A convertibility plan refers to a framework that allows countries to convert their domestic currencies into foreign currencies and vice versa. The plan establishes a fixed exchange rate and allows conversion between the currencies within certain parameters. Convertibility plans aim to stabilize exchange rates, facilitate trade and investment, and integrate a country’s economy into the global financial system.
Introduction
A convertibility plan entails the government pegging the value of its currency to that of a foreign currency or basket of currencies. The central bank then stands ready to exchange domestic currency for foreign currency and vice versa at the fixed rate. This allows residents and businesses in the country to freely buy and sell foreign currencies needed for international transactions.
Convertibility helps attract foreign investment, enables domestic companies to import machinery and other inputs, and makes it easier for citizens to travel and conduct business abroad. At the same time, it requires a certain level of foreign currency reserves and conditions in the economy to maintain the pegged rates.
Countries implement various degrees of convertibility based on their macroeconomic situation and readiness. Partial or limited convertibility allows conversion for certain transactions like trade and foreign direct investment. Full convertibility removes all restrictions and lets residents freely exchange domestic for foreign currency.
This article will examine key aspects of establishing a currency convertibility plan, including:
- Types of convertibility plans
- Requirements for convertibility
- Process of transitioning to convertibility
- Benefits of currency convertibility
- Downsides and risks
- Examples of major convertibility plans
Properly implemented, a convertibility plan can be an important step for emerging market and developing economies to integrate into the global economy. But the system demands fiscal and monetary discipline to be sustainable.
Types of Convertibility Plans
Countries may implement different types of convertibility plans depending on their economic goals and conditions. The major types of convertibility include:
Current Account Convertibility
Current account convertibility allows conversion of domestic currency into foreign currency for purposes of trade in goods and services. This enables businesses to freely import and export.
Countries normally start with current account convertibility to kickstart international trade without fully exposing themselves to capital flight risks. India established current account convertibility in 1994 as part of its economic liberalization.
Capital Account Convertibility
Capital account convertibility permits the conversion of domestic currency into foreign currency for capital transactions like investments, lending, and borrowing. This lets citizens and businesses invest abroad more easily.
Capital account convertibility typically requires meeting macroeconomic stability prerequisites regarding inflation, fiscal deficit, foreign exchange reserves etc. Countries aim to sequence it after current account liberalization.
Limited Convertibility
As the names suggest, limited or partial convertibility plans only allow conversion for certain transactions, such as trade, travel, foreign education etc. This serves as an intermediate step before fuller convertibility.
For instance, China started with limited convertibility in the 1980s and 90s. It allowed conversion only for trade, foreign direct investment, and travel before later expanding.
Full Convertibility
Under full convertibility, there are no restrictions on exchanging domestic for foreign currency. This represents complete capital and current account liberalization.
Attaining full convertibility is difficult and requires significant foreign exchange reserves and sound monetary policies. Economies like Switzerland, Japan, and Singapore have full convertibility.
Requirements for Establishing Currency Convertibility
Implementing a convertibility system demands meeting certain economic prerequisites and policy conditions. The key requirements are:
Adequate Foreign Exchange Reserves
The central bank needs sufficient foreign currency reserves to be able to exchange domestic currency based on market demand. Reserves provide the backing for the convertibility commitment.
The adequate level of reserves depends on factors like the country’s importing needs, external debt obligations, and susceptibility to volatility from capital flows. Typically reserves equivalent to at least three months of imports are considered sufficient.
Low Inflation
High inflation erodes the value of the domestic currency and makes the pegged exchange rate unrealistic. Inflation needs to be controlled through prudent monetary policy for convertibility to work.
Single digit inflation rates are ideal. Countries may also peg to the currency of an economy with low stable inflation like the U.S. dollar. This imports credibility and imposes discipline.
Limited Fiscal Deficits
Large sustained budget deficits are incompatible with fixed exchange rates, as they tend to be monetized and create high inflation. Fiscal consolidation is required prior to adopting convertibility.
Fiscal deficits below 3% of GDP are recommended. The government revenue and expenditure must be well balanced.
Financial Sector Reforms
Convertibility plans involve deregulation of the banking system and capital markets. Interest rates need to be market determined, and constraints on capital flows gradually lifted to facilitate currency conversion transactions.
Prudential regulations and supervision of banks are also strengthened to assess and manage associated risks. These reforms take time and require strong institutions.
Flexible Exchange Rate Policy Experience
Pegging exchange rates after having a flexible regime requires demonstrated capability in macroeconomic management and inflation control. Gradual move towards fixed rates can build this experience.
For instance, Singapore first established a managed float regime before moving to a crawling band and finally to convertibility.
Enabling Laws and Regulations
The legal and regulatory framework must allow residents to freely buy, hold and sell foreign exchange domestically and overseas. Foreign exchange regulations get gradually eased.
Provisions for foreign entry and capital account transactions are introduced as part of the shift to convertibility.
Process for Transitioning to Convertibility
The transition to a convertibility system is usually incremental through a sequenced process spread over several years. Gradual relaxing of foreign exchange restrictions paves the way. It involves steps like:
Current Account Convertibility
As a first step, restrictions on foreign currency for trade-related payments including imports, exports, and invisibles are removed. This establishes current account convertibility.
For instance, India introduced current account convertibility in 1994 after balance of payments crisis in 1991.
Partial Capital Account Liberalization
Selected restrictions on capital transactions are gradually eased. Priority may be given to foreign direct investment and equity flows which are perceived as more stable.
Malaysia progressed to partial capital account convertibility by 1999 after the Asian financial crisis by selectively easing controls.
