Foreign Exchange Control – Definition and Objectives

Exchange controls, like currency devaluations, form a part of expenditure-switching policy package. Because, they, too, like devaluation, aim at directing domestic spending away from foreign supplies and investment. Exchange controls try to divert domestic spending into consumption of domestically produced goods and services on the one hand and into domestic investment on the other.

Exchange controls represent the most drastic means of BOP adjustment. A full-fledged system of exchange controls establishes a complete government control over the foreign exchange market of the country. Foreign exchange earned from exports and other sources must be surrendered to the government authorities. The available supply of foreign exchange is then allocated among the various buyers (importers) according to the criterion of national needs and established priorities. From a purely BOP standpoint, the sole purpose of exchange controls, is to ration out the available supply of foreign exchange in accordance with national interests.

There are also a variety of milder forms of exchange control which merely limit certain sources of demand for foreign exchange; thereby they try to minimize their pressure on the BOP deficit. For example, a country may restrict foreign tourism or foreign study by the nationals of the country, in order to save foreign exchange. Similarly, domestic residents may restrict some of the capital transfers abroad, again to conserve scarce foreign exchange. Partial exchange controls such as these may be scrapped if a more basic improvement in the foreign exchange earnings has occurred. India at present gained confidence with bulging forex reserves  lifted several controls in recent times. The following section lists the most frequently used currency control measures. These controls are a major source of market imperfection, providing opportunities as well as risks for multinational corporations.

Typical Currency Control Measures

  • Restriction or prohibition of certain remittance categories such as dividends or royalties.
  • Ceilings on direct foreign investment outflows.
  • Controls on overseas portfolio investments.
  • Import restrictions.
  • Required surrender of hard-currency export receipts to central bank.
  • Limitations on prepayments for imports.
  • Requirements to deposit in interest-free accounts with central bank, for a specified time, some percentages of the value of imports and/or remittances.
  • Foreign borrowings restricted to a minimum or maximum maturity.
  • Ceilings on granting of credit to foreign firms.
  • Imposition of taxes and limitations on foreign-owned bank deposits.
  • Multiple exchange rates for buying and selling foreign currencies, depending on category of goods or services each transaction falls into.

Objectives of Exchange Control

The object of controlling exchange is to fix it at a level different from what it would be if the economic forces were permitted free interplay. The objectives of exchange control may be:-

  1. Conservation of Foreign ExchangeExchange control may be introduced by the monetary authority to conserve the gold, bullion, foreign exchange currencies, etc., i.e., foreign exchange resources, of the country. It may be necessary to ensure the availability of sufficient amount of foreign exchange needed to buy essential foreign goods.
  2. Check on Flight of Capital: Under the free exchange system there is the danger of huge outflow of capital which may weaken the country’s economy. Especially erratic shifting of capital tend to accentuate the disequilibrium in the balance of payments and it also adversely affects future growth of the country. Exchange control, however, offers a prompt and effective means to prevent such capital outflows.
  3. Correcting Disequilibrium in Balance of Payments: To correct the deficit in the balance of payments, the country needs to put a curb on imports. For this purpose, the use of Foreign exchange earnings by exporters for import of goods must be checked through appropriate exchange control. Again, exchange control is essential to implement an import policy very effectively. In short, exchange control may be introduced to protect the country’s balance of payments.
  4. Stabilization of Exchange Rates: In a free exchange market, exchange rate is a fluctuating phenomenon. Thus, exchange control may be adopted to maintain exchange rates at an arbitrarily chosen fixed point.
  5. Protecting the Interest of Home Producers: Exchange control may be used for giving protection to domestic producers by restricting the competition from foreign traders through import control.
  6. Redemption of External Debt: The Government may use the exchange control device to obtain foreign exchange needed for repaying or servicing of its foreign loans.
  7. Effective Economic Planning: For successful economic planning, foreign trade has to be coordinated with planned programmes and the outflow of capital should be restricted in order to make it available to domestic industries. Thus, for mitigating the economic repercussions of foreign trade endangering economic plans, exchange control becomes inevitable.
  8. Maintaining Over-value of Home Currency: Sometimes exchange control is used in order to maintain the external value of the country’s currency at an overvalued level. For this purpose, the available foreign exchange resources are rationed for use of specific and important purposes only and the government thereby, seeks to adjust total demand with total supply of foreign currencies.
  9. Generating Public Revenue: Under exchange control, by adopting multiple exchange rates system, the Government can yield revenue income through difference of average buying and selling rates, less costs of administration.
  10. To prevent Spread of Depression: Depression in a big country may spread from country to country via international economic relations. Exchange control may work as a preventive against such spread of depression by controlling the main doors – imports and exports.

In all these circumstances, a free exchange would be either embarrassing or prejudicial to the object in view, and exchange control becomes an imperative necessity.