Meaning of Exchange Control:
Exchange control means the interference by the state, central bank or any other agency with the free play of market forces that determine foreign exchange rate. Exchange rates, under exchange control system, are fixed arbitrarily by the government and are not determined freely by the forces of demand and supply. In other words, exchange control system represents government domination of the foreign exchange market.
Each international transaction requiring payment in foreign currencies is sanctioned by the government and all foreign exchange receipts from international transactions are surrendered to the government. The main object of exchange control is to secure stability of fixed exchange rate and to ensure balance of payments equilibrium.
According to Haberler, exchange control is the state regulation excluding the free play of economic forces from the free play of foreign exchange market. In the words of G.N. Halm, “By exchange control we refer to measures which replace part of the equilibrating function of foreign exchange market by regulations alien to the pricing process.”
According to Ellsworth, “Exchange control means dealing with the balance of payments difficulties, disregards market forces and substitutes for them the arbitrary decisions of government officials”. According to G.D.H. Cole. “The essence of exchange control is that the possessor of the controlled currency has no right, without special leave to convert it into foreign currency.”
Exchange control maybe complete or partial. Exchange control is complete when the government has full control over the exchange market. In fact, under complete exchange control, there exists no exchange market and disequilibrium in the balance of payments is impossibility.
The exchange control applies to all types of international transactions and the government restricts the sale and purchase of all currencies. Exchange control is partial when the government partially controls the exchange market. The exchange control applies only to certain types of international transactions and the government restricts the sale and purchase of some selected currencies.
Exchange control is a method of influencing international trade and investment as well as the payments mechanism. As such, it has the advantages and disadvantages of other means of protection. It is adopted by and is specially suited to those nations which seek to achieve economic goals by manipulating the market behaviour.
It is not an appropriate measure for the free-market economies. For this reason, the system of exchange control is commonly used in the less developed countries and the communist countries.
Exchange control is the most drastic means of balance of payments adjustment.
It may be compared with other trade restrictions in respect of its impact and administration:
(a) Exchange control is more certain than tariffs in its impact on a country’s balance of payments,
(b) Exchange control has the advantage of controlling visible trade and invisible transactions and capital movements,
(c) Whereas the trade controls are generally operated by the ministry of trade through customs department, the exchange controls are usually operated by the central bank through commercial banks.
(d) There may be some degree of discretion given to the individual banks in case of exchange control. But, no such discretion exists in case of trade controls.
The system of exchange control possesses the following broad features:
(i) The government monopolises the foreign exchange business and exercises full control over the foreign exchange market.
(ii) The rate of exchange is fixed officially by the government and the market forces of demand and supply have no effect on its determination.
(iii) The government centralises all foreign exchange operations in the hands of the central tank which administers various foreign exchange regulations.
(iv) The exporters have to deposit their all foreign exchange earnings with the central banks.
(v) Imports of the country are regulated and the importers are allocated foreign exchange at the official rates to enable them to make payments for the goods imported.
(vi) The government or the central bank determines the priorities in the allocation of scarce foreign currencies.
(vii) As a result of exchange control, the volume of imports gets automatically reduced and there is a favourable impact on country’s balance of payments.
Important among them are given below:
1. To Correct Adverse Balance of Payments:
A country may follow the system of exchange control when it faces a deficit in its balance of payments and does not want to leave the process of adjustment either on the mercy of automatic mechanism of fluctuating foreign exchange rates or on deflation.
By adopting exchange control, imports are restricted to the level permitted by the availability of foreign exchange reserves and, thereby, the balance of payments equilibrium is established.
2. To Check Flight of Capital:
Exchange control may be adopted to prevent the flight of capital from the country. Flight of capital refers to the action of the citizens of a country to convert their cash holdings (i.e., short- term securities and bank deposits) into foreign currencies. Flight of capital maybe the result of speculative activities, economic fluctuations and political uncertainty.
Flight of capital exhausts the country’s limited reserves of foreign exchange and destabilise the economy. Through exchange control, the government imposes restrictions on the sale of foreign currencies and there-by checks the flight of capital.
3. To Stabilise Exchange Rate:
The government may adopt exchange control to check fluctuations in the rate of exchange. Fluctuations in the rate of exchange are the normal feature in a free exchange market and cause disequilibrium in the economic life of a country. These fluctuations can be checked by officially fixing the exchange rate at a predetermined level.
4. To Conserve Foreign Exchange:
Exchange control may be used to conserve country’s foreign exchange reserves through exports. These reserves are restricted for- (a) paying off external debt, (b) importing essential goods for economic development, and (c) purchasing defence materials.
