In Chapter 3, we described how exchange rate risk could be hedged using forward contracts. In pegged or limited-flexibility exchange rate systems, countries imposing capital controls sometimes force their importers and exporters to hedge

Question

First, assuming that forward contracts are to be used, and an exporter has future foreign currency receivables, what will the government force him to do? Second, how does this help the government in defending their exchange rate peg?

Answer 1

Exporters, who have foreign currency receivables, have an incentive to lag the foreign currency payments (e.g. by giving generous trade credit), if they think their domestic currency is under pressure and may be devalued. Doing so allows them to potentially profit from an impending devaluation of the local currency. Of course, extending trade credit involves an opportunity cost, but the interest rates reflect some probability that the peg will hold. Hence, if the currency is actually devalued, lagging the payment is beneficial ex-post.
Lagging foreign currency payments causes further pressure on the local currency as the exporter's demand for local currency is postponed. A forced hedge would require the exporter to sell the foreign currency forward for the local currency. Hence, there is immediate positive demand for the local currency. That the demand is in the forward market is inconsequential. Because of covered interest rate parity, if the forward rate decreases (in local currency per foreign currency) it would result in lower local interest rates. This is because the spot rate is fixed and the foreign interest rate is not likely affected. Hence, this relieves the speculative pressure.