When tariffs and quotas do not help in restoring the balance of payments equilibrium, countries very often resort to exchange control. Under exchange control, the payments for imports and other international payments are determined solely by the government. There may be two types of exchange pegging; the government intervenes to keep the rate of exchange at a particular level. The British Exchange Equalization Account and the US Exchange Stabilization Fund are two examples of mild exchange control. In case the demand for dollars goes up and as a result the value of the pound falls, the UK Government would sell dollars for pounds thus increasing the supply of dollars ad preventing a fall in the value of the pound.
If exchange control is to be effective, it must be fairly strict inasmuch as there are various methods to evade control viz., overvaluation of imports, undervaluation of exports, taking domestic currency while going abroad and retaining foreign exchange receipts in foreign countries over a longer period of time than ordinarily allowed.
A full-fledged system of exchange control aims at establishing complete control over the entire foreign exchange transactions. For example all receipts from exports and other sources had to be surrendered to the Reserve bank of India in India before 1992. The available supply of foreign exchange was then allocated to the various buyers of foreign exchange according to some stated criteria determined by the control authorities.
Objectives of Exchange Control:
1. To limit the demand for foreign exchange up to the available resources;
2. To protect domestic industries;
3. To maintain an overvalued rate of exchange;
4. To follow independent monetary and fiscal policies
5. To prevent flight of capital, and
6. To earn revenue in the form of difference between selling and purchasing rates of foreign exchange.
The effectiveness of foreign exchange control lies more in the fact that it controls flight of capital. This is especially important when a countryâ€™s currency is under speculative pressure. In such cases, tariffs and quotas would not help. Exchange control being a direct control on exchange would be able to prevent flight of capital or what is known as hot money.
However, it should be noted that exchange control is not the remedy to the disease. It just keeps the deficit to the minimum and does not attack the basic cause of the trouble. Exchange control can be effective so long as the balance of payments deficit is only due to fear of war or sudden crop failure or some such reasons. But if there are some other underlying reasons, exchange control will not be effective.
Another form of exchange control is the use of multiple exchange rates. Under this method, there are a number of buying rates and a number of selling rates by product categories. The rates are determined by the exchange control authorities according to the priority of import requirements and the ease of selling exports. This method was very popular in some of the Latin American countries specially Argentina and Chile. For example, while foreign exchange for essential raw materials and other essential imports was allowed at a low rate, for non-essential requirement like luxuries, foreign travel etc. it was sold at a high rate. Foreign exchange earned by exports, which could be easily sold was converted into domestic currency at a lower rate but for difficult to sell exports the foreign exchange was converted at a higher rate thus giving an indirect subsidy to exports.
Exchange control has also been utilized for discriminating between various sources of supply. For example, immediately after World War II, due to acute dollar shortage while imports from soft currency areas were liberally allowed those from hard currency areas were subject to tight import control. Even in India until recently many import licenses were issued for use in rupee currency areas only, i.e. the countries with which India had signed rupee trade agreements.