Journal Issue

The Case for Open Foreign Exchange Systems

International Monetary Fund. External Relations Dept.
Published Date:
January 1989
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Increasingly, developing countries are finding that controls on foreign exchange transactions are counterproductive. Some of the reasons why, and a review of issues in moving to more open systems

Governments manage and intervene in foreign exchange systems in essentially two ways: (1) by pegging or managing the exchange rate, as opposed to allowing it to float (be set by the market); and (2) by imposing restrictions or taxes and subsidies on the use of foreign exchange. Restrictions—particularly exchange restrictions—that limit the openness of the external sector may be aimed at keeping a pegged or managed exchange rate at a desired level, or at influencing the level of a floating exchange rate. Policies for the exchange rate and for exchange and trade restrictions are therefore two sides of one coin.

Even though their exchange and trade restrictions remain more widespread and intense than those of industrial countries, developing countries have taken a leap forward in freeing these restrictions in recent years (Chart 1). Restrictions have had well-publicized effects in distorting the allocation of resources. But there is a growing realization, too, that they simply have not worked: evasion has been endemic and black markets for goods and currencies have flourished.

Chart 1Developing countries’ main changes in exchange and trade systems, 1986—87

(Number of changes)

Source: IMF, Annual Report on Exchange Arrangements and Exchange Restrictions, 1987 and 1988 editions.

Developing countries have also been shifting away from fixed exchange rates. Here too, much of the impetus has been practical: governments have run out of the international reserves needed to support fixed or managed exchange rates, even temporarily, and controls have been ineffectual in providing this support. The fiscal and monetary reversal needed to lower the price level, and thus to restore competitiveness without depreciating the exchange rate, has also been out of reach in almost all cases.

This article briefly reviews the practical aspects and policy implications of the main techniques for managing exchange systems and then discusses arrangements for liberalizing such systems.

Exchange rate regimes

The major forms of exchange rate regime are distinguished from one another by their degree of flexibility, that is, the frequency with which the rate is permitted to adjust. An increasing number of countries have floated their exchange rates in recent years (Chart 2). A major reason has been a desire to shed political responsibility for devaluing the exchange rate, because discrete adjustments to managed or fixed rates often have unpopular results, particularly for groups in society favored by the previous exchange rate regime.

Chart 2Developing countries move to more flexible exchange rate regimes

(Number of countries, and end-period)

Source: IMF, Annual Report on Exchange Arrangements and Exchange Restrictions, various issues.

1 Including indicator arrangements.

2 First quarter.

Currency pegs. About one half the developing countries have single currency pegs. In most of these cases the country attempts to stabilize the value of its currency by pegging it to a major currency (often the US dollar or the French franc), adjusting the parity infrequently on the basis of discrete decisions by its authorities. About a quarter of all developing countries have currency composite pegs, designed to stabilize the value of the currency against some average of major trading partner currencies. Some countries use the Fund’s Special Drawing Rights, based on a basket of major currencies, as a composite peg.

Currency pegs generally have not achieved their purpose of preventing exchange rate variability, first because they must be adjusted from time to time and second because pegged currencies float against currencies outside the peg. Pegging has also, in many instances, led to incentives for increasing use of the parallel or black market exchange rate, which exchange controls have proved ineffectual in preventing.

Managed indicator arrangements. Under this type of arrangement, the basis on which exchange rate changes are made is formalized. A common form is the inflation-adjusted “real exchange rate peg,” which has the aim of achieving continuous competitiveness against a basket of the currencies of major trading partner countries. Another form of indicator arrangement is the preannounced exchange rate or “tablita,” by which the exchange rate crawls at a predetermined rate.

The problem with both forms of indicator arrangement is the resulting predictability of exchange rate movement, which may create obvious profit-making opportunities and adversely affect expectations of future price movements, even if they are only used for relatively short-run management of the exchange rate.

Managed floating arrangements. In a managed float, the central bank rather than the market sets the rate, but varies it frequently. The difference between this and pegged or indicator arrangements is that broad judgmental factors are used to set the rate, and adjustments are made frequently though not automatically. The rate may be set with regard to many factors, such as the real effective exchange rate, or developments in the balance of payments, international reserves, or parallel black markets for foreign exchange.

