Unfortunately for the governments that impose them, exchange controls simply don't work. The longer they're in place, the more ways clever people find to get around them.
To begin with, exchange controls create a huge black market and an accompanying criminal class. This phenomenon is well known in countries with stiff criminal penalties against mind-altering drugs.
Exchange controls also inevitably disrupt legitimate businesses. For instance, Venezuelan exchange controls, re-imposed in 2003, bankrupted thousands of small and middle-sized businesses because they could no longer obtain foreign currency.
Moreover, while Venezuela's foreign currency reserve position stabilized after it imposed exchange controls, remittances of foreign currency fell dramatically. This led to a steep decline in the standard of living for most residents. Many of Venezuela's most successful citizens emigrated to other countries, particularly those lucky enough to qualify for another passport, or wealthy enough to purchase one.
Despite the many shortcomings of exchange controls, the historical record is clear. In times of economic crisis, protectionist sentiments grow. Those advocating protectionist measures label anyone with offshore investments or other financial interests as traitors. Foreign exchange controls are a way of dealing with these purportedly disloyal citizens.
Human ingenuity being what it is, exchange controls are successfully—and often illegally—bypassed almost as soon as they're imposed. For instance, in Venezuela, individuals and businesses use the following strategies to deal with them:
- Purchase Venezuelan stocks traded in the United States using bolivars (the national currency) acquired at the official government rate. The buyer then sells these shares for U.S. dollars at the market exchange rate.
- Open a brokerage account with a Venezuelan stockbroker and deposit bolivars there. Purchase dollar-denominated Venezuelan government bonds in local currency. They buyer then exchanges them for U.S. Treasury bills in New York and deposits the proceeds in a U.S. account.
- Exchange bolivars for dollars in the foreign exchange black market. In downtown Caracas, thousands of black market currency traders are available to facilitate such exchanges.
- Miscategorize imported goods to qualify for exchange control preferences or exemptions. Venezuelan exchange controls include a permit system by which the central bank controls who can purchase foreign currency to pay for imports. The government gives top priority in foreign currency allocation to imports of capital goods, food, and medicine. Importers may provide false customs declarations listing these items when in fact they are importing other, non-exempt goods.
- Maintain bank or securities accounts outside Venezuela. These accounts are funded through the proceeds of the stock or bond transactions previously described and are effectively out-of-reach of the Venezuelan authorities.
- Bribe officials at the exchange control board (CADIVI) to approve preferences or exemptions. Theoretically, an importer should be willing to pay a bribe up to the amount that would be the difference between the official exchange rate and the black market exchange rate. Such corruption has been thoroughly documented by the Venezuelan press.
In the United States, President Obama hasn't proposed exchange controls, at least not yet. The dollar continues to appreciate against other currencies, so there's no immediate pressure to do so. However, Obama has advocated that offshore "tax havens" be shut down. And as I mentioned in Part I, the Treasury is already studying a dramatic expansion of reporting requirements for international transactions—a necessary prerequisite to exchange controls. When investors begin fleeing the dollar, and its value collapses, exchange controls may quickly follow.
U.S. residents concerned about the prospect for exchange controls in this country need to prepare for them now. The most basic strategy is to open a foreign bank account or to store precious metals at an offshore safekeeping facility. However, any U.S. exchange controls (in common with those in most other countries) may prohibit U.S. residents from maintaining a foreign account or other foreign investments without a "permit" to do so. Without a permit, the government may force you to repatriate your foreign account in exchange for dollars at the official exchange rate. This rate may be much less than the market exchange rate.
A better strategy may be to create an international structure in which you are not the owner of the underlying investments, but only a beneficiary. An offshore trust and some types of offshore annuity investments provide this sort of protection. Historically, payments from overseas life insurance and annuity policies have been exempt from foreign exchange controls—although there's no guarantee they would be in the future. An additional benefit is that these structures provide significant protection against claims in civil litigation.
Are foreign exchange controls coming to the United States? I certainly hope not. But if they do, I hope you've made arrangements to prepare for their arrival.
Copyright © 2009 by Mark Nestmann
(An earlier version of this post was published by The Sovereign Society).