Pegged Managed Float
The exchange rate is first tightly managed against a major global currency and allowed to fluctuate within a band. This band is progressively widened to test the markets before a hard peg.
For example, Singapore widened its band from 2.25% in the 1980s to about 6% just before pegging the SGD in 1981.
Fixed Official Rate
A fixed official exchange rate is established, with the central bank committed to converting domestic currency at this rate. This represents a transition to full convertibility.
Argentina established a currency board and fixed 1 Peso = 1 U.S. dollar in 1991 as part of its convertibility plan.
Timing Reforms with Business Cycles
Convertibility plans are easier to implement when the economy is strong, export demand robust, and capital inflows rising. This provides the reserves buffer needed.
Reforms may be timed during upcycles, as in South Korea before the 1997 Asian crisis. Starting during downturns increases risks.
Benefits of Currency Convertibility
Convertibility plans offer several potential benefits when pursued gradually and accompanied by proper policies:
Boosts International Trade
Current account convertibility lets importers and exporters easily buy foreign currencies needed for payments. This gives a major boost to international trade flows.
India’s exports nearly quadrupled in 10 years after introducing current account convertibility in the 1990s.
Attracts Foreign Investment
Access to foreign exchange removes a key hurdle for foreign investors, making the country more attractive as an investment destination.
FDI inflows accelerated in China after limited convertibility was introduced starting in 1996.
Deepens Financial Sector
Banks and capital markets adapt to service the growing demand for foreign exchange transactions and cross-border capital flows. The financial sector deepens as a result.
For instance, Argentina saw rapid growth in FX and derivatives trading after it established convertibility.
Disciplines Policies
The hard peg imposes monetary and fiscal discipline to maintain exchange rate stability. This helps control inflation and deficits.
Eurozone economies experienced downward pressure on budget gaps and inflation after adopting the Euro.
Integrates with Global Economy
Convertibility enables easier integration into global trade and finance, as seen in Eastern European transition economies that became more open.
It reduces dependence on foreign currencies like the dollar, as domestic currency can be freely exchanged.
Signals Credibility
A convertibility commitment signals to investors that the economy is open and policies sustainable. This bolsters confidence.
Argentina gained investor confidence in the early 1990s after dollar convertibility was established under its currency board.
Risks and Downsides of Convertibility
Despite benefits, currency convertibility also carries significant risks if not supported by adequate policies and conditions:
Requires Large Foreign Exchange Reserves
Maintaining convertibility drains forex reserves whenever demand for foreign currency exceeds available supply. Reserves may get depleted.
For example, Argentina experienced a reserves crisis in 2001 due to overvalued peso and fiscal woes.
Loss of Independent Monetary Policy
Interest rates and money supply need to be aligned with the anchor nation. Domestic policy autonomy is lost under fixed exchange rates.
Eurozone nations cannot set localized interest rates and rely on the ECB’s monetary policy.
Vulnerability to Speculation
Sentiment can quickly turn against an overvalued currency, triggering capital flight. Currency pegs then collapse.
This happened during the 1992 Black Wednesday crisis when speculators broke the British pound’s ERM peg.
Risk of Overheating
Easy capital inflows under convertibility may feed excessive domestic credit and investment bubbles, causing financial instability.
Thailand, Malaysia and Indonesia faced overheating risks that culminated in the 1997 Asian financial crisis.
Requires Fiscal Discipline
Lax fiscal policy forces the central bank to monetize deficits, fueling inflation and eventual devaluation. Running large deficits is untenable.
For example, Brazil had to move away from convertibility in the 2000s due to rising public debt and inflation.
Inflexible Exchange Rates
The fixed peg can become misaligned with fundamentals. Having flexibility to adjust forex rates is better.
Argentina ultimately had to break its dollar peg in 2002 after a prolonged recession made it unviable.
Notable Examples of Convertibility Systems
Some major emerging economies implemented different types of convertibility plans in the post-World War 2 period:
Bretton Woods System (1945-1973)
The Bretton Woods system fixed exchange rates against the dollar, with the dollar in turn pegged to gold at $35 per ounce. This quasi-convertibility operated successfully till 1971.
The European “snake in tunnel” plan also had European currencies pegged within a range to one another. This served as a precursor to the Euro.
Argentina (1991-2002)
Argentina established a currency board that fixed the peso one-to-one with the U.S. dollar. This full convertibility aimed to control hyperinflation.
But fiscal strains and external shocks depleted reserves and forced abandonment in 2002 after a prolonged recession.
Poland (1990-2000)
Poland transitioned in the 1990s from a peg to a crawling band antes finally floating exchange rate. Gradual relaxation enabled orderly liberalization.
However, it faced periodic currency crises as reforms faltered due to political factors and fiscal laxity.
Thailand (1990s)
Thailand maintained a heavily managed U.S. dollar peg during its rapid growth phase in the 1990s prior to being forced to float after the 1997 Asian crisis.
Lack of flexibility proved costly when exports became uncompetitive and asset bubbles emerged.
Eurozone (1999 – Present)
Members of the European Monetary Union adopted the euro, establishing irrevocable convertibility between national currencies and the euro at fixed rates.
The Eurozone currency union brought benefits like inflation convergence but also loss of policy autonomy that deepened the impact of crises.
Conclusion
Convertibility plans allow easier exchange between domestic and foreign currencies, offering multiple benefits for integrating into the global economy. But they also require stringent fiscal and monetary policies. Gradual implementation in line with underlying fundamentals is ideal.
Countries should sequence the transition from current to capital account liberalization. They must also avoid overvaluation, build reserves buffers, and retain some exchange rate flexibility. With prudent macro-management, convertibility plans can aid development.
