Exchange Control

Government-imposed controls on restrictions on private transactions conducted in foreign currency

What is Exchange Control?

Exchange controls are government-imposed controls on 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 exchange control authorities, typically the central bank.

 

Exchange Control

 

Understanding Exchange Controls

The foreign exchange pool is rationed to cater for “essential” or priority payments abroad. It involves controlling the trading of foreign currency and transfers across national borders. The government will determine how foreign exchange earned by individuals and businesses is spent. It will be mandatory for all earned foreign exchange to be sold at the central bank at a predetermined rate.

Limits on foreign currency amount that individuals and businesses can purchase from the central bank will also be put in place. Exchange control is also used to restrict non-essential imports, encourage the importation of priority goods, control the outflow of capital, and manage the country’s exchange rate. Generally, countries use foreign exchange control to manage the value of the local currency.

It’s not every nation that can legitimately introduce exchange control measures. According to the articles of agreement by the International Monetary Fund (IMF), only countries with transitional economies can apply exchange controls. Several western nations employed exchange control measures soon after World War II but gradually phased them out before the 1980s as their economies strengthened overtime.

The phasing out of exchange controls was also necessitated by trends towards globalization, free trade, and economic liberalization in the 1990s, which does not co-exist with the application of exchange controls. Presently, exchange controls are mostly utilized by developing countries with weak economies, low exports, are import-dependent, and with low foreign currency reserves.

 

Countries with History of Exchange Controls

  • United Kingdom – until 1979
  • South Korea – 1985 to 1989
  • Egypt – until 1995
  • Argentina – 2011 to 2015; and
  • Fiji, Mexico, Peru, Finland, Chile, Zimbabwe, among others

 

Factors that Lead Governments to Impose Exchange Controls

The justification and motivation for the imposition of foreign exchange controls vary from country to country and their respective economic situations. Below are some of the justifications:

  • Capital flight at unprecedented levels, mainly due to speculative pressure on the local currency, fear, and extremely low confidence levels.
  • A marked decline in exports resulting in a BOP deficit
  • Adverse shifts in terms of trade
  • War/conflict budgeting. The BOP may be in disequilibrium due to war, drought, etc.
  • Economic development and reconstruction

 

Objectives of Foreign Exchange Control

 

1. 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.

 

2. 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.

 

3. 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.

 

4. 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.

 

5. 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.

 

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.

 

Conclusion

There are various exchange control methods at the government’s disposal, including a mixture of direct and indirect methods. Each method comes with its own advantages and drawbacks.

Governments can use various forms of exchange control strategies, but they must carefully consider each one and its effectiveness, given its economic and political landscape. However, the IMF encourages the removal of exchange controls as they usually discourage international trade, inhibit the expansion of world trade, and distort the functioning of an efficient global trade market.

 

Related Readings

CFI offers the Certified Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:

  • Balance of Trade (BOT)
  • Capital Flows
  • Exchange Rate
  • International Trade

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