Friday, August 28, 2009

Exchange Control, its Objectives and Techniques

Foreign exchange control is defined by Haberler as “State regulation exchange the free play of economic forces from the foreign exchange market”. According to Prof. Ells Worth, “Disregards market forces and substitutes for them the arbitrary decisions of governments officials. Impacts and other international payments are no longer determined slowly by international price comparisons, but also by considerations of national need as perceived by frequently misinformed bureaucrats. Not only in government intervention direct rather than indirect, but since the core of exchange control is a set of restrictions on international payment, convertibility is also sacrificed. In short the government to regulate the payments dealings in foreign exchange and import export of currencies is called Exchange Control.

Objectives of Exchange Control:

There have been varied objectives of adopting the system of exchange control by governments before, during and after World War II. We discuss these objectives as under.

1. Over Valuation: Some countries resort to exchange control to keep their currencies over valued. Under this the foreign exchange value of the currency is fixed at higher level than allowed by market forces. The currency is over valued for three reasons. First the country is engaged in the development process and needs raw materials and capital equipment from abroad and the second the country has to repay foreign debt. When the country over values its currency, its country becomes dearer relative to other countries. So it pays less to other countries in terms of its currency both for imported goods and for repayment of foreign debt. However, exchange control for the purpose of overvaluing the currency can be adopted only as short term measure. In the long-run, it will lead to adverse balance of payments, because export become dearer and imports cheaper with overvaluation of the currency.

2. Under Valuation: Some countries also exercise exchange control to keep their currencies undervalued. This is done to suitable exports and reduce imports and to raise the general price level of the country. But such a policy can succeed only in the case of a small country, whose participation in the world trade is insignificant. But if a large country were to adopt this policy, it will lead other countries to retaliate and follow this policy, which is highly dangerous for the world economy. Crowther regards deliberate undervaluation as an immoral policy.

3. Stabilization of Exchange Rate: Exchange control is adopted to stabilize the rates of exchange. Fluctuating exchange rates harm commerce and industry. The government therefore adopts exchange control measures to stabilize the exchange rates by announcing conversion at the official fixed rates of exchange.

4. Prevention of Capital Flight: Another objective of exchange control is to prevent the fight of capital from the country. Gold and capital funds cannot be exported. Without the permission of exchange control authority. The latter may totally ban such movements or give specific purposes. In this way exchange control not only prevents the flight of capital but also conserves foreign exchange.

5. Protection to Domestic Industries: Exchange control is resorted to for giving protection to domestic industries against foreign producers. The exchange control authority controls the imports of such commodities which compete with domestic producers and thus protects then from foreign competition.

6. Checking Non-essential Imports: Exchange control also aims at checking imports of non-essential commodities. The exchange control authority restricts imports of non-essential luxury and harmful commodities through foreign exchange control. Licences are issued for imports of essential commodities sonly so that foreign exchange is utilised fruitfully.

7. Help to The Planning Process: Exchange control helps the process of planning by controlling the non-essential and wasteful expenditures on imports and encouraging the flow of exports. The exchange control authority encourages the inflow of essential raw materials, capital goods and technical know-how by allocating scarce foreign exchange resources. Such imports are needed for execution of plan projects.

8. Remedying Unemployment Balance of Payments: Exchange control is introduced to remedy adverse balance of payment. This is achieved by checking and regulating imports and foreign exchange.

9. Earning Revenue: Exchange control is also used to earn revenue by the government. The central bank of the country which is usually the exchange control authority, sells foreign currencies to traders, businessmen and individuals at the rates higher than at which it buys in international market. The difference between the selling and buying rates goes to the government as revenue.

10. Repaying Foreign Debt: One of the objectives of exchange control is to earn and conserve foreign exchange for the purpose of repaying the principal and interest changes on foreign debt.

11. Retaliations: Exchange control is used to secure bargaining power in trade with other countries and also as a retaliatory device. Exchange control gives monopoly power to country which can get essential commodities at favourable rates from the other country. It can thus be used to exploit the other country. Under the circumstances, the other country can also adopt exchange control as retaliatory measure.

Methods and Techniques of Exchange Control:

There are two methods of exchange control. One is direct and other is indirect.

Direct Method:

The central bank of the country, which is exchange control authority, adopts a number of direct methods, which restrict the use and quantity of foreign exchange. They are as under.

