The convertibility of currency matters a lot when it comes to international payments and transactions. For that reason, it’s essential to understand how currency convertibility will affect your business operation. So, what’s currency convertibility, and how does it work?
This guide explores all the basics of currency convertibility, including its meaning and factors that affect it. You’ll also learn all the categories of currency convertibility and how they influence international funds transfers and payments. Keep reading to learn more.
Currency convertibility refers to the ability to convert a particular currency into another currency or gold. It plays a vital role in global commerce. So, when ordering goods from another country that uses a different currency, you’ll pay for the items using the currency specified by the seller, and it may not be your local currency.
The level of a currency’s convertibility depends on the exchange rate determined by the foreign exchange market. Further, the demand and supply of a currency in the foreign market will influence its convertibility. It means each currency has unique convertibility.
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Notably, authorized currency exchange dealers offer foreign exchange services based on the convertibility of the currencies involved. They can be banks or specialized foreign exchange companies like Knightsbridge FX, which provides better exchange rates.
As an exporter receiving other foreign currencies, you can go to the currency exchange providers to convert them into Canadian dollars at the current exchange rate. Importers can also convert Canadian dollars into foreign currencies to import goods.
So what does it mean to have a poor or strong currency convertibility?
When a currency has strong convertibility, it becomes easy to exchange for other currencies. However, if the currency has poor convertibility, swapping it for another currency can be very challenging.
This is because such a currency has significant risks and is a barrier to international trade as other countries may not need it.
In countries with poor currency convertibility, international transactions may not run as smoothly as those with stronger currency convertibility. As a result, other countries may shy away from trading with the countries whose currencies have poor convertibility.
The main drawback of poor currency convertibility is that it contributes to slow economic growth due to reduced international trade.
As mentioned earlier, currency convertibility is all about the ease of exchanging one currency for another. As a result, there are three currency convertibility categories: full convertibility, partial convertibility, and non-convertibility.
So, what does each of the categories mean to each currency?
A fully convertible currency is easy to trade as it doesn’t have limits or restrictions. You can quickly sell or buy it in the foreign exchange market. In other words, the currency is highly liquid compared to other currencies controlled and regulated by central banks.
A good observation is that most countries with stable economic performance use fully convertible currencies. An excellent example is the U.S. dollar. Other fully convertible major currencies include the Japanese Yen, Swiss Franc, and the pound sterling.
Besides the major currencies, there are also exotic and minor currencies falling in this category. The minor currencies include the Australian dollar, Canadian dollar, and the New Zealand dollar, while the exotic ones are the Indian rupee and Hong Kong dollar.
Notably, fully convertible currencies come with numerous benefits, including:
Despite the numerous advantages of a fully convertible currency, there are also a few drawbacks. For example, it increases the risks of foreign debt and reduces competitiveness in foreign markets, negatively affecting the economy.
A partially convertible currency is quite different from a fully convertible currency since it has limits and restrictions. The government has imposed restrictions to control the flow and exchange of its currency in the international market.
People holding a partially convertible currency must adhere to the legal constraints implemented by the government to freely convert it into other currencies at a specific exchange rate. Also, most countries with partially convertible currencies are less stable economically.
But why would a country impose restrictions on its currency?
The economy of most countries with unstable currencies is likely to plunge when not regulated. For example, if the prices of imports increase, it could destabilize the fragile economy. So, the government must impose limits, hence partial convertibility.
However, the rules and regulations for exchanging partially convertible currencies often vary by country. In some countries, the government imposes restrictions on where to take their currencies. For example, one needs to keep the Indonesian rupiahs onshore.
Another example of a restriction is the in-country conversion, in which you can only convert a currency within the borders of a country. In some cases, you may give valid reasons to exchange the money. The Philippine peso is an example of this.
Other restrictions common for most partially convertible currencies are the minimum amounts of money you can have as foreign currencies. The limitation can also apply to the maximum amount of domestic currency to take out of a country.
Some of the most popular partially convertible currencies include the Malaysian ringgit, Chinese yuan, and South African rand. China, Malaysia, and South Africa governments limit the amount of currency entering and exiting the respective countries.
Non-convertible currencies are the most rigid among the three categories as you can’t trade them on the foreign exchange market. For that reason, some people refer to them as blocked currencies. You cannot freely convert the currency into other currencies.
The issuing government usually blocks their currency to protect their country from the adverse effects of an unstable economy. As a result, you can only use the currency for domestic transactions. Unfortunately, some people usually exchange non-convertible currencies on the black market, putting the currency and the country’s economy at risk.
Most non-convertible currencies are exotic and are popular in South American countries with extreme economic volatility. Examples of blocked currencies include the Brazilian real, Chilean peso, Venezuelan bolivar, and the Argentine peso.
You now know what it means to have poor and robust currency convertibility. So, what factors determine the convertibility of currencies? A country’s economy is the primary factor influencing a currency’s convertibility as there is a correlation between the two.
If a country has a well-established economy, it will be easier to exchange its currency for other currencies. That’s why countries with stable economies, like the U.S., have currencies with better convertibility.
Other factors affecting currency convertibility are government restrictions. A government with low reserves of stronger foreign currencies may restrict currency convertibility. This is because the government may not intervene in the forex market to support its currency.
The convertibility of currency is subject to various factors, including economic stability and government restrictions. Countries with robust economies and few government constraints on foreign exchange usually have fully convertible currencies.
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