Exchange Arrangements and Policy and Regulatory Framework

The exchange rate stability observed in many transition countries of late reflects, operationally, quite active foreign exchange market intervention in some cases. But it has generally been achieved in a more fundamental sense through restrained monetary and fiscal policies, rather than reflecting the type of exchange rate arrangement chosen and the amount of foreign exchange reserves usable for intervention. Nevertheless, it is interesting to note that such stability has been observed in those transition countries that have also maintained or moved further toward liberalized exchange markets.

By contrast, countries that maintained restrictive exchange regimes and lagged in the implementation of exchange reforms also faced depreciation of their nominal exchange rates during 1995. In Turkmenistan and Uzbekistan, currency depreciation and significant spreads between official exchange rates and bureaus and parallel market rates were observed, notwithstanding large holdings of foreign exchange reserves that were frequently used to intervene in the foreign exchange market. In Turkmenistan, recognition of the ineffectiveness of efforts to regulate access to foreign exchange and maintain overvalued official exchange rates led the authorities recently to indicate their intention to revert to an official exchange rate that closely approximates that of the interbank market, unify the exchange rate at the level of the interbank exchange market, and reintroduce a foreign exchange auction system. Similarly, Uzbekistan has also adopted some additional liberalization measures.

Significant progress has been made toward currency convertibility. In addition to the Baltic states, the Kyrgyz Republic and Moldova have accepted the obligations of Article VIII of the IMF’s Articles of Agreement. Russia plans to accept the obligations of Article VIII status this year. Efforts to achieve current account convertibility were also made by Azerbaijan and Kazakstan. Exchange rates were unified and surrender requirements eliminated in Armenia, Georgia, and Kazakstan. In addition, several countries (Armenia, Georgia, the Kyrgyz Republic) have lifted exchange controls on capital account transactions. Adherence to strong stabilization measures contributed to the growth of official foreign reserves in these countries. By contrast, less progress was made toward currency convertibility in Tajikistan, Ukraine, and Belarus, and the latter reintroduced some exchange restrictions. Particularly, active government intervention in the foreign exchange market appeared to be a common feature for these countries, reflected in depleted foreign reserves (which fell in Ukraine and Tajikistan to the equivalent of less than one month of imports), accumulation of external payment arrears, and widespread evasion of foreign exchange controls.

Foreign Exchange Market

Liberalization of exchange controls has had a significant impact on the structure and efficiency of the foreign exchange markets. In most countries, multiple exchange rates and wide spreads have been eliminated with the advent of interbank exchange and auction markets, and bureau markets.

An interbank foreign exchange auction, with the central bank acting as a major supplier to the commercial banks, appears to have served well as a transitional arrangement in an environment characterized by weak emerging banking systems, inefficient payments systems, and unstable or limited supply of foreign exchange in the market. As realistic exchange rates and currency convertibility have been established, auction arrangements have evolved into genuine interbank auctions with dealers trading on both sides of the auction. Auction systems were also extended by increasing auction frequency and opening access to a wider range of participants. For example, Armenia, Belarus, Georgia, Kazakstan, and Moldova have moved to daily auctions; the frequency of auctions was increased to three times a week in Azerbaijan, and to twice weekly in Uzbekistan; Turkmenistan, Tajikistan, and Ukraine reopened interbank foreign exchange auctions, previously suspended; Armenia established two additional auction centers with the objective of encouraging competition and reducing bid and offer spreads. It therefore joined Russia as the only other CIS country with regional auction centers. In a number of countries, auction sessions are not held on a daily basis and transactions outside the auction are limited to the exchange bureau operations. By permitting the banks to trade in foreign exchange on the days when no auctions are held, the authorities effectively promote continuous foreign exchange trade and the interbank market.

Favorable conditions for the development of interbank foreign exchange markets have been created in the Baltics, Kazakstan, Moldova, Russia, and in the Kyrgyz Republic through eliminating or lowering surrender repatriation requirements, introducing regulation on open position limits and prudential standards, improving payments systems, and strengthening correspondent banking relations. Such limits are set in most transition countries, but the calculation and monitoring of the limits vary significantly across the countries. Some have adopted and implemented adequate open position regulations (Estonia, Kazakstan, the Kyrgyz Republic, Moldova, Tajikistan, and Uzbekistan). In other countries, the regulations are ambiguous or do not comply with international norms—for example, Belarus and Russia. In Armenia, Azerbaijan, and Kazakstan, the limits are high (40 percent, 30 percent, and 50 percent, respectively, of the bank’s capital base), and while Georgia and Latvia have adequate regulations, they have not enforced them strictly. Open foreign exchange positions are not regulated in Turkmenistan and Ukraine.

