Convertibility refers to the ability of a currency to be freely transformed into foreign exchange. There are two types of convertibility: current account convertibility and capital account convertibility. The first term applies when the purpose of such transformation is to acquire foreign goods or services activities that are typically recorded in the current account.The second termis usedwhen the purpose is the acquisition of foreign assets, such as foreign stocks and bonds activities that are typically recorded in the capital account.
Currency convertibility has direct consequences for international trade, capital mobility, and economic growth. When a country imposes restrictions on the conversion of domestic currency for foreign exchange, it necessarily impedes transactions between domestic residents or entities and foreign ones: most foreign counterparts will not accept a currency that is hard to convert into foreign exchange as a form of payment. Without current account convertibility, the cost of engaging in international transactions increases, leading to fewer transactions and to a lower level of trade. So important is current account convertibility that member nations of the International Monetary Fund (IMF) are required to fully adopt it under article VIII, sections 2, 3, and 4 of the Articles of Agreement.
Capital Account Convertibility and Growth
A similar consensus, however, does not exist regarding capital account convertibility. The debate is more empirical than theoretical in nature. Theory tells us that in a perfect world, countries with full capital account convertibility can successfully exploit international capital markets to smooth out their consumption patterns over time; such countries can borrow from the rest of the world at a time when domestic consumption and investment are high relative to domestic income, and lend to the rest of the world when domestic consumption and investment are low relative to domestic income (Cole andObstfeld 1991; Obstfeld and Rogoff 1995). Countries that have the ability to smooth out these incomeexpenditure patterns are theoretically better off than they would be otherwise. Without the ability to tap into international capital markets, a country would have to rely primarily on its own savings to fund domestic investment. Such a situation could limit future economic growth if domestic savings could notmatch the domestic level of investment demand.
According to the theory, countries that adopt and maintain full capital account convertibility should be able to grow faster than countries that do not. Empirical studies, however, have not been able to settle this issue convincingly. Some researchers have found that convertibility has a positive effect on growth; others argue that it has either no effect or a negative effect.
During the late 1970s, many countries systematically removed restrictions on that is, liberalized their capital accounts. The experiences of these countries presented an opportunity for researchers to test the hypothesis that liberalization is associated with subsequent output growth. Although some researchers found empirical support for this hypothesis (e.g., Quinn 1997), others found positive effects only for high-income countries, not for emerging-market economies (Edwards 2001).More recent research has examined the microeconomic consequences of capital account restrictions to ascertain whether they affect different industrial sectors or even firms differently.
A case study of capital controls in Chile during the 1990s found that these restrictions changed the way firms chose to do their financing. Specifically, firms in Chile switched from relying primarily on shortterm debt to relying on internal funds for financing investment spending (Gallego and Hernandez 2003). This change is what one would expect to observe if capital controls introduced a cost wedge between domestic sources of funds and international capital markets. Although the results suggest that capital controls were costly for at least some firms, they cannot be used to judge the desirability of imposing or removing controls. Such policy decisions must be based on their effects on society as a whole rather than on a particular sector of society.
Although some evidence suggests that convertibility influences growth at some stages of development, research also suggests that such influence is limited at best and negative at worst. For example, one study estimates standard growth regression equations and does not find that capital account convertibility is associated with long-run growth (Rodrik 1998). Another study finds that many European countries enjoyed impressive growth rates during the 1950 73 periodnot despitehaving capital account restrictions, but instead precisely because they had them (Wyplosz 1999).
Theory versus Reality
Why does research find capital account restrictions to be beneficial for growth when basic economic theory tells us otherwise? The discrepancy appears to stem from the fact that the ‘‘real world’’ is more complicated than basic theoreticalmodelsmake it out to be. Ina worldwithasymmetric information (i.e., buyers and sellers do not have the same information) and other capital market distortions, the conditions for smoothly operating markets do not exist.Many researchers note thatwith free capital mobility or full capital account convertibility a country is exposed to the whims and fads of investors and traders who make trading decisions for all kinds of reasons, some of them rational but many of them seemingly irrational. When enough of them decide to pull their investments out of a country, the sudden demand for foreign exchange may trigger a currency crisis with devastating consequences for the banking sector and the rest of the economy. Work by Kaminsky and Reinhart (1999) offers empirical evidence substantiating this effect.
The lack of consensus in the empirical literature reflects the beneficial effects of full capital account convertibility for some countries but not others (Prasad et al. 2003). As a result, the literature has shifted its focus to ask whether countriesmust have a set of institutions or economic conditions before they adopt full capital account liberalization, andwhether the sequence of capital account liberalization matters. For the first question, researchers have hypothesized that sound macroeconomic conditions such as low and controlled fiscal deficits or low and controlled inflation are crucial for countries considering full capital account liberalization (Sen 2007; Williamson, Griffith-Jones, and Gottschalk 2005). Other researchers believe that countries must implement a set of reliable institutions in the financial sector, such as imposing minimum information requirements, prudential supervision and regulation of the banking sector, and investor protection, when pondering the adoption of full current account convertibility (Chinn and Ito 2002; Arteta et al. 2001; Gelos and Wei 2002).
Research has also investigated whether the method and timing of liberalization (or the sequencing of liberalization) matter as well. It is well known that short-term capital flows (such as portfolio investment) tend to bemuchmore volatile than long-term flows (such as foreign direct investment). Given that this is the case, it is more prudent to liberalize long-term capital flows before liberalizing short-term ones. The idea is, of course, to reduce the country’s exposure to what the literature has popularized as ‘‘hot money’’: short-term funds that enter and leave countries very suddenly and unexpectedly.
China and India are examples of countries that have considered adopting full capital account convertibility. Some commentators have argued that countries should always strive to adopt full capital account convertibility as soon as possible in order to reap all of its benefits (Forbes 2005). Others, however, argue that given the potentially disastrous consequences of implementing a liberalization program too rapidly, it ismore prudent to go at it slowly and onlywhen the country is ‘‘ready’’ (that is,when it hasmet all of the necessary preconditions). Given the theoretical complexities involved and the ambiguity of the empirical results, the advice that all researchers should probably offer to countries embarking on a full convertibility program is ‘‘proceed with caution.’’ See also asymmetric information; balance of payments; banking crisis; Bretton Woods system; capital controls; capital mobility; currency crisis; financial crisis; gold standard, international; hot money and sudden stops