Currency convertibility means that a particular currency can be easily and readily changed into another currency.
Free convertability is a factor of a hard currency. (A hard currency is expected to be stable and retain its value in long term, e.g. Dollar, Japanese Yen)
Convertibility is a feature of fully flexible exchange rates.
Restrictions on convertibility
- Some countries may place restrictions on their currency, e.g. limiting the amount you can hold or take out of a country.
- Some currencies, such as Cuban national peso and North Korean won are 100% non-convertabile and cannot be exchange on official markets.
Convertibility and Exchange rate pegs
Governments which seek to keep the exchange fixed at a certain peg, often use exchange controls to prevent the currency moving away from the official exchange rate peg.
Balance of Payments crisis and Convertibility
In a major balance of payments crisis where a country is struggling to meet its foreign creditors, it may impose currency controls to prevent the outflow of currency.
In 1958, the UK government allowed Sterling to be convertible and encourage the use of Sterling as a reserve currency. Many foreign investors and governments saved Sterling deposits in London banks. £4.5 billion in sterling balances banked in London. (pdf)
For example, the Chinese government place limitations on the amount of foreign currency that can be bought. This means the Chinese Yuan is only partially convertible.
If a currency is convertible, market forces on the foreign exchange reserves will determine its value.