(i) Intervention: Intervention means “a government may intervene in the foreign exchange market to hold the value of its currency up or hold it down”. This method is known as “pegging exchange rates”. If the government fixes the exchange rate of its currency at the higher level than prevailing in the foreign exchange market is it is called “pegging up”. On the other hand, fixing a lower exchange rate than prevailing in the foreign exchange market is called “pegging down”.

Intervention in these two cases mean selling or buying local currency in exchange for foreign currencies at fixed rates. When a country pegs up its currency it means that the demand for its currency at the higher exchange rate is less than its supply. So the central bank must intervene to purchase local currency in exchange for foreign currencies at the fixed rate. On the other hand in the case of pegging down of its currency, the central bank must sell the local currency in exchange for foreign currencies at the fixed rate, this is because the demand for the local currency at the lower exchange rate is more than its supply.

(ii) Exchange Restriction: Crowther defines a policy of exchange restriction as one which involves “a compulsory reduction by the government of the supply of its currency coming into market”. Under it all foreign currencies are pooled with the central bank which in turn sanctions and allocates than in accordance with the rules laid down by the government. Different exchange restrictions are discussed as under.

(a) Allocation according to priorities: This is the simplest method. As the foreign currencies available with the central bank are always limited in quantities, it will allocate then to finance imports and to make other foreign payments. It will dot so in accordance with certain principles of priorities. All essential items of imports such as food, raw materials, capital goods, intermediate products etc will be accorded priorities in allocating foreign exchange over non-essential and luxury imports.

(b) Multiple Exchange Rates: When a country establishes different exchange rates for earn of several categories of imports exports and capita transfers it is known as the methods of multiple exchange rates. This system of exchange control is operated in such a way that the foreign value of imports is reduced and the foreign value of exports is increased. The aim is to achieve balance of payments equilibrium for the country by reducing imports and increasing exports. Despite this different exchange rates are fixed for different types of imports. For instance, the central bank may fix a low buying rate for foreign currency for the import of essential commodities and a much higher rate for the import of luxuries. On the export side it may subsidies exports by fixing higher exchange rates. But the rates for invisibles including capital transfers are usually very high. The foreign exchange rates are fixed not only on the basis of the nature of the commodities but also for the elasticity of demand for them.

(c) Blocked Accounts: Under this system of exchange control, payments for imports are credited to blocked accounts in the name of the foreign exporters. Such accounts may be kept in the central bank of the debt or country. The creditors are prohibited for some time from drawing on them. However they can be used in the controlling country where such accounts are located.

(iii) Clearing Agreements: Under this method of exchange control two trading countries agree to establish an account in their respective central bank through which all payments for export and imports are cleared. This method is known as bilateral clearing or clearing agreement of exchange clearing. Germany was the first country to make such agreement with Sweden and Switzerland in 1930’s.

(iv) Payments Agreements: Payment agreements are another form of bilateral agreements but they are wider in scope than clearing agreements. Beside trade transactions they include various service transactions such as shipping charges, debt service, tourism etc which are reflected in the balance of payments. A payments agreement is usually made for the repayment of the debt by one country to the other. Under this system of exchange control a certain percentage of payments for imports by the credit or country are passed on to its clearing account for the repayment of its debt. The credit or country does not impose any restrictions on the imports from debt or country. But debt or country can restrict its imports from the credit country so that it is in a position to repay its debt through larger exports.

Indirect Methods:

(i) Quantitative Restrictions: Quantitative restrictions or commercial control include import restrictions, import embargoes, import quotas and buying policies of state trading corporations. All these limit imports. Quantitative import control restricts the amount (in value or quantity) of commodity to be imported. The aim is to curtail the value to correct disequilibrium in the balance of payments. The import quota is another device by which a specified amount of a commodity is imported free of any duty, while imports above that amount levied on import duty. The state trading corporations or authority is given to a monopoly for the import of certain commodities. It regulates the amount of commodities to be imported and distributes them with in country. The aim of these quantitative restrictions is to make the rate of exchange in favour of the country.

(ii) Export Bounties: A bounty on exports has effect of raising the external value of the country giving the bounty. But export bounties are limited by the amount of funds with the government.

(iii) Raising Interest Rates: Changes in the interest rates within a country also influences its foreign exchange rate. When interest rate increases in a country, it attracts capital funds from other countries and prevents the outflow of domestic funds to other countries. Consequently, the demand for its currency rises which raises its external value and makes the foreign exchange rate favourable to it.

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