Essay on Exchange Controls | International Economics

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Essay # 1. Introduction to Exchange Controls:

The exchange controls, like other expenditure- switching policies, divert the domestic spending from the foreign produced goods and services to the home produced goods and services. Similarly, exchange controls tend to divert resources from foreign investments to domestic investments.

After the abandonment of gold standard, the countries started taking resort to direct or indirect exchange controls for regulating trade and payments. Even after the adoption of IMF’s fixed exchange parities, the exchange controls assumed much importance in the BOP adjustment policies followed by both developed and the LDCs.

Even after the breakdown of Bretton Woods System in 1970’s, when the world turned towards the managed floating system, the exchange controls continued to remain in practice under both fixed and flexible exchange rates. There is no direct interference with the operation of the market forces.

Exchange controls differ radically from the both in so far-as they disregard the market forces and give primacy to the government decisions related to foreign exchange rates and the utilization of foreign exchange reserves. Exchange controls have been accepted as an important means for making the BOP adjustments.

Essay # 2. Meaning of Exchange Controls:

The exchange control signifies the imposition of restrictions by either central bank or the government of a country upon the foreign exchange resources for establishing equilibrium between the foreign receipts and payments. The term ‘exchange control’ has been defined by Haberler as the “State regulation excluding the free’ play of economic forces from the foreign exchange market.” It means the exchange controls tend to restrict free transactions in the foreign exchange market and establish the governmental or central banking domination over the foreign exchange market.

The exchange control, in the words of Ellsworth and Leith, “disregards market forces and substitutes for them the arbitrary decisions of government officials. Imports and other international payments are no longer determined solely by international price comparisons, but also by considerations of national need, as perceived by frequently misinformed bureaucrats. Not only is government intervention direct rather than indirect, but since the core of exchange control is a set of restrictions on international payments, convertibility is also sacrificed.”

A definition of exchange control in more specific terms has been given by Salvatore. According to him, the exchange controls signify, “restrictions on international capital flows, official intervention in forward markets, multiple exchange rates, and other financial and monetary restrictions imposed by a nation.”

A full-fledged regime of exchange controls involves a complete government or central banking control over the foreign exchange market of the country. All the foreign exchange receipts from exports and other sources are surrendered to the central bank which is authorised to allocate the available supply of foreign exchange among the importers of goods and services and others in a way which is consistent with national needs and specified priorities.

Thus the central bank occupies the pivotal position in regulating the demand and supply flows of foreign exchange for maintaining the official exchange parity and also the BOP equilibrium. This may be the most drastic form of exchange control. In fact, the central bank may pursue exchange control policies of varying severity depending upon the foreign exchange position prevailing in the country at a specified time.

In a fast deteriorating foreign exchange situation, general and more stringent exchange controls may be enforced. On the contrary, if there is some perceptible or fundamental improvement in exchange situation, some of the severe restrictions can be scrapped.

Essay # 3. Objectives of Exchange Controls:

The imposition of exchange controls has found justification from the economists and statesmen from both the advanced and LDC’s.

They were induced to prescribe different forms of exchange controls to realise various objectives which are detailed below:

(i) Balance of Payments Equilibrium:

Those countries which are faced with limited export capacity or export market have to restrict their imports lest the BOP deficit will assume more serious proportions. These countries, having low export earnings and capital inflows have to resort to drastic exchange controls to neutralize the BOP deficit.

(ii) Prevention of Capital Flight:

Sometimes adverse monetary and fiscal policies, speculation and disturbed political condition cause flight of capital from the home country. The unchecked capital outflow may threaten a complete exhaustion of foreign exchange reserves of the country and cause serious economic destabilization. In such circumstances, the central bank must intervene through appropriate exchange controls and prevent the outflow of capital.

(iii) Over-Valuation:

Over-valuation of currency means that the exchange value of a currency is maintained by a country at a level higher than what would have been permitted by the market forces. The currency is kept over-valued for three reasons. First, the country wants to have a larger inflow of development goods such as raw materials, capital equipments and technical know-how from abroad for achieving a higher rate of growth. Second, the country wants to have larger imports of defence materials to keep a higher level of defence preparedness.

Third, the country is saddled with a heavy burden of foreign debts. The exchange restrictions are enforced to maintain the exchange value of home currency artificially at a higher level than the natural level of rate of exchange. The over-valuation of currency through exchange controls can be, at the maximum, a short term solution. If carried over a long period, it will cause serious deterioration in the BOP situation.

(iv) Under-Valuation:

The under-valuation means keeping the exchange value of home currency at a level lower than what would have been permitted by the market forces. The under-valuation stimulates exports and restricts imports. A country, faced with BOP deficit, may resort to under-valuation through appropriate exchange controls. In this connection, it is pointed out that such a policy can be suited to a small country.

If a large country, having a substantial share out of world trade, adopts such a policy, it will create a highly uncertain and dangerous situation because the other countries too are likely to resort to similar exchange restrictions. Crowther considers contrived under-valuations through exchange controls as a totally selfish and immoral policy.

(v) Rapid Economic Growth and Maximum Employment:

The policy of exchange controls may be adopted by a country that has the objective of achieving accelerated growth and maximum employment. Exchange controls insulate the economy from external influences. Since BOP situation remains unaffected, no matter what types of changes take place internally, the monetary and fiscal authorities can freely adopt the expansionary money supply and public spending policies.

The exchange controls thus can be helpful in the pursuit of growth and employment-oriented internal economic policy. Any pressures that are likely to be generated by these internal policies on external equilibrium can be effectively handled by the exchange controls.