Because the rate does not completely clear the market at all times, a parallel black market may emerge, but it is less likely to do so than under pegged arrangements.

Independent floating. A key feature of this approach is that the exchange rate responds directly to exchange market pressures. The form of intervention associated with independent floating is purchases or sales of foreign exchange by the authorities. Generally speaking, the intervention is aimed either at stabilizing the market against periodic unsustainable movements in either direction, or at slowing down the rate of change by leaning against market pressures.

There are two main types of market arrangements for an independently floating exchange rate system: the auction and the interbank spot exchange markets. The participants in an interbank market are commercial banks and in some instances licensed foreign exchange dealers; in this system the exchange rate is determined in negotiations between banks and their clients and in transactions between the banks, and is therefore free to vary from hour to hour and day to day. Under an auction system, receipts from specified exports and services are surrendered to the central bank at the prevailing exchange rate and are auctioned by the authorities on a regular (say weekly) basis.

It often used to be argued that independent floating was not an option open to developing countries, given their limited state of institutional development. However, markets in these countries have proved themselves capable of managing floating exchange rates and also smoothing out considerable seasonality in the balance of payments. They have operated efficiently even in countries with only one or two commercial banks.

Exchange and trade restrictions

An exchange rate that cannot be sustained on the basis of economic fundamentals can be maintained in the short run by running down international reserves, or by placing restrictions on the use of foreign exchange. Such restrictions take diverse forms.

Import licensing and controlled allocation of imports through the use of foreign exchange budgets are used by most developing countries to restrict imports, whether for balance of payments support, industrial protection, health, security, sanitary, or social reasons. Of those countries maintaining import licensing systems, more than half require licenses on all imports. In some cases import licenses are granted more frequently if financed with the importer’s “own” foreign exchange, obtained outside the official exchange market (for example from retained export earnings). The most efficient way to operate a relatively free import licensing system is to permit all payments and transfers to proceed unless they are specifically prohibited or subject to prior approval—the so-called “negative list” approach.

Taxes on imports include tariffs, import surcharges, and stamp duties, and are applied by virtually all developing and industrial countries. Tariffs are generally applied very broadly. Nonetheless, the system can be designed with more specificity, for example to promote domestic industry. Duty drawback schemes (whereby importers receive partial refunds of the import duties they pay) may be allowed for imported raw materials, if local raw materials are not competitive in price and quality. Certain import duties may be earmarked for export promotion purposes, taxes on capital or consumer goods may be used to finance an export subsidy fund, and tariffs may be geared to protecting “infant” industries. Support to domestic industry may also be qualified and indirect: raw materials may be exempted from customs duties and commercial taxes, providing that products in which they are used are exported within a specified period, while tax exemptions for joint ventures and special economic zones may be used to encourage investment.

Advance import deposits and multiple exchange rates may also be used to tax or subsidize imports, although such practices have grown less widespread in recent years. The effective tax or subsidy is the difference between the (usually appreciated) official exchange rate and the exchange rate that would clear the market in the absence of the restrictions or, for import deposits, the ratio between the forgone interest and the value of the import.

Restrictions on international service transactions include those on foreign exchange for payments for travel, transport and freight, banking, and services rendered by nonresidents. These latter payments include remittances, investment income, and wages. In some service sectors (such as computer services, some forms of insurance, construction, communications), where trade can be a substitute for foreign direct investment, restrictions on capital transactions may affect trade so much that they make foreign direct investment unattractive, or provide promotional incentives to encourage it.

Surrender requirements and retention allowances (whereby exporters are allowed to keep some of the foreign exchange they earn) influence the supply of foreign exchange to the domestic economy in many developing countries. Most often the retention allowances are aimed at promoting certain export industries. In evaluating an export earnings retention scheme, it is important to look both at the restrictions that may be placed on the uses of retained foreign exchange and, if the exchange is saleable, at the exchange rate that is applicable. Retention allowances are a recognition that the exchange rate is unrealistic and that surrender at the official rather than the parallel exchange rate cannot be enforced.

