There is now a free forward exchange market.26 Authorized foreign exchange dealers (banks and nonbank financial institutions) are permitted to negotiate forward exchange contracts in any currency. They may deal among themselves and with their customers, including both residents and nonresidents, at mutually negotiated rates. The Reserve Bank sets a limit for each dealer’s overall overnight foreign exchange exposure. However, in aggregate, dealers rarely use more than 25 percent of their approved limit.
Systems for forward cover against exchange rate risk exist either in the official or the commercial sectors in most member countries of the International Monetary Fund. However, the form of the arrangements varies widely from one country to another, and has consequences for economic efficiency and macroeconomic management. Essentially, there are three types of forward exchange systems: market determined, with the possibility of official intervention; “market approximating,” in which the authorities attempt to set forward rates that simulate free market conditions; and official cover and exchange rate guarantees at fixed nonmarket rates. In practice, the last two forms of arrangement have frequently given rise to government subsidies, with serious consequences in a number of instances for central bank profits, and hence, fiscal budgets and rates of monetary expansion.
There has always been a desire to avoid the risk associated with trade and economic activity across currency boundaries. An early form of exchange risk hedging in industrial countries was the use of long bills that constituted an asset or liability in foreign currencies—a practice dating back several centuries. With the improvements in financial techniques in the latter half of the nineteenth century in Europe, genuine forward exchange markets—markets in which currencies were traded for future delivery—emerged. Since that time, official or unofficial forward exchange trading has taken place whenever exchange rates fluctuated or were subject to significant uncertainty, provided that the authorities did not directly suppress the markets.
There is a small but growing number of forward exchange markets in developing countries in which forward cover is provided to the private sector under competitive conditions by commercial banks.15 In some cases, these markets have been introduced in association with floating spot exchange systems and are at an early stage of development (as they are in Jamaica, Nigeria, the Philippines, and Zaire). In other cases, forward markets have arisen in association with relatively advanced financial systems or relatively free exchange systems, or both (as in Brazil, Chile, Indonesia, Jordan, Korea, Malaysia, Singapore, Thailand, and the United Arab Emirates).
Forward exchange markets in industrial countries in the 1980s have shown a substantial reduction of government regulation and intervention, and increasing innovations in financial instruments. Forward markets now operate in all industrial countries except Iceland.
This paper describes and analyzes forward market systems with varying degrees of sophistication, and it assesses them from the viewpoint of a smaller industrial or developing country asking itself how it could institute such a system, or how it could further develop an existing system in a way consistent with its institutional and macroeconomic structure. All industrial countries except Iceland now have forward exchange markets in which the rate is determined by the market. Forward markets that have been liberalized in several countries in the 1980s have matured quickly. There are several variants of market-determined systems which could be envisaged. An auction market could be devised for forward transactions, but is unlikely to be practical, because the supply of forward exchange probably may not be determined in advance sufficiently accurately. As the last stage of its development, the market could be extended from underlying commercial transactions to forward transactions of a purely financial character, a process that is taking place in most of the few industrial countries that have retained regulated forward systems. Development of a forward market is not a panacea for incorrect financial policies. In fact, cultivation of the market will require the adoption and maintenance of realistic financial policies.
In response to increased exchange rate variability, there has been a rapid growth of forward exchange markets in recent years. Forward foreign exchange systems in developed and developing countries remain diverse, but as in the spot markets, there has been a convergence toward greater flexibility and freedom of access.