5. To Check Economic Fluctuations:
Cyclical fluctuations depression and inflation, spread from one country to another through international trade. Exchange controls are used to check the spread of the destabilising tendencies by controlling imports and exports.
6. To Protect Home Industry:
Exchange control may be resorted to protect the home industry from foreign competition. For this purpose, the government restricts the imports through foreign exchange controls and thus provides opportunity to the domestic industries to develop without any fear of international competition.
7. To Practise Discrimination in Trade:
Exchange control helps a country to follow a policy of discrimination in international trade. The government fixes favourable rates of exchange for the countries with which it wants to strengthen its trade relation.
8. To Check Undesirable Imports:
Exchange control is also needed to check the import of certain nonessential, harmful and socially undesirable goods in the country.
9. Source of Income:
Exchange control can also be used as a source of income to the government. Under the multiple exchange rate system, the government fixes the selling rates higher than the buying rates and earns income equal to the difference between the two rates.
10. Important for Planning:
Exchange control forms an integral part of economic policy in a planned economy. Planned economic development requires expansion, conservation and proper use of foreign exchange reserves of the country according to the national priorities. Exchange control system is directed to achieve these objectives.
11. To Check Enemy Nations:
Exchange control is also used by some countries to prevent the enemy countries from using their foreign assets. Regulations are adopted to freeze the assets held by the residents of the enemy country and they are not allowed to use or transfer these assets.
Overvaluation refers to the fixing of the value of a currency at a rate higher than the free market rate. It! is also called ‘pegging up’. Overvaluation, by making the home currency dearer for the foreigners, reduces the prices of imports and raises the prices of exports.
The policy of overvaluation is adopted to facilitate the country to make its purchases at cheaper prices and to pay off the foreign debts.
Undervaluation refers to the fixing of the value of a currency at a rate lower than the free market rate. It is also known as ‘pegging down’. Undervaluation, by making the currency cheaper for the foreigners, reduces the prices of exports and raises the prices of imports. The policy of undervaluation is adopted to promote exports, reduce imports and to give support to general rise in prices.
A country desirous of adopting exchange control system can employ various methods. Prof. Paul Einzig has mentioned as many as 41 methods of exchange control.
Broadly these methods can be classified into two categories:
A. Direct methods and
B. Indirect methods.
Important methods of exchange control are discussed below:
1. Intervention or Exchange Pegging:
A commonly adopted method of exchange control is the interference in the foreign exchange market by the government or the monetary authority with the purpose of either holding up or down the foreign exchange rate of its currency.
This interference takes the form of purchasing and selling of home currency in the exchange market and, thereby influencing the exchange rate. Intervention may be active or passive.
In the passive intervention, the monetary authority is prepared to buy or sell the foreign currency at fixed rate without curtailing the right of the public to deal in foreign exchange. In the active intervention the monetary authority itself takes the initiative and bids for the foreign currency or offers it for sale with a view to influence the exchange rate.
The government intervenes the foreign exchange market through exchange pegging. Exchange pegging refers to the act of fixing the exchange value of the currency to some chosen rate. The government buys and sells the home currency in exchange for foreign currency in order to establish a desired rate of exchange.
The pegging operation involves pegging up or pegging down the exchange rate. When the exchange rate is fixed higher than the market rate, it is called pegging up; when the exchange rate is fixed lower than the market rate, it is called pegging down. In other words, pegging up means overvaluation of home currency and pegging down means undervaluation of home currency.
In the pegging up operation, public demand for foreign currency increases and the government must be ready to sell adequate foreign currency in exchange for home currency.
In the pegging down operation, public demand for home currency increases and the government must be in a position to purchase foreign currency in exchange for home currency. The exchange pegging should be used as a temporary measure to remove fluctuations in the foreign exchange rate.
In Figure 1, D£ and S£ represent demand for pound (or supply of dollar) curve and supply of pound (or demand for dollar) curve respectively. In the absence of intervention, the equilibrium market rate of exchange is OR dollars per pound.
OM is the quantity of pounds demanded and supplied at this market rate. If the U.K. government pegs up the exchange rate at OR1, the supply of pound exceeds the demand for pound (or demand for dollar exceeds the supply of dollar) by the amount A1B1.
Thus, if the U.K. government wants to maintain the exchange rate at OR1, it must be prepared to purchase A1B1 quantity of pounds (or to sell A1B1 quantity of dollars). For this it must use its holdings of gold, dollars and other resources.
Similarly, if the U.K. government pegs down the exchange rate at OR2, the demand for pound exceeds the supply of pound (or the supply of dollars exceeds the demand for dollars) by A2B2 amount.
