Methods of Exchange Controls | International Economics

The methods of exchange control may be classified broadly into two groups: 1. Direct Methods 2. Indirect Methods.

1. Direct Methods:

The direct methods of exchange control are adopted by the central bank with the object of restricting the use and the quantity of foreign exchange. These include intervention, exchange restriction, exchange clearing agreements and payments agreements.

They are briefly described as under:

(i) Intervention:

The central bank or government of a country may intervene in the foreign exchange market with a view to raise or lower the exchange value of home currency relative to foreign currency through the sale or purchase of the former. It is termed as pegging. The sale of home currency in the foreign exchange market is made to peg the rate of exchange at a lower than the free market rate of exchange. The buying of the home currency, on the other hand, permits the pegging of rate of exchange at a level higher than the free market rate.

It means the central banking or government intervention in the foreign exchange market through sale of home currency takes place, when the excess demand for the home currency is likely to cause its significant appreciation. In the event of excess demand pressures for the foreign currency, when the depreciation of home currency is likely to occur, the intervention will take the form of purchase of home currency in the foreign exchange market. So intervention can ensure stability of exchange rate at the officially fixed level.

As regards the effectiveness of intervention, it has certain limitations. Firstly, the intervention through the sale of foreign currency can be successful only, if a country has sufficiently large reserves of foreign currencies.

Secondly, it is easier for a country to sell the home currency and buy the excess amount of foreign exchange through the use of home currency. It is greatly constrained in the sale of foreign currency.

Thirdly, the intervention in the foreign exchange market or the pegging operations should be employed as a temporary expedient and cannot be a permanent remedy of exchange instability. In this context, Crowther said, “But it is nevertheless an expensive and hazardous proceeding for any country that adopts it more than a temporary expedient. We may conclude that intervention is temporarily, rather than permanently, possible.”

(ii) Exchange Restrictions:

The exchange restriction is a more severe form of exchange control. The exchange restrictions include such policies or measures as are directed to restrict or reduce compulsorily the flow of domestic currency in the foreign exchange market.

The policy of exchange restriction, according to G. Crowther, is a compulsory reduction by the government of the supply of its currency into the market. The essence of this type of control is the acquisition by the government or the central bank of all foreign exchange earnings and receipts and their exchange for domestic currency.

The importers and other categories of people can purchase foreign exchange only from the government or central banking authorities.

The exchange restrictions assume following inter-linked forms:

(A) Compulsory surrender of all foreign exchange earnings or receipts to the central bank or government;

(B) Prevention of the exchange of local currency with foreign currencies without prior permission of government or central bank;

(C) Prescription of all foreign exchange transactions through the central agency;

(D) Enactment of laws providing for punishment in the event of non-­compliance of foreign exchange regulations.

The prominent variants of exchange restrictions are as follows:

(a) Blocked Accounts:

Under the system of blocked accounts, the central bank of an importing country maintains the foreign exchange accounts of the foreign exporters. The central bank does not permit the creditors to use their currency holdings in their accounts for a specified period.

That is why these accounts are referred as blocked accounts. The balances held in these accounts, no doubt, can be utilised by the creditors in the country where the accounts are blocked. This provides some time during which a debtor or deficit country can adopt appropriate corrective actions.

Germany adopted this practice in 1931. England resorted to it during 1939-45 period when large sterling balances, payable to India, got accumulated on account of large scale imports of goods from the latter during war period. The payment remained blocked till the termination of war. Only after 1945, the payments were released in installments at the convenience of England. The system of blocked accounts has certain drawbacks.

Firstly, this exchange restriction is clearly unethical and illegal.

Secondly, it leads to corruption and black marketing in foreign exchange.

Thirdly, it hinders the international flow of goods and services and adversely affects the welfare of the peoples of the concerned countries.

Fourthly, it can have serious strains on political relations between the creditor and debtor countries and hamper international economic co-operation.

(b) Multiple Exchange Rates:

Under this system, a country has an elaborate structure of exchange rates applicable to different categories of imports, exports and capital transfers. Low exchange rates are maintained in the case of exportable goods for stimulating their export. In case of imports, low exchange rates are established in the case of necessaries but prohibitive (or high) exchange rates are set in the case of luxury goods or harmful products.

(c) Allocation of Exchange According to Priorities:

The exchange restrictions may be practiced by the central bank of a country, when the foreign exchange is allocated for the import of different categories of goods and for other purposes according to a specific order of priorities. For instance, the import of essential items like food, raw materials, intermediate products, defence materials, machinery, and technology may be accorded a higher priority compared with luxury imports. This method of exchange restriction remained in use in England and several others advanced as well as LDC’s. There are certain pitfalls in this method.

Firstly, the priorities are often laid down by the government or central banking officials in an arbitrary way.

Secondly, the procedures related to the processing and sanctioning of applications for the grant of foreign exchange are quite time-consuming.

Thirdly, this method involves high administrative cost.

Fourthly, this method is often iniquitous as a large proportion of exchange allocations are cornered by large import houses.

(iii) Exchange Clearing Agreements:

In this system of exchange control, two or more trading countries establish accounts in their respective countries. The importers of a given country make payments into that central account in the domestic currencies. These amounts are paid out to the exporters for the goods exported by them to each country. The claims and counter-claims upon foreign exchange related to different countries are adjusted through appropriate book entries.

Any surplus or deficit after the clearing operations is settled either in terms of gold or a convertible currency acceptable to the trading partners. This method greatly simplifies the payment mechanism. This method is expedient for those countries which do not have sufficient foreign exchange reserves.

