Liberalization of the Foreign Exchange Market

Frank C. Child


There is a pattern in the evolution of exchange control
systems. A typical sequence of events is: Phase 1, implementation—in
response to a serious balance-of-payments deficit, a free
foreign-exchange market is abandoned in favour of price control and
rationing of foreign exchange. Initially exchange control applies only
to major categories of receipts and payments but is rapidly extended to
cover all external transactions. Phase 2, consolidation—a black market
appears; regulations are extended and revised to close loopholes, to
cope with shortages, and to repair inequities and anomalies. The
foreign-exchange market is fragmented and differential treatment is
accorded to different types of trade or traders. Taxes, subsidies, or
multiple-exchange rates are introduced to offset, in a discriminatory
way, iie effect of an overvalued currency on foreign-exchange receipts
and the demand >r imports. The system becomes increasingly complex
and administratively burdensome. Phase 3, rationalization—the complexity
of the system is reduced by consolidation of market fragments.
Regulations are simplified and applied to broader categories of
transactions. De facto but selective devaluation, through iax, subsidy,
and exchange-rate adjustments, becomes a policy instrument. Portions of
the market are "liberalized" by returning to a limited free market in
which price resumes its functions of evoking supply and limiting demand.
Continued disequilibrium, however, sustains the black market which may
be "tolerated" as a sort of unofficial free market.

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