Peter J. Quirk and Viktor Schoofs
Since the advent in 1973 of widespread floating exchange rates in major industrialized countries and the internationalization of financial markets, forward markets for foreign exchange have developed considerably, to guard against exchange risks in international transactions. Forward exchange markets reduce the risk associated with foreign trade by matching the importers’ demand for foreign currency against the exporters’ demand at a given exchange rate, or by spreading the risk of an adverse shift in exchange rates among agents who are willing to assume such a risk.
There are essentially three types of systems that provide “forward cover” or insurance against foreign exchange risks in international transactions: market-determined systems with possible official intervention; market-approximating systems, with authorities attempting to determine forward rates on the basis of simulations of free market conditions; and official cover at fixed nonmar-ket rates. Mainly as a result of the presence of the last two types of systems, there has been a predominance of government subsidies leading to losses by the central bank and complications in fiscal and monetary policies. In some countries these losses have been absorbed by budgets and subsequently financed by monetary expansion, producing inflation and weakening the balance of payments. Prospects of further losses have in various instances prompted governments to delay adjustment of exchange rates in order to remove balance of payments disequilibria. As a result, exchange rate policy has been held hostage to the cover schemes, contributing to increased financial instability. In other countries, the losses have been reduced gradually by moving to more market-related systems.
This article is based on a more comprehensive study Policies for Developing Forward Foreign Exchange Markets, by Peter J. Quirk, Graham Hacche, Viktor Schoofs, and Lothar Weniger, issued as IMF Occasional Paper No. 60, 1988.
A number of developed countries that did not have market-determined forward arrangemerits in the 1970s have now introduced them. In addition, new facilities and institutions have been created that provide a choice of instruments to protect against exchange rate risk, including foreign exchange futures and options markets.
Developing countries have also increasingly, since the early 1980s, moved to more flexible exchange rates in order to adjust to external financial imbalances (see IMF Occasional Paper No. 53, 1987). More flexible and market-determined spot exchange rates have favored the development of forward foreign exchange markets. A small but growing number of forward exchange markets have emerged in the developing world in which commercial banks provide forward cover to the private sector under competitive conditions. However, more often than not, forward exchange cover is officially regulated, being provided either by the commercial banking system or by the central bank or other official institutions. The provision of such cover by commercial banks to the private sector under competitive conditions is still restricted to some 15 developing countries (Table 1).
|Unregulated forward rates Argentina, Brazil, Chile, Indonesia, Jordan, Korea, Malaysia, Nigeria, Philippines, Singapore, South Africa, Sri Lanka, Thailand, United Arab Emirates, Uruguay, and Zaire.|
|Regulated forward rates Bangladesh, People’s Republic of China, India, Kenya, Malta, Pakistan, and Zimbabwe.|
Sources: IMF; Annual Report on Exchange Arrangements and Exchange Restrictions, 1987, and data provided by national authorities.
Sources: IMF; Annual Report on Exchange Arrangements and Exchange Restrictions, 1987, and data provided by national authorities.
The risk of losses from unfavorable exchange rate movements tends to discourage international transactions. For instance, an exporter stands to lose if between the time his goods are shipped and he receives payment for them, the domestic currency appreciates so that he ends up receiving domestic currency than he had anticipated at the time of export. But if he had been able to protect himself by “locking in” the rate at which his foreign currency earnings would be exchanged into domestic currency, he would have no risk. He can insure himself against such risk by obtaining forward cover, that is by selling the foreign currency he expects to earn long before he actually receives payments (say three months).
Forward cover arrangements assist by lowering import costs. Moreover, as these arrangements foster a more stable economic environment, they can help improve investment climate in a country. Further, by covering against adverse exchange rate movements, a business can reduce its need to maintain large working balances of foreign exchange. Developing country importers may also be able to use available trade financing facilities abroad, if they are protected against exchange losses. They might consider such financing too risky otherwise.
