Chapter 9 Outline

Currency Convertibility

Until this point we have assumed that the currencies of various countries are freely convertible into other currencies. This assumption is invalid. Many countries restrict the ability of residents and nonresidents to convert the local currency into a foreign currency, making international trade and investment more difficult. Many international businesses have used "countertrade" practices to circumvent problems that arise when a currency is not freely convertible.

Convertibility and Government Policy

Due to government restrictions, a significant number of currencies are not freely convertible into other currencies. A country's currency is said to be freely convertible when the country's government allows both residents and nonresidents to purchase unlimited amounts of a foreign currency with it. A currency is said to be externally convertible when only nonresidents may convert it into a foreign currency without any limitations. A currency is nonconvertible when neither residents nor nonresidents are allowed to convert it into a foreign currency.

Free convertibility is the exception rather than the rule. Many countries place some restrictions on their residents' ability to convert the domestic currency into a foreign currency (a policy of external convertibility). Restrictions range from the relatively minor (such as restricting the amount of foreign currency they may take with them out of the country on trips) to the major (such as restricting domestic businesses' ability to take foreign currency out of the country). External convertibility restrictions can limit domestic companies' ability to invest abroad, but they present few problems for foreign companies wishing to do business in that country. For example, even if the Japanese government tightly controlled the ability of its residents to convert the yen into US dollars, all US businesses with deposits in Japanese banks may at any time convert all their yen into dollars and take them out of the country. Thus, a US company with a subsidiary in Japan is assured that it will be able to convert the profits from its Japanese operation into dollars and take them out of the country.

Serious problems arise, however, when a policy of nonconvertibility is in force. This was the practice of the former Soviet Union, and it continued to be the practice in Russia until recently. When strictly applied, nonconvertibility means that although a US company doing business in a country such as Russia may be able to generate significant ruble profits, it may not convert those rubles into dollars and take them out of the country. Obviously this is not desirable for international business.

Governments limit convertibility to preserve their foreign exchange reserves. A country needs an adequate supply of these reserves to service its international debt commitments and to purchase imports. Governments typically impose convertibility restrictions on their currency when they fear that free convertibility will lead to a run on their foreign exchange reserves. This occurs when residents and nonresidents rush to convert their holdings of domestic currency into a foreign currency--a phenomenon generally referred to as capital flight. Capital flight is most likely to occur when the value of the domestic currency is depreciating rapidly because of hyperinflation, or when a country's economic prospects are shaky in other respects. Under such circumstances, both residents and nonresidents tend to believe that their money is more likely to hold its value if it is converted into a foreign currency and invested abroad. Not only will a run on foreign exchange reserves limit the country's ability to service its international debt and pay for imports, but it will also lead to a precipitous depreciation in the exchange rate as residents and nonresidents unload their holdings of domestic currency on the foreign exchange markets (thereby increasing the market supply of the country's currency). Governments fear that the rise in import prices resulting from currency depreciation will lead to further increases in inflation. This fear provides another rationale for limiting convertibility.

Countertrade

Companies can deal with the nonconvertibility problem by engaging in countertrade. Countertrade is discussed in detail in Chapter 15, so we will merely introduce the concept here. Countertrade refers to a range of barterlike agreements by which goods and services can be traded for other goods and services. Countertrade can make sense when a country's currency is nonconvertible. For example, consider the deal that General Electric struck with the Romanian government in 1984, when that country's currency was nonconvertible. When General Electric won a contract for a $150 million generator project in Romania, it agreed to take payment in the form of Romanian goods that could be sold for $150 million on international markets. In a similar case, the Venezuelan government negotiated a contract with Caterpillar in 1986 under which Venezuela would trade 350,000 tons of iron ore for Caterpillar heavy construction equipment. Caterpillar subsequently traded the iron ore to Romania in exchange for Romanian farm products, which it then sold on international markets for dollars.²⁰

How important is countertrade? One estimate is that 20 to 30 percent of world trade in 1985 involved some form of countertrade agreements. Since then, however, more currencies have become freely convertible, and the percentage of world trade that involves some form of countertrade has fallen to between 10 percent and 20 percent.²¹ Since countertrade apparently remains an important method for conducting international trade, we discuss it again in Chapter 15.