What is Limited Convertibility
Limited Convertibility refers to a situation in which government regulations prevent the free conversion of the home currency into a foreign one. Because the government is only able to regulate currency transactions within its borders, foreigners are still able to trade the currency. Only residents are unable to convert a currency with limited convertibility.
BREAKING DOWN Limited Convertibility
Limited convertibility can have a cooling effect on trade as well as foreign direct investment. However, countries that are in the process of moving to a more open economy may need to open up currency restrictions in steps rather than all at once. This has been the case in the development of countries that once had centrally planned economies, as opening up domestic markets would subject the home market to foreign competition.
Monetary Policies and Limited Convertibility
Convertibility first became an important issue in monetary policy when banknotes began to replace commodity money in the money supply. Under the gold and silver standards, notes were redeemable for coin at face value, though often failing banks and governments would overextend their reserves.
By contrast, a convertible currency is a liquid instrument when compared to currencies tightly controlled by a central bank or other regulating authority, which result in their limited convertibility.
Developing countries, or those with more authoritative governments, are more likely to place restrictions on the exchange of currency. Currencies from these countries are typically less stable, with higher inflation rates, and they are more illiquid, which contributes to their limited convertibility.
Convertibility is an important factor in international trade, as it allows companies to do business across borders with confidence and transparent pricing. Also, a convertible currency is more liquid, which reduces volatility and less volatility means less risk. As global trade continues to increase, currency convertibility will become ever more critical. Currencies with limited convertibility are at a natural disadvantage because transactions aren't as smooth, and one effect of limited currency convertibility is slow economic growth.
The most convertible currency in the world is the U.S. dollar. It is the most traded currency in the world. Central banks hold the U.S. dollar as their main reserve, and a number of asset classes are denominated in U.S. dollars, meaning payment and settlements are made in U.S. dollars. Currencies such as the South Korean won, and Chinese Yuan are deemed convertible, but on the lesser side, as the government places capital controls that limits the amount that can exit or enter the country. Some socialist countries such as Cuba and North Korea even issue nonconvertible currency.