Exchange Control

Exchange control is a governmental restriction on private transactions in foreign exchange. These systems serve as a primary means of preventing or redressing an unfavorable payment residue by minimizing foreign exchange purchases to an amount that is not more than foreign exchange receipts.

Controls in exchanges are essential to managing shortages of freely convertible foreign currency. Through these measures, governments hope to correct negative balances of payments. The government achieves it by imposing restrictions on the free flow of capital in and out of the country and on currency exchange rates.

• Exchange control refers to actions directly regulating or affecting the influx and outflow of capital across national borders. These regulate exchanges and limit the buying and selling of foreign money.
• It is used to allocate available foreign currency to suit the country's interests as a whole and to control local demand for foreign currency to safeguard the nation's foreign exchange reserves.
• Preserving capital, protecting domestic industries, and maintaining the rate of exchange and balance of payments are some of the objectives of placing these control measures.

Exchange control refers to actions directly regulating or affecting the influx and outflow of capital across national borders. These control regulations on exchanges restrict the buying and selling of foreign money. Most exchange control systems serve as a primary means of preventing or redressing an unfavorable balance of payments.

Countries use these capital restrictions to try to control the exchange rates of their native currencies on global markets. The limitations may restrict residents' ability to purchase foreign currencies and nonresidents' ability to buy or sell local money.

The link between capital and exchange control and trade is the key to the smooth functioning of the international economic and financial system. They represent a noticeable barrier to trade. However, their impact on international trade depends upon the controls' structure, interactions, and effectiveness concerning other economic distortions.

Controlling exchange is a tax on foreign currency necessary to purchase goods and services. These controls raise the domestic price of imports. And the price rise hurts the trade. It also influences trade through a variety of channels. These include the cost of transactions, exchange rates, foreign exchange risk hedging, and financing trade.

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.

A regulated exchange rate is typically 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.

Some of the main objectives of foreign exchange control measures are as follows:

#1 - Balance of Payments (BOP)

Negative balances of payments can pull down the economic growth of a nation. Depending on the circumstances, countries may restrict or remove import restrictions. Specific exchange control authority may also devalue its currencies to increase exports and bring about a steady BOP by the exchange control act or other regulations.

#2 - Protection of domestic industries

Curbs on the exchange can induce domestic industries to produce and export more, and governments can thus protect domestic trade from international competition.

#3 - Rate of exchange

The government resorts to exchange control regulations to bring the exchange rate to the desired level. The countries can sell their currency from the separate account maintained for the same purpose, such as the exchange equalization fund, in the open market to reduce the currency rate. Thus, by increasing or decreasing supply, governments can overvalue or undervalue their currency depending on the situation.

#4 - Preserve capital

Governments impose exchange control regulations to prevent capital from flowing out of the country and may limit exports.

These regulations can also help the government earn revenue through the difference in buying and selling rates, stabilize the exchange rate, and even pay off foreign liabilities. In addition, control measures aim to promote exchange stability by reducing exchange rates and volatility caused by currency transfers across borders.

Applying foreign exchange regulations can frequently obstruct international investors who want to transfer their money to other nations. In an ideal scenario, these measures would be helpful to stop the capital flight from a nation with a weaker currency. However, a country's exchange control act or other regulations make decisions on the above matters, which in turn decide the degree of impact.

Some of the standard foreign exchange control measures are:

#1 - 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.

#2 - 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.

#3 - 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.

#4 - 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.

#5 - 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.

One of the historical examples related to foreign exchange control can be seen when Britain abolished controls on foreign currency back in the 1980s. In 1979, Britain could buy and use the foreign currency without restriction. The regulations were placed in 1939, in the wake of World War II, to prevent a panic outflow of capital. The changing times and the strength of the sterling as a strong currency were the primary reasons for regulation rollback. 

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.

This article has been a guide to what is Exchange Control. Here, we explain its objectives, methods, example, advantages, and disadvantages. You may also find some useful articles here -

• Currency Board
• Foreign Exchange Risks
• Fixed Exchange Rate