What Are Exchange Controls?
Let me explain what exchange controls are: they're limitations imposed by governments on the purchase or sale of currencies. You see, these controls help countries stabilize their economies by restricting the inflows and outflows of currency, which can otherwise lead to wild exchange rate swings. Not every country uses them legitimately; according to the 14th article of the International Monetary Fund's Articles of Agreement, only nations with transitional economies are allowed to implement exchange controls.
Understanding Exchange Controls
Many western European countries put exchange controls in place right after World War II. They phased them out gradually as their post-war economies got stronger; take the United Kingdom, for instance—it removed its last restrictions in October 1979. If you're looking at countries with weak or developing economies, they typically use foreign exchange controls to curb speculation against their currencies. Often, they combine these with capital controls that limit foreign investment in the country.
Fast Fact on Exchange Controls
Here's a key point: countries with weak or developing economies may impose controls on how much local currency can be exchanged or exported, or they might ban a foreign currency entirely, all to prevent speculation.
How Exchange Controls Are Enforced
Governments enforce exchange controls in several common ways. They might ban a specific foreign currency and stop locals from holding it. Or they could set fixed exchange rates to discourage speculation, limit all foreign exchange to a government-approved entity, or cap the amount of currency that can be imported or exported from the country.
Measures to Thwart Exchange Controls
Companies often use tactics to get around currency controls and hedge their exposures, like forward contracts. In these setups, you arrange to buy or sell a certain amount of an untradable currency on a future date at an agreed rate against a major currency. When it matures, the gain or loss settles in the major currency since settling in the controlled one is prohibited.
In many developing nations, exchange controls don't allow forward contracts, or they restrict them to residents for things like buying essential imports. That's why non-deliverable forwards (NDFs) are usually done offshore, where local rules can't be enforced. You'll find active offshore NDF markets in places like China, the Philippines, South Korea, and Argentina.
Exchange Controls in Iceland
Take Iceland as a recent example of exchange controls during a financial crisis. This small country of about 384,000 people saw its economy crash in 2008. Its economy, once based on fishing, had essentially become a massive hedge fund run by its three biggest banks—Landsbanki, Kaupthing, and Glitnir—whose assets were 14 times the nation's entire economic output.
Initially, Iceland benefited from a flood of capital chasing the high interest rates from those banks. But when the crisis struck, investors yanked their money out, causing the local currency, the krona, to nosedive. The banks failed, and the economy needed a bailout from the IMF.
Lifting the Exchange Controls and Imposing New Ones
Under those exchange controls, investors with high-yield offshore krona accounts couldn't bring their money back into Iceland. In March 2017, the Central Bank lifted most controls on the krona, allowing cross-border movements of Icelandic and foreign currency again. However, it also introduced new reserve requirements and updated foreign exchange rules to manage the influx of hot money into the economy.
To resolve issues with foreign investors stuck with illiquid Icelandic holdings during the controls, the Central Bank offered to buy their currency at a rate discounted by about 20 percent from the normal exchange rate. Icelandic lawmakers also mandated that foreign holders of krona-denominated government bonds sell them back to Iceland at a discount, or face having their profits locked in low-interest accounts indefinitely when the bonds mature.
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