converted to other valuables like another currency or gold. This concept has had a significant role in the life of the world economy; it indeed is a key aspect of the seamless functioning of international commerce. All goods that are sourced globally undergo all stages of trade upon a mutual agreement to be paid in a currency that is not the buyer’s domestic currency. A currency’s value can be determined from the convertibility it possesses. With poor currency convertibility, the chances for it to have a high storage value or get swapped for other currencies are quite low. Such currencies with a low value for convertibility will pose a huge risk to the domestic market and economy within those countries owing to the disinterest the other countries express in trading for the domestic currency.
World trade has one of its pillars set on currency convertibility since it is the factor that leads to exponential growth in the capital flow between countries. The need for currency convertibility was felt at a point where the world economy was seemingly in a precarious state without supporting the standard living conditions through essential trading. The use of foreign exchange was regulated by many countries to maintain a decent exchange rate for their currencies.
A Closer Look at Currency Convertibility
In the simplest terms, currency convertibility is the value for free conversion of a country’s currency into the foreign exchange at market rate as determined by the demand and supply. When you have foreign currency (Euros, Pound Sterling) with you and want it converted, currency convertibility comes into play. You can get it converted it into your domestic currency at the exchange rate that has been determined by the market. Authorized dealers such as banks provide proper conversion rate data based on which you can get the money exchanged for your domestic currency or vice-versa.
Only on the capital and current accounts for import and export of invisible and merchandise is the currency convertible. In capital account convertibility, the flows of portfolio capital, direct investment, dividends and their interest, and borrowed funds are easily convertible into the foreign exchange at the fixed exchange rate.
In less complex terms, capital account convertibility can be defined as the ease with which foreign investors can access industries in your country through the domestic stock markets by converting their money into the domestic currency even without the government’s permission. Stability of currency is imperative for the capital account convertibility to function flawlessly. An impeccable performance of the concept within the market cannot be expected of always since the volatility could set in anytime. Therefore, the convertibility over capital is considered to be quite risky, making it valid only after the introduction of current account convertibility which will also entail the stability of currency and control of the deficit in the balance of payments.
How Will Currency Convertibility Benefit You?
- The potential for high profits makes export an indispensable part in the market. For the same reason, currency convertibility promotes the business of exporting, consequently adding to its profitability. This rise in profit occurs due to the increase in the exchange rate from the previous market fixed exchange rate. Products that have a lower intensity of import are highly promoted by currency convertibility for exports.
- Import substitution is encouraged more when the imports fall with rising expenses due to currency convertibility. This situation is caused when the market-determined exchange overtakes the value of the previous fixed exchange rate.
- Currency convertibility also provides incentives to the remittances of foreign exchange by the non-resident citizens and ones living abroad. This step reduces gold smuggling and the inflow of illegal currency formats into the country.
- Deficit balance of payments caused by over-valued exchange rates can lead to depreciation of the country’s currency, which in turn will boost the exports. These can be achieved by reducing the imports and raising their prices and also taking down the prices of export. The deficit gets corrected in the process without much of an intervention by the Central Bank.
- Prices of goods and in a country will also affect the purchasing power of a currency, which will be further influenced by the currency convertibility. Currency convertibility will, therefore, make sure that the various trading countries have their specific production patterns and international trade ensured through comparative advantage.
- Since currency convertibility boosts the capital flow and trade between countries, the chances for the world economy to fall are reduced, and a firm ground is held onto as the value of currency maintains consistency. Hence, it can be concluded that globalization has its strongest roots in currency convertibility.
Types of Currency Convertibility
The International Monetary Fund has set three crucial aspects which have to be conformed to by the currencies for it to be convertible. Usability, exchangeability, and the exchange value of a currency are the factors that determine its convertible value. Currencies all across the world have to satisfy these standards set by the IMF, which according to the variation in its compliance will differ in its convertibility. Currency convertibility has been classified into three depending on these standards:
Currencies that have sufficient value to be freely or fully traded at any point of time without any conditions to limit it are known as fully convertible currencies. Almost all the wealthy and stable countries like the US, Japan, Switzerland, and the UK have fully convertible currencies.
The currencies that can be traded only with certain restrictions imposed on them by the issuing government are tagged partially convertible. Less stable economies hold such currencies, which include the South African rand, Malaysian ringgit, and Chinese yuan.
Currencies that hold no value to be traded at any point of time on the foreign exchange market are tagged non-convertible. It is also known as blocked currency, one of which is the Venezuelan bolivar.