In recent years, an increasing number of developing countries have adopted market-determined floating exchange rates. This development has represented a significant step forward in the evolution toward exchange rate flexibility that has taken place in the developing country group since the adoption of generalized floating by industrial countries in 1973. Before 1983 there had been only isolated instances of floating by developing countries in the context of the post-par value regime. Lebanon has had such a floating exchange rate for several years. Other experiences with market-determined unitary floating rates were quite short lived, lasting for less than one year (Mexico, 1976/77; Argentina, 1978; Costa Rica, 1981; and Chile, 1982).

Discussion of the scope for floating exchange rates in developing countries has been characterized by concerns that in most of these countries exchange markets are thin and financial markets in general are underdeveloped, increasing the potential volatility of market-determined rates and the cost of hedging against it. In the literature, the use of flexible management of reserves rather than exchange rate flexibility and the adverse consequences of floating systems for domestic price stability have often been emphasized, and the discussion has questioned the developing countries’ capacity to operate market-determined exchange rates.¹ Despite these perceived shortcomings, within the past four years countries with fairly diverse economic and financial structures have adopted market-determined exchange rate systems. The more widespread use of unified floating exchange rate systems by developing countries began with the introduction by Uganda in mid-1982 of a secondary auction market for foreign exchange. Uruguay changed to a unified floating rate from a preannounced rate in late 1982. This was followed in close order by Jamaica, Uganda, and Zaïre in the first half of 1984 (each involving unification of an existing official market and a free market introduced in the context of a Fund program). The Philippines adopted a system in which the exchange rate is determined in a unified market in October 1984, and was followed by Bolivia, the Dominican Republic, and Zambia in 1985. In 1986, The Gambia, Guinea, and Sierra Leone adopted unified floating markets, and Ghana and Nigeria put in place arrangements for transition to a unified float.

General aspects of exchange rate policies in developing countries were reviewed by the Fund’s Executive Board in 1982.² Developments in exchange rate arrangements on the basis of the Fund’s classification system were also examined by the Executive Board in 1982, when the present system of identifying “independently” (market-determined) floating arrangements was established.³ The role of exchange rate adjustment in members’ programs supported by use of Fund resources has also been reviewed in the context of conditionality reviews. The intention of this paper is not to re-examine these general policy areas but to focus specifically on recent experience with floating exchange rates, including a comparison with the experience of countries that have managed their exchange rates essentially in accordance with relative purchasing power parity. Given that the capacity of developing countries for operating the arrangements for floating exchange rates has been a key issue in these countries, the paper also deals in some detail with technical and institutional aspects of those arrangements in which the Fund staff has been closely involved.

The paper is organized as follows. Section II examines the institutional setting and the form of exchange market arrangements. Problems that have arisen in the process of setting up the markets and in ensuring their efficient operation are also discussed in this section. Section III deals with related actions in the field of exchange and trade liberalization and development of forward exchange markets. The impact of floating exchange market developments is examined in Section IV of the paper, including developments in nominal and real effective exchange rates, black markets for foreign exchange, payments arrears, capital flows, and foreign exchange reserves. Although the emergence of floating markets is a relatively recent phenomenon in most of these countries, an attempt is made in this section to appraise the macroeconomic aspects of the experience, including a comparison with performance under regimes in which the exchange rate is managed in such a way as to stabilize the real effective rate. Section V provides a summary of the main issues.