Experience and problems
As mentioned above, forward cover arrangements in developing countries usually involve an exchange rate guarantee provided, directly or indirectly, by the authorities and backed by official resources. In most instances the guarantee is provided for a fee, but in some, such as in Costa Rica before 1983, there is no charge for the service. In some cases (e.g., Argentina, Israel, and Malta before 1981, Mauritius, Mexico, Morocco, Turkey, and Venezuela), the government or central bank provides guarantees directly, but in others the commercial banking system administers them on behalf of the authorities for a small fee (Table 1).
Exchange rate guarantees usually cover repayments of suppliers’ credits for imports and export credits for exporters. In the case of import credits, the guarantees are designed partly to encourage traders to mobilize additional foreign resources for the economy by seeking suppliers’ credits. This has sometimes been the rationale for subsidizing charges or for not charging fees for officially-supported guarantees. When the fees do not cover the costs of the scheme, the benefits to importers are negated by losses suffered by central banks.
Exporters generally do not request exchange rate guarantees where the domestic currency has a history of devaluations. They normally anticipate that further devaluations will increase their receipts in domestic currency terms. Consequently, official losses arising from exchange rate guarantees extended to importers during a period when the domestic currency is depreciating will normally not be offset by corresponding gains from guarantees extended to exporters. Table 2 shows estimates of heavy losses for some central banks administering exchange guarantee schemes.
Estimated subsidies actually paid by the central bank.
On a fiscal year basis.
Estimated subsidies actually paid by the central bank.
On a fiscal year basis.
Several developing countries have attempted to approximate the working of a market system, while regulating the forward market rates. Relatively sophisticated versions of such schemes were introduced by Mexico in 1983 (FICORCA) and by the Philippines in 1985. Both schemes were confined to the servicing of external debt outstanding at the time the loans of individual entities were rescheduled. The schemes provided cover for relatively long periods corresponding to the term of the rescheduling (up to 8 years in Mexico and up to 10 years in the Philippines). Such long-term cover is not widely available even in industrialized countries.
Both schemes used the “covered interest parity condition”—and linkages through projected inflation rates to interest rates—to determine the calculated premium on forward cover. The covered interest parity condition states that, in the absence of political risk and actual or potential credit or exchange controls, the interest differential between financial assets of the same maturity and liquidity denominated in different currencies is equal to the expected rate of exchange rate adjustment between these currencies. Expected rates of inflation in turn determine the interest differential to the extent that they are reflected in the nominal interest rates on assets denominated in the respective currencies.
A basic difficulty with this “quasi-market” approach is that it applies only when both the domestic and foreign financial markets are free from controls and taxes or subsidies. Nevertheless, this kind of market-approximating scheme represents an improvement over the simple provision of forward cover at either a zero premium, or arbitrarily set premiums. However, in cases where the premium is determined on the basis of international interest differentials while domestic interest rates have been kept artificially low, losses will ultimately arise because the restoration of financial equilibrium will require exchange rate adjustments that are larger than those indicated by interest differentials. The extent of parallel foreign exchange or domestic financial market premium or discounts may be used to indicate such disequilibria.
Governments have adjusted their forward cover schemes following losses either by shifting toward application of covered interest parity to determine the forward premium, or by removing subsidies and other distortions. For example, Costa Rica has withdrawn the scheme that led to large losses in 1981-83. Indonesia in 1986 moved to a closer approximation of interest rate differentials in its provision of forward cover by the central bank, and more recently to an open-market competition among the commercial banks. Israel reacted to losses from its export insurance scheme by limiting subsidies to a percentage of value added, and adopting in principle transition to self-financing. Fees for official cover in Pakistan have been raised recently.
Types of forward markets
Although in recent years some 17 developing countries have allowed their currencies to float, only a few of them have a well developed market for forward exchange. However, in several other countries maintaining more flexible spot exchange arrangements, market-determined forward rates have evolved—mainly from official cover arrangements. There are several existing and potential variants of market-determined forward markets in developing countries.
