Exchange Control Mechanisms

International Economics
Learning Objectives
♥ Exchange Control – Definition & Meaning.
♥ Objectives Exchange Control.
♥ Over Under Valuation of Currency.
♥ Methods Exchange Control
♥ Exchange Control – Merits & Demerits.

15.1 Introduction
♥ After abandonment of Gold Standard in

1930s, freely fluctuating exchange rates
prevailed for some years. The rates were
determined by market forces of demand &
supply for the currency.
♥ This would mean there were wide
fluctuations in rates harmful to the
international trade and national economy.
♥ Hence countries opted for exchange
controls to protect their national
economy.
15.2 Definition and Meaning of Exchange Control

‘State regulation to exclude the free play
of economic forces from foreign exchange
market’ is termed Exchange Control.
Comprehensive exchange control system
requires all exporters to surrender
foreign exchange earned by them to Central
Bank for conversion into domestic
currency. Similarly importers are required
to buy foreign currency from the bank to
pay for imports.
Central Bank uses the rate determined by the
Government for conversion.
15.2 Definition and Meaning of Exchange Control
As a result
▀ Importers have to apply in advance for

foreign currency, which will be released
based on government’s priority for
imports, availability of currency, balance
of payment position etc.
▀ The role of market forces of demand and

supply is ruled out.
15.3 Main Objectives of Exchange Control Policy
The objectives are not static and change

from time to time
▀ Avoid fluctuations in the exchange rates.

This permits smooth international trade.
▀ Correct disequilibrium in the balance of

payment by controlling imports,
encouraging exports and thus minimizing
deficits.
▀ Protect domestic industries from foreign

competition by imposing import
restrictions.
▀ Check imports of nonessential & luxury

items.
▀ Facilitate economic planning process by

optimum utilization of scarce exchange
earned through exports for investment in
priority sectors.
▀ Handle problem of foreign debt repayment

in such a way that developing country’s
credit worthiness is maintained.
▀ Prevent flight of domestic capital to

greener pastures overseas.
▀ Arrange retaliation against arbitrary

impositions of foreign countries on one
hand and obtain concessions in terms of
trade from them.
15.4 Policy of Overvaluation of National Currency.
Through exchange control countries

sometimes keep the exchange rate over what
it would have been if determined by normal
market forces.
Thus if market was to decide the rate at

Re. 1 = cents 10, the government may fix
exchange rate at Re. 1 = cents 15.
This is known as overvaluation of Indian

currency.
15.4 Policy of Overvaluation of National Currency.

With overvaluation –
Importers can buy essential capital goods
for development of economy at cheaper
rates.
Exporters find it difficult to meet
foreign competition as Indian currency has
become costlier.
There will be more demand for foreign
currency, country need to build large
reserve of foreign currency.
Hence the policy of overvaluation can only be a
short term measure.
15.5 Policy of Undervaluation of National Currency.
Through exchange control countries at other

times keep the exchange rate under what it
would have been if determined by normal
market forces.
Thus if market was to decide the rate at

Re. 1 = cents 15, the government may fix
exchange rate at Re. 1 = cents 10.
This is known as undervaluation of Indian

currency.
15.5 Policy of Undervaluation of National Currency.

With undervaluation –
Exporters are able to meet foreign
competition with cheaper Indian currency.
But Importers are required to pay more for
their purchases.
This is supposed to improve BOP with more
exports and less imports.
The policy of undervaluation of one country is
likely to be met by retaliation from others
as they find their exports have become
costlier, and markets are inundated by cheap
imports from undervaluing country.
15.6 Methods of Exchange Control

Direct Methods
[a] State intervention :
Here state decides the rate at which

foreign currencies will be converted into
local currency by the central Bank which
is the repository of all foreign exchange.
Such pegging up or pegging down of the

currency can be only a temporary measure.

Direct Methods
[b] Exchange restrictions :
Exporters are required to deposit the
foreign exchange earned by them with the
Central Bank.
Importers will get foreign currency to
finance their purchases from the Bank as
per priorities fixed by the Government.
This allows the government to plan
economic development and build infra
structure.

Direct Methods
[c] System of multiple exchange rates :

Here priority imports are allowed under a
lower exchange rate, while higher rate is
charged for imports of non essential
commodities.
This assured best use of precious exchange

earned from exports and to establish
equilibrium in balance of payments.

Direct Methods
[d] Blocked accounts :

This is strictly illegal method whereby
the government froze accounts of foreign
exporters to whom huge amounts are due for
payment.The method was adopted in world
wars by Germany & UK.
UK did not pay for Indian exports into UK
for essential goods needed by UK. The
amount was kept as sterling balance
payable to India and released later in
installments.

Direct Methods
[e] Clearing agreements :

These are agreement between two countries
by which amounts due to each other are
kept as balances payable in the country’s
Central Bank.
Actual payments from the bank are released

as per schedule drawn in the bilateral
agreement.

Direct Methods
[e] Clearing agreements :

In second type of agreements between two
countries, importers and exporters settle
payments for their purchases/sales through
the Central Bank of the country and
amounts are not transferred to the other
country.
Net balances in the respective Banks are
only settled through transfer of
currencies.

