A currency is not convertible when both residents and nonresidents are prohibited from converting their holdings of that currency into another currency.
Until this point, we have assumed that the currencies of various countries are freely convertible into other currencies. 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 nonresidents to purchase unlimited amounts of a foreign currency with it. A currency is said to be externally convertible when only nonresidents may convert it into a foreign currency without any limitations. A currency is nonconvertible when neither residents nor nonresidents are allowed to convert it into a foreign currency.
Free convertibility is not universal. 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 U.S. dollars, all U.S. 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 U.S. 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.
Serious problems arise, however, under a policy of nonconvertibility. This was the practice of the former Soviet Union, and it continued to be the practice in Russia for several years after the collapse of the Soviet Union. When strictly applied, nonconvertibility means that although a U.S. company doing business in a country such as Russia may be able to generate significant ruble profits, it may not convert those rubles into dollars and take them out of the country. Obviously this is not desirable for international business.
ANOTHER PERSPECTIVE No Letup in Capital Flight Despite Ban
KARACHI—Billions of dollars are flying out of Pakistan through unofficial channels and the government and the State Bank of Pakistan seem to have failed to control the trend, as many politicians, officials and money changers are allegedly involved in the illegality. There are a number of networks allegedly indulged in the illegitimate cross border trade of foreign exchange, violating the relevant laws. More than one billion dollars in foreign exchange is being transferred to Dubai and some other countries per year through clandestine channels. Investors seem unwilling to invest in Pakistan and they have been transferring their assets and funds to foreign countries since 2008.
Residents convert domestic currency into a foreign currency.
Governments limit convertibility to preserve their foreign exchange reserves. A country needs an adequate supply of these reserves to service its international debt commitments and to purchase imports. Governments typically impose convertibility restrictions on their currency when they fear that free convertibility will lead to a run on their foreign exchange reserves. This occurs when residents and nonresidents rush to convert their holdings of domestic currency into a foreign currency—a phenomenon generally referred to as capital flight. Capital flight is most likely to occur when the value of the domestic currency is depreciating rapidly because of hyperinflation or when a country’s economic prospects are shaky in other respects. Under such circumstances, both residents and nonresidents tend to believe that their money is more likely to hold its value if it is converted into a foreign currency and invested abroad. Not only will a run on foreign exchange reserves limit the country’s ability to service its international debt and pay for imports, but it will also lead to a precipitous depreciation in the exchange rate as residents and nonresidents unload their holdings of domestic currency on the foreign exchange markets (thereby increasing the market supply of the country’s currency). Governments fear that the rise in import prices resulting from currency depreciation will lead to further increases in inflation. This fear provides another rationale for limiting convertibility.