Richard H. Miller
Foreign exchange arrangements already exist for handling transactions on a spot (or immediate settlement) basis. A few developing countries have market arrangements which include sophisticated techniques for dealing in foreign exchange, money, and gold, within which banks offer a wide range of facilities and deal through the medium of brokers in a relatively broad range of currencies, and in which central bank intervention is limited to dealing at established margins and to ironing out undesirable fluctuations in exchange rates. But this article is concerned with countries where the institutional arrangements are more limited and much less sophisticated, where there may be no interbank dealing, no brokers, and operations may be confined to a very small range of currencies, with total purchases and sales covered separately each day by each commercial bank with the central bank.
Providing the best type of forward exchange facilities in this situation could take the form of an administered forward market, more like an insurance scheme, for which exporters and importers pay a nominal premium. For a number of countries this would probably be the short-term practical answer to eliminating that element of uncertainty in trade which stems from fluctuating currency values. But the establishment of forward exchange facilities is not always to be recommended—each country must determine its need according to its individual market characteristics and trade patterns.
Whether to establish forward exchange facilities
There are some generalizations which can be made in favor of establishing a forward market. It helps to protect trade flows from the disturbances caused by fluctuating exchange rates, although there is the disadvantage that price fluctuations may be an even more severe impediment to trade than currency fluctuations. In times of temporary loss of confidence, these facilities can add stability to the market, as they can also add to a competitive advantage or reduce a competitive disadvantage vis-á-vis traders in other countries. Forward exchange facilities also enable the central bank to evaluate its foreign exchange requirements more precisely and, because of its advance knowledge of part of the markets’ purchases and sales of foreign currency, enable it to improve the effective management of the national foreign exchange reserves and of its investment portfolio.
But there are disadvantages too. A danger exists that the central bank’s obligations in relation to a forward position in foreign currency might make it more difficult for it to recommend, or agree to, a change in the basic value of its currency, if this becomes necessary for balance of payments reasons. Establishing these facilities will entail some costs to the central bank or to the government, although these are mitigated by the income from the arrangements themselves, and other fiscal revenue resulting indirectly from them. There will be losses if the domestic currency is depreciated. The introduction and administration of forward exchange facilities could absorb scarce managerial resources, and there is always the possibility that attempts will be made to use the facilities for speculation.
More generally, the need to establish forward facilities backed by the central bank is debatable, and the central bank may well be influenced by the particular requirements of the import/export sectors. The speed of development of a country is often dependent on essential imports of a capital nature. These can be costly, and delays in delivery frequent—the delays alone can cause financial problems for importers. In such circumstances, it may be in the national interest to provide forward exchange to cover at least the risk of exchange loss. On the other hand, exporters may be concerned that they are at a competitive disadvantage to exporters in other countries, who might receive practical assistance and encouragement from their governments, or who may be able to rely on existing forward facilities to cover their exchange risks. The establishment of forward facilities, even at some cost to a central bank, may be aimed at removing such competitive disadvantages and reducing the risk inherent in exchange rate changes.
A change in the relationship between currencies following revaluation or devaluation will not affect the actual volume of the foreign currency holdings of the central bank immediately. It is the value of these holdings in the central bank expressed in domestic currency which will change; the amount of the domestic currency counterpart will be increased if that currency has been devalued, and decreased if it has been revalued. In meeting its obligations for maturing forward contracts and using the example of a devaluation, the central bank will be receiving less of its own currency in payment for the foreign currencies it delivers than the new exchange rate would justify, but it will also be paying less for the foreign currency it receives under contracts which date from the predevaluation period. The accumulative effect of these operations can cause a central bank to suffer reduced profits and even losses. These losses are in its own currency. In many countries, profits or losses incurred by the central bank in the exercise of these reponsibilities are absorbed by the government—an exchange loss will reduce the amount of profit that may be passed to the ministry of finance, while exchange profits may increase the central bank’s contribution to the ministry and the national budget.
Establishing rates of exchange
A developing country with unsophisticated market arrangements would have a central bank which, as successor to a currency board, has as its principal responsibility the issue and management of the domestic currency. It would also handle the management of the national foreign currency reserves and carry out the limited functions of the foreign exchange and money markets. The commercial banks may be branches of foreign banks, or former branches which have since been incorporated locally. Their expertise tends to continue as it was before independence, in the fields of currency management (to assist the central bank), agricultural loans, and the finance of trade. The rate of exchange for the domestic currency is likely to be fixed in terms of a single major trading currency—the U.S. dollar, the pound sterling, or the French franc. The buying and selling rates for one or two other currencies, in which the central bank is prepared to deal with its commercial banks, are calculated daily to reflect any changes in their value on international markets in relation to the value of the currency to which the domestic currency is pegged. Spot deals carried out at these rates by commercial banks with their customers are reversed with the central bank daily. Local commerical banks hold only working balances of foreign exchange with their correspondent banks abroad, and they deal with their customers on the basis of the rates of exchange established by the central bank. Their costs are covered by charging their customers commission, at a rate fixed by the central bank. There are generally no forward exchange operations, and communications internally and externally may be less than reliable.