International capital transactions are subject to restrictions in most developing countries, but about one in three of these countries maintain free or relatively liberal capital control systems. Capital controls, where maintained, tend to be comprehensive, affecting commercial banks’ international transactions and the portfolio, direct, and real estate investments of residents other than banks. Capital receipts are typically less controlled than payments, as might be expected in view of the present widespread foreign exchange scarcities in developing countries, but they are generally subject to repatriation and surrender requirements, as noted above. Most foreign direct investment controls include case-by-case scrutiny of proposed investments by a government review board.

Exchange controls on capital movements, though widespread, have not succeeded in stemming large capital outflows. In some of the major debtor countries, the flight capital would have been sufficient to refinance a sizeable portion of the debt incurred by the country as a whole, and to avoid rescheduling.

Designing reforms

An important reason why developing countries have been liberalizing restrictions in recent years is the growing internationalization of information about incentives, with all Fund member countries being increasingly integrated into a global market place. This has made it more difficult for individual countries to isolate their systems from those of other countries, because it has made more evident the financial disadvantages created by the controls. Even in the industrial countries which have relatively sophisticated methods of administering control systems, capital controls have been abandoned in part because they are no longer effective.

The ineffectuality of import controls in meeting the social objectives for which they were designed is clear in several respects. To the extent that controls are designed to limit the overall import bill, the question of their efficacy in fact has two parts: (1) Were imports limited to the level sought or did smuggling result? and (2) If the controls did indeed limit imports to that level, were they more efficient than raising the price of imports through a depreciation of the exchange rate—or has the depreciated exchange rate in fact been reflected in the price of the goods?

In a number of countries, prices of essential imports of food and raw materials at the final point of consumption or input are much higher than would be calculated by converting the international dollar import price at the official exchange rate in the country concerned. The difference reflects the parallel or black market exchange rate, and accrues to importers, or in some countries (and illegally) to officials administering the import control system. This outcome is at odds with the aim of ensuring cheap foodstuffs for lower income groups or of supporting a productive industry through inexpensive raw materials. The same aim could be achieved without distorting the structure of relative prices, by valuing the exchange rate at a realistic level and, in the case of food, using more targeted measures such as a food stamps program or a more progressive income tax structure. In a number of countries, foodstuffs subsidized by an overvalued exchange rate have destroyed the domestic agricultural base, and capital goods so subsidized have shifted the production function away from labor, adding to underemployment.

In practice, the choice of exchange rate policy, and of exchange and trade controls, is dominated by issues of political economy. In liberalizing restrictions and moving toward a flexible exchange rate, the political and social consequences in the transitional period are often of concern to governments. It is feared that exchange rate adjustment will raise the prices of key imported goods, adversely affect politically sensitive sectors of the economy, and speed the general rate of inflation. Without exchange and trade restrictions, imports, including those of luxury goods, may flood in. Out of such fears, a number of countries have delayed adjustment in the exchange rate and complementary macroeconomic policies. The balance of payments has then weakened to the point where they have no longer been able to meet their payments obligations. Credit lines have dried up and the forced adjustment has then been even harsher.

Concerns that the general price level will rise, as a result of exchange rate adjustment and the liberalization of import controls, are often allayed by looking at true retail prices or wholesale prices at the point of consumption or input into production. The effect can be made explicit by examining the expected depreciation of the exchange rate, say, to the parallel exchange rate level, in terms of the ratio of imports to GDP, adjusted for prices that already reflect the parallel exchange rate.

Generally, such calculations show that the free market exchange rate is already embodied in the prices at the point of consumption or input. Because the free or black market exchange rate is the point to which a floating rate tends to move, after the system is liberalized, this gives some indication of the overall inflation effect—which is often much less than feared by politicians and officials. This inflation effect, such as it is, should then be offset by adjustments in macroeconomic policies that accompany the exchange rate adjustment.

