What are Exchange Controls?
Exchange controls are government-imposed limitations on the purchase and/or sale of currencies. These controls allow countries to better stabilize their economies by limiting in-flows and out-flows of currency, which can create exchange rate volatility. Not every nation may employ the measures, at least legimately; the 14th article of the International Monetary Fund's Articles of Agreement allows only countries with so-called transitional economies to employ exchange controls.
Background on Exchange Controls
Many western European countries implemented exchange controls in the years immediately following World War II. The measures were gradually phased out, however, as the post-war economies on the continent steadily strengthened; the United Kingdom, for example, removed the last of its restrictions in October 1979. Countries with weak and/or developing economies generally use foreign exchange controls to limit speculation against their currencies. They often simultaneously introduce capital controls, which limit the amount of foreign investment in the country.
Countries with weak or developing economies may put controls on how much local currency can be exchanged or exported—or ban a foreign currency altogether—to prevent speculation.
Exchange controls can be enforced in a few common ways. A government may ban the use of a particular foreign currency and prohibit locals from possessing it. Alternatively, they can impose fixed exchange rates to discourage speculation, restrict any or all foreign exchange to a government-approved exchanger, or limit the amount of currency that can be imported to or exported from the country.
Measures to Thwart Controls
One tactic companies use to work around currency controls, and to hedge currency exposures, is to use what are known as forward contracts. With these arrangements, the hedger arranges to buy or sell a given amount of an un-tradable currency on a given forward date, at an agreed rate against a major currency. At maturity, the gain or loss is settled in the major currency because settling in the other currency is prohibited by controls.
The exchange controls in many developing nations do not permit forward contracts, or allow them only to be used by residents for limited purposes, such as to buy essential imports. Consequently, in countries with exchange controls, non-deliverable forwards are usually executed offshore because local currency regulations cannot be enforced outside of the country. Countries where active offshore NDF markets have operated include China, the Philippines, South Korea, and Argentina.
Exchange Controls in Iceland
Iceland offers a recent notable example of the use of exchange controls during a financial crisis. A small country of about 334,000 people, Iceland saw its economy collapse in 2008. Its fishing-based economy had gradually been turned into essentially a giant hedge fund by its three largest banks (Landsbanki, Kaupthing and Glitnir), whose assets measured 14 times that of the country's entire economic output.
The country benefited, at least initially, from a huge inflow of capital taking advantage of the high interest rates paid by the banks. However, when the crisis hit, investors needing cash pulled their money out of Iceland, causing the local currency, the krona, to plummet. The banks also collapsed, and the economy received a rescue package from the IMF.
Under the exchange controls, investors who held high-yield offshore krona accounts were not able to bring the money back into the country. The Central Bank announced in 2015 that the controls would be lifted by the end of 2016. It also introduced a program through which account-holders would be able to move money back onshore by either buying domestic krona at a discount from the official exchange rate or investing in long-term Icelandic government bonds, with a significant penalty for selling early.