In a situation where a developing country’s currency is pegged to a major trading currency, the exchange risk stems from a change in the direct relationship between the two. The nature of this direct relationship is sometimes established in a currency act; the ratio between the currency of a member of the French franc area and the French franc is fixed, for example, in a Cooperation Agreement and is guaranteed by the French Treasury. A relationship established in this way may inhibit change, but its legal nature does not prevent the private sector evaluating its validity in the light of developing economic circumstances.
The value of a developing country’s currency will have been established in terms of gold, special drawing rights, or a single intervention currency, with due regard to its relationship with the major currencies reflected in its balance of payments structure. The value in terms of the intervention currency provides a base for the quotation by the central bank of spot rates for purchases and sales of the intervention currency to which it is pegged. These rates can in turn form a basis from which forward quotations can be calculated. The fixed relationship between the domestic currency and the trading currency to which it is pegged, may also provide the reference point from which spot quotations for other foreign currencies can be calculated. These calculations would be based on the previous days’ closing quotations in an international market, such as London, New York, or Paris. If, for example, the domestic currency is pegged to the pound sterling, and the central bank of the developing country also feels it to be useful to quote U. S. dollars and French francs, quotations for these two currencies can be calculated from the previous days’ closing quotations in London for the pound sterling against the U. S. dollar, and the pound sterling against the French franc. Spot quotations will be calculated by the central bank and telephoned to each commercial bank before the opening of business each day. The spread between the buying and selling rates has a relationship to operating costs, and is frequently of the order of ¼ to ½ of 1 per cent in those developing countries where the values of their currencies are fairly stable. In countries where the value of the currency is less stable, somewhat wider margins are commonplace. The spread can also be asymmetrical, in that the margin between the reference rate and the rate at which the central bank is prepared to sell the foreign currency is often wider than the margin between the reference rate and the rate at which the central bank is prepared to buy the foreign currency, thus demonstrating a clear preference as a buyer rather than a seller.
The central bank could quote forward rates for these or for other currencies if necessary. It is unlikely, however, that the diversification of trade would warrant a forward market in more than a very limited number, which may be determined by official prescription of the currency or currencies in which imports or exports are invoiced. For normal purposes it would be unnecessary for such quotations to extend beyond six months into the future (a very large proportion of international trade is in fact financed over three months or 90 days), but the central bank might well be prepared to extend longer term cover in exceptional cases, such as the delivery of capital equipment, if it were in the national interest to do so.
In the less developed type of market, transactions on a forward basis are extremely unlikely to be in equilibrium, and it is this imbalance which leads to a central bank’s exposed forward position. It is also unlikely that commercial banks could cover their open positions in external foreign exchange markets. To be able to do this, the currency of the developing country would need to be quoted in the external market, as very few of such currencies in fact are, even for spot transactions, and fewer are quoted on a forward basis. Forward quotations would call for comparable investment facilities in the two markets and interest yields capable of comparison. Dealing in two external currencies in an international market one against the other would involve a degree of judgment as to the future development of both currencies, and would be more in the nature of speculation than exchange cover. For example, it is sometimes felt that a developing country which finds itself, say, with a larger balance of sterling than it needs, can sell that balance against U.S. dollars, and that by so doing it is covering its exposed, position. Operations of this kind would be unsuited to the needs of a developing country although, of course, this does not imply that such a transaction is entirely inappropriate when a central bank needs to adjust the balance between its reserve holdings. The forward facilities in international markets are, therefore, of little practical use in covering the exchange risk between the currency of a developing country and the major currencies in which its trade is financed.
As an alternative, some countries have developed a form of administered forward cover which is provided by the central bank on an insurance basis, with the importers and exporters paying a calculated premium in the exchange rate. The cost of this cover needs to be determined by the central bank. Clearly, it cannot simply reflect the interest rate differentials between the markets, nor can it equate to the costs of any anticipated change in parity. The percentage margin is fixed, therefore, bearing in mind a number of factors such as the costs of operating such a scheme, the additional burden on a marginal export sector, the stimulation that such a scheme might give to exports, and the additional foreign exchange income that may be earned. A balance has to be found between the impact of the cost as an incentive and as a disincentive. In fixing the actual percentage there will be a relationship between the percentage spread between the spot buying and selling rates and the rate appropriate for the forward margins. Where the spread between the spot rates is 3/16 or ¼ of 1 per cent, a margin for the forwards of 1 or 1½ per cent may be appropriate, but this would not be the case if the spread between the spot buying and selling rates was itself 1 or 2 per cent. Some developing countries with a relatively narrow spread between their spot buying and selling rates in the market have adopted forward margins based on about 1 or 1½ per cent, and these have been found to be practical in Kenya and Tanzania, for example. The final selection might, for ease of administration, fall on a percentage which provides margins readily divisible into months and days.
