Since the mid-1980s, developing countries have increasingly adopted various forms of market-determined exchange rate systems, including interbank or auction systems or both, and foreign exchange bureaus. This paper discusses the main operational issues involved in the implementation of interbank foreign exchange systems in six selected African countries--The Gambia, Ghana, Kenya, Mozambique, Nigeria, and Sierra Leone. In contrast to the ideal case (which is approximated by transactions for the major world currencies), the exchange rates in these markets tend to be determined, for the most part, through transactions between dealers and clients at the retail level rather than through wholesale interdealer transactions. There are a number of explanatory factors: the generalized shortage of foreign exchange in the countries that leaves little or no excess foreign exchange balances for interdealer transactions, the larger spread between the buying and selling rates in dealer-client transactions compared with interdealer transactions, the newness of the market arrangements, and the lack of comprehensive prudential regulations limiting the foreign exchange exposure of dealers.
In addition, many factors continue to limit the full development of these markets. Dealers in the countries operate with an inadequate communications infrastructure, which leads to a limited flow of “real time” information in the foreign exchange markets, especially in relation to the exchange rates being quoted at different institutions. The foreign exchange markets in these countries are dominated by a small number of players and may not be sufficiently competitive to avoid the distortions that stem from oligopolistic behavior. The absence of an electronic exchange or other medium to carry out transactions and receive quotes instantaneously has hampered the ability of the central banks to regulate and participate in the interbank foreign exchange markets in these countries. Most of the countries in the study have insufficient foreign exchange regulations to reduce exchange rate risk and encourage “true” interdealer transactions.
Despite these limitations, the markets studied have improved the efficiency of foreign exchange allocation. The substantial narrowing of exchange rate differentials between the official and parallel markets is evidence of progress toward eliminating market segmentation. Available data suggest an increased allocation of foreign exchange through official channels. To improve market operations, the central banks may have to be more active in educating participants about the functioning of the market, the nature of the reporting required for dealers’ foreign exchange transactions, the management of foreign exchange resources, and the need to turn to other dealers instead of the central bank to reduce open positions. In order to improve their own effectiveness, central banks need to continue to develop their capabilities to monitor, intervene, and provide sound guidance through regulation and dialogue with the market.