II Experience with Instituting and Operating Market Arrangements for an Independent Float
- Kyong Huh, Benedicte Christensen, Peter Quirk, and Toshihiko Sasaki
- Published Date:
- May 1987
Fifteen developing country members of the Fund have adopted market-related floating exchange arrangements.4 Members adopting floating exchange rate systems have represented a variety of economic structures and per capita income levels within the group of developing countries, and have also been geographically dispersed (see Table 6 in the Appendix). However, one fairly general characteristic has been the openness of their economies to trade, and therefore the critical importance of the exchange rate. The depth of the financial systems in the economies under study has also varied, broadly with per capita income.
The developing countries that have adopted independently floating systems5 had previously implemented a broad spectrum of arrangements. Bolivia shifted to floating from an exchange rate pegged to the U.S. dollar which had been devalued from time to time in an attempt to counteract the effects on competitiveness of rapid domestic inflation. In the Dominican Republic, on the other hand, there was a one-to-one parity with the U.S. dollar that had been in place for many years, even before the establishment of a par value in 1948. The currencies of Ghana and Guinea had also been pegged to the U.S. dollar prior to floating. The Gambia changed from an exchange rate that was fixed against the pound sterling, while prior to floating Sierra Leone, Zaïre, and Zambia had fixed their exchange rates in terms of currency baskets (the SDR in Sierra Leone and Zaïre). Nigeria, the Philippines, and Uganda changed from a system of managed flexibility vis-à-vis the U.S. dollar that involved small but frequent changes, and Uruguay had an exchange rate involving preannounced changes in terms of the U.S. dollar. Jamaica previously had a system of managed flexibility by which the exchange rate varied within movable bands according to market forces.
Most of the countries with an independently floating exchange rate had previously maintained arrangements involving a fixed or managed exchange rate for some transactions, combined with a legalized free floating market for other transactions, before merging the two into a unified float (Bolivia, Dominican Republic, Ghana, Guinea, Jamaica, Nigeria, South Africa,6 Uganda, and Zaïre). In four of these countries, the multiple exchange rates were maintained for a short time as a transitional device before unification. During the transition period, foreign exchange transactions were shifted to a newly created floating market (Guinea, Jamaica, Uganda, and Zaïre). Similar transitions to a unified exchange market are planned in Ghana and Nigeria.
Exchange arrangements that include a legal secondary exchange market in which the exchange rate is freely floating are currently maintained by more than 15 Fund members. Although a free secondary market may serve as a basis for early exchange rate unification in accordance with established Fund policies, in most instances the market has been in place for a number of years and was, in virtually all instances, not adopted with this aim. The experience of Fund members with multiple exchange rate arrangements was discussed by the Executive Board in April 1984 and February 1985.7 The focus of the present paper is not on these arrangements; a brief summary of the experience with multiple rates and the treatment in Fund programs of exchange rate policies of members that have unified their exchange rates on the basis of a free secondary market is presented below, page 16.
Reasons for Floating
Of the developing countries that have adopted floating rates, most did so because of severe balance of payments difficulties reflected in sizable external payments arrears, and in the context of discussions for a Fund-supported program. The exceptions were Lebanon, South Africa, and Uruguay. In Lebanon, the maintenance of a floating exchange rate was seen as part of the country’s commitment to an open and commercially free environment for trade, and reflected the highly developed financial markets in Lebanon. The decision by South Africa to float its currency, at a time of relative balance of payments strength, was influenced at least in part by the desire to improve conditions for monetary control.
Uruguay, which has been one of the few Latin American countries to avoid external payments arrears in recent years, adopted a market-determined rate in 1982 following adverse experience with other relatively flexible arrangements. Prior to 1978, there had been a dual exchange market in which the secondary market was freely operating. After unification in 1978, Uruguay for several years undertook a program of preannounced exchange rate changes, but this system ultimately caused considerable instability in the capital and current accounts because the exchange rate adjustments were insufficient.
In all other cases, the choice of floating exchange rates, all in the context of Fund-supported program discussions and most with technical assistance provided by the Fund,8 has been made by countries with protracted balance of payments problems that included arrears. These problems had previously been addressed by extensive controls on foreign exchange transactions instead of exchange rate adjustments, which had in turn led to disintermediation in official exchange systems. In such circumstances, it was difficult to predict the equilibrium market rate, although the parallel market rate provided some indication. This uncertainty regarding appropriate levels for pegging or managing exchange rates has been an important reason for the adoption of floating rates. Also in these circumstances, it has been difficult, given the lack of official foreign exchange resources, to support a pegged rate that has come under market pressure, apart from through the accumulation of arrears. This is another reason why floating has often seemed the only feasible option.
The desire to bring into the open sector a large illegal or unofficial market in which the local currency was substantially depreciated, coupled with smuggled goods and capital flight associated with that market, was an important reason for adoption of the unified floating arrangements (Bolivia, The Gambia, Jamaica, Nigeria, Sierra Leone, Uganda, Zaïre, and Zambia). The initial depreciation when floating began and subsequent movements to maintain continuously a realistic exchange rate were seen as major factors in encouraging market participants to repatriate earnings. This was so particularly where the introduction of the floating market was accompanied by liberalization of exchange controls, permitting repatriated earnings either to be used for import needs or to be moved freely abroad. Proximity to a major financial center may provide an added stimulus for adoption of floating.
In Nigeria, Sierra Leone, and Zambia, the primary factors leading to adoption of the foreign exchange market arrangements were a perception that the previous administrative system for allocating foreign exchange had broken down and that the system would lead to a more efficient allocation, including more effective provision of foreign exchange for critical spare parts.
Another important reason in several instances was the desire on the part of the authorities to shed political responsibility for the adjustment of the exchange rate. Discrete adjustments to a managed or fixed exchange rate usually involved unpopular political connotations. With the rate determined in an open market, the authorities were better able to deflect political criticism and to focus their attention on other areas of economic management.
Choice of Floating Market Arrangements
Experience with different forms of free exchange markets is as yet relatively limited, being for the most part of recent origin. The authorities must nevertheless choose the institutional arrangements that are best suited to their economic structure and financial institutions. An important concern in designing a market arrangement and in deciding on the role that the authorities themselves will play in instituting the market and monitoring its performance is to prevent the emergence of destabilizing monopolistic or collusive behavior.
