Methods of Exchange Control

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.

The various methods of exchange control may be broadly classified into (1) Unilateral methods and (2) Bilateral/multilateral methods.

Unilateral Methods

Unilateral measures refer to those methods which may be adopted by a country unilaterally i.e., without any reference to or understanding with other countries. The important unilateral methods are outlined below.

  1. Regulation of Bank Rate: A change in the bank rate is usually followed by changes in all other rates of interest and this may affect the flow of foreign capital. For example, when the internal rates of interest rise, foreign capital is attracted to the country. This causes an increase in the supply of foreign currency and the demand for domestic currency in the  foreign exchange market and results in the appreciation of the external value of the currency. A lowering of the bank rate is expected to produce the opposite results.
  2. Regulation of Foreign Trade: The rate of exchange may be controlled by regulating the foreign trade of the country. For example, by encouraging exports and discouraging imports, a country can increase the demand for, in relation to supply, its currency in the foreign exchange market and thus bring about an increase in the rate of exchange of the country’s currency.
  3. Rationing of Foreign Exchange: By rationing the limited foreign exchange resources, a country may restrict the influence of the free play of market forces of demand and supply and thus maintain the exchange rate at a higher level.
  4. Exchange Pegging: Exchange pegging refers to the policy of the government of fixing the exchange rate arbitrarily either below or above the normal market rate. Pegging operations take the form of buying and selling of the local currency by the central bank of a country in exchange for the foreign currency in the foreign exchange market, in order to maintain an exchange rate whether, it is overvalued or undervalued. Thus, pegging may be pegging up or pegging down. Pegging up means holding fixed overvaluation, i.e., to maintain the exchange rate at a higher level. Pegging down means holding fixed undervaluation, i.e., to maintain the exchange rate at a lower (depressed) level. In the case of pegging up, the central bank shall have to keep itself ready to buy unlimited amount of local currency in exchange for foreign currencies at a fixed rate, because overvaluation tends to increase the demand for foreign currencies by creating import surplus. In the case of pegging down, the central bank or central agency shall have to keep itself ready to sell any amount to local currency by creating export surplus. Similarly, pegging up involves holding of sufficient amount of foreign currencies while pegging down involves holding of sufficient amount of local currency by the central bank. It goes without saying that pegging up, is more difficult to maintain as it requires huge amounts of foreign currencies which is difficult to obtain. As such pegging up can be adopted only as a temporary expedient. It should be noted that intervention by a government in the foreign exchange market has the effect of neutralizing the forces of demand and supply of foreign exchange. However, it is generally assumed that government intervention or pegging up and pegging down operations should be used as temporary expedients to remove fluctuations in the exchange rate.
  5. Multiple Exchange Rate: Multiple exchange rates refer to the system of the fixing, by a country, of the different rates of exchange for the trade or different commodities and/or for transactions with different countries. The main object of the system is to maximize the foreign exchange earning of country by increasing exports and reducing imports. The entire structure of the exchange rate is devised in a manner that makes imports cheaper and exports more expensive. The multiple exchange rate system has been severely condemned by the IMF.
  6. Exchange Equalization Fund: 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.
  7. Blocked Accounts:  Blocked accounts refer to bank deposits, securities and other assets held by foreigners in a country which denies them conversion of these into their home currency. Blocked accounts, thus, cannot be converted into the creditor country’s currency. Under the blocked accounts scheme, all those who have to make payments to any foreign country will have to make them not to the foreign creditor directly but to the central bank of the country which will keep the amount in the name of the foreign creditor. This amount will not be available to the foreigners in their own currency, but can be used by them for purchase in the controlling country.

Bilateral/Multilateral Methods

The important bilateral/multilateral methods are the following:

  1. Private Compensation Agreement: Under this method, which closely resembles barter, a firm in one country is required to equalize its exports to the other country with its imports from that country so that there will be neither a surplus nor a deficit.
  2. Clearing Agreement: Normally, importers have to make payments in foreign currency and while exporters are paid in foreign currency. Under the clearing agreement, however, importers make payments in domestic currency to the clearing account and exporters obtain payments in domestic currency from the clearing fund. Thus, under the clearing agreement, the importer does not directly pay the exporter and hence, the need fore foreign exchange does not arise, except for settling the net. balance between the two countries.
  3. Standstill Agreement: The standstill agreement seeks to provide debtor country some time to adjust their position by preventing the movement of capital out 01 the county through a moratorium on the outstanding short-term foreign debts
  4. Payments Agreement: Under the payments agreement, concluded between a debtor country and a creditor country, provision is made for the repayment of the principal and interest by the debtor country to the creditor country. The creditor country refrains from imposing restrictions on the imports from the debtor country in order to enable the debtor to increase its exports to the creditor. On the other hand, the debtor country takes necessary measures to encourage exports to and discourage imports from the creditor country.

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