(vi) Servicing of Foreign Debts:

In order to facilitate the servicing of external debts i.e., repayment of foreign loans and interest thereon, it is necessary for the government to have the compulsory acquisition of foreign exchange receipts of the exporters and other capital inflows and allocate them to different uses in a controlled manner such that all national needs including the servicing of foreign debts are adequately met.

(vii) Stability of Exchange Rates:

The recurring fluctuations in exchange rate of domestic currency vis-a-vis foreign currency have serious destabilising effects upon trade, production and foreign payments. The effective exchange control measures including restraints upon the activities of speculators can ensure the stability in exchange rates.

(viii) Conservation of Foreign Exchange:

One of the objectives of imposing exchange controls is to conserve the scarce foreign exchange reserves. In the absence of effective exchange controls, it is possible that these precious resources are dissipated on unproductive and wasteful purposes.

(ix) Protection of Domestic Industries:

The exchange controls can afford protection to domestic industries from foreign competition. Through the enforcement of appropriate exchange controls, the import of such products as compete with domestically produced goods can be restricted. That provides opportunities for the home industry to grow strong and get diversified.

(x) Check upon Non-Essential Imports:

The object of exchange control is also to check the import of non-essential luxury consumer goods and harmful goods. This enables a country to utilise the valuable foreign exchange resources for the import of more essential scarce goods.

(xi) Effective Economic Planning:

In the less developed planned economies, the development programmes have a large foreign exchange component. Exchange controls help conserve the foreign exchange resources so that these are utilised in accordance with the plan priorities. Thus exchange controls make valuable contribution in making the process of planning successful and effective.

(xii) Generation of Revenues:

The exchange controls can be employed by the government to generate additional revenues. Under a system of multiple exchange rates, the central bank may buy the foreign exchange from exporters at a relatively lower exchange rate and sell it out to traders and others at some higher rate. The difference between the buying and selling rates of foreign exchange can be a source of additional revenues for the government.

(xiii) Prevention of Depression:

Depression in a big country like the U.S.A. is likely to spread to other parts of the world. Every country want that such a situation should not developed any possibility of transmission of depression from foreign countries to the home country, through dumping or other means can be effectively countered through exchange controls.

(xiv) Retaliation:

Exchange controls are sometimes employed by foreign countries to restrict exports from home country or to extract concessions or to secure more favourable terms of trade. In order to protect the domestic economy from foreign exploitation, the home country may also resort to exchange controls by way of retaliation. The home importers are not allocated foreign exchange to buy goods from the offending foreign country.

Essay # 4. Merits and Demerits of Exchange Control:

Both developed and the developing countries have been making use of different types of exchange control policies. There have been several merits of exchange controls that made economists and statesmen to advocate such measures.

The chief merits of exchange controls are as follows:

(i) Adjustment of balance of payments disequilibrium,

(ii) Prevention of flight of capital,

(iii) Over-valuation of currency,

(iv) Under-Valuation of currency,

(v) Rapid economic growth,

(vi) Servicing of foreign debts,

(vii) Stability of exchange rates,

(viii) Conservation of foreign exchange,

(ix) Protection of domestic industries,

(x) Check upon non-essential imports,

(xi) Effective economic planning,

(xii) Generation of revenues,

(xiii) Prevention of depression and

(xiv) Retaliation.

The exchange control policy has, of course, many merits.

There are, however, certain demerits of this policy also as listed below:

(i) Reduction in the Volume of International Trade:

The exchange restrictions have an adverse effect upon the volume of international trade. As one country enforces restrictions upon imports, the exports of foreign countries are hit. That makes the foreign countries to adopt retaliatory exchange restrictions. The regime of exchange restrictions causes a reduction in the volume of foreign trade.

(ii) Industrial Inefficiency:

The protection afforded to the domestic industries from foreign competition through exchange controls breeds industrial inefficiency, technological stagnation, deterioration in quality and escalation of costs. These factors depress exports and raise internal price level.

(iii) Red-Tapism and Corruption:

The exchange controls have to be administered by the government officials. The controls create vested interests among the administrative machinery. That breeds the evils of red-tapism and corruption among the government officials.

(iv) Wasteful:

Since the government or central bank has to maintain a large work force for operating the exchange control policy, it means the cost of maintaining the exchange control regime is often prohibitive. That is why, the exchange control policies are considered as uneconomical and wasteful.

(v) Black-Marketing of Foreign Exchange:

Howsoever efficiently an exchange control policy is operated, the evils like black-marketing in hard currencies, under-invoicing and retention of concealed amounts in foreign banks, utilization of such funds in foreign countries rather than the home country for the purposes of development are present. In some cases, there is smuggling out of foreign exchange.

(vi) Arbitrariness:

The exchange control policy involves the fixation of certain priorities for the allocation of foreign exchange. Sometimes these priorities are altogether arbitrary. The decisions based upon the whims of the bureaucracy are bound to be unsound.

(vii) Creation of Vested Interests:

The exchange controls invariably result in the creation of vested interests. They maintain pressure upon the government to continue the policy of exchange restrictions indefinitely. It implies perpetuation of protection for inefficient industries and consequent worsening of the welfare of the community in general.

(vii) Inequitable Distribution of Income and Wealth:

The restriction on imports through exchange controls offers opportunities for certain groups of producers to secure abnormally large profits. The imposition of exchange controls often benefits large established producer more than the small ones. Consequently, the distribution of income and wealth becomes inequitable.

In view of the defects of the policy of exchange controls, there has been an increased emphasis by the institutions like IMF and GATT upon the member states to relax and ultimately dismantle the rigid structure of exchange restrictions. However, the developing countries faced with a persistently increasing BOP deficit find it extremely hard to do away with exchange controls.