The various methods of exchange control may broadly be classified into two types, direct and indirect. Direct methods of exchange control include those devices which are adopted by governments to have an effective control over the exchange rate, while indirect methods are designed to regulate international movements of goods.
There are many ways to introduce exchange control in an economy. These are usually classified into two groups:
(i) Direct Exchange Control and
(ii) Indirect Exchange Control.
Direct Methods of Exchange Control :
In direct exchange control, certain measures are adopted which effectuate immediate direct restriction on foreign exchange from all sides - its quantum, use and allocation.
In general, direct exchange control includes measures like:
(ii) Exchange restrictions;
(iii) Exchange clearing agreements;
(iv) Payment agreements; and
(v) Gold policy.
It refers to the government's intervention or interference in the free working of the exchange market with a view to overvalue or undervalue the country's currency in terms of foreign money.
The government or its agency - the central bank - can intervene in the free market by resorting to buying and selling the home currency against foreign currency in the foreign exchange market to support or depress the exchange rate of its currency.
Government intervention in the foreign exchange market takes the from of pegging up or pegging down of the currency of the country to a chosen rate of exchange. Since undervaluation or overvaluation is not the equilibirum rate, it has to be pegged. Thus, pegging means keeping a fixed exchange value of a currency; however, intervention may be practised by a government without resorting to pegging as such.
Pegging operations take the form of buying and selling of the local currency by the central bank of a country in exchange for the foreign currency in the foreign exchange market, in order to maintain an exchange rate whether, it is overvalued or undervalued.
Thus, pegging may be pegging up or pegging down. Pegging up means holding fixed overvaluation, i.e., to maintain the exchange rate at a higher level. Pegging down means holding fixed undervaluation, i.e., to maintain the exchange rate at a lower (depressed) level. In the case of pegging up, the central bank shall have to keep itself ready to buy unlimited amount of local currency in exchange for foreign currencies at a fixed rate, because overvaluation tends to increase the demand for foreign currencies by creating import surplus.
In the case of pegging down, the central bank or central agency shall have to keep itself ready to sell any amount to local currency by creating export surplus. Similarly, pegging up involves holding of sufficient amount of foreign currencies while pegging down involves holding of sufficient amount of local currency by the central bank. It goes without saying that pegging up, is more difficult to maintain as it requires huge amounts of foreign currencies which is difficult to obtain. As such pegging up can be adopted only as a temporary expedient.
It should be noted that intervention by a government in the foreign exchange market has the effect of neutralising the forces of demand and supply of foreign exchange. However, it is generally assumed that government intervention or pegging up and pegging down operations should be used as temporary expedients to remove fluctuations in the exchange rate.
Exchange restrictions refer to the policy or measures adopted by a government which restrict or compulsory reduce the flow of home currency in the foreign exchange market. Exchange restrictions may be of three types:
(i) The government may centralise all trading in foreign exchange with itself or a central authority, usually the central bank; (ii) the government may prevent the exchange of local currency against foreign currencies without its permission; (iii) the government may order all foreign exchange transactions to be made through its agency.
Exchange restrictions may take various forms, the most common of them being: (1) Blocked accounts, (2) Multiple exchange rates.
Under the condition of severe financial crisis, a debtor country may adopt the scheme of blocking the accounts of its creditors. In 1931, Germany, for instance, had done so in order to have exchange restrictions.
Blocked accounts refer to bank deposits, securities and other assets held by foreigners in a country which denies them conversion of these into their home currency. Blocked accounts, thus, cannot be converted into the creditor country's currency. Under the blocked accounts scheme, all those who have to make payments to any foreign country will have to make them not to the foreign creditor directly but to the central bank of the country which will keep the amount in the name of the foreign creditor. This amount will not be available to the foreigners in their own currency, but can be used by them for purchase in the controlling country.
Blocked accounts system has two drawbacks: (i) It reduces international trade to a minimum, and (ii) it leads to black-marketing in foreign exchange.
Multiple Exchange Rates:
In the early thirties, Germany had initiated the device of multiple rates, as a weapon to improve her balance of payments position. Under this system, different exchange rates are set for different classes and categories of exports and imports. Generally a low rate, i.e., low prices of foreign money in terms of domestic currency, is confined to imports of necessary items having an inelastic demand, while a high penalty rate is fixed for the imports of luxury items. In short, the multiple exchange rates system implies official price discriminatory policy in foreign exchange transactions.
By simply fixing a high exchange rate for a commodity, the government can check its imports (when its elasticity of demand for import is greater than unity). Similarly, its imports can be encouraged by fixing a low exchange rate.
Likewise, the export of a commodity can be encouraged by setting a high rate of exchange. Thus, the device of multiple exchange rates can be effectively used by the government for making short-term adjustments in the balance of payments, without resorting to quantitative restrictions and licensing. Indeed, multiple exchange rates amount to discriminatory export taxation and varying rates of tariffs on imports.
In other words, the system of multiple exchange rates in essence is a form of discriminatory partial devaluation, because instead of devaluing the currency for the whole of foreign trade, under this system, the currency is devalued for imports and exports of goods with an elasticity greater than unity and appreciating the currency for goods with an elasticity less than unity. It is thus more effective in bringing about the desired effect on the level of trade and thereby, improve the balance of payments.
Thus, the main merit of the system of multiple exchange rates is that it allows more effective control of the balance of payments. Secondly, it also contains disguised subsidies and tariffs, which may encourage or discourage trade in certain goods and affect the level of foreign trade.
Apparently, buying foreign exchange at a rate above the equilibrium rate amounts to subsidisation of exports, while selling foreign exchange at a rate above the equilibirum rate amounts to a tariff on imports.
