Liberalization of the Foreign Exchange Market

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.