Members contemplating floating exchange rates are faced with essentially two forms of market arrangements (Table 1). In most of the countries under discussion in this paper (The Gambia, the Dominican Republic, Lebanon, the Philippines, Sierra Leone, South Africa, Uruguay, and Zaïre), as in all developed countries with floating exchange rates, members have opted for a market that is operated within the private sector by commercial banks and licensed foreign exchange dealers. In other countries, the authorities have felt constrained by institutional or social considerations to use an auction system to ensure a sufficiently competitive market. Foreign exchange is then surrendered to the central bank for auction to the highest bidders (Bolivia, Ghana, Guinea, Jamaica, Uganda, and Zambia). In an auction market, the central bank conducts the market and serves as the channel for the auction process. The system recently instituted by Nigeria is a composite of both forms, as an auction is used by the authorities to price and distribute foreign exchange receipts from oil to an interbank market.
|Number of Commercial Banks in Market||Form of Arrangement||Regulation of Commercial Banks’ Position||Rate Determination||Role of Central Bank Intervention||Foreign Exchange Surrender Requirements||Forward Exchange Market: Development and Plans|
|Bolivia||19||Auction (daily)||Spot position, daily||Successful bidders pay their bid prices (Dutch auction)||Possible by adjusting the amount of foreign exchange supplied to auction, within the constraint of reserves, arrears, and external debt obligations; setting of base price||100 percent of goods to the central bank||No plans to implement in the near future|
|Dominican Republic||16||Interbank||Spot position, daily||Negotiable between banks and their clients||No intervention to influence the exchange rate||All the export proceeds to the central bank through commercial banks, with exceptions of some export proceeds of mining companies and tourism||No plans to implement in the near future|
|Gambia. The||31||Interbank||Spot position, daily||Negotiable between banks and their clients||No intervention to influence the exchange rate||100 percent of goods and services to commercial banks except for some tourism proceeds; receipts of Marketing Board to the central bank||No plans to implement in the near future|
|Ghana||7||Auction (weekly)||Limit on gross spot position||Successful bidders pay their bid prices (Dutch auction)||Possible by adjusting the amount of foreign exchange supplied to the auction||100 percent of all receipts to central bank||No plans to implement in the near future|
|Guinea||3||Auction (weekly)||Spot position, weekly||Successful bidders pay clearing rate (marginal price)||Possible by adjusting the amount of foreign exchange supplied to auction, within the constraint of reserves, arrears, and external debt obligations||Joint ventures in the mining sector pay a special export tax amounting to about 40 percent of export proceeds; partial surrender requirements apply to the other major exports||No plans to implement in the near future|
|Jamaica||10||Auction (twice a week)||Limit on total forward sales not matched by forward purchases||Successful bidders pay their bid prices (Dutch auction)||Intervention to meet net reserve target2||100 percent of all receipts to the central bank||Organized market exists, but very few transactions|
|Lebanon||Many||Interbank||Net foreign position (debit) should be within 15 percent of capital||Negotiable between banks and their clients||Smoothing operations||None||Market exists|
|Nigeria||41||Interbank (auction for oil receipts)||Net foreign position, both spot and forward||Negotiable between dealers and their clients; marginal price for successful bidders at auction||None in interbank; possible by adjusting amount of foreign exchange supplied to the auction||100 percent of all receipts to commercial banks||Organized market exists, but very few transactions|
|Philippines||33||Interbank (telephone market and trading floor at central bank)||None||Negotiable between banks and their clients||Net accumulation of international reserves to keep minimum level||100 percent of goods and services to commercial banks||Unorganized market exists, but very few transactions|
|Sierra Leone||5||Interbank||Net foreign position, spot and forward||Negotiable between banks and their clients||None||100 percent of all receipts||No plans to implement in near future|
|South Africa3||5||Interbank||An open position limit, both spot and forward, equal to 10 percent of the banks’ capital and reserve funds||Negotiable between banks and their clients||Smoothing operations||100 percent of goods and services to commercial banks||Organized market exists, but number of transactions is limited|
|Uganda4||7||Auction (weekly)||None||Successful bidders pay clearing rate (marginal price)||Possible by adjusting the amount of foreign exchange supplied to auction||100 percent of goods and invisibles to the central bank through commercial banks||No plans to implement in the near future|
|Uruguay||12||Interbank||None||Negotiable between banks and their clients||No intervention by the central bank, although the largest commercial bank (government owned) has intervened in 1986 to influence the exchange rate||None||Organized market exists, but very few transactions|
|Zaïre||10||Interbank||Spot position daily||Negotiable between banks and their clients||Some intervention on the interbank market||Receipts of mining company GECAMINES and oil companies to the central bank; all other export and invisible proceeds to commercial banks||Forward transactions permitted, but very few transactions|
|Zambia||6||Auction (weekly)||Transactions subject to existing regulations||Successful bidders pay their bid prices (Dutch auction)||Possible by adjusting the amount of foreign exchange supply to auction, within the constraint of reserves, arrears, and external debt obligations||All the export proceeds and proceeds from invisibles to the central bank through commercial banks, except for the retention of privileges of the mining company and exporters of nontraditional products||No plans to implement in the near future|
The participants in an interbank market are commercial banks and, in some instances, foreign exchange dealers (if these are licensed for the purpose). Individuals and firms are permitted to bid through the commercial banks or dealers acting as their agents. Of the developing countries that have adopted an interbank system, most already had a sufficient number of commercial banks and foreign exchange dealers operating in the economy to ensure a competitive environment. In other instances, major considerations in the choice of an interbank system were the absence of sufficient manpower and expertise at the official level to conduct auction arrangements and the belief that, with sufficient freedom of entry into the newly created market, the necessary institutions would develop quickly.
