by Exchange controls are government-imposed controls and restrictions on private transactions conducted in foreign currency. The government’s major aim of exchange control is to manage or prevent an adverse balance of payments position on national accounts. It involves ordering all or part of foreign exchange received by a country into a common pool controlled by authorities, typically the central bank. Foreign exchange controls are various forms of controls imposed by a government on the purchase/sale of foreign currencies by residents, on the purchase/sale of local currency by nonresidents, or the transfers of any currency across national borders. These controls allow countries to better manage their economies by controlling the inflow and outflow of currency, which may otherwise create exchange rate volatility. Countries with weak and/or developing economies generally use foreign exchange controls to limit speculation against their currencies. They may also introduce capital controls, which limit foreign investment in the country.
Foreign exchange controls used to be common in most countries. For instance, many western European countries implemented exchange controls in the years immediately following World War II. The measures were gradually phased out, however, as the post-war economies on the continent steadily strengthened; the United Kingdom, for example, removed the last of its restrictions in October 1979. By the 1990s, there was a trend toward free trade and globalization and economic liberalization.
In France, exchange controls started after the First World War. It then reappeared between 1939 and 1967. After a very short interruption, exchange controls were restored in 1968, relaxed in 1984, and finally abolished in 1989.
Francoist Spain kept foreign exchange controls from the Spanish Civil War to the 1970s.
Other countries that formerly had exchange controls in the modern period include:
- Argentina – between 2011 and 2015, and from 2020
- Egypt – until 1995
- Finland – until 1990
- Israel – until 1994
- Taiwan – until 1987
- United Kingdom – until 1979
Regulated Exchange Rate
In the system, residents must sell any foreign currency they acquire to the designated exchange-control authority (often the central bank or a specific government agency) at the rates specified by the authority. Some systems allow those who get exchanges from particular sources to sell a portion of those receipts on a free market. As the only foreign exchange market, the regulatory authority can set the permitted uses for foreign exchange and the resources and capacities one can use for each.
The regulated exchange rate is basically higher than a free-market rate and has the effect of reducing exports and boosting imports. The authority that monitors the measures can prevent a drop in its overall gold reserves and payment balances by limiting the number of foreign exchange residents can purchase. A country’s Specific exchange control authority decides the limits of control.
Objectives of Foreign Exchange Control
Protect the value of the national currency
Governments may defend their currency’s value at a certain desired level through participating in the foreign exchange market. The control of foreign exchange trading is the government’s way to manage the exchange rate at the desired level, which can be at an overvalued or undervalued rate.
The government can create a fund to defend currency volatility to stay in the desired range or get it fixed at a certain rate to meet its objectives. An example is an import-dependent country that may choose to maintain an overvalued exchange rate to make imports cheaper and ensure price stability.
Restore the balance of payments equilibrium
The main objective of introducing exchange control regulations is to correct the balance of payments equilibrium. The BOP needs realignment when it is sliding to the deficit side due to greater imports than exports. Hence, controls are put in place to manage the dwindling foreign exchange reserves by limiting imports to essentials items and encouraging exports through currency devaluation.
Prevent capital flight
The government may observe increased trends of capital flight as residents and non-residents start making amplified foreign currency transfers out of the country. It can be due to changes in economic and political policies in the country, such as high taxes, low interest rates, increased political risk, pandemics, and so on.
The government may resort to an exchange control regime where restrictions on outside payments are introduced to mitigate capital flight.
Build foreign exchange reserves
The government may intend to increase foreign exchange reserves to meet several objectives, such as stabilize local currency whenever needed, paying off foreign liabilities, and providing import cover.
Protect local industry
The government may resort to exchange control to protect the domestic industry from competition by foreign players that may be more efficient in terms of cost and production. It is usually done by encouraging exports from the local industry, import substitution, and restricting imports from foreign companies through import quotas and tariff duties.
Consequences of Exchange Controls
Exchange controls can be effective in some instances, but they can also come with negative consequences. Often, they lead to the emergence of black markets or parallel markets in currencies. The black markets develop due to higher demand for foreign currencies that is greater than the supply in the official market. It leads to an ongoing debate about whether exchange controls are effective or not.
Methods:
Full-Fledged System of Exchange Control
The government controls the exchange rate and all foreign exchange transactions in this system. The control authority receives all export and other transaction receipts. In this sense, the government is the only foreign exchange dealer.
Exchange pegging
Exchange pegging, or a mild exchange control system, is the government’s attempt to maintain a rate of exchange at desired levels. Governments maintain exchange equalization funds in foreign currencies. The U.S. exchange stabilization fund is one such example.
Compensating Arrangement
This concept works similarly to a barter system where one country exchanges goods or services on mutual understanding, agreeing on a particular exchange rate.
Payments Arrangements
The payment arrangement maintains the conventional method of sending money overseas through the currency market. In addition, each nation consents to set up a system of control wherein its population is compelled to buy products and services from other nations. This should be in quantities equal to what that other nation paid to the first nation for those goods and services.
Clearing Agreement
A clearing agreement is between two or more nations to exchange products and services at predetermined exchange rates for payments. The payment is made exclusively in the purchasers’ home currencies. The central banks satisfy the remaining unpaid claims at the end of the predetermined periods. It does this through transfers of gold, an approved third currency, or any other means.
Advantages:
Control measures prevent volatile foreign exchange markets and sudden rate swings. They prevent capital outflows. Exchange control is used to allocate available foreign currency to suit the country’s interests and control local demand for foreign currency to safeguard the nation’s foreign exchange reserves.
However, one major drawback of these restrictions is that they create black markets for foreign currencies. In addition, they can also hurt international trade in the long term, negatively impacting investments.
Disadvantages:
- It leads to the contraction of foreign trade and the world’s welfare at large.
- It develops economic nationalism but obstructs economic co-operation internationally.
- It encourages bilateral trade but deprives the country from the benefits of multi-lateral trade.
- Exchange control is an instant remedy to check disequilibrium in the balance of payments. But, in the long-run it results in the creation of basic disequilibrium which harms the economy at large.
-
It vests extraordinary powers in the hands of government officials and there are chances of corruption.
