Methods of Exchange Control
Paul Einzig in his book Exchange Control has mentioned as many as 41 different methods of exchange control. Broadly speaking, these methods may be classified into two types: direct and indirect methods. Direct methods consist mainly of intervention, restriction and exchange clearing agreements. Indirect methods of exchange control consist of quantitative restrictions on international trade and interest rate changes to influence the rate of exchange.
Direct Methods of Exchange Control
(a) Intervention. For an effective control of foreign exchange rates and foreign exchange market the government should have a central authority—the central bank—which should have complete power to control and regulate foreign exchange market. Anyone wanting foreign exchange should purchase it only from the central authority and from no other source. Likewise anyone wanting to sell foreign exchange should sell it only to the central authority. The buying and selling of foreign exchange by a single authority shall enable the latter to adjust demand and supply of foreign exchange according to the needs of the country.
Government intervention in the foreign exchange market takes the form of "pegging-up" or "pegging down" the currency of the country to a chosen rate of exchange. The pegging operations take the shape of buying and selling of the home currency either by the Government or by the central bank of the country in exchange for the foreign currency in the foreign exchange market. Intervention of the Government in the foreign exchange market has the effect of influencing the forces of demand and supply of foreign exchange. Besides, in order to carry on intervention, the authorities must have reserves of both local and foreign currencies. If that is not possible, the Government will either have to resort to the alternative method of direct exchange control, viz., restriction, or the Government will fail in their purpose of controlling the rate of exchange.
(b) Restriction. A more powerful weapon of exchange control has been devised in exchange restriction. Exchange restriction refers to the policy by which the Government restricts the supply of its currency coming into the exchange market. Restriction may be of three types. The first method of restriction is to .centralize all trading in foreign exchange with one central authority, normally the central bank of the country. The second method is to prevent the exchange of national currency against foreign currency without the permission of the Government. The third method is to make all foreign exchange transactions through the agency of the Government.
Exchange restriction was first adopted by Germany in 1931, where non-compliance of currency regulations was punishable with .death. During the Second World War, many other countries followed the German example.
(b) Exchange Clearing Agreements. Exchange clearing is a method of exchange control which was practiced during the Depression of 1930's. Under it, two countries engaged in trade pay to their respective central banks the amounts payable to their respective foreign creditors. The central banks then use the money in offsetting the corresponding claims after fixing the value of the currencies by common agreement. AH that happens is a notification by one central bank to another that a certain payment has been received or made. This system is essentially one of offsetting each other's payments, and the basic assumption is that the countries entering into such an agreement will see that imports and exports are more or less equal and there is no necessity for either making payments to or receiving payments from the other country. The basic principle is to offset international payments so that they have not to be settled through the medium of foreign exchange markets.
However, the exchange clearing agreements suffer from an important defect, that there is a possibility of economic exploitation of a weaker country by a powerful country.