What Is Limited Convertibility?
A currency has limited convertibility if it cannot be converted to a foreign currency due to regulation imposed by the issuing country.
A government can only regulate currency transactions within its borders, so this policy cannot outright prevent currency conversions outside the country. It does, however, limit the entry of foreign currencies into the country and therefore becomes a barrier to international trade.
- A currency can have limited convertibility due to controls imposed by its issuing government.
- Limited convertibility reduces or eliminates foreign currency from the country.
- Some countries impose limited convertibility due to geopolitical issues or sealed-off economies.
Understanding Limited Convertibility
Convertibility only became an issue in monetary policy when banknotes began to replace commodity money tied to a gold or silver standard. Minted coins were redeemable at face value, although failing banks or governments could overextend their reserves.
A convertible currency, by contrast, is less easy for a central bank or other regulating authority to control.
Developing countries and authoritative governments are more likely to place restrictions on the exchange of their currencies. Countries in financial trouble may, too. Greece had currency controls in place from 2015 until 2018 to prevent the wholesale flight of its euro capital to stronger economies.
Why Convertibility Is Important
Currency convertibility is an important factor in international trade, as it allows companies to do business across borders with confidence and with predictable costs. A prospective trading partner in another country will not want to be paid in currency with limited convertibility. Meanwhile, the local partner cannot accept the foreign currency.
Also, a convertible currency is more liquid, which means its value is less volatile. Less volatility means less risk. Limited convertibility currencies, on the other hand, tend to be less stable, and associated with higher inflation rates.
Impact on International Trade
As global trade continues to increase, currency convertibility will become more critical. Currencies with limited convertibility are at a severe disadvantage. The effect of limited currency convertibility is slow economic growth.
The U.S. dollar is the most convertible currency and most traded currency in the world. Central banks around the globe hold the U.S. dollar as their main reserve currency. A number of asset classes are denominated in U.S. dollars, meaning their payments and settlements are made in U.S. dollars. As a result, the U.S. dollar is the most convertible in the world.
Currencies such as the South Korean won and the Chinese yuan are convertible, but only moderately so. Their governments have controls in place that restrict the amount of currency that can exit or enter the country.
Some closed-off countries such as Cuba and North Korea issue nonconvertible currency.
Limited convertibility can have a cooling effect on foreign direct investment (FDI) as well as international trade. However, countries that are in the process of moving to a more open economy may need to open up currency restrictions gradually to avoid economic disruption.
This has been the case in the development of countries that once had centrally planned economies. Opening domestic markets rapidly could subject the home market to crushing foreign competition.