As a consequence, the U.K. government must be ready to sell A2B2 quantity of pounds for dollars (or to buy A2B2 quantity of dollars for pounds) at this lower rate OR2 dollar per pound.
2. Rationing of Foreign Exchange:
Under this method of exchange control, the government keeps the exchange value of its currency fixed by rationing the ability of its residents to acquire foreign exchange for spending abroad. The government imposes restrictions on the use, sale and purchase of foreign exchange.
All foreign exchange business is centralised either with the government or with its agents. All foreign exchange earnings are to be surrendered by exporters to the central bank at the fixed exchange rate. The importers are allotted foreign exchange at the fixed rate and in fixed amount. The government also determines the priorities in the allocation of scarce foreign currencies.
3. Blocked Accounts:
Blocked accounts refer to a method by which the foreigners are restricted to transfer funds to their home countries. The method of blocking the accounts of creditor countries is adopted by the debtor countries particularly during the periods of war or financial crisis. Under this method, the foreigners are not allowed to convert their deposits, securities and other assets into their currency.
Their banking accounts are blocked and they are not permitted to withdraw their funds and remit them to their own countries. The method of blocked accounts is defective because of the following reasons- (a) It causes hardships to the foreigners, (b) It harms the reputation of the blocking country, (c) It reduces the volume of foreign trade. (d) It encourages black marketing in foreign exchange.
4. Multiple Exchange Rates:
When a country, instead of one single exchange rate, fixes different exchange rates for the import and export of different goods, it is known as the system of multiple exchange rates. Even for different countries or imports, different exchange rates are fixed. The system of multiple exchange rates amounts to a type of rationing by price rather than by quantity and therefore does not directly restrict free trade.
The system of different exchange rates for different goods and for different countries is adopted with the objective of earning maximum possible foreign exchange by increasing exports and reducing imports. Multiple exchange rates were adopted first by Germany, and then by Chile, Argentina, Brazil, Peru and many other countries. The under developed countries can employ this system to improve their balance of payments.
The system of multiple exchange rates has the following advantages:
(i) It permits a country to discriminate between goods as well as countries in international transactions.
(ii) It encourages exports and discourages imports and thus helps to correct balance of payment deficit.
(iii) It encourages the inflow and discourages the outflow of capital.
(iv) It provides additional source of income of the government. The government earns revenue by purchasing the foreign currency at low rate and selling it at a higher rate.
(v) It substitutes the system of rationing foreign exchange through administered prices for that of rationing foreign exchange through administered quantities of foreign exchange and thus avoids the complex problems of the latter such as arbitrary rationing of the foreign exchange, large administrative staff, potential improprieties, etc.
(vi) Multiple exchange rates is a better method than devaluation of currency.
However, the multiple exchange rate system has the following defects:
(i) Instead of correcting the balance of payments disequilibrium, it adversely affects the growth of international trade.
(ii) It involves complexities of calculation of different rates of exchange for different imports and exports and for different countries.
(iii) It gives too much arbitrary powers to the government to control international trade.
(iv) Undue restrictions on international trade may encourage black marketing and other corrupt practices by importers and exporters.
(v) In so far as multiple exchange rates overvalue the country’s currency, they amount to a tax on exports and subsidy on imports. In the opposite case, they represent subsidy on exports and a tax on imports. In both situations, the multiple exchange rates disturb the competitive conditions and divert the international trade in the unnatural directions.
(vi) It distorts the economic structure of the trading nations and adversely affects the efficient and optimum utilisation of resources.
5. Standstill Agreements:
Standstill agreement aims at maintaining status quota in the relationship between two countries in terms of capital movement. This method was first adopted by Germany after the Great Depression of 1929.
The main features of standstill agreements are as follows:
(a) The movement of capital is checked and the payments to the foreign exporters are made in easy installments instead of in lumpsum.
(b) Short-term loans are converted into long-term loans with a view to allow more time to the debtor country to repay his debt.
Standstill agreements have two advantages:
(a) The rate of exchange is kept under control by preventing the movement of capital.
(b) The debtor country is provided enough time to improve his economic position and pay off the debt.
6. Clearing Agreements:
Clearing agreement refers to a system under which agreement is made between two countries for settling their international trade accounts through their respective central banks. In the words of Kent, “Clearing Agreement is an agreement between the governments of the two countries by which each undertakes to make payments to its exporters which it receives from its own importers”.
Under this system, the importers instead of making payment for the imported goods in foreign currency pay in home currency to their central bank. Similarly, the exporters, instead of receiving payment for goods exported in foreign currency receive it through the central bank in the home currency.