Exports may take two to three years to respond to the liberalization of the exchange and trade system. Import effects may be more immediate but less politically tolerable. In these circumstances, a major consideration in the short run is the effect of the liberalization package on capital flows. Evidence is mounting that a combination of freeing interest rates and allowing the exchange rate to find an equilibrium level (both on the spot and forward exchange markets) can serve as a strong incentive for the repatriation of capital (see Peter Quirk and Viktor Schoofs “Forward Foreign Exchange Markets in LDCs,” Finance & Development, September 1988). This can effectively smooth the transition toward the new set of relative prices resulting from the liberalization package by providing early support to the balance of payments.


In the movement toward more open and flexible systems several techniques seem to hold particular promise.

Auction and interbank exchange markets, used in association with an independently floating currency, were described above. Here it is worth noting that the authorities need to play a much more active role under the first of these options than under the second; if a government adopts an auction system it is less likely to be seen as shedding political responsibility for movements in the exchange rate. Another potential disadvantage of an auction market is that, because foreign exchange is only partly surrendered to the market, less information tends to be available on the overall supply of foreign exchange under this system than under an interbank market. In some instances where the authorities have borrowed short-term funds heavily to sustain an appreciated rate, and then have had to repay those loans, volatility has risen and the consequent sharp corrections in the exchange rate under an auction system have led to its abandonment. Being less centralized, interbank markets have been less prone to such destabilizing actions by governments.

Forward exchange markets reduce the risk associated with foreign trade, to the extent that importers’ demand for and exporters’ supply of foreign currency are matched in the market at a given exchange rate, or the risk is shifted to speculators who are willing to assume it. Forward exchange markets, when combined with realistic domestic interest rates, make borrowing abroad more attractive to importers. They are an important development where trade lines are open to a country experiencing temporary balance of payments difficulties, and where importers have previously been unwilling to assume the exchange risk in the absence of forward cover. Forward foreign exchange markets also facilitate some of the more sophisticated financial transactions that are necessary if the domestic banking sector is to develop an appropriate share of the international services market.

There are several variants of market-determined forward systems. In developing the market, it is clearly preferable to have commercial banks handle transactions as much as possible, and to have the central bank withdraw both its support for or regulation of the rate as early as possible. Central banks’ losses from nonmarket import cover have been extremely large. Experience suggests that outright forward contracts for commercial cover are usually the most desirable point at which to begin operations. Futures and options markets may well emerge later.

Import license auctions are useful if import licensing is retained for a period following an exchange reform. Under these arrangements, importers bid for licenses up to the total value available but with no limitation on the type of goods. Efficiency results, because licenses go to those importers who place the lowest bids, and flow to the goods for which there is most demand. Government revenue from the auction of import licenses has been an important element in narrowing the fiscal deficit in some countries.

Open general licensing. This approach helps the import system to be liberalized through selective decontrol of categories of imports. The list of OGL commodities (i.e., commodities not requiring specific import licenses) can be progressively broadened as liberalization proceeds. The major issues relate to the level of the exchange rate for goods on the OGL list; an overvalued exchange rate could lead to serious overimporting of these goods and consequent deterioration of the balance of payments. Exchange rate or equivalent action on pricing should therefore accompany the adoption of such a system.

Tariff reforms undertaken by developing countries in recent years have had several common elements. Most have been combined with, or preceded by, a reduction of quantitative import restrictions. Most included a simplification of the tariff structure, and a reduction in the dispersion of tariff rates—usually in tandem with the lowering of the average tariff rate. Simplifying and redirecting tariffs is important for appropriate resource allocation, and for fiscal revenues. Tariff systems in some developing countries are complex and capricious.

Capital liberalization can play an important role in reversing capital flight in the initial stages of exchange and trade liberalization. As noted above, severe controls on capital movements have not been able to stem widespread capital flight in recent years. Indeed, a case can be made that the presence of controls has contributed to capital outflows because, even where exchange and interest rates are realistic, and exchange risk cover is offered, problems of transfer resulting from the controls have induced residents to hold currency abroad. A country’s residents will not repatriate capital if by doing so they lose flexibility in its use thereafter. This suggests that simultaneous liberalization of the exchange rate, interest rates, and capital controls is likely to provide the strongest incentive for reversing capital flight and supporting the balance of payments in the short term. Given that the real sector takes time to adjust to changes in the exchange rate regime, the short-run effects may be critically important for the success of a liberalization program.

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