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 country's economy and the convertibility of its currency.
UNDERSTANDING Currency Convertibility
Government constraints 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 that 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.
Countries with currency that has poor convertibility are at a global trade disadvantage because transactions don't run as smoothly those with good convertibility, which will deter other countries from trading with them. Poor currency convertibility can contribute to 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 put in place.
Currency Convertibility and Capital Controls
Capital controls are most prevalent in emerging market countries due to the higher uncertainty in their economic outlook. In the wake of the 1997 Asian financial crisis, many countries in the region imposed tight capital controls to reduce the threat of a run on their currency. Investors tend to flock to the U.S. dollar as volatility increases, leading to a reduction in the country's own currency supply, further weakening its convertibility.