Another merit of the system is that it enables the government to yield revenue by buying foreign exchange at low prices in domestic money from exporters and then selling it at higher prices to importers.
However, the system has the following drawbacks:
(i) Instead of correcting the balance of payments, it adversely affects the growth of international trade and the maximisation of world output and welfare.
(ii) It puts too much arbitrary powers into the hands of the government to influence foreign trade.
(iii) It creates undue complexities in calculation, due to different exchange rates for different imports and exports which may be changed from time to time, resulting in uncertainty in foreign trade.
(iv) The system has a formidable administrative problem of effective control. Utmost vigilance has to be maintained against the undervaluation of export invoices and overvaluation of import invoices and care should be taken to see that exporters do not sell their proceeds of foreign exchange in the black-market and importers do make specific and proper use of the allotted foreign exchange. Further, the system is also likely to breed corruption.
We may thus, conclude with Ellsworth that exchange control by the system of multiple exchange rates is only a partial solution to devaluation, and introduces uncertainties and distortions of its own.
Exchange Clearing Agreements :
European countries had adopted this form of exchange control in the Thirties. It was a system for the direct bilateral bartering of goods on a national scale. Under this device, two countries engaged in trade pay to their respective central banks the amounts payable to their respective foreign creditors.
These central banks then use the money in offsetting the corresponding claims after fixing the value of the currencies by mutual agreement. And, importers have to deposit their payment with the central bank can use such money to pay the domestic exporters.
This economises exchange needs for trade. Therefore, exchange clearing device is helpful to a country which has little or no foreign exchange reserves and which is more interested in selling than buying. However, this system is essentially one of offsetting each other's payments, and the basic assumption is that countries entering into such an agreement should try to equalise their imports and exports so that, there will be no necessity for either making or receiving payments from the other countries.
Following are the drawbacks of exchange clearing agreements:
(i) There is a possibility of exploitation of an economically weaker country by a stronger country.
(ii) The exchange clearing agreements involve bilateral transactions in foreign trade, which cause a diversion of normal trade pattern and endanger the promotion of world trade.
(iii) This device also reduces the volume of international trade. Besides, it attempts to do away with the foreign exchange market.
(iv) The scheme requires that all payments have to be centralised.
Payment Agreements :
To overcome the difficulties of the problems of waiting and centralisation of payments observed in clearing agreements, the device is formed as payment agreements. Under this scheme, a creditor is paid as soon as informants.
Under this scheme, a creditor is paid as soon as information is received by the central bank of the debtor country from the creditor country's central bank that its debtor has discharged his obligation and vice versa. By designing the arrangement for mutual credit facilities, thus, possibilities of delay are ruled out. Payment Agreements have the advantage that direct relation between exporters and importers are maintained.
However, payment agreements suffer from two defects:
(i) The agreement accounts could only be debited or credited for licensed payments.
(ii) The balances in the accounts could only be used for payment from one partner to another.
Gold Policy :
Through a suitable gold policy, the country can bring the desired exchange control. For this, the country may resort to the manipulation of the buying and selling prices of gold which affect the exchange rate of the country's currency. In 1936, for instance, the U.K., France and U.S.A. signed the Tripartite Agreement in this regard for fixing a suitable purchase and sale price of gold.
Indirect Methods of Exchange Control :
Apart from the direct methods, there are several indirect methods also regulating the rates of exchange. Important ones are briefly discussed below.
Changes in Interest Rates :
Changes in interest rate tend to influence indirectly the foreign exchange rate. A rise in the interest rate of a country attracts liquid capital and banking funds of foreigners. It will tend to keep their funds in their own country. All this tends to increase the demand for local currency and consequently the exchange rate move in its favour. It goes without saying that, a lowering of the rate of interest will have the opposite effect.
Tariffs Duties and Import Quotas :
The most important indirect method is the use of tariffs and import quotas and other such quantitative restrictions on the volume of foreign trade. Import duty reduces imports and with it rise the value of home currency relative to foreign currency. Similarly, export duty restricts exports; as a result, the value of home currency falls relative to foreign currencies. In short, when import duties and quotas are imposed, the rate of exchange tends to go up in favour of the controlling country.
Export Bounties :
Export bounties of subsidies increase exports. As such the external value of the currency of the subsidy-giving country rises.
It should be noted that import duties and export bounties are treated as indirect instruments of exchange control only if they are imposed with the object of conserving the foreign exchange. Otherwise, the fundamental aim of import duty is merely to check imports and that of export bounty is to encourage exports.
In fine, interest rates, import duty or export subsidy, each has its limitations. For instance, import duty cannot go so far as to completely restrict imports. There is also the fear of retaliation in regard to tariff policy. Similarly, the volume of subsidy depends upon the support of public fund. Likewise, manipulation of exchange rate through changes in interest rate may not be always effective. Moreover, rates of interest cannot be raised to any limit without engendering depression.
Concluding Remarks :
There are various forms in which the exchange control system may be devised. Each form has its own merits and demerits and each one serves a specific purpose. Therefore, the whole economic situation of foreign trade of a country must be carefully viewed while resorting to exchange control and more than one methods must be combined together.
In so far as the correction of disequilibirum is concerned, it should be noted that exchange control does not basically solve the problem, it only prevents the situation from becoming worse.
Moreover, exchange control is always an inhibiting factor to an expanding world trade. With its adoption the gains from international trade are reduced and channels of trade are distorted. It also checks the flow of international investments which are very essential for the planned development of world's economic resources. In normal peace times, therefore, it has hardly anything to commend. That is why, International Monetary Fund also has mentioned the removal of exchange controls as one of its major objectives.