UNIT-IV

Definition of Foreign Exchange Control:

In modern times various devices have been adopted to control

international trade and regulate international indebtedness arising out of
international workings and dealings.

The spirit of economic nationalism induces every country to look primarily

to its own economic interests. Foreign Exchange control is one of the
devices adopted for the purpose.

Foreign Exchange control is a system in which the government of the

country intervenes not only to maintain a rate of exchange which is quite
different from what would have prevailed without such control and to
require the home buyers and sellers of foreign currencies to dispose of their
foreign funds in particular ways.

Definition:

(1) “Foreign Exchange Control” is a method of state intervention in the

imports and exports of the country, so that the adverse balance of
payments may be corrected”. Here the government restricts the free play of
inflow and outflow of capital and the exchange rate of currencies.

2. According to Crowther:

“When the Government of a country intervenes directly or indirectly in

international payments and undertakes the authority of purchase and sale
of foreign currencies it is called Foreign Exchange Control”.
Objectives of Foreign Exchange Control:
Important objectives of Exchange Control are as follows:

1. Correcting Balance of Payments:

The main purpose of exchange control is to restore the balance of payments

equilibrium, by allowing the imports only when they are necessary in the
interest of the country and thus limiting the demands for foreign exchange
up to the available resources. Sometimes the country devalues its currency
so that it may export more to get more foreign currency.

2. To Protect Domestic Industries:

The Government in order to protect the domestic trade and industries from
foreign competitions, resort to exchange control. It induces the domestic
industries to produce and export more with a view to restrict imports of
goods.

3. To Maintain an Overvalued Rate of Exchange:

This is the principal object of exchange control. When the Government feels
that the rate of exchange is not at a particular level, it intervenes in
maintaining the rate of exchange at that level. For this purpose the
Government maintains a fund, may be called Exchange Equalization Fund
to peg the rate of exchange when the rate of particular currency goes up,
the Government start selling that particular currency in the open market
and thus the rate of that currency falls because of increased supply.

On the other hand, the Government may overvalue or undervalue its

currency on the basis of economic forces. In over valuing, the Government
increases the rate of its currency in the value of other currencies and in
under-valuing; the rate of its over-currency is fixed at a lower level.
4. To Prevent Flight of Capital:

When the domestic capital starts flying out of the country, the Government
may check its exports through exchange control.

5. Policy of Differentiation:

The Government may adopt the policy of differentiation by exercising

exchange control. If the Government may allow international trade with
some countries by releasing the required foreign currency the Government
may restrict the trade import and exports with some other countries by not
releasing the foreign currency.

To Practise Discrimination in Trade

6. Other Objectives:

(i) To earn revenue in the form of difference between selling and

purchasing rates of foreign exchange;

(ii) To stabilise the exchange rates;

(iii) To make imports of preferable goods possible by making the necessary

foreign exchange available; and

(iv) To pay off foreign liabilities with the help of available foreign exchange
resources.

5 Demerits Points of Currency Exchange Control

1. It develops economic nationalism but obstructs economic co-
operation internationally.
2. It leads to the contraction of foreign trade and the world’s welfare at
large.
 3. It encourages bilateral trade but deprives the country from the
benefits of multi-lateral trade.
4. It vests extraordinary powers in the hands of government officials
and there are chances of corruption.
5. Exchange control is an instant remedy to check disequilibrium in the
balance of payments. But, in the long-run it results in the creation of
basic disequilibrium which harms the economy at large.

Features of Exchange Control:

The system of exchange control possesses the following broad features:

1. The government monopolises the foreign exchange business and
exercises full control over the foreign exchange market.
2. The rate of exchange is fixed officially by the government and the
market forces of demand and supply have no effect on its
determination.
3. The government centralises all foreign exchange operations in the
hands of the central bank which administers various foreign
exchange regulations.
4. The exporters have to deposit their all foreign exchange earnings
with the central banks.
5. Imports of the country are regulated and the importers are allocated
foreign exchange at the official rates to enable them to make
payments for the goods imported.
6. The government or the central bank determines the priorities in the
allocation of scarce foreign currencies.
7. As a result of exchange control, the volume of imports gets
automatically reduced and there is a favourable impact on country’s
balance of payments.
Methods and Techniques of Exchange Control:
A country desirous of adopting exchange control system can employ
various methods. Prof. Paul Einzig has mentioned as many as 41 methods
of exchange control.