Auction markets. It would be possible to devise mechanisms for forward auction markets in the same way as auction markets for spot exchange that were established in a number of developing countries (e.g. Bolivia, Ghana, Guinea, Jamaica, Nigeria, Somalia, Uganda, and Zambia). However, it could be difficult to operate such a forward market because it may not be possible to determine accurately the timing and amount of forward exchange available in advance of the auction (in a spot exchange auction, foreign exchange is surrendered in advance). It would therefore be necessary to undertake an iterative auction in which representatives of buyers and sellers were present, and bids could then converge on an equilibrium market-clearing price. No country at present operates such an exchange market. The only forward market in the group of countries with a functioning spot exchange auction is that of Nigeria. However, this forward market operates only in the autonomous (interbank) market for foreign exchange involved in non-oil transactions and secondary sales of oil receipts.
Brokered markets at the central bank. Brokering of forward transactions by the central bank means that the central bank does not assume the exchange risk itself. Instead it matches up transactions at the various maturities on the basis of rates agreed among buyers and sellers of forward cover. In such cases, the central bank may not charge a risk premium, but it may charge a small brokerage fee. A probable difficulty in initiating a market with such arrangements is that exporters and importers may wish to delay involving themselves in these transactions until exchange rate expectations stabilize.
Funded markets at the central bank. The central bank may set up a small fund initially to provide foreign exchange at rates determined on the basis of covered interest differentials, or of a modified interest parity condition that takes into account the specific disequilibria in the country’s financial markets, reflected for instance in spreads between official and parallel market exchange and/or interest rates. Such a scheme would be similar at its outset to the exchange rate guarantee schemes described above. The difference is that, under a market-oriented approach, the aim would be to move to open competition so that the forward rates clear the market.
Parallel forward markets. In some countries, such as Argentina, officially unrecognized parallel markets may exist for spot and forward exchange. Parallel forward markets may be used to cover the exchange risks in the parallel spot market. These risks may be perceived differently by market participants from those in the official spot market. Nevertheless, the premiums charged in the parallel forward market may be used to help determine the forward premium in the official market.
Forward exchange markets in the private sector. Forward exchange market facilities in the developing countries that have floating exchange rates are at a relatively early stage of development. A limited volume of forward transactions takes place in Jamaica, Nigeria, the Philippines, Uruguay, and Zaire. The major aim of the efforts to develop forward markets in these countries has been to give the commercial banks free rein to operate them. This has worked well in the Philippines. A reason for this may be that the Philippines has had in place for some time extensive official arrangements for forward cover which have increased the private sector’s awareness of the benefits of such cover.
In the group of developing countries that do not have floating exchange rate arrangements, forward markets have evolved, mainly in the form of official forward cover schemes. These countries include Brazil, Chile, Indonesia Jordan the Republic of Korea, Malaysia, Singapore, Sri Lanka, Thailand, and the United Arab Emirates. The markets in Indonesia, Malaysia, Singapore, and the United Arab Emirates are not regulated, while the market in Thailand is subject to minimal regulation. Forward premia or discounts in these markets have closely followed differentials in international interest rates.
In a number of countries, access to forward markets has been restricted, usually by limiting the provision of cover by banks to purchases and sales of forward exchange associated with international trade transactions, and by requiring that maturities correspond to trade financing terms. In Brazil, Nigeria, and Sri Lanka, the forward market is open for commercial purposes. In Jamaica, only importers eligible for the spot auction market may participate in the forward market, while in Jordan the market is confined to specified commercial operations. Korea does not maintain restrictions on the coverage of forward transactions between banks, but transactions with nonbanks are restricted to forward purchases and sales for specific commercial transactions. The most common restriction on maturities is a limit of up to six months (e.g., in Brazil, Chile, Jamaica, Nigeria, Thailand, and Sri Lanka). In Jordan the cover is permitted up to one year, and also in Korea for nonbanks (interbank transactions have unrestricted maturities). In addition to these restrictions, limits on the open position of individual banks exist in Brazil, Chile, Jordan, Thailand, and Nigeria, while in Jamaica an aggregate limit of $10 million applies to uncovered forward commitments of commercial banks.