In Latvia, foreign exchange dealing has graduated to a telephone-based system, a new law on credit institutions has tightened regulations on open foreign exchange positions, and interbank market participants have started weekly meetings. In Russia, where 50 percent of export surrender requirements could be sold in the interbank market from late June 1995, the share of the interbank market has increased to 80 percent of total exchange transactions (including MICEX) from 70 percent at the end of 1994.

In Ukraine, in the space of barely a year, interbank trading has gone from being prohibited to being larger than auction turnover. In Moldova, Kazakstan, and the Kyrgyz Republic, the share of interbank transactions in total exchange market operations has grown to 65, 30, and 15 percent respectively. Other countries have also made progress toward the establishment of the interbank markets by liberalizing interbank transactions outside auctions, either fully (Armenia) or partially. In some other countries where such transactions were not restricted, interbank market exchange transactions were impeded by weaknesses in the banking and payments systems.

Developments in exchange bureaus varied across countries but such institutions continued to be an important element in liberal exchange systems and served as a major channel for retail foreign exchange transactions. For example, in Kazakstan, the number of exchange bureaus has continued to grow (to reach 2,000); while in Armenia, increased competition and, in some cases, failures of banks to whom they belonged resulted in a decline in the number of bureaus by over one-third. In Uzbekistan, the number of bureaus has not changed much notwithstanding the liberalization of invisible transactions that in many other countries triggered a rapid growth in this market. Exchange bureaus there are owned by a few banks.

Central Bank Foreign Exchange Operations

In many countries, further progress has been made in the organization of the foreign exchange department, reserve centralization, and reserve management operations at the central banks.

In addition to the Baltic states, Russia, and Moldova, an adequate organization of foreign exchange departments has been generally completed in Armenia, Belarus, Georgia, Kazakstan, and the Kyrgyz Republic. Further steps in separating the front and back offices and streamlining operations of the foreign exchange department has been achieved in the central banks of Turkmenistan and Ukraine. In Latvia, further improvements in the efficiency of the foreign exchange department have resulted in the settlement period for foreign currency transactions dropping from five to two days. Close and frequent contacts with the market participants on all levels have also secured a better level of information on the situation in the market.

In almost all transition countries, the process of centralization of official foreign exchange reserves at the central bank has been completed. The Russian authorities intend to complete centralization of official reserves at the central bank in 1996. Tajikistan and Turkmenistan still have to complete the process.

Improvements in foreign exchange reserve management have been evident in most countries. To define the investment policy, Investment Committees have been formed in Armenia, Georgia, the Kyrgyz Republic, and Latvia. Reserve management guidelines recommended by the IMF have been reviewed in Latvia and are planned to be implemented in Georgia. Belarus has made progress in reserve management with regard to the maturity structure and currency composition of foreign exchange assets. The Bank of Lithuania has stopped the practice of pledging official foreign reserves as a collateral for the loans to the energy sector and has completed steps necessary for the release of pledges made earlier. The Bank of Estonia has ceased its forward operations. In Armenia, the central bank has closed its foreign exchange accounts with local banks. Kazakstan has started to apply some advanced techniques in managing precious metals reserves, and Latvia designed a system of currency exposure management on a net basis with real-time reporting of exposures. However, many weaknesses in reserve management systems are still evident. Such weaknesses often relate to exposures to particular institutions, or management of currency and interest rate risks. They sometimes also relate to internal controls and accounting and auditing procedures. For example, some part of official reserves in Azerbaijan, Belarus, and Russia are held with domestic banks, while Turkmenistan has concentrated its reserves with one major bank abroad. Russia has maintained part of its foreign reserves with Russian commercial banks established abroad.

Foreign exchange intervention operations have been active in those central banks that manage a floating exchange rate. In several countries, foreign exchange market intervention has substituted for domestic money operations reflecting the relatively underdeveloped nature of domestic markets and instruments. In countries that still have surrender requirements to the central banks, the need for central bank intervention in the foreign exchange market may be, in part, a direct result of such surrender. Coordination with monetary management, however, continues to be an issue in a number of countries (Armenia, Azerbaijan, Russia, and Tajikistan), not least because larger-than-anticipated foreign capital inflows are occurring in some cases. More generally, it is critical that foreign exchange policies be supported by the development of more active domestic liquidity management.