III Foreign Exchange Markets and Official International Reserve Management

Malcolm Knight
Published Date:
February 1998
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Recent Developments

As a group, the Baltics, Russia, and the other countries of the former Soviet Union have made significant progress in convertibility, foreign exchange market development, and central bank foreign exchange operations over the last five years. Virtually all these countries have made significant progress toward external current account convertibility (Table A4). Armenia, the Baltics, Georgia, Kazakhstan, the Kyrgyz Republic, Moldova, Russia, and Ukraine have removed restrictions on payments and transfers for current international transactions and have accepted the obligations of Article VIII of the IMF’s Articles of Agreement.21 In Armenia and Tajikistan, current (and capital) transactions are in practice virtually free of restrictions, and the authorities of Armenia intend to accept Article VIII status in 1997. Azerbaijan also intends to remove some remaining restrictions on current account transactions in accepting Article VIII. The Baltics, Georgia, and the Kyrgyz Republic have abolished controls on capital transactions, while Kazakhstan, Moldova, and Russia maintain limited controls, and Azerbaijan and Ukraine continue to restrict capital movements. By contrast, little progress has been made toward either current or capital account convertibility in Belarus, Turkmenistan, and Uzbekistan; indeed, during 1996–97, Belarus and Uzbekistan reintroduced exchange restrictions for current international transactions. A general pattern of direct government intervention in the foreign exchange market has been a common feature in these countries. Moreover, all three countries maintain strictly enforced controls on capital flows.

Requirements to surrender export proceeds to the central banks have been eliminated by all countries other than Belarus, Turkmenistan, Ukraine, and Uzbekistan. However, all but five countries (Azerbaijan, the Baltics, and Kyrgyz Republic) have retained requirements for repatriation to commercial banks.

The liberalization of exchange controls has had a significant effect on the structure and efficiency of foreign exchange markets. Progress toward unified exchange rates has been virtually completed in all but a few countries through the introduction of market-determined exchange rates supported, for the most part, by monetary and fiscal discipline. However, exchange rate unification is far from complete in Belarus; in Uzbekistan, which imposed strict exchange controls in late 1996 and introduced a two-tier exchange rate system in early 1997; and in Turkmenistan, where rationing of foreign exchange, prescreening of bids, and indicative rates for auctions are features of the system.22 In these countries, attempts to maintain overvalued official exchange rates and to restrict access to foreign exchange have caused cash and noncash spreads to rise significantly and induced parallel exchange market activities, in general with substantial spreads between official and parallel market rates.23 In Ukraine, a large spread between cash and noncash exchange rates has occasionally been observed.

Except in the Baltics, Kazakhstan, Moldova, and Russia, the central bank has continued to act as the main supplier of foreign exchange through auction arrangements. In Armenia, Georgia, and the Kyrgyz Republic, the importance of central bank foreign exchange auctions has declined with the evolution of two-way interbank auction systems (with the central bank in a reduced role) or more continuous inter-bank markets. In the Baltics, Kazakhstan, Moldova, and Russia, interbank trading has become relatively deep and competitive, and this evolution is now occurring in Armenia, Georgia, and Ukraine as well.24 The share of interbank trading in total foreign exchange transactions has grown to about 65 percent in Kazakhstan, 30 percent in the Kyrgyz Republic, 70 percent in Moldova, and more than 80 percent in Russia.

In Belarus, Tajikistan, Turkmenistan, and Uzbekistan, auctions could benefit from improved transparency through the removal of existing restrictions on foreign exchange transactions and through the liberalization of the allocation and pricing of foreign exchange in the market. In 1996, Tajikistan and Turkmenistan reopened their previously suspended auctions; some attempts were made to improve the efficiency of the system by increasing auction frequency in Azerbaijan and Uzbekistan. In Azerbaijan, Belarus, Tajikistan, Turkmenistan, and Uzbekistan, interbank markets are generally small and immature, with their development hindered by an absence of a number of features: market codes of conduct, adequate reporting on foreign exchange positions, efficient settlement procedures, and open position limits or by the maintenance of surrender requirements to the central banks.25 The interbank market in Belarus was effectively closed following the intensification of restrictions on transactions in April 1996. In Azerbaijan, interbank trading outside the auction is currently prohibited, but is scheduled to be permitted in mid-1997.26

In the central banks of many of the countries under review, the organization of foreign exchange departments is generally adequate, with reforms having achieved the separation of front and back offices, settlement procedures in line with international practice, adequate reporting, suitable equipment, and more skilled staff. However, internal audit procedures for foreign exchange operations need to be strengthened further. Also, refinements may be needed in some cases—for example, better reporting and coordination between back and front offices (Armenia and Azerbaijan), or more back-office training (Kyrgyz Republic). Belarus and Turkmenistan have made some progress in separating back and front offices, and Ukraine has improved operations at the technical level. More substantial reforms, however, are needed in all three countries, as well as in Tajikistan and Uzbekistan, where progress has been slow.

The centralization of official reserves has also been generally completed. In Tajikistan, the central bank has recently assumed full control of reserves. However, a portion of Russia’s official reserves is managed by the Ministry of Finance, and some reserves are managed by the central bank but are placed with former Soviet trade banks. In Azerbaijan, a portion of the official reserves is managed by the International Bank (a state bank). Presidential control over the country’s official reserves continues in Turkmenistan. In Uzbekistan, the National Bank of Economic Activity (state-owned) administers about one-third of the official reserves. Some official reserves of Belarus are held with domestic banks.