Under this system, the exchange rate is determined in negotiations between banks and their clients and in transactions between the banks. The exchange rate is free to vary from hour to hour and day to day. However, to ensure the competitive operation of the market, in all instances except the Philippines and Uruguay there are maximum or minimum limits imposed on commercial bank holdings of foreign exchange. The purpose of such regulations is twofold: first, to prevent major dealers from cornering the market or from using inside information to speculate on their foreign exchange operations; second, to prevent imprudently large exposure of banks to exchange risk. Such limits on stocks may be important particularly in the initial stages of the market when a minimum volume of trading is necessary to establish confidence. The size of the limits may be established initially by reference to the previous behavior of commercial banks’ working balances, and then adjusted in the light of experience with the market. Such limits may also be seen as assisting the responsibility of the central bank for managing accumulation of international reserves from the low initial levels generally prevailing in these countries. A second type of regulation on the market would involve an upper limit on the volume of foreign exchange surrendered to each commercial bank, to prevent any bank from cornering the market in a flow sense. Such a limit, as introduced in Sierra Leone, could be necessary in countries where the foreign exchange receipts of the economy accrue to one or a few major transactors who could then direct all of their foreign exchange earnings to one exchange dealer. If constrained by the stock or flow limits, banks must either buy or sell from other banks or, if other banks were also at their limits, transact with the central bank.
Another important form of official involvement in the interbank market is the periodic fixing session, at which the central bank has representatives present, who may also transact.9 At the rate-fixing sessions, held at least once a week, the commercial banks trade in foreign exchange, and an exchange rate is fixed taking into account the outcome of the previous fixing and subsequent transactions between banks and their customers during the week. The fixing exchange rate is usually set at a level which allows the largest volume of purchase orders to be transacted, and in the course of the fixing session commercial banks trade short and long positions according to their needs at this rate; a minimum volume of transactions may be specified by the central bank. Except for customs valuation and other official statistical purposes, the fixing rate normally does not apply to transactions other than in the fixing session; it is immediately superseded by rates in the interbank market. Particularly in economies marked by a relatively small number of transactors, or by other political or institutional tendencies toward collusion, the fixing session is an important means of providing the authorities with a view into the operation of the system, and thus preventing abuses. In countries where there are inadequately defined budgets for foreign exchange expenditures by the government itself, there may also be rules concerning the entry of the government or government enterprises into the interbank market, either in the course of the week or at the time of the fixing. Such rules may be especially relevant where the floating arrangements are introduced ahead of fiscal adjustment measures.
In most instances, there are official requirements for surrender of exchange to the official market. All countries in this group, except Lebanon and Uruguay, have surrender requirements for foreign exchange. In Nigeria, the Philippines, and Sierra Leone, all receipts from exports of goods and services are required to be surrendered to commercial banks (except oil receipts in Nigeria, which are surrendered to the central bank). Receipts of the marketing board in The Gambia and receipts of mining companies and oil companies in Zaïre are required to be surrendered to the central bank. In the Dominican Republic, foreign exchange earnings of traditional exports of goods and services previously subject to an exchange surcharge (sugar, cocoa, coffee, tobacco, most metals and minerals, and services other than tourism) are required to be surrendered to the central bank. The significance of the surrender requirement to government authorities is that, although the government uses the exchange rate determined in the market, it may seek to guarantee the provision of foreign exchange for certain purposes. The surrender requirements are therefore a consequence of official intervention in the allocation of foreign exchange by nonprice methods, for example, import licenses or exchange restrictions.
In some cases, portions of the supply and demand of foreign exchange are allocated outside the market, although at the same exchange rate. Such extra-market transactions occur when the central authorities retain exchange surrendered to them for their own use or when private sector exchange earners are granted retention privileges to use or sell the retained amounts outside the market. This results in less information on transactions being channeled through the market, and a consequent loss of efficiency in the floating arrangements. As will be seen below, this has led on occasion to severe instability of the exchange rate, especially when the information is ultimately made available to market transactors, and expectations are corrected suddenly.
Demand for foreign exchange by the public sector, including public enterprises, is met at the prevailing exchange rates either through the commercial banks or through the central bank. In Nigeria and Uruguay the central bank acts as an agent when it is requested by the government to purchase on its behalf foreign exchange from commercial banks (or at the auction also in the case of Nigeria). In the Dominican Republic, the central bank sells foreign exchange to the government from receipts surrendered to it. In The Gambia and Zaïre, debt service obligations of the public sector are paid from exchange surrendered to the central bank. However, the government may obtain foreign exchange from commercial banks for other purposes. In most countries severe shortages of foreign exchange for building up depleted reserves and meeting external debt service obligations, including the elimination of arrears, make it very difficult for the central bank to become a net seller to the interbank market. On the other hand, excessive purchases by government would tend to overdepreciate the domestic currency, leading to political and social difficulties. Intervention will therefore usually be limited to very short-run smoothing or seasonal operations and to purchases for gradual reconstitution of international reserves.
For the efficient and competitive operation of the interbank market, it is important that exchange rates determined in these transactions be widely and openly published so that the possibility of collusive practices by commercial banks is reduced and that the regulations set specific requirements to this effect. The central bank may in addition set maximum commissions or spreads between buying and selling rates that may be charged by commercial banks. Purchasers of foreign exchange may also be required to provide documentation that the purchase is for transactions in accordance with prevailing exchange and trade controls and income tax regulations.
An important question in setting up a competitive market is the degree of freedom of access to the market. In several countries, exchange transactions are limited to certain groups. In Zaïre, foreign exchange dealing licenses are granted only to commercial banks and hotels. There is no specific information on the network of informal foreign exchange dealers, but it is thought to be small and scattered. In the Dominican Republic, the foreign exchange market is a very broad one owing to the openness of the economy and the prior existence of a secondary market in which some 16 commercial banks and more than 90 foreign exchange houses participated. Nigeria also has a large number of commercial banks (over 40), and other dealerships may be licensed. At the other end of the spectrum is the market in The Gambia, in which only 3 commercial banks participate, and nonbank foreign exchange dealers are not permitted to participate in the fixing session. Generally speaking, the easier are entry requirements into the market, the more competitive and stable it will be.
