What is a Non-convertible Currency?

Non-convertible currency is any nation's legal tender that is not freely traded on the global foreign exchange market.

Key Takeaways

  • Non-convertible currency is any nation's legal tender that is not freely traded on the global foreign exchange market.
  • One of the main reasons that a nation chooses to make their currency into a non-convertible currency is to prevent a flight of capital to offshore destinations.
  • For offshore investors seeking to engage in trade with nations that have non-convertible currencies, they must do so through the use of a financial instrument known as a non-deliverable forward (NDF).

Understanding Non-convertible Currencies

As the name implies, it is virtually impossible to convert a non-convertible currency into other legal tender, except in limited amounts on the black market. When a nation's currency is non-convertible it tends to limit the country's participation in international trade. In addition, it can also distort its balance of trade.

A non-convertible currency is one that is used primarily for domestic transactions and is not openly traded on a forex market. This is usually the result of government restrictions, which prevent it from being exchanged for foreign currencies. A non-convertible currency is commonly known as a "blocked currency."

One of the main reasons that a nation chooses to make its currency into a non-convertible currency is to prevent a flight of capital to offshore destinations. Non-convertibility can be used to protect a country's currency from experiencing unwelcome volatility. It's especially advantageous if a country's economy is unduly vulnerable to market movements. Countries with non-convertible currencies have, in the past, experienced periods of hyperinflation.

Many South American countries operate a non-convertible currency because of historic excess economic volatility. The Brazilian real, Argentinian peso, and Chilean peso are three such examples. All three have a black market currency, which is where the local currency is traded and exchanged for goods and services.

Non-convertible Currency and NDF

For offshore investors seeking to engage in trade with nations that have non-convertible currencies, they must do so through the use of a financial instrument known as a non-deliverable forward (NDF). A NDF has no physical exchange in the local currency, rather the net of the cash flows is settled in a convertible currency, usually the U.S. dollar, which gets around the non-convertibility of the domestic currency.