This paper examines the experiences under floating interbank exchange rate systems of five developing countries--The Gambia, Guyana, Jamaica, Nigeria, and Sri Lanka--which employed a variety of institutional and regulatory arrangements in the interbank market. It describes their prefloat economic conditions and exchange arrangements and the factors affecting their choice of an interbank system. The role of financial institutions and the official regulatory framework in making the transition to the interbank exchange rate system are also discussed, along with the macroeconomic adjustment framework and the exchange and trade system reforms adopted. The paper assesses the performance of the interbank floats in terms of both exchange market and macroeconomic developments.
All five countries introduced an interbank floating exchange system to provide a more efficient, noninterventionist mechanism for determining the official rate and allocating scarce foreign exchange resources. However, some phased in the new system, removed exchange and trade restrictions, and liberalized interest rates more gradually than did others; in several countries, too, remaining regulations constrained banks and other authorized exchange dealers in negotiating the exchange rate between themselves and the public. The interbank floats and the accompanying exchange and trade liberalizations generally resulted in convergence between the official and parallel exchange rates; an appropriate flexibility and movement of nominal and real exchange rates; and spreads between the buying and selling rates that stayed within reasonable limits. Economic gains from the floating interbank systems also appear to have accrued more visibly to the countries that moved early and decisively to abandon previous restrictions--The Gambia, Guyana, Jamaica, and Sri Lanka.
The paper concludes that interbank exchange rate markets can operate relatively well with minimal banking infrastructure (for example, The Gambia and Guyana); licensing of nonbank foreign exchange dealers can provide additional market competition. However, the paper argues, these markets can operate well only if the authorities remove trade barriers and exchange restrictions on both current international transactions and capital transfers, liberalize interest rates, and introduce prudential regulations and supervision over exchange transactions. Segmented exchange markets may persist if regulations prevent the free flow of resources across market participants (as shown by the experience of Nigeria with a composite exchange rate system--an official auction and an interbank market). Moreover, any residual official restrictions that remain are likely to foster the continued existence of parallel, informal markets. Finally, the paper concludes, floating exchange rates and liberalized exchange and trade systems--although they are helpful in balancing the external sector--are not substitutes for sound macroeconomic policies.