In the Baltics, Moldova, and Russia, the management of foreign exchange reserves has been relatively advanced for some time. Substantial progress has been made recently in developing adequate guidelines in Armenia, Belarus, Georgia, Kazakhstan, and the Kyrgyz Republic. In the latter group of countries, further work is needed in risk management to improve the structure of reserve portfolios. Even greater work is necessary in Azerbaijan, Tajikistan, Turkmenistan, and Uzbekistan to introduce meaningful guidelines and reporting procedures and to diversify reserve asset holdings.

Foreign exchange market intervention has been prominent mostly in those central banks that actively smooth, or steer, the exchange rate. In a few cases (Armenia through late 1996, Azerbaijan, Georgia, the Kyrgyz Republic, and, recently, Tajikistan), such intervention has substituted in part for money market operations, reflecting relatively less developed domestic instruments.

Country Rankings

The 15 countries are grouped into three categories on the basis of the level of development they have achieved since initiating reforms (Table 3). The countries in Group III have made substantial progress in most or all areas of foreign exchange reform. Armenia, Georgia, and Kazakhstan have joined this group through the notable progress they have made in the last year or so. There is now only limited need for further reforms in this group, although some additional specialized advice may still be needed in several countries to refine interbank market development, international reserve-management policies, and coordination with monetary policy. The countries in Group II have also shown reasonable progress, although the need for further reforms continues in a number of broader areas, such as establishing an interbank foreign exchange market (Azerbaijan), achieving current account convertibility, and improving reserve-management policies. Foreign exchange reforms in Group I have slowed down or have even been reversed. The main impediments to progress appear to be delayed implementation of structural and economic reforms and limitations in implementation capacity (Tajikistan and Turkmenistan), as well as an extremely cautious approach to adopting market-oriented reforms (Belarus, Turkmenistan, and Uzbekistan)—and even a lack of conviction as to their merits.

Table 3.Country Rankings in Foreign Exchange Operations and Markets and in Official International Reserve Management





Substantial Progress
Kyrgyz Republic

Priorities for Reforms

Conditional on countries’ demonstrated implementation capacity, including their overall stance toward market-oriented reforms, further action will be needed in four broad areas. First, efforts must continue to support the move toward current account convertibility, including the acceptance of Article VIII status. Consideration should also be given to encouraging the liberalization of capital account transactions, consistent with macroeconomic stabilization and financial system reform. Second, efforts should be devoted to permitting and setting up the basic conditions for the development of an interbank foreign exchange market. Refinements will include tightening or strengthening the enforcement of open position limits, improving settlement systems and correspondent relations, training dealers and establishing codes of conduct, and eliminating surrender requirements to the central banks. Third, designing and implementing prudent guidelines for reserve management and improving the organization of foreign exchange operations will continue to be a priority in several countries. Fourth, consideration will also need to be given to improving coordination between money and foreign exchange operations, as well as in devising strategies for a smooth transition between alternative monetary and exchange arrangements (Lithuania). (Table A5 provides details as to where further reforms are needed in individual countries.)

21Article VIII, Sections 2, 3, and 4, defines the obligations of convertibility that IMF members are required to undertake. Under Section 2, members may not, without the approval of the IMF, impose restrictions on the making of payments and transfers for current international transactions; under Section 3, members may not engage in discriminatory currency arrangements or in multiple currency practices that are not approved by the IMF. Section 4 contains provisions regarding the convertibility of foreign-held balances.By end-1997, Russia is scheduled to eliminate one exchange restriction resulting from the inconvertibility of interest income on foreign holdings of government securities.Ukraine has notified the IMF of its intention to accept Article VIII.
22In March 1997, the National Bank of Belarus pledged, in a pact with the Central Bank of Russia, to introduce unlimited cur-rent account convertibility for the domestic currency.
23In Turkmenistan and Uzbekistan, the spread between the parallel and official exchange rates rose to about 30 percent and about 100 percent, respectively, by the end of 1996; in Belarus, the spread is 30 percent at present. In Tajikistan, an informal parallel market exists for small transactions, but the rate for cash transactions in that market has not varied significantly from the rate in the cash auction market.
24In Armenia, the central bank has recently withdrawn almost entirely from the auctions.
25Limits on open positions in foreign exchange exposures have been introduced in virtually all of the countries in this study as part of a set of prudential regulations for banking systems. However, limits are inadequately enforced in Azerbaijan, Estonia, Georgia, Kazakhstan, and Ukraine, and appear to be unduly loose or inconsistent with international practice in Armenia, Belarus, Kazakhstan, and Russia.
26In addition to auctions and interbank markets for foreign exchange, foreign exchange bureaus have been quite active in Armenia, Kazakhstan, and Moldova as a major channel for retail and cash transactions. In Armenia, bureaus are allowed to have brokerage activities, with no requirement that they be affiliated with banks. In Ukraine and Uzbekistan, restrictions were imposed on the spread between noncash rates and cash rates in bureaus. Bureau trading remained sporadic in Belarus, while that in Uzbekistan was characterized by a lack of arbitrage activity.

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