The role of the authorities in an auction system (as conducted by Bolivia, Ghana, Guinea, Jamaica, Uganda, and Zambia) is a more central one than in an interbank market. 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 basis. The central bank decides the amount of exchange to be auctioned and the minimum reserve price below which it will not accept bids. The minimum amount of the sales may be predetermined as part of a macroeconomic program. The central bank may decide to auction foreign exchange in minimum amounts (say, US$50,000), allowing banks to bid on behalf of their customers. Where licensing requirements are retained, all bidders with a valid import license are required to lodge an advance deposit, either partial or equivalent to 100 percent of the foreign exchange they intend to purchase, before the submission of bids. The bids submitted to the auction are then examined, and all bids in excess of the highest bid which fully exhausts the available supply of foreign exchange (i.e., the market-clearing price) are accepted, providing they exceed any reserve price established by the central bank. The market-clearing marginal rate (the average exchange rate in Bolivia) becomes the market exchange rate. After the auction, the market exchange rate, the total number of bids received, and the number of successful bidders are announced. The auction-determined exchange rate applies until the next auction date to all exchange transactions, including surrenders for the next auction and any transactions that may not be required to be channeled through the auction market (e.g., transactions of the government).10 Advance deposits lodged by unsuccessful or partly successful bidders are returned in whole or in part, respectively, but bids are normally not permitted to be withdrawn. If a successful bidder fails to make full payment for his foreign exchange within a specified period, he may be subject to a fine that may be collected from the deposit he has lodged. Spreads between buying and selling rates of individual commercial banks and any limits on commercial bank foreign exchange positions are closely monitored by the central bank to ensure that collusive practices are not involved and that they reflect reasonable profit margins.
Perhaps the basic differences between interbank and auction system arrangements are the treatment of the supply of foreign exchange to the market and the frequency or continuity of adjustment of the rate. An essential feature of an auction market arrangement is that it requires the surrender of foreign exchange to a centralized unit, which to date has been the central bank of the country organizing the market. In contrast, in an interbank arrangement the ownership of foreign exchange may remain diffused in the private sector. In some auction arrangements (as with the interbank arrangements described above) the surrender requirement is less than complete, and retention allowances have been kept for certain export or other foreign exchange earners. Similarly, the supply by the central bank of foreign exchange it has collected may be less than complete, as the central bank retains a certain portion of foreign exchange from the market for the use of government.
In Bolivia, Ghana, Jamaica, and Uganda, all export proceeds are required to be surrendered to the central bank. In Guinea, joint ventures in the mining sector pay a special export tax in foreign exchange, and partial surrender requirements apply to other major exports. In these five countries, all sellers of foreign exchange to the central bank are entitled to receive local currency at the auction market exchange rate for all foreign exchange surrendered. In Bolivia, in order to stimulate surrender, those surrendering foreign exchange were for a short time able to obtain an exchange reimbursement certificate in an amount equivalent to 10 percent of the foreign exchange surrendered. In Zambia, the authorities have accepted, on a transitional basis, retention privileges for the mining company and exporters of nontraditional products, reflecting concerns about the availability of foreign exchange. For example, in the latter case, about 50 percent of total export proceeds are estimated to be retained by exporters. However, the Zambian and the Ugandan authorities have introduced policies whereby the source of foreign exchange earnings is no longer subject to declaration, in order to encourage capital inflows into the system.
Once the central bank obtains the foreign exchange, it may put some portion aside for its own uses— reduction of external arrears, accumulation of reserves, and payments of external debt obligations. In Guinea, Jamaica, Ghana, Uganda, and Zambia, payments for official imports, such as petroleum and some other payments, are made by the central bank from the surrendered foreign exchange, and the other available foreign exchange is auctioned. The foreign exchange requirements of public enterprises may also be provided at the official exchange rate, or the enterprises may be required to purchase foreign exchange in the auction market (Bolivia, Ghana, Jamaica, and Uganda). Most of these requirements are, in practice, met outside the auction in Jamaica. The net effect of these arrangements under which government needs are met outside the auction at the market rate is to limit severely the proportion of overall foreign exchange earnings that is channeled through the auction market.11 In Uganda and Zambia, the amount supplied to the market has been largely prespecified in absolute terms, although subject to some variation according to the balance of payments performance. In Jamaica, the amount supplied to the market has been larger and has naturally fluctuated with overall balance of payments developments. The retention and sequestering of exchange for official purposes, although undertaken to ensure availability, has often created problems both for the flow of information to the auction market and for the provision of sufficient exchange for the orderly discharge of current demands, by reducing confidence in the operation of the market and thus sales to it.
The other aspect of the supply side of the market, namely the exchange rate applying to sales to the central bank, in part for the auction, also marks an important difference from the interbank market system. Under the interbank system the exchange rate may be determined directly and may vary continuously during business hours by negotiation between buyers and sellers, but under the auction system, which functions discretely, surrender occurs in practice at the exchange rate determined in the preceding auction. This may create uncertainty for market participants, and a risk of exchange loss in the interim for participants engaged in both purchases and sales in the market. Of course, the more frequently the auctions are conducted, the less inefficiency in the market-clearing process will result from this source. In addition to adding to exchange risk, infrequent auctions could also cause delays in the availability of exchange. Further delays will result if participants’ difficulties in assessing the clearing price cause them to make one or two unsuccessful bids before finally obtaining exchange. Auctions take place daily in Bolivia, twice a week in Jamaica, and weekly in Ghana, Guinea, Nigeria, Uganda, and Zambia.
Eligibility for participating in the auction on the demand side of the market is basically determined by the restrictive system of the particular country (see next section). In addition, there may be technical requirements that must be satisfied in order to establish the ability of a participant to make the local currency payment and to otherwise consummate a successful bid. Bids in the Ghanaian auctions must be accompanied by a deposit equivalent to 100 percent of the bid amount. In Bolivia, any individual or legal institution that wishes to obtain foreign exchange is permitted to submit a bid in the auction, although each bid must have a minimum value of US$5,000 and must be accompanied by a banker’s check in domestic currency equivalent to the bid. In Jamaica, private participants in the market comprise all bona fide importers with valid due or outstanding payments and other nonbank applicants holding foreign exchange approvals of the central bank. Bids for transactions below US$50,000 are aggregated and presented by Jamaican commercial banks (US$500 for Ghanaian banks) on behalf of their clients. In Bolivia, all public sector institutions must also validate their participation by producing a banker’s check. In Guinea, all transactions of the public sector are conducted at present in the primary exchange market (first window) which handles, inter alia, external debt service obligations and official petroleum imports. Transactions of the mining companies are also conducted at this window, while all other trade transactions are conducted at the second market window. Authorized Nigerian foreign exchange dealers are free to participate in that country’s auction for a portion of foreign exchange receipts, without provision of documentation regarding end-use of exchange; for the purpose of capital controls they act as agents of the government in their sales in the interbank market. In the initial stage of operation of the Ugandan market, bids for foreign exchange were limited to imports (excluding oil and essential spare parts and capital goods), to invoices made out by foreign airlines for transportation, and to private sector service and transfer payments. In Zambia, all public enterprises, except the mining enterprise, must bid for their foreign exchange requirements in the auction. Advance deposits, amounting to 30 percent of the kwacha offered at the auction have been required of all participants since November 1986; in effect this has constituted a restriction on access to the auction.