Broadly these methods can be classified into two categories:

A. Direct methods and

B. Indirect methods.

Important methods of exchange control are discussed below:

A. Direct Methods:

1. Intervention or Exchange Pegging:

A commonly adopted method of exchange control is the interference in the
foreign exchange market by the government or the monetary authority
with the purpose of either holding up or down the foreign exchange rate of
its currency.
This interference takes the form of purchasing and selling of home
currency in the exchange market and, thereby influencing the exchange
rate. Intervention may be active or passive.
In the passive intervention, the monetary authority is prepared to
buy or sell the foreign currency at fixed rate without curtailing the right of
the public to deal in foreign exchange. In the active intervention the
monetary authority itself takes the initiative and bids for the foreign
currency or offers it for sale with a view to influence the exchange rate.
The government intervenes the foreign exchange market through
exchange pegging. Exchange pegging refers to the act of fixing the
exchange value of the currency to some chosen rate. The government buys
and sells the home currency in exchange for foreign currency in order to
establish a desired rate of exchange.
The pegging operation involves pegging up or pegging down the
exchange rate. When the exchange rate is fixed higher than the market rate,
it is called pegging up; when the exchange rate is fixed lower than the
market rate, it is called pegging down. In other words, pegging up means
overvaluation of home currency and pegging down means undervaluation
of home currency.
In the pegging up operation, public demand for foreign currency
increases and the government must be ready to sell adequate foreign
currency in exchange for home currency.
In the pegging down operation, public demand for home currency
increases and the government must be in a position to purchase foreign
currency in exchange for home currency. The exchange pegging should be
used as a temporary measure to remove fluctuations in the foreign
exchange rate.
In Figure 1, D£ and S£ represent demand for pound (or supply of
dollar) curve and supply of pound (or demand for dollar) curve
respectively. In the absence of intervention, the equilibrium market rate of
exchange is OR dollars per pound.
OM is the quantity of pounds demanded and supplied at this market
rate. If the U.K. government pegs up the exchange rate at OR1, the supply
of pound exceeds the demand for pound (or demand for dollar exceeds the
supply of dollar) by the amount A1B1.
 Thus, if the U.K. government wants to maintain the exchange rate at
OR1, it must be prepared to purchase A 1B1 quantity of pounds (or to sell
A1B1 quantity of dollars). For this it must use its holdings of gold, dollars
and other resources.
Similarly, if the U.K. government pegs down the exchange rate at
OR2, the demand for pound exceeds the supply of pound (or the supply of
dollars exceeds the demand for dollars) by A2B2 amount.
As a consequence, the U.K. government must be ready to sell
A2B2 quantity of pounds for dollars (or to buy A 2B2 quantity of dollars for
pounds) at this lower rate OR2 dollar per pound.

