What Is an Inconvertible Currency?
Inconvertible currency, also known as non-convertible or blocked currency, refers to money in which exchanges into another country's currency is not allowed. These are several reasons for making a money inconvertible including foreign exchange regulations, government restrictions, physical barriers, political sanctions, or extremely high volatility.
How Inconvertible Currencies Work
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.
Inconvertible currency helps regulators protect currency investors from risk and unsafe investments. An example is if a particular developing nation was to experience the rapid onset of hyperinflation, which is the swift, out-of-control rise in prices for goods and services and fall in purchasing power. In that case, regulators might declare the currency to be inconvertible, preventing investors from converting funds into the unstable currency and protecting them from losses.
While hyperinflation is typically the most common reason for a currency to become inconvertible, occasionally there are domestic political motives which caused the restriction. Some countries may issue non-convertible money to safeguard its citizens from outside influences and to control the flow of funds within the country better. This control makes the trade in the currency illiquid which means investors cannot buy, sell or exchange the money.
Inconvertible currency most often refers to money that cannot convert or trade on the foreign exchange market known as the forex (FX). In some cases, only limited amounts of the currency are allowed for trading. Once blocked, it is very difficult, if not impossible, to convert the currency into a freely traded one, such as the U.S. dollar. However, that does not mean it won’t happen. Inconvertible currencies may still swap, but only on the black market. Here, demand and availability drive the rate of exchange.
- Inconvertible currency refers to money in which exchanges into another country's currency is not allowed, typically in forex markets.
- Non-deliverable forwards (NDFs) are contracts used to work around trade with countries that have inconvertible currency.
- These are several reasons for making money inconvertible, including foreign exchange regulations, government restrictions, physical barriers, political sanctions, or extremely high volatility.
Trading Inconvertible Currency
Inconvertible currency, by its nature, is useful only in the money's domestic markets and is not available for forex trading. But although inconvertible designations are meant to protect investors, they are also necessary as a mechanism to protect national economies. Listing a currency as nonconvertible can be a valuable tool used in safeguarding the economies of developing nations. These growing economies can be susceptible to large swings in its markets. An inconvertible currency could help protect against capital outflows which could damage the broader economy.
However, even strong economies will use inconvertibility as an economic tool. For instance, the Chinese yuan has traditionally been an inconvertible currency although recently China has been working toward full convertibility for investors. By limiting exchange, the country can better control the exchange rate of their currency on the world stage.
There are ways to trade in foreign currencies which do not exchange internationally or whose trade is limited or legally restricted in the domestic market. Using a non-deliverable forward contract (NDF) can give a trader exposure to the Chinese renminbi, Indian rupee, South Korean won, new Taiwan dollar, and Brazilian real and other inconvertible currencies. NDFs are cash-settled and usually short-term forward currency contract. Many South American countries operate a nonconvertible currency because of historic excess economic volatility. The Brazilian real, Argentinian peso, and Chilean peso are three examples. All three have a black market currency, which is where the local currency is traded and exchanged for goods and services. For offshore investors want to trade with these nations they do business using NDFs.