Direct Methods
[f] Payments agreement :

This is the same method as clearing
agreements. However, clearing agreements
usually cover imports and exports of only
commodities. Payment agreements include
commodities as well as services including
shipping, tourism, debts etc.
Under such agreements creditor countries do
not impose any restrictions on trade, but
debtor country imposes restrictions on
imports so that it can square up positions
with less difficulty.

Indirect Methods
[1] Quantitative restrictions on imports:

These restrictions take form of heavy
import duties, import quota fixation,
complete ban of imports or restrictions
through state trading corporations.
The objective is to diminish deficits in

balance of payments by reducing demand for
foreign currency.

Indirect Methods
[2] Export bounties:
The objective here is to improve inflow of

foreign currency by increasing exports.
Exporters are provided with incentives and
subsidy to increase their comparative cost
advantage in international trade. These
bounties allow them to increase volume of
their exports.

Indirect Methods
[3] Changes in interest rates:
An attempt is made to increase rate of

interest to attract foreign capital.
Higher rates prevent flight of domestic
capital into foreign countries.
There are obvious limits to which this

method can be applied as higher interest
have negative impact on investments & cost
of production.
15.7 Exchange Control : Its merits & demerits

Merits : Exchange control permits countries
► to secure essential capital goods,
spares & essential raw materials and high
level technology locally unavailable.
► to strengthen their defense
arrangements
► to stop flight of capital from the
country.
► to protect infant domestic industry
from foreign competition.
► to attain equilibrium in balance of
payment.

There is no doubt that the policy of
exchange control, if used judiciously and
impartially does help development of
domestic industries and optimum use
foreign exchange earned for the growth of
economy.
But it also suffers from some grave
defects, discussed in the next slide,
World finance bodies like GATT are
advocating removal of exchange controls or
their restriction to the minimum.
.

Demerits : Policy of exchange control
generally results into
1] Reduction in volumes of international

trade as moment restrictions are imposed
by one country there is retaliation from
the affected country and as a result
volumes of both countries reduce.
2] Inefficiency & rising cost in protected

domestic industry.

3] Red tapism and corruption among those

administering controls.
4] An element of arbitrariness in
administration. Some sectors favored and
others penalized.
5] Black market in restricted commodities.


6] Vested interests in protected infant

industries misuse their monopoly and do
not allow removal of protection even after
attaining maturity. Consumers bear
unnecessary burden.
7] Disadvantages to industries that do not

receive protection and continue to be
exposed to foreign competition.
15.7 Exchange Control

To sum up
Exchange Control in the long run has grave
economic defects.
United nation’s agencies like GATT
advocate their elimination, and if not at
least minimization.
Countries, especially developing, are
bound to exercise controls to protect
their national economies.
The End

Exchange Control Mechanisms

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International Economics

♥ Exchange Control – Definition & Meaning.

♥ Objectives Exchange Control.

♥ Over Under Valuation of Currency.

♥ Methods Exchange Control

♥ Exchange Control – Merits & Demerits.

♥ After abandonment of Gold Standard in

15.2 Definition and Meaning of Exchange Control

15.2 Definition and Meaning of Exchange Control

▀ Importers have to apply in advance for

▀ The role of market forces of demand and

15.3 Main Objectives of Exchange Control Policy

The objectives are not static and change

▀ Avoid fluctuations in the exchange rates.

▀ Correct disequilibrium in the balance of

15.3 Main Objectives of Exchange Control Policy

▀ Protect domestic industries from foreign

▀ Check imports of nonessential & luxury

▀ Facilitate economic planning process by

15.3 Main Objectives of Exchange Control Policy

▀ Handle problem of foreign debt repayment

▀ Prevent flight of domestic capital to

▀ Arrange retaliation against arbitrary

15.4 Policy of Overvaluation of National Currency.

Through exchange control countries

Thus if market was to decide the rate at

This is known as overvaluation of Indian

15.4 Policy of Overvaluation of National Currency.

15.5 Policy of Undervaluation of National Currency.

Through exchange control countries at other

Thus if market was to decide the rate at

This is known as undervaluation of Indian

15.5 Policy of Undervaluation of National Currency.

15.6 Methods of Exchange Control

[a] State intervention :

Here state decides the rate at which

Such pegging up or pegging down of the

15.6 Methods of Exchange Control

15.6 Methods of Exchange Control

[c] System of multiple exchange rates :

This assured best use of precious exchange

15.6 Methods of Exchange Control

[d] Blocked accounts :

15.6 Methods of Exchange Control

[e] Clearing agreements :

Actual payments from the bank are released

15.6 Methods of Exchange Control

[e] Clearing agreements :

15.6 Methods of Exchange Control

[f] Payments agreement :

15.6 Methods of Exchange Control

[1] Quantitative restrictions on imports:

The objective is to diminish deficits in

15.6 Methods of Exchange Control

[2] Export bounties:

The objective here is to improve inflow of

15.6 Methods of Exchange Control

[3] Changes in interest rates:

An attempt is made to increase rate of

There are obvious limits to which this

15.7 Exchange Control : Its merits & demerits

15.7 Exchange Control : Its merits & demerits

15.7 Exchange Control : Its merits & demerits

1] Reduction in volumes of international