Some of these countries have penalties for the successful bidder who fails to take the bid within a certain period, even though he has deposited with his commercial banks checks against the full local currency value of his foreign exchange application. In Zambia, for example, a penalty not exceeding 10 percent of the amount of the bid will be imposed on the bidder if the Foreign Exchange Committee finds a blatant abuse of the foreign exchange arrangements. A bidder found persistently abusing the arrangements may be placed by the Committee on a black list for up to 12 months, during which time the individual is disqualified from participation in the market. In countries with floating systems that have retained import or capital controls, pre-existing legal penalties for contravention of these regulations may also continue to apply.
Another aspect of auctions is the choice of arrangements for determination of the exchange rate between a “Dutch auction” and a “marginal pricing” approach. Under the Dutch auction system, each bidder whose bid is accepted must pay his bid price for foreign exchange. This system has been applied recently by Bolivia, Ghana, Jamaica, and Zambia. Participants in this type of auction may pay a price for foreign exchange that is significantly higher than the market-clearing price if they assess demand conditions in the market incorrectly but their bid is successful. Guinea, Nigeria, and Uganda operate marginal price auctions. Under the marginal price system, a single rate—the most appreciated bid price at which the available foreign exchange is exhausted, which is the market-clearing price—is applied to all successful bidders. Bidders who have offered rates more depreciated than the market-clearing rate will receive all the foreign exchange they have bid for at the clearing rate. Those who have offered a rate more appreciated than the clearing rate will not receive foreign exchange and those who have offered the marginal rate will receive only part of what they have bid for, on the basis of an allocative rule. In Jamaica and Zambia, the authorities switched to a Dutch auction from a marginal pricing auction mainly because they were concerned that speculators would act on the belief that the local currency would depreciate sharply against foreign currencies and that these speculators should pay the full price of their bid. In practice, however, participants in the Jamaican auction have been able to obtain sufficient information regarding each other’s bids for the spread between buying and selling rates to remain very narrow. Similarly, in Bolivia, following a settling down period of a month or so after introduction of the Dutch auction, the successful bids in the auction also converged within a narrow (less than 2 percent) range. Bids in the recently constituted Ghanaian auctions have been converging, and as of November 1986 were in the 6-7 percent range, but convergence has not been observed to date in Zambia.
A possible difficulty with the Dutch auction system is that it may inhibit entry to the market by participants who fear having to pay a price significantly higher than the clearing price for exchange if their bid is successful, leading to continuous existence of a black market and collusion before auctions. The risk would be increased if significant spreads actually do emerge between successful bids. For example, an importer could be left with overpriced goods on his hands relative to those held by others bidding in the market. However, the experience of the Jamaican and Bolivian Dutch auction systems to date has been that the spreads in the market have been very small, in part in Bolivia because the parallel market provides a guide. A more basic criticism of the Dutch auction system is that it involves price discrimination, and constitutes an additional incentive for collusion, to ensure that the consumer surplus is not appropriated by those administering the auction. The marginal approach to auction pricing is the best approximation to normal private markets, in which the consumer surplus is not appropriated. Under a marginal pricing approach, rates of return are free to vary and thus to direct foreign exchange to the most valued uses.
The Dutch auction approach raises questions as to which exchange rate will be relevant to extra-auction market transactions (e.g., government transactions). In Bolivia, the exchange rate struck and announced for this purpose is the weighted average of successful bids,12 while in Jamaica it is the lowest price at which exchange was bought and sold in the auction—that is, the marginal price.13 Another aspect of the Dutch auction system is that, to the extent that it gives rise to exchange rate spreads of more than 2 percent between the buying and selling rates as a result of official action, a multiple currency practice arises. In countries maintaining the Dutch auction system, the Fund approved the resulting multiple currency practice on a temporary basis.
Another consideration in the setting of exchange rates is the use of a reserve price for foreign exchange, that is, the most appreciated exchange rate at which the central bank will undertake to supply exchange. In general, a reserve price has not been set and should not be necessary, as countries adopting these systems have normally been in a situation of overall excess demand for foreign exchange. Where the market is subject to sporadic supply, including strong seasonality, the experience with floating exchange markets having sufficient freedom of entry is that even relatively rudimentary markets effectively discount such seasonality. For example, in Somalia a secondary free market in which the sole commercial bank does not participate has been marked by relatively small two-way variability of the exchange rate. Where the arrangements have not been in place sufficiently long to ensure adequate confidence in the free operation of the system, a reserve price may be used to ensure against untoward appreciation of the currency with respect to a level that the authorities regard as an equilibrium (Ghana).
Issues that Have Arisen in the Choice and Implementation of Floating Arrangements
The basic objective of auction and interbank market systems is to establish an exchange rate that will move flexibly to equilibrate the supply of and demand for foreign exchange and thus to reduce dependence on exchange and trade restrictions. The choice between the two forms of arrangement must take into account the institutional and economic structure of the country concerned. Where a sufficient number of capable commercial banks exists or there is a pre-existing network of operators dealing in the parallel market, the interbank arrangement is likely to be the more efficient, and will require less resources at an official level to ensure its success. However, one question that may be considered open is whether provision for freedom of entry into a floating interbank market, even when the number of capable banks is initially small, will result quickly in sufficient institutional depth. The existence of experienced brokers in often extensive legal and illegal parallel markets suggests that this will normally be the case. The recent experience with the institutionally limited market in Somalia, noted above, and also the market in The Gambia, in which only three commercial banks participate, has also provided evidence of the general applicability of interbank or other arrangements centered on the private sector. One further consideration in the choice of the form of floating arrangement is the extent to which collusion among participants may be expected. As discussed above, there are ways of ensuring that one or several operators do not corner the market, but in a country that has had a history of commercial domination by a small group, central bank organization of an auction market may be preferable to an interbank arrangement, at least until wider participation in foreign transactions becomes established. On the other hand, where a primary consideration of the authorities in choosing floating is their desire to distance themselves from responsibility for the setting of the exchange rate, the administration of the auction by the central bank may run counter to that objective.
