What is Currency Convertibility
Currency convertibility is the ease with which a country's currency can be converted into gold or another currency. Currency convertibility is extremely important for international commerce. When a currency is inconvertible, it poses a risk and barrier to trade with foreigners who have no need for the domestic currency.
There tends to be a correlation between a countries economy and the convertibility of its currency.
BREAKING DOWN Currency Convertibility
Government restrictions can often result in a currency with a low convertibility. For example, a government with low reserves of hard foreign currency usually restricts currency convertibility because the government would not be in a position to intervene in the foreign exchange market (i.e. revalue, devalue) to support their own currency if and when necessary.
As global trade continues to increase currency convertibility has become more critical. Countries that currency has poor convertibility are at a natural disadvantage because transactions don't run as smoothly as hoped, which will deter other countries from engaging in trade with them. The flow-on effect from poor currency convertibility is slow economic growth.
Currency convertibility requires a readily available supply of the physical currency which is why some countries impose capital controls on money leaving its country. As economies slump into recession investors will often seek investment offshore so to ensure money doesn't flood out of the country controls are placed.
Currency Convertability and Capital Controls
Capital controls are most prevalent in emerging market countries due to the higher uncertainty in its economic outlook. As a result of the 1997 Asian financial crisis many countries in the area imposed tight capital controls to lessen the threat of a run on its currency in times of stress. Investors tend to flock to U.S. dollars as volatility rises, which sees the supply of its currency fall, weakening its convertibility.