The development of a forward exchange market
The initial assumption here is that the central bank holds reserves in foreign currencies with central banking correspondents, that these have been diversified to cover the requirements of trade and invested to mitigate exchange risks, that a system of cable and telephone communications has been established between the domestic and foreign centers, and that commercial banks are already in operation. An analysis follows of the basic institutional arrangements which need to be developed before forward exchange facilities become practicable.
• The establishment of a foreign exchange market limited to spot transactions
The central bank first selects commercial banks to be designated as authorized dealers in foreign exchange. It then decides which currencies are to be dealt in and makes balances of these available to commercial banks through renewable accommodation swaps. (An accommodation swap, in this sense, would be a spot sale of currency to a commercial bank and a compensating forward purchase at, say, six months at the same exchange rates. The commercial bank exchanges the domestic currency counterpart for a foreign exchange holding, while the central bank does not relinquish ownership of the foreign currency, which would thus remain part of the official reserves.) The commercial banks then open accounts with correspondent banks in foreign centers and establish communication procedures.
The central bank establishes operating procedures by announcing spot buying and selling rates for the prescribed currencies (which may be done daily or weekly as required). It should instruct authorized dealers (the commercial banks) to handle all transactions with their customers and the central bank at these rates, and establish rates of dealers’ commissions. The central bank is responsible for instructing authorized dealers to reverse all transactions daily with the central bank (a total of all sales and all purchases in each currency), and providing that confirmations of all transactions will be exchanged at the opening of business on the following day. It should also establish cable procedures to pay and to receive funds abroad, and establish spot usance at two working days’ value. In foreign exchange parlance, all transactions are either spot or forward. They are “spot” if the time lag between the day the transaction is agreed and the value date on which it is consummated is not more than two working days. All other deals are “forward.” Since the practice for spot transactions varies slightly between markets (some have a time lag of only one working day), it is necessary to prescribe which procedure will obtain. Two working days are regarded as essential for developing countries which may have to rely on less than wholly efficient communications. Any arrangement should be avoided which could lead to the receipt of payments’ instructions in the foreign center too late to effect payment on the value date. (Late payments can too easily be interpreted as reflecting a shortage of foreign currency and an inability to pay.) Finally, the central bank should prescribe for periodic reports of foreign exchange holdings to be submitted to the central bank.
After a period during which experience is gained, buying and selling rates may be widened, or narrowed, with the permissible margins. Commission arrangements may be terminated and authorized banks permitted to compensate sales against purchases, covering the daily (and later weekly) balance with the central bank, and accommodation swaps may be terminated.
• The establishment of procedures for transactions on a forward basis
The central bank establishes additional rules and operating procedures by providing generally that if a particular currency is required to meet future commitments and it is desired to cover immediately, the currency must be purchased on a forward basis. To permit individual traders to buy currency spot and hold it for, say, three months until it is needed to effect payment, would mean a less than efficient use of foreign exchange reserves.
Authorized banks should be permitted by the central bank to enter into forward exchange contracts with their (resident) customers, provided that (1) the transaction relates to a genuine commercial contract involving the movement of goods (exchange control procedures will be necessary to ensure that this is so); (2) the deal is effected on an outright basis (not as a swap); (3) the forward date is not longer than six months ahead (authorized banks might be permitted to renew such contracts on a swap basis provided that the accumulative period does not exceed six months from the original date of contract); (4) all other requests for forward cover are referred to the central bank; and (5) authorized dealers continue to cover open positions in each specified currency, with the central bank—marrying up spot purchases and sales but reporting separately forward sales and purchases in each currency.
The central bank will establish premiums to be applied as margins against the official spot rates of exchange. These margins may represent approximately a charge of, say, 1½ per cent per annum and will be broken down into margins for months and days. Moreover, the periodic return of specified currencies should be redefined to show the commercial bank’s position on the last working day of each quarter.
After some experience, authorized dealers may be permitted to compensate not only spot purchases and sales, but also to marry them against forward transactions, and, furthermore, to carry an open position in each currency—with the central bank prescribing limits for each commercial bank appropriate to its size and operational importance.