Thus, the individual importers and exporters need not clear their accounts in foreign currencies, but in home currencies through their respective central banks and the transfer of currencies from one country to another is avoided.
If the exports and imports of the two countries balance with each other, no further difficulty arises. But, if the exports and imports of the two countries are not equal to each other, the net balance in the clearing account is paid off in terms of gold. In this way, stability of exchange rate is maintained through clearing agreement.
The system of clearing agreement as a method of exchange control has the following advantages:
(i) It is a novel and revolutionary method of exchange clearing which was evolved, first of all by Germany in 1930, when other restrictive devices of exchange control failed to remove the deficit in balance of payments of many European countries.
(ii) Volume of international trade increases between two countries under the clearing agreement without being unduly worried about the scarcity of foreign exchange.
(iii) Each country under the clearing agreement tries to balance its imports with exports. So no foreign exchange problem arises.
There are also certain drawbacks of clearing agreement system:
(i) It promotes bilateral trade at the cost of multilateral trade and therefore reduces the total volume of international trade.
(ii) It by-passes the foreign exchange markets and renders them unnecessary and useless.
(iii) It is not based on the sound principle of international trade.
(iv) Under this system, there is a possibility of exploitation of economically weaker nations by the stronger nations because of the greater bargaining power of the latter.
(v) It requires all international payments to be centralised.
(vi) It requires that the value of a country’s total imports from the other country must always be equal to that of its exports. When the value of a country’s exports is in excess of the value of its imports, the exporters in the country cannot be paid because the total out payments to be made by the exchange clearing institution (i. e., the central bank) to the exporters exceed the total in payments received by it from the importers.
(vii) Under this scheme, the payments to the exporters are not made immediately. The central bank of the exporter’s country pays to the exporter only after it has received payments from the importers in the country on behalf of the exporters in the other country.
7. Payment Agreements:
The system of payment agreement solves two major problems experienced under the system of clearing agreement, i. e., (a) the centralisation of payments, and (b) the problem of waiting for the exporters. Under the payment agreement between the two countries A and B, the exporter in country A is paid as soon as information is received by the central bank of country A from country B’ s central bank that the importers in country B has discharged his payment obligation and vice versa.
The advantage of payment agreement is that the direct relation between the exporters and importers is maintained and there is no need for centralisation of payments. The payments between the concerned parties are made through special non-resident accounts opened for that very purpose.
The system of payment agreement, however, suffers from two defects:
(a) The agreement accounts can be debited or credited for only licensed payments.
(b) The balances in the accounts can only be used for making payment from one partner to another.
8. Compensation Agreements:
This is a kind of barter agreement between the two countries under which the exporter in a country is paid by the importing country in terms of certain goods on an agreed basis. Since no payment is made in foreign exchange, the problem of foreign exchange does not arise.
Since the imports and exports of the two countries exactly balance with each other, the rate of exchange between them remains stable and the balance of payments equilibrium is maintained in the two countries.
The compensation agreements suffer from certain drawbacks:
(a) They encourage bilateral trade and discourage multilateral trade.
(b) They discourage division of labour and specialisation among different countries,
(c) They give undue protection to home industries.
9. Transfer Moratoria:
Under the method of transfer moratoria, the payments for the imported goods or the interest on the foreign capital are not made immediately but are suspended for a pre-determined period, known as period of moratorium. A country adopts this method of exchange control to temporarily solve its payments problems.
The importers and debtors make payments in the home currency and this payment is deposited with some authorised bank, generally the central bank. During the period of moratorium, the government uses these funds and solves the foreign exchange problems of the country. After the expiry of the moratorium period, these deposits are transferred to exporters and creditors.
10. Exchange Stabilisation Fund:
The exchange stabilisation fund was established by England in 1932, by America in 1934, and by France, Holland and Belgium in 1936 with the objective of neutralising the effects of wide fluctuations in the exchange rates as a result of any abnormal movements of capital.
The purpose of such a fund is to control seasonal or temporary fluctuations in the exchange rate and not to interfere with the general trend in the exchange rate and the forces influencing it.
If there is large inflow of foreign currency in the country, the exchange rate of the home currency rises. In such a situation, the fund starts purchasing the foreign currency as a result of which the upward movement in the exchange rate is checked. On the other hand, if there is large outflow of foreign currency, the exchange rate of the home currency falls. In this case, the fund will sell the foreign currency which, in turn, will control the downward movement of the exchange rate.
1. Changes in Interest Rates:
The government can influence the rate of exchange indirectly through changes in the rate of interest. The exchange rate can be reduced by lowering the interest rate and can be increased by raising the interest rate. When the rate of interest is raised in the country, it attracts liquid capital and banking funds of the foreigners.
