What is an Exchange Control
Exchange controls are governmental limitations on the purchase and/or sale of currencies. These controls allow countries a greater degree of economic stability by limiting the amount of exchange rate volatility due to currency inflows/outflows. The Articles of Agreement of the International Monetary Fund include Article 14, which only allows countries with so-called transitional economies to employ foreign exchange controls.
BREAKING DOWN Exchange Control
Countries with weak and/or developing economies generally use foreign exchange controls to limit speculation against their currencies. They are often accompanied by capital controls that limit the amount of foreign investment in the country. In the years immediately following World War II, many western European countries had such controls, but they were gradually phased out with the United Kingdom removing the last of its restrictions in October 1979. Countries sometimes introduce such controls for a limited period of time during an economic crisis.
How Exchange Controls Can Be Implemented
There are a few common ways that countries can enforce exchange controls. The use of a foreign currency can be banned and locals can be prohibited from possessing a specific currency, using fixed exchange rates, restricting any foreign exchange to a government-approved exchanger and limiting the amount of currency that can be imported or exported.
Many developing countries have exchange controls that do not allow forward contracts, or only allow them to be used for residents and for limited purposes, such as essential imports. Companies with a need to hedge currency exposures in those countries sometimes use non-deliverable forward contracts. These are agreements in which the hedger agrees 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 the other currency cannot be delivered.
Non-deliverable forwards are usually executed offshore because they skirt or break local currency regulations that cannot be enforced outside of the country. Countries where NDF markets have been active include China, the Philippines, South Korea and Argentina.
Exchange Controls in Iceland
In 2008, the economy of Iceland — a small country of about 334,000 people — collapsed. Its fishing-based economy had gradually been turned into a 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 had benefited from a huge inflow of capital, taking advantage of the high interest rates paid by the banks, while Icelanders borrowed overseas at lower interest rates. When the crisis hit, investors needing cash pulled their money out of Iceland, causing the local currency, the krona, to collapse. 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 though 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.