In general, restrictions on transactions have been established to support existing capital controls, or to curb speculative influences on the market. In fact, only a few of the countries with market-determined forward rates have no restrictions on outward capital flows and permit residents to hold foreign currency accounts (Indonesia, Malaysia, Singapore, and the United Arab Emirates). This suggests that the presence of moderate restrictions on international capital flows is not a bar to the establishment of private or market-determined forward markets for commercial cover.
To develop forward markets
Several general characteristics of an economy help determine the growth of forward market arrangements. Chief among these are the existing stage of development of forward cover arrangements, if any, and institutional characteristics of the financial system.
The central bank has a major role in the choice of techniques for providing forward cover. Although forward markets have developed more or less spontaneously in one or two developing countries, in most instances free forward markets have evolved from more limited arrangements involving the central banks. While the degree of central bank involvement has varied from country to country, the experience with losses indicates that the central bank should shed exchange rate risk as quickly as possible.
As a first step to initiate forward transactions, if these have not emerged spontaneously, the central bank could set up a small fund to provide cover to importers. This fund would be replenished by purchases of forward foreign exchange from exporters. Other existing cover schemes would be terminated and official support would be channeled through the new fund. At the outset, the willingness of exporters and importers to engage in transactions in the market probably will be highly sensitive to the rates charged by the central bank. In establishing the market, the central bank would search for rates that would not only be acceptable to importers but also would generate enough forward foreign exchange from exporters to keep the fund liquid. To this end—but only temporarily—the central bank might itself pay a premium when purchasing foreign exchange. However, experience with such “reverse spreads” under fixed rate forward cover arrangements points to a rapid exhaustion of the central bank fund.
The covered interest parity condition may help the value of the forward rate in countries whose spot exchange rates and interest rates are in equilibrium. However, it is important to account for the particular financial environment of the country. For countries whose spot exchange rates and interest rates are in severe disequilibrium, it would be necessary to find a surrogate for covered interest parity. For example, a simple approximation might be made by setting the forward premium on the US dollar at the present domestic rate of inflation plus an estimate for the real interest rate in the domestic economy minus the interest rate in the Eurodollar market. Where the spot exchange rate disequilibrium is large, as evidenced, for example, by the parallel market exchange rate or by extensive restrictions that are also effective, the premium may need to be increased beyond the calculated interest parity level in order to set market clearing rates. It might be more appropriate to eliminate or reduce the underlying disequilibrium before establishing a forward market. Once an initial forward rate has been established, both the rate and the margin payable from the central bank’s fund would need to be adjusted continuously to attract both buyers and sellers.
In order to facilitate the transition to a commercial bank forward market, the central bank could operate the scheme through the commercial banks from the beginning. In this case, it would be important that the central bank allow only a small margin to the commercial banks to operate the scheme because, through the funding arrangement, it would be initially taking some of the risk itself. Transaction costs for such arrangements are relatively low. It would withdraw from the market after a short transitional period, having established an equilibrium forward rate.
During the transition, the central bank would closely monitor domestic monetary and fiscal conditions relative to the international markets, in order to maintain the forward premiums or discounts at realistic levels. Moreover, domestic monetary and exchange rate policies should be conducted in a way that avoids sudden and large movements in key financial variables to avoid destabilizing and destroying the forward markets.
A strategy for developing forward exchange arrangements along the lines suggested above is open to any developing country whose arrangements do not already involve a market-determined forward rate. Either fixed or managed forward arrangements could evolve in this way; with the managed market-approximating arrangements the transition might be quicker. As explained above, the existence of moderate exchange controls does not preclude the formation of a forward foreign exchange market so long as they allow a balance between supply and demand. The evolution of markets to date also points to the need for continuing progress towards greater realism of spot exchange rate and interest rate policies to permit development of a forward market.
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