These will be largely dependent on parallel development of the money market. If this occurs, the central bank may fix spot rates of exchange for each specified currency at, or within, the Fund limits. It may cease to quote forward rates and permit authorized banks to deal between themselves and in competition with each other: for spot transactions at rates within the established margins—calling on the central bank only at the limits; and in forward transactions, for which the rates for each currency would be determined by supply and demand and by relative international interest rate considerations.
Quarterly returns of open positions will still be required to control the development of speculative positions. The restrictive controls on the use of forward exchange cover may be eased. The establishment of brokers may be considered to determine whether they would assist in the efficient operation of the market. Brokers would earn commissions from the authorized dealers, charged on transactions handled, and would not be permitted to hold balances of currency, or to take up long or short positions in foreign currency.
Some basic operating techniques
In those countries where the spot foreign exchange quotation is in terms of one domestic unit, equaling either a part or a multiple of the foreign currency unit, then the forward margin is added to the spot buying rate, but deducted from the spot selling rate to determine the forward quotation. If the spot quotations are
Buying—domestic currency 1 = $2.5
Selling—domestic currency 1 = $2.3
and the margin for three months forward is 0.05, then the three-month quotations will be
Buying—domestic currency 1 = $2.55
Selling—domestic currency 1 = $2.25
The dealing maxim in such cases is to “buy high” and to “sell low,” to get as much foreign exchange as possible for domestic currency and sell as little domestic currency as possible.
If the basic quotation is made in the reverse sense, i.e., a number of domestic units against a fixed amount of foreign currency, then dealing maxims are reversed. So if the spot quotations are
Buying—domestic currency 2.3 = £1
Selling—domestic currency 2.5 = £1
and the margin for three months forward is 0.05, then the three-month quotations will be
Buying—domestic currency 2.25 = £1
Selling—domestic currency 2.55 = £1
In such cases the dealing maxim is to “buy low” and “sell high,” to pay as little as possible for the foreign currency you buy while selling foreign currency as advantageously as possible in terms of domestic currency.
It is normal practice to calculate the forward value date from the spot value date. If a commercial bank wishes to buy U. S. dollars from the central bank for delivery three months ahead, and it asks for a rate on Tuesday, July 24, spot settlement would be on Thursday, July 26, and the three-month date, Friday, October 26. The exception to this rule is when dealing “end-end” which means from the end of one month to the end of another, irrespective of the number of days involved. Much business will be for the three-month period in cover of documentary credits, as international usance is largely for that period. Care is taken to avoid holidays in both the domestic and foreign centers when fixing value dates.
If a commercial bank wishes to buy currency for a broken date, e.g., the bank comes to the central bank on Tuesday, July 24, to buy U.S. dollars for delivery Thursday, September 20, the calculation is made from the spot value date of Thursday, July 26—one month to August 26 plus 5 extra days in August and 20 in September. The quotation is thus based on the spot rate, plus the margin for one month, plus 25 times the margin for one day.
There are occasions when a commercial bank customer cannot, for some reason beyond his control, such as delay in shipment, complete a contract on the agreed forward date, and needs to adjust the date of sale of currency, or the date he takes delivery. This is a common situation and the deal to correct the foreign exchange contract is called a “swap.” If a commercial bank has a contract to deliver U. S. dollars to the central bank for say, July 24, two days in advance of this date (or, in fact, any time in advance but no later than the two days), it might approach the central bank indicating that the funds are not coming forward until August 3, and it wishes to adjust its position. In order to effect this adjustment, the central bank makes a compensating sale to the commercial bank of the identical amounts of U. S. dollars at the same rate, giving the same amount of domestic currency and for the original forward value date. This effectively cancels the whole forward leg of the deal. The central bank then enters into a new contract to purchase the same amount of U. S. dollars for value August 3, but adjusts the rate of exchange by a margin calculated for an additional ten days. Such swaps to adjust value dates are extremely common in any forward exchange market.
Many developing countries share a similar historical background as a dependent territory within a currency area where trade was mainly financed with bills drawn in the currency of the parent country, and where their currencies had fixed relationships with that of the parent country. The same pattern of trade and finance tended to follow independence, but in those cases where it did not, the narrow margins within which currencies could fluctuate under Fund Articles of Agreement, limited exchange risks. The breakdown of the par value system and the growth of the number of “floating” currencies has presented developing countries with entirely new problems in the fields of foreign exchange and the finance of trade. In such circumstances it is the central bank which has the responsibility of evaluating its domestic situation to determine whether the continued development of its country is prejudiced by a reduction in trade. This article has outlined one way in which a central bank can respond to these responsibilities.