Currency convertibility is a simple concept. It means residents and non‐residents of a country are able to exchange domestic currency for foreign currency. However, there are many degrees of convertibility, reflecting the extent to which governments impose controls on the exchange and use of currency. When convertibility is restricted, financial risk increases, and so the risk‐adjusted interest rate employed to value assets is higher than it would be with full convertibility. That is because property is held hostage and subject to a potential ransom through expropriation. As a result investors are willing to pay less for each dollar of prospective income and the value of property is less than it would be with full convertibility.
Therefore, investors become justifiably nervous when it seems a government is considering the imposition of exchange controls. At this point, settled money becomes “hot” and capital flight occurs. Asset owners liquidate their property and get out while the getting is good. Contrary to popular wisdom, restrictions on convertibility do not retard capital flight; they promote it.
As we enter the 21st century, globalization (the liberalization of financial and trade flows) is threatened. Volatile hot money flows are identified as the problem and exchange controls as the remedy. This prescription, which is based on a wrongheaded diagnosis, will lead to monetary nationalism and the type of economic chaos the world encountered after World War I. The only way to avoid such a disaster is for developing countries to unify their currencies with stronger ones. That can be accomplished either by establishing a currency board system — as Argentina did in 1991 — or by replacing a national currency with a strong foreign currency (official dollarization).