Currency Convertibility: What it Means, How it Works

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 important for international commerce as globally sourced goods must be paid for in an agreed-upon currency that may not be the buyer's domestic currency.

When a country has poor currency convertibility, meaning it is difficult to swap it for another currency or store of value, it poses a risk and barrier to trade with foreign countries who have no need for the domestic currency.

Understanding Currency Convertibility

A convertible currency is any nation's legal tender that can be easily bought or sold on the foreign exchange market with little to no restrictions. A convertible currency is a highly liquid instrument as compared with currencies that are tightly controlled by a government's central bank or other regulating authority. A convertible currency is sometimes referred to as a hard currency.

Currencies such as the South Korean won and the Chinese Yuan are known as partially convertible currencies. A partially convertible currency is the legal tender of a country that is traded in low volumes in the global foreign exchange market. The governments of these countries place capital controls that limit the amount of currency that can exit or enter the country.

Nearly all countries have currencies that are at some level at least partially convertible. However, currencies such as the Brazilian real, Argentinian peso, and Chilean peso are considered non-convertible because it is virtually impossible to convert them into another legal tender, except in limited amounts on the black market.

A blocked currency is a currency that can’t freely be converted to other currencies on the forex markets as a result of exchange controls. Such money is mainly used for domestic transactions alone and does not freely exchange with other currencies, often due to government restrictions at home or abroad.

Convertibility and Geo-Political Considerations

There tends to be a correlation between a country's economy and the convertibility of its currency. The stronger an economy is on the global scale, the more likely its currency will be easily converted into other major currencies. Government constraints may result in a currency with low convertibility.

For example, a government with low reserves of hard foreign currency usually restricts currency convertibility because that government would otherwise not be in a position to intervene in the foreign exchange (forex) market (i.e., to revalue, devalue) in order to support their own currency if and when necessary.

Countries with a currency that has poor convertibility are at a global trade disadvantage because transactions don't run as smoothly as those with good convertibility. This reality will deter other countries from trading with them. Poor currency convertibility can contribute to slower economic growth as global trade opportunities are missed. 

There are ways to trade in foreign currencies which do not exchange internationally or whose trade is severely limited or legally restricted in the domestic market. Non-deliverable forward contracts (NDFs) can give a trader, for instance, indirect exposure to the Chinese renminbi, Indian rupee, South Korean won, new Taiwan dollar, and Brazilian real and other inconvertible currencies.

Currency Convertibility and Capital Controls

Good currency convertibility requires a readily available supply of 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 or convert their money into one of the safe-haven currencies. To combat this and ensure money doesn't flood out of the country, some governments put controls in place to reduce capital flight during trying economic times. 

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.

More recently, Greece imposed capital controls in June 2015 to slow the capital outflows during the Greek Debt Crisis and these stayed in place until 2018. Those controls limited how much money could be withdrawn from the banking system. The interesting thing about the Greek controls is that the country is an EU member and uses the euro, so the capital controls did not actually affect the currency convertibility as Greece is just one part of the economies underlying the euro.

The Bottom Line

Currency convertibility describes how easy it is to convert a specific currency into another currency or gold. Economics of a specific country can greatly impact, and be impacted by, currency convertibility. Additionally, the advent of digital currencies has created a new category, virtual convertibility.