It will also prevent the capital flight because the nationals of the country will tend to keep their funds in their own country. All this will tend to increase the demand for home currency and, as a result, the exchange rate will move in its favour (i.e., will rise). Similarly, lowering the rate of interest in the country will have the opposite (i.e., depressing) effect on the rate of exchange.
2. Import Restrictions:
Another indirect method of exchange control is to restrict the imports of the country through measures like tariffs, import quotas and other such quantitative restrictions. Import duties reduce imports by making them costly. This raises the value of home currency relative to the foreign currency.
Similarly, import quotas fixed by the government also reduce the volume of imports in the country, as a result of which the demand for foreign currency falls, thus raising the value of the home currency in relation to foreign currency. In this way, imposition of import duty and import quotas raise the rate of exchange making it favourable to the country using import restrictions.
3. Export Subsidies:
Export subsidies or bounties refer to the financial assistance to industries producing exportable goods. Export subsidies increase exports. As a consequence, the demand for home currency in the foreign exchange market increase, thus raising the rate of home currency in terms of foreign currencies.
Defects of Exchange Control (Demerits):
In spite of the fact that a large number of nations, especially the less developed countries, have resorted to the exchange control system, International Monetary Fund (IMF) strongly opposes the adoption of exchange control by the member countries because of its serious defects.
Important defects are as follows:
(i) The system of exchange control is not based on the sound comparative cost principle of international trade according to which every country tends to specialise in the production and export of that commodity in which it enjoys comparative natural advantage. Thus, the advantages of international specialisation are sacrificed under the system of exchange control. Economic resources are not optimally utilised.
(ii) Exchange control leads to the reduction in the volume of international trade and contraction of world’s welfare.
(iii) Exchange control encourages bilateral trade and deprives the country from the gains of multilateral trade.
(iv) Exchange control is an arbitrary system. It encourages retaliation and restrictive tendencies.
(v) Exchange control interferes in the competitive working of the economy and distorts its economic structure by diverting the resources in less economical and less efficient areas of production which do not represent maximum natural advantage.
(vi) Exchange control has undesirable effects on the internal economy of the country. Restrictions on imports may lead to inflationary rise in prices due to scarcity of restricted goods.
(vii) Exchange control provides only a temporary remedy to the problem of disequilibrium in the balance of payments. Instead of basically solving the problem, it prevents the situation from becoming worse.
(viii) Exchange controls involve- (a) large administrative costs to enforce the exchange controls; (b) resource waste in the process of trying to evade the controls or of applying for foreign exchange licenses; and (c) psychological costs of the inevitable perceived injustices created by the controls or their evasion.
(ix) Exchange control system is also morally undesirable because it breeds corruption in the country. Needy traders use all types of illegal methods to obtain the desired amount of foreign exchange which has been rationed by the government.
(x) Exchange control system involves great social costs and does not lead to the maximisation of community’s welfare.
In terms of welfare economics, exchange controls involve large social costs. They impose welfare losses on society by hampering private transactions. Social costs of exchange control can be graphically represented with the help of Figure 2.
If Figure 2, D£ is the demand for pound (or supply or dollar) curve and S£ is the supply of pound (or demand for dollar) curve. OR dollars per pound represent the equilibrium market rate of exchange in the absence of exchange control. OM is the amount of pounds demanded and supplied at the market rate.
Suppose the U.S. government imposes exchange control and fixes the exchange rate of pound at a lower rate (or exchange rate of dollar at a higher rate) at OR1. All exporters are required to surrender all their foreign exchange earnings (i.e., pounds) to the U.S. government and the U.S. government gives them OR1 dollars per pound.
OR1 exchange rate indicates an excess of demand for pound over its supply (or excess of supply of dollars over their demand) by AB amount and the U.S. Government must make available R1B amount of pounds to their buyers to meet the excess demand at OR1 rate. But, the U.S. government which is committed to OR1 rate, instead of increasing the supply of pounds, decides to ration foreign exchange at OM2 level.
Now with this restriction of the availability of foreign exchange at OM2 level, some mutually profitable bargains are prohibited. At M2 level of pound availability, point C on the demand curve shows that there are certain U.S. importers who are willing to pay upto OR2 dollars for a pound and point A shows that there are certain U.S. exporters who are willing to get OR1 dollars for a pound.
Yet the exchange controls prevent these two groups from getting together to realise the net gain of OR2-OR1 = R1 R2 or AC dollars per pound. Thus, AC represents the social loss from not being able to trade freely. Similarly, each extra vertical gap between the demand curve and the supply curve upto point E also adds to the social loss. Thus, total social loss in this case will be ACE.