2. Rationing of Foreign Exchange:

Under this method of exchange control, the government keeps the
exchange value of its currency fixed by rationing the ability of its residents
to acquire foreign exchange for spending abroad. The government imposes
restrictions on the use, sale and purchase of foreign exchange.
All foreign exchange business is centralised either with the
government or with its agents. All foreign exchange earnings are to be
surrendered by exporters to the central bank at the fixed exchange rate. The
importers are allotted foreign exchange at the fixed rate and in fixed
amount. The government also determines the priorities in the allocation of
scarce foreign currencies.
3. Blocked Accounts:
Blocked accounts refer to a method by which the foreigners are
restricted to transfer funds to their home countries. The method of blocking
the accounts of creditor countries is adopted by the debtor countries
particularly during the periods of war or financial crisis. Under this
method, the foreigners are not allowed to convert their deposits, securities
and other assets into their currency.
Their banking accounts are blocked and they are not permitted to
withdraw their funds and remit them to their own countries. The method
of blocked accounts is defective because of the following reasons-
(a) It causes hardships to the foreigners,
(b) It harms the reputation of the blocking country,
(c) It reduces the volume of foreign trade.
(d) It encourages black marketing in foreign exchange.
4. Multiple Exchange Rates:
When a country, instead of one single exchange rate, fixes different
exchange rates for the import and export of different goods, it is known as
the system of multiple exchange rates. Even for different countries or
imports, different exchange rates are fixed. The system of multiple
exchange rates amounts to a type of rationing by price rather than by
quantity and therefore does not directly restrict free trade.
The system of different exchange rates for different goods and for
different countries is adopted with the objective of earning maximum
possible foreign exchange by increasing exports and reducing imports.
Multiple exchange rates were adopted first by Germany, and then by Chile,
Argentina, Brazil, Peru and many other countries. The under developed
countries can employ this system to improve their balance of payments.

The system of multiple exchange rates has the following advantages:

 It permits a country to discriminate between goods as well as
countries in international transactions.
 It encourages exports and discourages imports and thus helps to
correct balance of payment deficit.
 It encourages the inflow and discourages the outflow of capital.
  It provides additional source of income of the government. The
government earns revenue by purchasing the foreign currency at low
rate and selling it at a higher rate.
 It substitutes the system of rationing foreign exchange through
administered prices for that of rationing foreign exchange through
administered quantities of foreign exchange and thus avoids the
complex problems of the latter such as arbitrary rationing of the
foreign exchange, large administrative staff, potential improprieties,
etc.
 Multiple exchange rates is a better method than devaluation of
currency.
However, the multiple exchange rate system has the following defects:
 (i) Instead of correcting the balance of payments disequilibrium, it
adversely affects the growth of international trade.
 (ii) It involves complexities of calculation of different rates of
exchange for different imports and exports and for different
countries.
 (iii) It gives too much arbitrary powers to the government to control
international trade.
 (iv) Undue restrictions on international trade may encourage black
marketing and other corrupt practices by importers and exporters.
 (v) In so far as multiple exchange rates overvalue the country’s
currency, they amount to a tax on exports and subsidy on imports. In
the opposite case, they represent subsidy on exports and a tax on
imports. In both situations, the multiple exchange rates disturb the
competitive conditions and divert the international trade in the
unnatural directions.
 (vi) It distorts the economic structure of the trading nations and
adversely affects the efficient and optimum utilisation of resources.

5. Standstill Agreements:
Standstill agreement aims at maintaining status quota in the
relationship between two countries in terms of capital movement.
This method was first adopted by Germany after the Great
Depression of 1929.
The main features of standstill agreements are as follows:
 (a) The movement of capital is checked and the payments to the foreign
exporters are made in easy installments instead of in lumpsum.
(b) Short-term loans are converted into long-term loans with a view to
allow more time to the debtor country to repay his debt.

6. Clearing Agreements:
Clearing agreement refers to a system under which agreement is
made between two countries for settling their international trade accounts
through their respective central banks. In the words of Kent, “Clearing
Agreement is an agreement between the governments of the two countries
by which each undertakes to make payments to its exporters which it
receives from its own importers”.
Under this system, the importers instead of making payment for the
imported goods in foreign currency pay in home currency to their central
bank. Similarly, the exporters, instead of receiving payment for goods
exported in foreign currency receive it through the central bank in the
home currency.
Thus, the individual importers and exporters need not clear their
accounts in foreign currencies, but in home currencies through their
respective central banks and the transfer of currencies from one country to
another is avoided.
If the exports and imports of the two countries balance with each
other, no further difficulty arises. But, if the exports and imports of the two
countries are not equal to each other, the net balance in the clearing account
is paid off in terms of gold. In this way, stability of exchange rate is
maintained through clearing agreement.

