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The Use of Foreign Exchange Controls to Promote Economical Stability

I. Introduction

Foreign exchange controls are various types of restrictions a government places on the purchase or sale of local currencies to other types of currencies. Limitations are often placed either on the residents of the country where the controls are imposed, or on the non-residents of the country. Foreign exchange controls are most often utilized by nations with weak currencies, and where there is significant demand for foreign currencies among their citizens.[i] The use of foreign exchange controls can often hinder foreign investors who wish to move their funds to other countries. These controls attempt to create exchange stability by limiting exchange rate volatility due to currency flows across borders. Such controls are hypothetically utilized to stem the outflow of capital from the country with the weaker currency.

Article XIV of the International Monetary Fund’s Articles of Agreement allow for “transitional arrangements” whereby a country may enact foreign exchange controls.[ii] The IMF allows these arrangements with the proviso that the country will attempt to move to create commercial and financial arrangements which will facilitate international payments and ultimately promote a stable system of exchange rates. However, the IMF has performed research showing that exchange controls may have a negative impact on international trade.

Often, foreign exchange controls can result in the creation of black markets to exchange the weaker currency for stronger currencies.  This leads to a situation where the exchange rate for the foreign currency is much higher than the rate set by the government, and therefore creates a shadow currency exchange market. As such, it is unclear whether governments have the ability to enact effective exchange controls.

II. Controlling Capital Flight

Countries use foreign exchange controls in an attempt to curtail capital flight. Capital flight refers to a situation where there are movements of funds across boundaries which are significant enough to affect national economies.[iii] Capital flight is more likely in a situation where a country’s exchange rates are volatile. The holders of the weaker currency want to exchange it for a currency which is more stable and less prone to uncertain fluctuations in value. Capital flight can also occur on a larger scale where significant capital outflows are caused by a perceived decline in the return on assets held in that country, or an increase in risk of holding those assets. Leaders of countries impacted by capital flight are concerned that the outflows negatively impact their economies, which are often sorely in need of investment in their infrastructure.  However, foreign exchange controls are often ineffective in preventing capital flight. The controls often lead to even greater demand for stable foreign currencies. Further, foreign exchange controls can erode confidence in an already battered currency.

III. Different Methods Foreign Exchange Controls

There are a number of different types of foreign exchange controls. Some of the types of controls can include:

  1. Rationing of Foreign Currency. By controlling the amount of foreign currency available for exchange, governments may influence the forces of supply and demand, and maintain the exchange at a higher rate than the free market would dictate.[iv]
  2. Exchange Rate Pegging/Fixed Exchange Rate. A government pegs the exchange rate for the conversion foreign currency, either above or below the market rate. This ostensibly helps to prevent volatile exchange fluctuations by helping to control the supply of local currency.
  3. Blocked Accounts. Governments enact regulations preventing foreigners from withdrawing funds from local bank accounts. Further, governments may require domestic parties to deposit funds for foreign payments in designated accounts. Governments may thereby control the flow of capital and prevent money from leaving the country.
  4. Multiple Exchange Rates. Governments use different fixed exchange rates for capital and current account transactions.[v] Under this type of system, governments have more than one rate at which currencies are exchanged. Multiple exchange rates serve as implicit tariffs on the import of certain goods into the country by creating a “tax” by imposing unfavorable exchange rates on the conversion of currency from the sale of those goods.[vi]

IV.Foreign Exchange Certificates as Proxy for Local Currency

Foreign exchange certificates are a type of currency. They are often used as surrogates for the foreign currency when exchange controls are in place. The rate of exchange for the certificates may be fixed higher or lower than the free market rate. The Soviet Union, China and East Germany all used foreign exchange certificates in the past. Burma recently voted to end the use of foreign exchange certificates.[vii]

V. China’s Use of Foreign Exchange Certificates

The Bank of China required the use of foreign exchange certificates during the 1980s and 1990s. Use of the certificates was discontinued in 1995. During this period, it was actually illegal for foreigners to use the local Chinese currency. Further, the certificates were only allowed to be used at certain designated stores and restaurants.[viii] As a result, foreigners were drastically limited to the places they could frequent.

