Use of Exchange Controls to Eliminate a Nation’s Balance of Payments (BoP) Deficit

The exchange control refers to a set of restrictions imposed on the international transactions and payments, by the government or the exchange control authority. Exchange control may be partial, confined to only few kinds of transactions or payments, or total covering all kinds of international transactions depending on the requirement of the country.

The main features of a full-fledged exchange control system are as follows:

  • The government acquires, through the legislative measures, a complete domination over the foreign exchange transactions.
  • The government monopolizes the purchase and sale of foreign exchange.
  • Law eliminates the sale and purchase of foreign exchange by the resident individuals. Even holding foreign exchange without informing the exchange control authority’s declared illegal.
  • All payments to the foreigners and receipts from them are routed through the exchange control authority or the authorized agents.
  • Foreign exchange payments arc restricted, generally, to the import of essential goods and service such as food items, raw materials and some other essential industrial inputs like petroleum products.
  • A system of rationing is adopted in the foreign exchange allocation for essential imports.
  • To ensure the effectiveness of the exchange control system and to prevent the possible evasion, strict, stringent laws arc enacted.
  • The circuitous legal procedure of acquiring import and export licences is brought in force. In the process, the convertibility of the home currency is sacrificed.

Why Exchange Control?

The exchange control system as a measure of adjusting adverse balance of payments. In contrast to the self-sustained and automatic functioning of the market system, the exchange control requires a cumbersome bureaucratic system of checks and controls. Yet, many countries facing balance of payment deficits opt for exchange control for lack of options. In fact, automatic adjustment in the balance of payments requires the existence of’ the following conditions.

  • International competitive strength of the deficit countries.
  • A fairly high elasticity of demand for imports.
  • Perfectly competitive international market mechanism.
  • Absence of government intervention with the demand and supply conditions.

The existence of these conditions has always been doubted. Owing to differences in resource endowments technology, and the level of industrial growth, countries differ in their economic strength and their industries lack the competitiveness. The protectionist policies adopted by various countries intervene with international market mechanism. Besides, automatic method of balance of payments adjustment requires a strict discipline, economic strength and political will to bear the destabilizing shocks which the automatic method is expected to bring to a country in the process of adjustment. Since these conditions rarely exist, the efficacy of international market mechanism to bring automatic balance of payments adjustment is often doubted.

For these reasons, exchange control remains the last resort for the countries under severe strain of balance or payments deficits. The exchange controls aid to possess a superior effectiveness in providing solutions to the deficit problem. Besides, it insulates an economy against the impact of economic distresses from foreign countries. Another positive advantage or exchange control lies in its effectiveness in dealing with the problem or capital movements. The governments monopoly over the foreign exchange can effectively stop or reduce the capital movements by simply refusing to release foreign exchange for capital transfer. Many countries adopted exchange control during 1930s great depression because of this advantage. Although the exchange control is positively a superior method of dealing with disequilibrium in the balance of payments, it docs not provide a permanent solution to the basic causes of deficit problem.

Issues with Exchange Control

Exchange control may no doubt provide solution to balance of payment deficits, but it also creates following problems:

  • When restrictions on exchange control becomes wide spread then large number of currencies are rendered nonconvertible.  This restricts foreign trade and the gains from foreign trade are either lost or reduced to a minimum.
  • Even after the interest of an economy is secured, i.e., external deficit is recovered and insulation of economy against external influence is complete; the exchange-control countries instead of giving up exchange control, feel it to gear their internal polices,  monetary and fiscal, towards the promotion of economic growth, achieving full employment and its maintenance. In doing so, they adopt easy monetary and promotional fiscal policies. Consequently, income and prices tend to rise, and inflationary trend is set in the economy.
  • Price also tends to rise, since in an insulted economy, import-competing industries are not under compulsion to check cost increases and to improve efficiency. As a result, exports become relatively costlier and imports relatively cheaper and hence, exports tend to shrink and imports tend to expand. These are the first outcome of overvaluation of home-currency. The balance of payments is no doubt maintained in equilibrium, but the initial advantage gradually disappears.

The countries confronted with the problems arising out of exchange control are forced to find new outlets for their exports and new sources of imports. The efforts in this direction give rise to bilateral trade agreements between the countries having common interest. The basic feature of the bilateral trade agreements is to accept each other’s nonconvertible currency for exports and use the same for imports. Under the trade agreements, the commodities and their quantities or values should also be specified. Another outcome of exchange control leading to bilateral trade agreement is the emergence of disorderly cross exchange rates, i.e., the multiplicity of inconsistent exchange rates. In other words, the currencies have different exchange rates between them.

Nonconvertible currency has different exchange relation with the countries . The bilateral trade agreement therefore, exchange rates are not consistent with each other. The multiplicity of inconsistent exchange rates came inevitable when countries having trade surplus and deficits fix up official rates from time to time depending upon their requirements, maintain it through arbitrary rules. Exchange rates become multiple also because ‘exchange arbitrage‘, i.e., the simultaneous purchase and sale of exchange in different markets, becomes impossible.

Under the multiple exchange rate system, there may be a dual exchange rate policy. In dual exchange rate policy, there is an official rate for permissible private transactions and official transactions and a market rate for all other kinds of transactions. However, the multiple exchange rate system has its own shortcomings . The system adds complexity and uncertainty to international transactions. Besides, it requires efficient and honest administrative machinery in the absence of which it often leads to inefficient use of resources. It is, therefore, desirable for the deficit countries to first evaluate the consequences efficiently and practicability of exchange control and then decide on the course of action. It has been suggested that exchange control, if adopted, should be moderate and as temporary measure until the basic solution to the problems of balance of payments deficit is obtained  The exchange control problem does not provide permanent solution to the balance of payments deficit and therefore, it should be adopted only with proper understanding.

Credit: International Economics-CU

Bookmark the permalink.