Foreign Exchange
Senior 6 · Economics
Foreign Exchange
Lesson 4 of 4
25 min
Less than a year after the 1994 Genocide against the Tutsi, with the economy in ruins, the BNR changed how Rwanda dealt in foreign currency. According to an IMF account of the reform:
The IMF judged that the change was made quickly and with limited instability in the exchange rate. This was foreign exchange liberalisation.
Definition
Foreign exchange liberalisation: removing government controls over the buying and selling of foreign currency, so that the exchange rate is set in the market and residents can obtain foreign exchange freely for trade and, increasingly, for investment.
Current account convertibility: freedom to buy foreign currency for current transactions such as imports, travel and profit remittance. Capital account liberalisation extends that freedom to investments and loans.
| Advantages | Disadvantages and risks |
|---|---|
| Ends the black market, since everyone can buy at the market rate | The rate can become volatile |
| Exporters receive the full market value of their earnings, encouraging exports | A depreciation raises the price of imported fuel, food and medicines |
| Attracts foreign investors, who know they can take profits home | Capital can leave suddenly in a crisis (capital flight) |
| Removes the delays and corruption of rationing | The central bank must build reserves and skills to manage the market |
| Allows the balance of payments to adjust through the exchange rate | Needs a sound banking system and supervision of dealers |
Rwanda has continued along this path: the BNR's Regulation N° 42 of 2022 governing foreign exchange operations (18 April 2022) states that it aims at "liberalization of capital account" and sets rules for how licensed banks, forex bureaus and other intermediaries handle foreign exchange.
Definition
Foreign exchange reserves: the foreign currencies, gold, SDRs and reserve position at the IMF held by the central bank, available to pay for imports, service foreign debt and intervene in the currency market.
Months of import cover: the number of months of imports of goods and services that the reserves could pay for.
By the end of calendar year 2024 reserves covered 5.4 months of prospective imports, and by the end of 2025, 4.2 months (BNR). The BNR compares cover with a benchmark of 4 months.
Worked example 1: import cover
(a) At the end of June 2025 the BNR held US$2,201.6 million, which it reported as 4.8 months of imports. The monthly import bill it assumed was about
(b) If monthly imports rose to US$520 million with reserves unchanged, cover would fall to
(c) To keep 4.8 months of cover at US$520 million a month, reserves would need to be million US dollars, an extra US$294.4 million.
| Causes | Effects |
|---|---|
| A narrow base of primary exports whose prices fall | Shortages of imported fuel, medicines, spare parts and raw materials |
| Rapid growth of imports for consumption and investment | Factories work below capacity; projects stall |
| Heavy debt service and profit remittances | The currency depreciates sharply; imported inflation |
| Falling aid and grants | Black markets for dollars and corruption in allocation |
| Capital flight when confidence is low | Loss of investor confidence; more capital flight |
| An overvalued fixed exchange rate | Arrears to foreign suppliers and lenders |
| Shocks: drought, conflict, pandemics, border closures | Pressure to borrow on costly terms or to seek IMF support |
Remedies include promoting and diversifying exports, developing tourism and other services, attracting FDI, encouraging remittances through formal channels, replacing some imports with local production, building reserves in good years, managing debt carefully, and keeping inflation low so the exchange rate stays competitive.
Definition
Exchange control: government or central bank restrictions on the buying, selling and use of foreign currency, used to conserve reserves or hold a fixed rate.
Parallel (black) market: an illegal market in foreign currency that appears when the official rate is controlled; the difference between the parallel and official rates, as a percentage of the official rate, is the parallel market premium.
| Merits | Demerits |
|---|---|
| Conserves scarce reserves | Creates black markets and corruption |
| Directs foreign currency to essential imports | Discourages exports (earnings surrendered at a poor rate) and FDI |
| Prevents capital flight in a crisis | Delays and paperwork raise business costs |
| Can support a fixed exchange rate | Treats the symptom, not the cause, of the shortage |
Worked example
Worked example 2: the parallel market premium (illustrative)
A country with exchange control fixes its official rate at 1,000 units per US dollar, but dollars change hands illegally at 1,380.
An exporter forced to surrender US$50,000 at the official rate receives units instead of the the dollars would fetch on the parallel market: a loss of 19,000,000 units. This is why exchange control discourages exports and pushes earnings into smuggling.
Warning
Reserves are not the government's savings to spend. They belong on the central bank's balance sheet and are held against specific needs: paying for imports in a crisis, meeting debt payments and smoothing the exchange rate. A country that runs its reserves down to finance a persistent deficit loses its protection against the next shock.
Tip
Control or cure? Exchange control, rationing and surrender requirements manage a shortage of foreign exchange. More exports, tourism, remittances and investment cure it. In an evaluation question, always say which one a policy is.
Important
Discuss. Rwanda liberalised its foreign exchange market in 1995 and in 2022 set out rules aimed at liberalising the capital account. Some countries facing dollar shortages have gone the other way and introduced controls. Under what conditions, if any, would you advise Rwanda to reintroduce exchange controls?
Bloomberg, "What Are Capital Controls?" (about 2 minutes, 2015). Filmed as Greece limited bank withdrawals and transfers abroad during its debt crisis. Watch for why a government limits the movement of money and what it costs.
Practice
Further reading
Sources and credits
Written by Ganzaa: the chart, the tables, the worked examples and the practice items. The rates in worked example 2 are illustrative.
