Abstract

Systems for forward cover against exchange rate risk exist either in the official or the commercial sectors in most member countries of the International Monetary Fund. However, the form of the arrangements varies widely from one country to another, and has consequences for economic efficiency and macroeconomic management. Essentially, there are three types of forward exchange systems: market determined, with the possibility of official intervention; “market approximating,” in which the authorities attempt to set forward rates that simulate free market conditions; and official cover and exchange rate guarantees at fixed nonmarket rates. In practice, the last two forms of arrangement have frequently given rise to government subsidies, with serious consequences in a number of instances for central bank profits, and hence, fiscal budgets and rates of monetary expansion.

Systems for forward cover against exchange rate risk exist either in the official or the commercial sectors in most member countries of the International Monetary Fund. However, the form of the arrangements varies widely from one country to another, and has consequences for economic efficiency and macroeconomic management. Essentially, there are three types of forward exchange systems: market determined, with the possibility of official intervention; “market approximating,” in which the authorities attempt to set forward rates that simulate free market conditions; and official cover and exchange rate guarantees at fixed nonmarket rates. In practice, the last two forms of arrangement have frequently given rise to government subsidies, with serious consequences in a number of instances for central bank profits, and hence, fiscal budgets and rates of monetary expansion.

A number of industrial countries have in recent years introduced market-determined forward exchange rate systems (Finland and Ireland in 1980; Australia and New Zealand in 1983) or have taken major steps to broaden access to their forward markets (France, Japan, and Spain). These changes have paralleled similar developments in spot exchange markets in those countries. Only a few industrial countries continue to limit access to forward markets to certain transactors or transactions, and in all these countries the forward rate is market determined. Iceland is the only industrial country without such a market.

In developing countries, however, only a few market-determined forward exchange systems exist. These either accompany still embryonic floating spot exchange systems introduced since 1983 (as in Jamaica, Nigeria, Philippines, and Zaïre) or relatively well-developed financial systems (as in Brazil, Chile, Indonesia, Jordan, Korea, Malaysia, Singapore, Thailand, and United Arab Emirates). Market-approximating forward systems are also relatively rare (as in Mexico and for certain transactions in the Philippines). On the other hand, exchange cover arrangements with officially set rates are numerous and long standing.

In Occasional Paper No. 28 (published by the Fund in July 1984) some attention was given to the role of forward cover in alleviating the disruptive effects of currency fluctuations. That study provided a detailed examination of the macroeconomic and microeconomic effects of increased exchange rate volatility, and concluded that facilities for hedging in industrial countries had been generally adequate to offset most of the adverse effects.1 The fortieth session of the GATT contracting parties took a decision in 1984 which noted that “adjustment of uncertainty over exchange market stability could be more difficult for small traders when hedging opportunities are limited, and for small trading countries and developing countries, inter alia, when the geographical distribution of the trade cannot be easily diversified.”2 The advantages of forward exchange markets in certain developing countries were also discussed in the context of a recent study of floating spot market arrangements.3 (Conventionally, transactions for settlement no more than two business days after a deal is contracted are regarded as spot transactions. Transactions for settlement over two days ahead are regarded as forward.)

While the benefits of forward exchange markets in offsetting exchange rate risk are widely understood, their development, either de novo or on the basis of existing arrangements, has been more limited than might have been expected. In particular for developing countries, discussion of the scope for market-determined forward exchange rate systems has reflected many of the same concerns previously evinced for market-determined spot arrangements, that is, the lack of depth of financial systems (exchange and credit markets) and the consequent potential volatility of the quotations. In addition, fears have been expressed of the greater sensitivity of forward than spot markets to exchange controls since they carry the added risk that foreign exchange may not be available to complete a transaction on maturity. Nevertheless, forward markets have been introduced and are operating in a number of developing countries.

This paper describes and analyzes forward market systems with varying degrees of sophistication, and it assesses them from the viewpoint of a smaller industrial or developing country asking itself how it could institute such a system, or how it could further develop an existing system in a way consistent with its institutional and macro-economic structure. Section II examines the main features of forward exchange systems, including their regulation, and market instruments in industrial countries. Section III describes and analyzes the more diverse arrangements presently in effect in developing countries. Developments in, and the consequences of, various forms of forward systems are described in Section IV—which notes recent developments toward more liberal regulatory treatment and innovations in market instruments in industrial countries, and responses to the budgetary consequences of certain forms of arrangements in developing countries. This section also discusses policies and available techniques for further developing forward markets in both groups of countries. Section V provides a summary of the main issues and conclusions. The appendices describe forward systems in a number of individual industrial and developing countries.