In Guinea, an interbank market was considered inappropriate by the authorities because there are only three commercial banks operating in the country and because the public sector is the main source of foreign exchange earnings. Likewise in Uganda, an interbank market was considered unworkable by the authorities because of the limited number of commercial banks and the danger of collusion. In addition, since coffee was the main source of foreign exchange earnings, and since it was exported by the Government, it was thought that an interbank market would not be efficient. Further, profits that the central bank would earn from foreign exchange auctions were seen as a source of budget revenue that could not be captured by an interbank market, although they gave rise to an allocative inefficiency because such profits also represented taxes on exchange transactions. Commercial banks have been the only legally recognized foreign exchange dealers in Uganda.
On the other hand, the authorities in The Gambia chose an interbank arrangement, although there were only four banks operating in the country at the time. The reasons for this were first, that the central bank did not have enough foreign exchange and manpower to conduct the auction; second, that the banks were trusted by the authorities to take a role in allocating foreign exchange efficiently to institutions, including small private traders; and third, that operation of the system was envisaged to be simple but comprehensive. In practice there were some initial difficulties in ensuring the competitive operation of this market, but these have since been overcome.
Owing to the wide dispersion of commercial banks throughout the Philippines, it has not been considered necessary to legalize foreign exchange dealerships other than commercial banks, but there are many unauthorized dealers specializing in workers’ remittances and other small flows. Similarly, the establishment of a market in Zaïre was facilitated by the existence of a well-established commercial banking system with 10 banks. Foreign exchange dealer licenses are granted only to commercial banks and hotels. There is no specific information on the network of foreign exchange dealers either before or after the float, but it is thought to be small and scattered. In the Dominican Republic, the existence before the float of a free secondary market in which 16 commercial banks and more than 90 foreign exchange houses and hotels participated meant that the foreign exchange market was already a relatively broad one.
In the implementation of some floating arrangements, the effects of pre-existing external payments arrears have created difficulties. In Jamaica, the overhang of arrears in the early operation of the market was so large that it adversely affected confidence in the auction market by causing an almost complete cessation of new imports. For this reason, the backlog of arrears was removed from the market and subjected to a phased repayment. In principle, this could have been accomplished through purchases from the auction, but actually a certain portion of the proceeds of surrender before the auction was set aside. Provision was made for all applications relating to previous due dates to be registered with the central bank for rescheduling. The applications were required to be accompanied by an affidavit from the foreign creditor to the effect that the amounts remained due and payable. Once verified, the foreign exchange for the arrears would not be permitted through the market; instead, a fixed sum would be set aside on a regular basis by the central bank for the rescheduled payments. An exchange rate guarantee was not provided, and supplementary local currency deposits were required at the rate on the day of actual payment. Modalities for the rescheduling might include cash payment of foreign exchange over a period of years, or investment of the local currency counterpart domestically; in the latter case, liquidation or repatriation of the investment might be permitted only at the end of a fixed period. Provision would be made for blocked counterpart deposits against all the arrears. An important aspect of the handling of the arrears “overhang” problem has been early contacts with creditors to ensure the best possible environment for the start-up of the market.
Questions of the adequacy of international reserves and techniques of foreign exchange “cash flow management” have also been raised in countries considering floating arrangements and other flexible arrangements for the exchange rate. To assist in providing as stable an environment as possible for the introduction of a floating rate system, and with the aim of minimizing the initial depreciation of the exchange rate after floating, arrangements have been made in several instances for “bridging” finance from official or commercial bank sources ahead of drawings under a Fund stand-by arrangement and rescheduling of existing external obligations. The discussions with the World Bank and other donors and creditors have been important at this stage in underpinning confidence in the new market by providing reasonable assurance that balance of payments financing would be forthcoming. The positive effect on the capital account of the floating arrangement itself in promoting a slowing or a return of capital flight, as examined in Section IV below, may also be expected to assist in stabilizing the exchange market.
For example, in the period preceding the establishment of an auction market in Bolivia, the authorities were concerned that, because of the thriving unofficial market, the supply of foreign exchange to the auction would be limited. They saw this problem as being exacerbated by the lack of an effective institutional apparatus to ensure that export proceeds flowed through the official channels. The authorities therefore considered using official reserves and borrowing from official sources abroad to supply the foreign exchange market in the initial stages. In the event, this proved unnecessary. The demand for foreign currency in the official market initially fell below supply, reflecting in part the high reserve price as well as the relatively low demand because of a lack of experience with the market mechanism. As a result, the authorities built up official foreign exchange reserves in the start-up period.
Beyond the start-up period for the floating market, the management of foreign exchange to accommodate seasonal or other identifiable reversible factors also plays an important role, given the generally low level of international reserves in this group of countries. A problem that might have been foreseen in the market established in The Gambia was the potential instability of both the volume of transactions and the exchange rate. Tourist receipts fluctuate widely from season to season, and exports of groundnuts also have strong seasonality. It is important for the market to absorb this instability, and accumulation of adequate reserves either by the central bank or in the banking system for use during the lean season is an aim of the arrangement. Tourism receipts are also highly variable in Uruguay. In both instances, the arrangements have been successfully implemented, and seasonal variability in the exchange rate has not been a significant factor.
In Guinea, all banks transacting business on behalf of customers credit the central bank with the entire counterpart of any transaction within three working days. Residents must also obtain permission to open convertible foreign currency accounts in order to auction funds through authorized banks; with liberal authorization of these accounts as at present, the auction market could become an important additional source of foreign exchange, but without it, supply could be curtailed.
Certain difficulties have marked the operation of the auction system in Jamaica from time to time. First, owing to political sensitivities there have been tendencies for large importers at times to restrain their demand for foreign exchange. Second, importers were for a time in 1984 not permitted to bid in the auction market for foreign exchange with which to repay letters of credit, and banks would not open letters of credit unless the importer had on deposit the foreign exchange. However, as most letters of credit were required by creditors to be on a prepaid basis (owing to Jamaica’s arrears), this documentation requirement effectively meant that market access was denied to importers. This vicious circle was addressed for a time by having importers present exchange control documentation following the auction, and by the institution of penalties should proper documentation not be presented. As the market settled down, banks have resumed opening letters of credit on a more normal basis. Third, importers who had no evidence of income tax clearance were for a period of months banned from the auction. Delays in obtaining this clearance were long enough to influence strongly the total demand of the auction, and the exchange rate was virtually fixed while this requirement was in effect. Fourth, sizable official foreign exchange operations outside of the auction have contributed from time to time to the instability of the exchange rate. This instability has occurred when supply to the market has been increased for a short time because of the incurrence of arrears, an unsustainable level of short-term credits by the public sector, or sales of government assets abroad. Subsequently, demand for foreign exchange increased, and the rate depreciated sharply. Since October 1985, although the market arrangements themselves have remained flexible in form, intervention by the central bank in the auction has in practice resulted in a virtually fixed exchange rate of the Jamaica dollar against the U.S. dollar.
