Recent developments in developing countries’ foreign exchange markets suggest that the need for more flexible exchange rates became apparent during the 1980s, evidenced by shifts in the exchange rate regimes toward more flexible arrangements, including floating exchange rates. A number of developing countries have adopted floating exchange rates within the context of interbank markets, but sometimes auction market arrangements have also been used.
This study provides an analysis of the group of developing countries that have adopted floating in the context of foreign exchange auctions. It surveys the major issues relating to foreign exchange auction arrangements, both in theory and in practice, and attempts to identify potential advantages and disadvantages of auction mechanisms. The study provides a guide to the actual operations of an auction market, and reviews the official fixing arrangements used by some developing countries with floating exchange rates.
The study accepts that auction markets in principle are likely to improve the allocation of foreign exchange while providing a transparent way of determining the price of foreign exchange. But the paper says the practical efficiency of auction markets is often undermined by government interference and manipulation of the auction-based exchange rate as well as the allocation of foreign exchange, which has led to situations where the credibility of the auction market is lost and the transparency of the auction system becomes doubtful. Sometimes market efficiency has been undermined because foreign exchange has been concentrated in the hands of a few influential buyers or sellers who were able to manipulate the market-based arrangement. Further, auction market arrangements have not generally succeeded in unifying official and parallel exchange rates.
Because of inconsistencies between macroeconomic policies and the desire to maintain a strong official presence in the foreign exchange market, auction market arrangements have rarely been sustainable in the long run. In fact, some developing countries that have introduced auctions have eventually terminated them and returned to a fixed exchange rate regime. Other countries that have continued to maintain an auction arrangement have combined it with an interbank market, but this raises questions about the degree of transparency and the transitional contribution that the auctions may have made to the efficiency of foreign exchange allocation.
Some developing countries use official fixing arrangements, either to fix the rate for the interbank market or to establish a rate to effect official transactions. Although such arrangements may, in the interim, be justified on the basis of lack of an efficient interbank market, in the longer run it is clear that direct interbank transactions should be encouraged. Since the fixing arrangements often underscore the centralized allocation by forcing most transactions through the fixing system, thus limiting the scope of the interbank trading, they are likely to slow down the development of a genuine interbank market.