Exchange controls are government-imposed limitations on the purchase and sale of currencies. These measures enable countries to stabilize their economies by managing currency flows, reducing exchange rate volatility, and curbing speculation. Not all nations employ exchange controls legitimately, as the International Monetary Fund (IMF) only authorizes transitional economies to utilize such measures under Article 14 of its Articles of Agreement.
Historical Context: The Post-World War II Scenario
Many Western European countries introduced exchange controls immediately following World War II. As post-war economies strengthened, these measures were gradually rescinded; for instance, the United Kingdom eliminated its last restrictions in October 1979. Alternatively, countries with weaker or developing economies employ exchange controls to limit currency speculation and typically also introduce capital controls to govern foreign investments. These countries may restrict the amount of local currency exchanged or exported, or they might ban foreign currency altogether to prevent rapid capital flight.
Mechanisms of Enforcement
Exchange controls are implemented through several common methods:
- Banning the use of specific foreign currencies.
- Fixing exchange rates to deter speculation.
- Mandating foreign exchange transactions through government-approved institutions.
- Limiting the quantity of currency that can cross international borders.
Strategies to Circumvent Exchange Controls
One common corporate tactic to work around currency controls and hedge currency exposures involves the use of forward contracts. These arrangements allow businesses to agree to buy or sell an amount of an untradable currency at a future date for a predetermined rate in a major currency. When the contract matures, settlements occur in the major currency because local currency settlements are prohibited by controls.
In many developing nations, forward contracts are either heavily restricted or banned, so businesses often rely on non-deliverable forwards (NDFs) executed offshore to hedge their positions outside the jurisdiction of the local currency regulations. Active offshore NDF markets can be found in countries such as China, the Philippines, South Korea, and Argentina.
Iceland: A Contemporary Case Study
A particularly notable example of exchange controls occurred during Iceland’s financial crisis in 2008. Following an overextension by its three largest banks, whose assets vastly outstripped the country’s economic output, the crisis led to a dramatic outflow of capital and the collapse of the local currency, the krona. Iceland put exchange controls in place to stabilize the situation and eventually received a rescue package from the IMF.
Lifting and Modifying Exchange Controls
In March 2017, Iceland’s Central Bank lifted most exchange controls, allowing the movement of the krona and foreign currency across borders. Still, new reserve requirements and adjusted foreign exchange rules were introduced to manage speculative capital flows into the country. Additionally, to resolve disputes with foreign investors unable to liquidate their Icelandic holdings earlier, the Central Bank offered to purchase currency holdings at a discounted rate. Iceland also mandated that foreign holders of krona-denominated bonds sell their bonds back at a discount or have their funds impounded in low-interest accounts upon maturity.
Understanding exchange controls, their purposes, historical applications, and enforcement mechanisms, as well as strategies to navigate these restrictions, offers essential insights for anyone involved in global economics and finance.
Related Terms: FOREX, currency peg, foreign exchange, IMF, capital flows.