The initial difficulty with the operation of the Philippine system was an unexpected rigidity of the exchange rate in terms of the U.S. dollar for some periods of time, which resulted in an initial appreciation of the real effective exchange rate that hindered export growth. In general, this outcome was explained by tight monetary policies reflecting the authorities’ intention to constrain inflation, accompanied by large short-term capital inflows; it was therefore not a necessary consequence of the exchange rate arrangements themselves. During other periods, most recently during the first quarter of 1986, flexibility in the exchange rate played an important role in limiting the re-emergence of a black market, in drawing back flight capital, and in protecting the balance of payments during periods of considerable financial uncertainty.
In Uganda, there were several problems during the implementation of the auction arrangements; the auction system was discontinued in November 1985. First, participation in the auction was subjected to various forms of government intervention such as import license requirements and tax payments certificates. Issuance of import licenses was for a time speeded up, but the issuance continued to be on an ad hoc and discretionary basis. Second, participation in the auction was on occasion confined to a limited group of influential importers. Third, it was not possible for participants to verify whether the announced rate was in fact the market-clearing exchange rate based on the actual bids submitted. Fourth, although import licenses and other supporting documents were required of participants in the auction, the use of foreign exchange was not closely monitored (e.g., the arrival of imports was not closely checked), so that the foreign exchange said to have been purchased for import payments may well have been used for illegal capital transactions. Fifth, initially the auction system required partial counterpart deposits against submitted bids; later, the commercial banks decided how much cash and credit were required to back a bid, depending on the credit-worthiness of the client.
The major problem in the institution of the market in Zaïre was an initial reluctance on the part of commercial banks to release foreign exchange to the market. To free up supply, the net foreign exchange position of each commercial bank was further limited to a certain proportion of its own resources, and the central bank also supplied foreign exchange to the market.
In the period preceding the establishment of Zambia’s auction market, the authorities were concerned with the possible effects of a completely free exchange market on the exchange rate and other macroeconomic variables, given the limited supply of convertible foreign currencies. Initially, therefore, the exchange rate was determined on the basis of an auction that involved only a selected group of foreign exchange users. Those excluded from the auction included the commercial banks, the government and government-owned enterprises, and the mining company. Importers not excluded had to show documentary evidence to the commercial banks of their import licenses and pro forma invoices for imports. Also in the initial stages of the auction, a number of bidders were unsuccessful in obtaining foreign exchange if their bid price was judged by the authorities to be too high, or if they had recently obtained foreign exchange through the auction market. The authorities have recently expanded the coverage of the auction to include the importers who were formerly excluded from obtaining foreign exchange in the auction market, and import licenses are now issued for a fee without restriction.
Role of the Fund in Floating Arrangements
The need for exchange rate flexibility has been an important ingredient in the design of members’ financial programs supported by the use of Fund resources. In the period surveyed here (January 1983–December 1986), most programs included elements to ensure greater flexibility in exchange rate policy, either by managing the rate or by permitting it to adjust in response to market forces. Out of a total of 106 arrangements for 65 members approved by the Fund’s Executive Board during the period under analysis (including 5 extended arrangements), the programs supported by 71 contained elements of exchange rate flexibility14 (Table 2). Most of these did not involve a formal change in the member’s exchange arrangements, such as adoption of floating, but rather an intention to increase the external competitiveness or at least to maintain the existing level of external competitiveness as measured by the real effective (inflation-adjusted) exchange rate. This type of objective was included in 48 programs in this period. In 42 programs, the target was linked to frequent exchange rate adjustments in the context of managed floating arrangements. In the other 6, the value of domestic currency was pegged either to the SDR or to another currency composite and was to be adjusted periodically.
|External Competitiveness Target1||Other Forms of Flexibility|
|Board Approval||Maintenance external competitiveness||Increase in external competitiveness||Transfer of transactions to free market||Adoption or maintenance of independently floating arrangements||Initial depreciation and review clause|
|Costa Rica||March 1985||*|
|Dominican Republic||January 1983||*|
|Dominican Republic||April 1985||*|
|Gambia, The||September 1986||*||*|
|Sierra Leone||February 1984||*|
|Sierra Leone||November 1986||*|
|Solomon Islands||June 1983||*2|
|Sri Lanka||September 1983||*2|
|Western Samoa||June 1983||*2|
|Western Samoa||July 1984||*|
Frequent adjustment to the exchange rate under managed floating arrangements with the aim of maintaining or increasing competitiveness (as measured by a real effective exchange rate) was therefore the prevalent form of flexible exchange rate policy in the period surveyed (65 percent of programs).15 Use of market factors in exchange rate policy implementation was involved in 35 percent of the programs—of which 11 percent represented provisions for the transfer of transactions to the free parallel exchange market and the remaining 24 percent called for the adoption and maintenance of independently floating arrangements.
