What is a non-convertible currency?
Non-convertible (inconvertible) currency is the legal tender of any nation that is not freely traded on the world currency market.
- Non-convertible currency refers to a currency that is not easily exchanged or traded in the currency markets.
- One reason a nation may choose to convert its currency to a non-convertible currency is to prevent capital flight to offshore destinations.
- For overseas investors looking to engage in trade with nations that have non-convertible currencies, they must do so through the use of a financial instrument known as a non-deliverable forward (NDF) contract.
Understanding non-convertible currencies
As the name implies, it is practically impossible to convert a non-convertible currency into another legal tender, except in limited quantities on the black market. When a nation’s currency is not convertible, it tends to limit the country’s participation in international trade. In addition, it can also distort your trade balance.
A non-convertible currency is one that is used primarily for domestic transactions and is not openly traded on a foreign exchange market. This is usually the result of government restrictions, which prevent it from being exchanged for foreign currencies. A non-convertible currency is commonly known as a “locked currency.”
One of the main reasons a nation chooses to convert its currency to a non-convertible currency is to avoid capital flight to offshore destinations. Non-convertibility can be used to protect a country’s currency from experiencing unwanted volatility. It is especially advantageous if a country’s economy is excessively vulnerable to market movements. Countries with non-convertible currencies have experienced periods of hyperinflation in the past.
Many countries in South America operate a non-convertible currency due to the historical excess of economic volatility.
Non-convertible currency and NDF
For overseas investors looking to engage in trade with nations that have non-convertible currencies, they must do so through the use of a financial instrument known as a non-deliverable forward (NDF) contract. An NDF has no physical change in the local currency, but rather the net of the cash flows is settled in a convertible currency, usually the US dollar, which avoids the non-convertibility of the national currency. NDFs are settled in cash and are generally structured as short-term forward currency contracts.
Thus, an NDF contract can give an operator exposure to the Chinese renminbi, the Indian rupee, the South Korean won, the New Taiwan dollar, the Brazilian real, and other inconvertible currencies. Many South American countries operate a non-convertible currency due to historical excess economic volatility, even if their currencies officially float freely on world currency markets.
For example, the Chilean peso is floating, but with certain limitations and restrictions that effectively keep it non-convertible for many practical purposes. Similarly, the Brazilian currency is not yet convertible due to exchange rate volatility and high inflation, but the country’s government has made a commitment to full convertibility for the next several years. For offshore investors who want to trade with these nations, they still do business using NDF.