Foreign exchange controls are various forms of controls imposed by a government on the purchase/sale of foreign currencies by residents or on the purchase/sale of local currency by non-residents. The various forms that exchange control has taken are briefly discussed below:
1. Exchange Pegging
This device is usually adopted during war in order to minimize exchange fluctuations. The internal value of a currency may depreciate due to inflation but the government may seek to keep its external value at a higher level than warranted by the purchasing power parity in order to facilitate international transactions.
England during First World War and again in the Second World War adopted the method. Between 1916 and 1919, the Sterling was kept artificially pegged at 4.765 dollars — a value which was higher than the real value of the Sterling. This was done by raising loans in America and through these funds, purchasing exchange in London at the above rate. Success in exchange pegging evidently depends on the resources at the command of the nation. Exchange pegging can iron out more or less sporadic and adventitious fluctuations and cannot avoid fundamental changes in the equilibrium rates of exchange.
2. Exchange Equalization Account
Exchange funds were the outgrowth of the transformation of the international gold standard convention into an international gold settlement system under which gold came to be used as a balancing item in international trade.
After the suspension of the gold standard exchange rate system in 1913 by England, there again arose the necessity of preventing violent exchange fluctuations. For this purpose, the device of the Exchange Equalisation Account (or Exchange Stabilisation Fund) was utilised. An Exchange Stabilisation Fund is a collection of assets segregated under a central control for the purpose of intervention in the exchange market to prevent undesirable fluctuations in exchange rate. Foreign currency was purchased or sold, as the necessity arose, with the help of this fund, and thus exchange was kept within a narrow range in the face of uncertain movements of short-term funds into and out of England. The Fund is not used to prevent long-term adjustments in the value of the currency concerned.
The purposes for which Exchange Stabilisation Funds have been used have differed in different countries and in the same country at different stages. The aim of the British Exchange Equalisation Account was that the Account was designed, without resisting general trends, to iron out undue fluctuations in the exchanges caused by erratic movements of capital and the disturbing activities of the speculators. Gradually, the object of the fund was extended, and it was used to combat seasonal exchange fluctuations. The major purpose of other Exchange funds was to establish and define appropriate exchange levels, i.e., to resist general trends in the exchange rates.
In a general way, we can say that the main purposes of such Funds are: (i) to iron out short-term fluctuations in the rates of exchange, and (ii) to safeguard against the disturbing influences arising out of the movements of short-term funds and of speculative activities.
Continually, fluctuating exchanges seriously hamper trade. The Fund is, therefore, meant to facilitate the smooth course of foreign trade. By similar devices the dollar-sterling rate was maintained at £ 1 = 4.03 dollars during World War II.
Other Exchange Control Devices
Strictly speaking, the term exchange control is applied to several devices most of which were first introduced in Germany during the Nazi regime. Later, other countries also adopted some of them. Such devices are: (a) Clearing Agreements. (b) Standstill Agreements, (c) Transfer Moratoria, and (d) Blocked Accounts.
- Clearing Agreements: Under a clearing agreement between two countries, importers in both countries pay into an account at their respective central banks the purchase price of the goods imported. This money is then used to pay off exporters. The rate between the currencies is usually fixed by the terms of agreement. The object is to regulate imports according to the wishes of the government, to ensure equilibrium in the balance of payments and to prevent uncertainties of fluctuating exchanges. The system tends to encourage bilateral trade at the expense of multilateral trade and thus has a restrictive effect on international trade. On the other hand, it discourages dumping and currency depreciation. On the whole, the system stands condemned except under special circumstances of a war or as a temporary measure to tide over a period of disequilibrium in a country‘s balance of payments until the basic causes of such a disequilibrium have been removed.
- Standstill agreement: A standstill agreement is a device to prevent the movement of capital through a moratorium on outstanding short-term foreign debts of a country and to give her time to put her house in order. Either the short-term debt is converted into long-term debt or provision is made for its gradual repayment. This device was used in Germany after the crisis of 1931.
- Transfer moratoria: It is another device of the same kind. Under this system, importers or others pay their foreign debts in their domestic currency to a specified authority. When the moratorium is concluded these funds are remitted abroad. A foreign creditor is sometimes allowed to use his funds in the country imposing the moratorium in a way specified by the government.
- Blocked accounts: This spring from the previously considered two devices of standstill agreement and transfer moratoria. When foreign debts paid in domestic currency to the central bank cannot be remitted abroad without the permission of the government, blocked accounts are said to arise. Since idle funds in the country lead to contraction of credit, the foreign creditors are not altogether prevented from using them. But they have to be used in manner prescribed by the government. Usually, they are allowed to be sold in the open market. In most cases, they are sold at a heavy discount.