Of the 15 countries that have operated a floating exchange rate regime in the period January 1983 to December 1986, the establishment of a unified floating exchange rate was linked to the member’s Fund-supported economic program either in place or under discussion in all but Lebanon and South Africa (Table 3). In all these instances, the Fund staff played a role in providing assistance at the level of broad macroeconomic policies, and at a technical level, in formulating and adapting the systems to take account of the individual characteristics of the member’s economic and financial structure.
|Date of Program||Date of Adoption of Independent Float||Floating Arrangements Linked to Program||Prior Use of Official Multiple Exchange Rate System (Introduced as Part of Program)1||Length of Time Multiple Rates Maintained|
|Bolivia||June 1986||August 1985||Yes2||Yes2||Yes (No)||8 months|
|Dominican Republic||April 1985||January 1985||Yes2||Yes2||Yes (No)||More than 2 years|
|Gambia, The||September 1986||January 1986||Yes2||Yes2||No|
|Ghana||August 1984||September 1986||Yes||No||Yes (Yes)||Unification planned for 1987|
|Guinea||February 1986||June 1986||Yes||Yes||Yes (Yes)||4 months|
|Jamaica||June 1984||November 1983||No||Yes||Yes (Yes)||6 months|
|Nigeria||December 1986||September 1986||Yes2||Yes2||Yes (Yes)||Unification planned for 1987|
|Philippines||December 1984||October 1984||No||Yes||No|
|Sierra Leone||November 1986||June 1986||Yes2||Yes2||Yes (No)||6 months|
|South Africa||February 1983||Yes (No)||More than 2 years|
|Uganda||September 1983||June 1984||Yes||No||Yes (Yes)||22 months|
|Uruguay||April 1983||November 1982||No||No||Yes (No)||More than 2 years3|
|Zaïre||December 1983||February 1984||Yes||No||Yes (Yes)||5 months|
|Zambia||February 1986||October 1985||Yes||No||No|
In some instances, the floating market was introduced gradually, by the institution of a secondary market for certain transactions in which the rate was freely determined, which was followed by a transfer of transactions to that market, and finally, by unification. This gradualist approach to adoption of a floating rate system was taken in the Dominican Republic, Ghana, Guinea, Jamaica, Nigeria, Sierra Leone, South Africa, Uganda, Uruguay, and Zaïre. In the Ghanaian, Guinean, Jamaican, Nigerian, Ugandan, and Zaïrean arrangements, the dual market was instituted in the context of the Fund-supported program, with a performance clause for early unification in accordance with Fund policies discussed by the Executive Board in 1983 when it reviewed the experience with multiple exchange rates.16 Temporary recourse to multiple exchange rates in some instances reflected a partial depreciation of the exchange rate for certain transactions. The existence of the secondary market was not seen initially as a basis for unification in accordance with the floating rate regime in the Dominican Republic, Jamaica, or South Africa. However, the presence of such a market may have made the transition to a unified floating rate system easier to accomplish than it might otherwise have been. In Ghana, Guinea, Nigeria, and Uganda, the secondary market represented an explicit transitional step to unification in a floating market. However, some of the multiple exchange rates were outstanding for considerable periods of time, and during that time, the exchange system was marked by distortions resulting from large implicit taxes on and subsidies to various segments of the economy.
In all programs containing provisions for floating, there was also provision for the reduction or elimination of external payments arrears during the program period. The operation of the floating exchange rate regime facilitated the management of external arrears by making it possible to avoid new arrears because foreign exchange to settle bona fide obligations could be purchased in the market. Along with the adoption of other adjustment measures, it also facilitated rescheduling and the improvement of relations with creditors. In addition, the authorities found it easier to provide foreign exchange for the settlement of preexisting payments arrears against which counterpart deposits had been lodged, because of the strengthened reserve position of the central bank. In the countries operating an auction system, the central bank set aside part of surrendered foreign exchange to service payments arrears. Payments arrears excluded from settlement in the auction market were registered with the central bank, and their settlements were arranged on a priority basis with foreign exchange which was withheld from auction. In all of the countries adopting floating arrangements, except The Gambia and Nigeria17 to date, outstanding payments arrears declined (in most cases substantially), and in three cases they were eliminated (Jamaica and the Philippines) or avoided altogether (Uruguay), although Jamaica again incurred arrears after October 1985.
See Table 1. Lebanon’s special security problems and associated data limitations make it difficult to assess comprehensively the form and effects of exchange rate flexibility on its economy. The assessment of South Africa’s recent arrangements is also complicated by special factors. Exchange arrangements in both countries are therefore discussed to only a limited extent in this paper.
Eleven percent of developing country Fund members at present maintain independently floating systems (as of September 30, 1986). In contrast, 18 percent have managed floating arrangements, including those using specific indicators to guide their exchange rate policies, 42 percent maintain pegs or have shown limited flexibility in terms of single currencies (quasi-pegs), and the remaining 29 percent peg to the SDR or some other currency basket (see Table 7 in the Appendix). The determination of countries as “independently floating” is based on the extent of the authorities’ intervention in the exchange market.
After abolishing a dual exchange system in February 1983, South Africa reintroduced it in September 1985.
International Monetary Fund, “Executive Board Warns of Harmful Effects Arising from Multiple Currency Practices,” IMF Survey (Washington: International Monetary Fund), Vol. 14 (June 24, 1985), pp. 197-99.
Because of the continued existence of arrears to the Fund which precluded discussions on the use of Fund resources, the floating system was not implemented in one instance as part of a Fund-supported program, although technical assistance was provided by the Fund and a program was subsequently adopted.
The fixing arrangements involve an auction of foreign exchange (typically small scale) between participants in the sessions.
Except in Nigeria’s composite auction/interbank arrangements, under which the interbank market exchange rate immediately supersedes the auction rate for all purposes other than customs valuation.
In Jamaica, approximately 47 percent of foreign exchange inflows in 1985 was auctioned. In Uganda and Zambia, the comparable ratio was estimated to be as low as 25 percent.
It has sometimes been suggested that this weighted average (or median) approach could also be used to determine the single “market rate,” but it would not be feasible for those successful bidders who bid below the average price. Initially, the official exchange rate was calculated by including also the unsold balances valued at the central bank’s minimum price. The reason for this practice was the central bank’s concern that exporters might manipulate the exchange rate in their favor in unusually thin exchange markets.
The use of a marginal auction approach for a secondary dual market may also make transition to a unified freely floating market easier to achieve than under a Dutch auction system, because of the multiplicity of exchange rates under the latter.
In 30 arrangements supporting programs in which no specific provisions were made for exchange rate arrangements, 16 were with Fund members that pegged the value of their currency to a major currency (Belize, the Central African Republic, Congo, Cote d’ Ivoire, Dominica, Equatorial Guinea, The Gambia, Grenada, Guatemala, Haiti, Liberia, Mali, Niger, Panama, Senegal, and Togo); all but six of the countries are members of regional monetary unions.
Comparisons of the experience with this type of arrangement with the independently floating arrangements are presented in Section IV below.
See footnote 7, above.
Pending completion of financing arrangements with official and private creditors that will lead to a substantial reduction of external payments arrears.