Governments use exchange controls to manage currency flow and prevent extreme exchange rate fluctuations by imposing restrictions on currency transactions. Companies can use forward contracts, which involve an agreement to buy or sell a specific amount of a non-tradable currency on a future date at a predetermined exchange rate against a major currency, to navigate these controls.
Basics
Exchange controls are restrictions imposed by governments on currency transactions. They are used to stabilize economies by regulating the buying and selling of currencies. These controls help manage the flow of currency and prevent excessive exchange rate fluctuations. However, not all countries are allowed to implement exchange controls. Only countries with transitional economies are authorized to employ these measures.
Brief History and Principles of Exchange Controls
Following World War II, several Western European countries implemented exchange controls. However, as these countries' economies grew stronger over time, these measures were gradually phased out. For instance, the United Kingdom removed its last exchange restrictions in 1979. In general, countries with weak or developing economies tend to employ foreign exchange controls to prevent currency speculation. They often introduce capital controls simultaneously to restrict foreign investment.
To prevent speculation, countries with weak or developing economies may impose restrictions on the exchange or export of local currency. In some cases, they may even ban the use of foreign currency and prohibit its possession by locals. Other methods of enforcing exchange controls include implementing fixed exchange rates to discourage speculation, limiting foreign exchange transactions to government-approved exchangers, or placing restrictions on the amount of currency that can be imported or exported.
Countermeasures From Companies
To navigate currency controls and mitigate currency risks, companies often employ a strategy called forward contracts. These contracts involve an agreement to buy or sell a specific amount of a non-tradable currency on a future date at a predetermined exchange rate against a major currency. When the contract matures, any gains or losses are settled in the major currency since settling in the restricted currency is prohibited by the controls.
In many developing nations with exchange controls, the use of forward contracts is either not allowed or restricted to specific purposes, such as essential imports, and is only available to residents. As a result, non-deliverable forwards (NDFs) are commonly utilized offshore in these countries. The reason is that local currency regulations cannot be enforced outside of the country. Countries like China, the Philippines, South Korea, and Argentina have had active offshore NDF markets.
Iceland’s Example of Exchange Controls
During a financial crisis in Iceland, the country's economy collapsed in 2008. The three largest banks in Iceland (Landsbanki, Kaupthing, and Glitnir) had grown significantly and were heavily invested, leading to the crisis. As a result, Iceland faced a massive outflow of capital, causing its currency, the Krona, to devalue. The banks failed, and the country sought assistance from the International Monetary Fund (IMF) to stabilize its economy.
New Reserve Requirements and Updated Foreign Exchange Rules
Under exchange controls, investors holding offshore Krona accounts faced limitations in bringing their funds back into the country. However, in March 2017, the Central Bank lifted most of these controls, allowing the movement of Icelandic and foreign currency across borders once again. To regulate capital flows, the Central Bank implemented new reserve requirements and updated foreign exchange rules. As part of resolving disputes with foreign investors, the Central Bank offered to buy their currency holdings at a discounted exchange rate. Furthermore, foreign holders of krona-denominated government bonds were required to sell them back at a reduced rate or have their profits held in low-interest accounts indefinitely.
Conclusion
Exchange controls are an important tool for governments to regulate the flow of currency and prevent excessive exchange rate fluctuations. While they can be effective in stabilizing economies, they can also create challenges for companies operating in countries with exchange controls. To mitigate currency risks, companies often employ forward contracts or non-deliverable forwards. Iceland's experience during its financial crisis illustrates the impact of exchange controls on investors and the measures governments may take to lift them.