The regulations which created the currency regime specifically prohibited any private dealings or speculation in the certificates.[ix] Still, as might be expected, an illegal black market of currency exchange arose. Locals wanted access to the certificates to buy “luxury” foreign goods sold in the state sponsored stores, such as American cigarettes and liquor, and foreigners wanted access to local restaurants and stores which did not require the use of the certificates. The proliferation of the black market in currency, as well as the greater availability of “luxury” foreign brands imported into China, ultimately led to the dismantling of the certificate exchange system.

VI. South Africa’s Dual Exchange Financial Rand System

South Africa has a long history of exchange controls, but began enacting controls in earnest as a result of capital flight in 1960.[x] More recently, South Africa enacted a system where there were two types of currency. There were two periods for use of the financial rand and the commercial rand. The first period was from 1979 to 1983. The second period was from September of 1985 to March of 1995. This second period was during a controversial period in South African history, as the financial rand was reintroduced in response to the imposition of United Nations economic sanctions. The sanctions were imposed due to the continuing apartheid regime in the country.

In 1985 the South African government defaulted on a large portion of its international debt obligations. At the same time, the government enacted the exchange controls. Investments in South African by foreigners could only be sold for financial rand. The government placed limitations on the exchange of financial rand for foreign currencies. There was a dual-rate rand exchange system, with the commercial rand rate set by current account transactions, while the financial rand rate was set by capital account transactions. Both types of currency were on a floating system, however, the financial rand traded at a discount to the commercial rand. The dual exchange system was ended in March of 1995.

VII. Venezuela’s CADIVI

Venezuela has also enacted various types of exchange controls. The Commission for the Administration of Currency Exchange (“CADIVI”) is the governmental organization which controls currency exchange in Venezuela.[xi] CADIVI enacted currency exchange controls in February of 2003 in response to a country-wide two month strike which attempted to overthrow the government headed by President Hugo Chavez. The state-run oil industry was the main industry impacted by the strike, as Venezuela’s GDP fell 37% during the first few months of 2003.[xii] It was estimated that the strike cost the oil industry around $13 billion.

Under the regulations enacted by the Venezuelan government, PDVSA, the state controlled oil and gas company, must sell its foreign currency to the Central Bank. The PDVSA is a major exporter for the country. It is estimated that PDVSA will transfer $41.5 billion to the Central Bank in 2013. Still, it appears that the exchange controls have not been successful. Despite the exchange controls, approximately $33 billion flowed out of Venezuela in 2011.[xiii]

In 2008, the Chavez government created a new currency known as the bolivar fuerte,(“bolivar”)  and pegged the currency to a higher rate against the dollar than the market value. This created a scarcity of foreign currency, as confidence in the bolivar declined, and foreign exchange, especially the U.S. dollar, was in greater demand. The foreign exchange controls have resulted in a substantial black market for foreign currency. The Venezuelan government has responded recently by holding auctions of U.S. dollars to importers in order to prevent the decline of the bolivar on the black market.[xiv] The official exchange rate for the auctions was 6.3 bolivars per dollar, versus the estimated black market rate of 23.5 bolivars per dollar. The auctions had the effect of weakening the bolivar by 32%, resulting in losses for foreign companies such as Pfizer and Blackberry which are operating in Venezuela.[xv]


There are many methods of currency exchange controls that may be used by governments. Countries have different reasons for imposing foreign exchange controls, including attempts to prevent volatile currency exchange rate swings, and to stem the tides of capital flight. Often, foreign exchange controls result in the creation of black markets for foreign currencies, and ultimately prove to be ineffective in stemming capital flight. While foreign exchange controls may work in the short term, they can often negatively impact national economies in the long term by hindering international trade and preventing outside investment in the country enacting the controls.