Currency Convertibility, What is it and How Does it Work?

The currency convertibility is the ease with which currency of a country can be converted into gold or another currency. Also, this is essential for international commerce as globally sourced goods need to be paid for in an agreed-upon currency. And this may not be the buyer’s domestic currency.

If the country has poor currency convertibility – hard to swap for another currency or store of value -, it poses a risk and barrier to trade with foreign countries who do not need the domestic currency.

Somehow, there tends to be a correlation between a country’s economy and its currency’s convertibility. Then government constraints might end up the currency with low convertibility. For instance, a government with low reserves of hard foreign currency often restricts currency convertibility. And this is because the said government would otherwise not be able to intervene in the forex market to support its currency when needed.

Furthermore, countries with its currency at poor convertibility are at a global trade disadvantage because transactions do not happen as smoothly as those with excellent convertibility. So, this would, in fact, deter other countries from trading with them. 

Also, poor convertibility might become one of the reasons for slower economic growth as global trade opportunities are missed.

Capital Controls

Meanwhile, excellent currency convertibility needs a readily available supply of the physical currency. And this is why several currencies implement capital controls on money going out of their country. 

While economies dipped into recession, investors would typically look for investment offshore or convert their money into one of the safe-haven currencies. Now, to fight this and guarantee that money does not flow out if the country, numerous governments place controls in place to cut capital flight during trying economic times.

A lot of countries in the region put tight capital controls to diminish the threat of a run on their currency. Before, Greece imposed capital controls in June 2015 to slow the capital outflows in the Greek Debt Crisis, and these remained until 2018.

The said controls limited the amount of money that they could withdraw from the banking system. Now, the striking thing about Greek controls is that the country is an EU member and uses the euro. Thus, the capital controls did not actually have any effect on the currency convertibility. And this was due to the fact that Greece is just a part of the economies underlying the euro.