The device of exchange clearing agreement was extensively used by many a country during the 1930’s. Germany, for instance, entered into clearing agreements in early 1930’s with such countries as Sweden, Switzerland, Egypt and Balkan countries.

After Second World War, the sterling area constituted by England and Commonwealth countries essentially represented a multi-lateral payments agreement. Another prominent example of multilateral arrangement was the European Payments Union (EPU) that existed between 1950 and 1958. Every clearing agreement has a tendency to restore the BOP equilibrium in an automatic way.

This method of exchange control has certain drawbacks. Firstly, the settlement of receipts and payments on account of international trade is made on the basis of some pre-existing exchange rate. The economically stronger countries, having superior bargaining power enforce a rate of exchange which is usually disadvantageous for an economically weaker country. Thus the clearing agreements involve the exploitation of the latter.

Secondly, the necessity of depositing the foreign exchange receipts from exports in the central bank account may tend to divert the trade from normal to abnormal channels.

Thirdly, the exporters may indulge in under-valuation of exports and accept payments from foreign importers in their currency directly from them or they may retain unaccounted accounts in foreign countries.

Fourthly, the exchange clearing agreements tend to make settlement without the transfer of foreign currencies. As there are no free flows of foreign currencies, these agreements are likely to do away with the foreign exchange market.

Fifthly, the clearing agreements are also likely to have discouraging effect upon the volume of international trade.

Sixthly, in the clearing agreements, it is not necessary that the volumes of exports and imports are in balance. In order to balance the two, the central banks supply their own currency at a fixed exchange rate to the other country upto a specified limit. This is called as a swing. The size of the ‘swing’ can have serious adverse effect upon trade between two or more countries. A very large ‘swing’ may be clearly wasteful.

On the opposite, if the ‘swing’ is too small, the limit may be reached soon and the country, faced with the prospect of losing gold, may impose physical tariff or non-tariff barriers upon trade. Thus there can be a possibility of trade coming to naught.

Finally, if a country has an excess of exports over imports, more money will flow out to exporters than what is deposited by importers in the clearing account. That is likely to have an inflationary impact upon the domestic economy. In the opposite case of excess of imports over exports, there is a net reduction in money supply. As a consequence, the economy is likely to face the deflationary conditions.

(iv) Payments Agreements:

The payments agreement between two countries is a more comprehensive type of exchange control than the exchange clearing agreements. It covers not only the payments on account of export and import of commodities but also the payments due to different types of services such as shipping, banking, insurance and items like debt servicing and tourism. It provides a mechanism for the repayment of external debts.

A part of the payments for imports by the creditor country is retained in the clearing account for repayment of debts and the remaining amount is paid out to the exporters of the debtor country. The creditor country normally does not impose any restriction upon the imports from the debtor country but the latter can impose restrictions upon the imports from the former so that it should repay its external obligations through enlarging its exports.

In 1947, Britain entered into payment agreements with India, Argentina, Brazil, Ceylon, Egypt and some other countries that were holding sterling balances over the years of Second World War. These agreements provided for the maintenance of two sterling accounts in favour of these countries in England. In the first account, the sterling balances could be withdrawn by the creditor countries for the current use.

The second account was a blocked sterling account. The provision in payments agreement was to permit the phased transfer of the sterling balances from the blocked account to the other to enable the creditor countries to make free use of them.

The payments agreements have certain shortcomings. Firstly, the terms of payments agreements generally favour the stronger or creditor countries. Secondly, the payments agreements can be operational for two trading countries. Such agreements cannot be possible on a multilateral basis unless there is intermediation of the international economic institutions. Thirdly, the payment agreements provide for the use of balances in the debtor country on the purchase of specified goods and services only from the debtor country.

Fourthly, no doubt the payment agreements provide some relief to the weak and developing countries through making provision for increased exports for making debt payments, yet the debt burden is extended over a longer period. There is the possibility of an increase in debt servicing. It is likely that the balance of payments position of the debtor country remains unfavorable for a long period.

2. Indirect Methods:

Apart from the direct methods of exchange control, countries sometimes resort to indirect methods which are as follows:

(i) Tarrif and Non-Tarrif Restrictions:

The countries can resort to tariffs, import quotas and other quantitative restrictions. These measures reduce the volume of imports and the demand for foreign currencies gets reduced. That brings about an improvement in the balance of payments situation. The quantitative restrictions on imports result in appreciation of home currency relative to the foreign currency.

(ii) Export Subsidies:

When the government follows the policy of subsidizing exports, the home exporters are induced to enlarge exports. This measure, on the one hand, can bring about an improvement in the BOP deficit and, on the other, can raise the external value of home currency.

(iii) Increase in Interest Rates:

The increase in the structure of interest rates in the home country leads to an inflow of capital from abroad and the prevention of capital outflow. These changes effect improvement in the BOP situation in addition to making the foreign exchange rate more favourable.

There is, however, a severe constraint in the form of possible adverse effect of higher rates of interest upon the home investments that dissuades the monetary authority from resorting to this measure beyond a specified limit. In addition, the increase in the structure of interest rate by the foreign countries can neutralise such a policy.

In evaluating the indirect exchange controls, G. Crowther comments, “These methods of indirect exchange control, therefore, though they are by no means negligible, are not merely strong or precise enough instruments for a government that aspires to bring the exchange rates under close control.” In order to make the system of exchange control fully effective and capable of achieving its different objectives, it is essential that there is a proper integration of direct and indirect methods of exchange control.