Payments Agreements:
The payments agreement between two countries is a more comprehensive type of exchange control than
the exchange clearing agreements. It covers not only the payments on account of export and import of
commodities but also the payments due to different types of services such as shipping, banking, insurance
and items like debt servicing and tourism. It provides a mechanism for the repayment of external debts.

A part of the payments for imports by the creditor country is retained in the clearing account for
repayment of debts and the remaining amount is paid out to the exporters of the debtor country. The
 creditor country normally does not impose any restriction upon the imports from the debtor country but
the latter can impose restrictions upon the imports from the former so that it should repay its external
obligations through enlarging its exports.

In 1947, Britain entered into payment agreements with India, Argentina, Brazil, Ceylon, Egypt and some
other countries that were holding sterling balances over the years of Second World War. These
agreements provided for the maintenance of two sterling accounts in favour of these countries in England.
In the first account, the sterling balances could be withdrawn by the creditor countries for the current use.

The second account was a blocked sterling account. The provision in payments agreement was to permit
the phased transfer of the sterling balances from the blocked account to the other to enable the creditor
countries to make free use of them.

The payments agreements have certain shortcomings. Firstly, the terms of payments agreements
generally favour the stronger or creditor countries. Secondly, the payments agreements can be operational
for two trading countries. Such agreements cannot be possible on a multilateral basis unless there is
intermediation of the international economic institutions. Thirdly, the payment agreements provide for
the use of balances in the debtor country on the purchase of specified goods and services only from the
debtor country.

Fourthly, no doubt the payment agreements provide some relief to the weak and developing countries
through making provision for increased exports for making debt payments, yet the debt burden is
extended over a longer period. There is the possibility of an increase in debt servicing. It is likely that the
balance of payments position of the debtor country remains unfavorable for a long period.

What Is a Moratorium?
A moratorium is a temporary suspension of an activity or law until future consideration warrants lifting the suspension,
such as if and when the issues that led to moratorium have been resolved. A moratorium may be imposed by a
government, by regulators, or by a business.

Moratoriums are often imposed in response to temporary financial hardships. For example, a business that has
exceeded its budget might place a moratorium on new hiring until the start of its next fiscal year. In legal proceedings,
a moratorium can be imposed on an activity such as a debt collection process during bankruptcy proceedings.

Under this system, the payments for the imported goods or the interest on foreign capital are not made
immediately but are suspended for a predetermined period called as period of moratorium. A country
adopts this method of exchange control for temporary solving its payments problems .
2. Indirect Methods:
Apart from the direct methods of exchange control, countries sometimes resort to indirect
methods which are as follows:
(i) Tarrif and Non-Tarrif Restrictions:
The countries can resort to tariffs, import quotas and other quantitative restrictions. These measures
reduce the volume of imports and the demand for foreign currencies gets reduced. That brings about an
improvement in the balance of payments situation. The quantitative restrictions on imports result in
appreciation of home currency relative to the foreign currency.

(ii) Export Subsidies:

When the government follows the policy of subsidizing exports, the home exporters are induced to enlarge
exports. This measure, on the one hand, can bring about an improvement in the BOP deficit and, on the
other, can raise the external value of home currency.

(iii) Increase in Interest Rates:

The increase in the structure of interest rates in the home country leads to an inflow of capital from
abroad and the prevention of capital outflow. These changes effect improvement in the BOP situation in
addition to making the foreign exchange rate more favourable.

There is, however, a severe constraint in the form of possible adverse effect of higher rates of interest
upon the home investments that dissuades the monetary authority from resorting to this measure beyond
a specified limit. In addition, the increase in the structure of interest rate by the foreign countries can
neutralise such a policy.

In evaluating the indirect exchange controls, G. Crowther comments, “These methods of indirect
exchange control, therefore, though they are by no means negligible, are not merely strong or precise
enough instruments for a government that aspires to bring the exchange rates under close control.” In
order to make the system of exchange control fully effective and capable of achieving its different
objectives, it is essential that there is a proper integration of direct and indirect methods of exchange
control.