Exchange control is one of the important means of achieving certain national objectives like an improvement in the balance of payments position, restriction of inessential imports and conspicuous consumption, facilitation of import of priority items, control of outflow of capital and maintenance of the external value of the currency. Under the exchange control, the whole foreign exchange resources of the nation, including those currently occurring to it, are usually brought directly under the control of the exchange control authority (the Central Bank, treasury or a specially constituted agency). Dealings and transactions in foreign exchange are regulated by the exchange control authority. Exporters have to surrender the foreign exchange earnings in exchange for home currency and the permission of the exchange control authority have to be obtained for making payments in foreign exchange. It is generally necessary to implement the overall regulations with a host of detailed provisions designed to eliminate evasion. The allocation of foreign exchange is made by the exchange control authority, on the basis of national priorities
There are three possible courses that a country adopting exchange control may like to pursue, considering the economic situation in which it may find itself;
- It may like to under-value or depreciate currency; or
- it may decide on over-valuation; or
- it may decide to avoid fluctuations and maintain a stable rate.
Let us consider when and with what consequences each of these courses of exchange control may be adopted;
1. Under-Valuation
Under valuation is advocated for curing depression. When a country decides on under-valuation or depreciation, i.e., fixing a rate lower than it would be in a free exchange market, exports are stimulated and imports are discouraged. It will give stimulus to export industries and domestic industries will also benefit because imports have been discouraged. Thus, under-valuation will increase economic activity in the country, add to the total output (GNP) and will create more employment.
But this object may not be fulfilled. Instead of internal prices rising, the external prices may fall. This would happen in the case of a big country like India and the U.S.A. Also, since prices are affected through exports and imports, the desired objective of modifying the price level is more likely to be achieved when foreign trade is extensive than when it forms only a small proportion of the aggregate trade of the country. The policy of under-valuation is more suitable for a country, whose exports consist of foodstuffs and raw materials, for during depression, prices of these goods are depressed to a greater extent. Since, however, under-valuation will make the imports dear, the purchasing power of the producers of raw materials and foodstuffs will be reduced. But it is considered more advantageous to prevent a fall in the prices of goods it has to sell than to prevent a rise in those, which it has to buy. During the Great Depression (1929-34), many countries adopted a policy of under-valuation and depreciated their currencies. In fact, there was regular competition in currency depreciation. Every country tried to cure its own depression. The Articles of the IMF now rule out competitive exchange depreciation. If depreciation has to come, it must come in an orderly fashion.
2. Over-Valuation
The second object of exchange control may be over-valuation or fixing the valuation of its currency at a level higher than it would be if there was no intervention in foreign exchange. This course is indicated in the following situations:
- When there is a serious imbalance in the country‘s trade relationship. As a consequence, the supply of national currency may far exceed the demand for it.
- The country may be in great need of foreign goods either for prosecution of a war or for reconstruction after the war or for economic development. If exchange rate were permitted to fall in these circumstances, it would make these much needed imports very costly, or almost prohibitive. When a country finds itself under the sudden necessity of making large purchases from abroad, over-valuation is found to be most suitable.
- If a country is suffering from inflation, the exchange value of the national currency will go down when exchanges are left free to move. If foreign trade plays a very important part in the economy of the country, this downward trend must be arrested by overvaluing the domestic currency, otherwise imports will become very dear and the exporters will have windfall profits.
- A policy of over-valuation is also in the interest of a country which has to meet a large debt payments expressed in foreign currency. If the rate of exchange fell, the burden of foreign debt would correspondingly increase.
We cannot lay down dogmatically whether a country should under-value or over value. It all depends on circumstances. Over-valuation may suit certain countries and under-valuation certain others. The same country may find over-valuation more suitable at one stage and under-valuation at another. The rough rule-of-thumb, therefore, is in times of slump and surfeit, under-value your currency.
3. Avoid Fluctuations and Maintain a Stable Rate
The third course is neither to under-value nor to over-value but to avoid fluctuations. Even here the object is not to keep exchanges rigidly fixed but simply to avoid sudden and big changes. It is intended only to iron out temporary ups and downs and to keep off the adventitious influences. This was done by Exchange Equalization Account. The IMF is also intended to achieve the same objective.
The main object of the Exchange Equalization Fund, also known as the Exchange Stabilization Account, is to stabilize the exchange rate of the national currency through the sale and purchase of foreign currencies. When the demand for domestic currency exceeds its supply, the fund starts purchasing foreign currency with the help of its own resources. This results in an increase in the demand for foreign currency and increases the supply of the national currency. The tendency of the rate of exchange of the national currency. to rise can thus be checked. When the supply of the national currency exceeds demand and the exchange rate tends to fall, the Fund. sells the foreign currencies and this increases the supply of foreign currencies and arrests the tendency of the exchange rate of the domestic currency to fall. This sort of an operation may be resorted to eliminate short term fluctuations.