In response to increased exchange rate variability, there has been a rapid growth of forward exchange markets in recent years. Forward foreign exchange systems in developed and developing countries remain diverse, but as in the spot markets, there has been a convergence toward greater flexibility and freedom of access.

In response to increased exchange rate variability, there has been a rapid growth of forward exchange markets in recent years. Forward foreign exchange systems in developed and developing countries remain diverse, but as in the spot markets, there has been a convergence toward greater flexibility and freedom of access.

All industrial countries but Iceland now have forward exchange markets in which the rate is determined by the market. Forward markets that have been liberalized in several countries in the 1980s have matured quickly. However, restrictions on various aspects of forward transactions remain in some countries—the most common of which are limitations to commercial or “underlying” transactions and corresponding forward maturities. There is a close correspondence between these remaining restrictions on forward transactions and those on spot capital transactions. In addition to liberalization, developments in the 1980s have also been marked by very rapid innovation—particularly in the currency options market, where the tailoring to particular risk situations and customer preferences has brought about a wide range of instruments. As with credit markets, the influx of instruments has led to some concern that the arrangements for prudential and management supervision may have become less adequate. Despite these rapid changes, the traditional FOREX products—spot and forward contracts—remain the staples of the market.

Arrangements in developing countries are typically more centralized. They fall into three broad categories: market determined (a small but growing number), market approximating (in which the interest parity condition or an approximation of it is used), and (more commonly) fixed or managed rates at noncommercial or intentionally subsidized terms. Active forward exchange markets have emerged mainly in those countries that have advanced financial systems or relatively free exchange systems. In those countries in which the interest parity condition has been used to approximate a market-determined forward rate, varying degrees of precision and success have resulted. The major difficulty has been that application of the covered parity condition does not ensure that the official agencies providing the cover will not incur losses. In most developing countries, forward premiums have been set by administrative fiat, without recognition of market realities. Consequently, central bank losses from risk exposure have been extremely large in some countries—in some cases representing multiples of the monetary base.

These experiences suggest strongly that governments and central banks need to be wary of participating in nonmarket cover arrangements. Although such arrangements may be entered into when there is relative exchange rate stability, the potential for unpredictable shocks, or for slippages in fiscal and monetary management under different administrations, means that future stability cannot be counted on. However, because of the important benefits to be derived from forward markets, it is not desirable that the governments simply withdraw without making adequate provision for private sector arrangements to be developed.

There are several variants of market-determined systems which could be envisaged. An auction market could be devised for forward transactions, but is unlikely to be practical, because the supply of forward exchange probably may not be determined in advance sufficiently accurately. No country at present operates such a system. The possibility also exists of the central banks passively brokering transactions, without taking an exposed position themselves. Here again, such markets have not emerged, probably owing to the unfamiliarity of exporters and importers with such markets. It may also be the result of bias in risk appraisals by exporters and importers unfamiliar with the market that would delay a coincidence of wants at specific maturities. Parallel forward markets have emerged in a few countries. They exist mainly to cover risks in the parallel spot market, but could provide some indication of a clearing forward rate for the official market.

An alternative to forward cover is the provision of foreign exchange deposit accounts, which exist in many developing countries. These accounts may either be for convertible foreign exchange per se or for foreign exchange denomination of deposits without a transferable claim on a foreign asset. The disadvantage with both accounts as a hedging facility compared with the use of forward exchange contracts is that they tie up liquidity. Questions of the exposure of commercial banks to exchange risk, beyond their ability to be involved prudently or at unrealistic regulated rates, also arise with the deposit facilities.

On the other hand, forward exchange markets operated in the private sector exist in a small but significant number of developing countries. In these cases, it is clear that the environment provided by exchange systems and domestic financial systems has been important in promoting, although not necessarily determining, the flexibility of the forward arrangements. In some cases, the markets have emerged more or less spontaneously, but in others they have been “cultivated” by the central bank. To achieve further development of markets, it is useful to consider arrangements that may be grafted onto the existing official cover—whether these involve simple guarantees or more market-oriented criteria for setting premiums. However, because of the potential for large destabilizing budgetary effects, any support in the form of exposure by the central bank to make the market should be clearly limited a priori in amount and defined as short-term in nature.

A major difficulty with many of the subsidized schemes examined above as starting points for development of a market is that they have been solely for provision of cover to importers and have not disseminated information on the forward market to exporters. Any official support should therefore be directed to both sides of the market. For this purpose, a facility could be set up at the central bank to provide cover at market-clearing rates that would be established by a search procedure. The optimal starting point for the forward exchange rate would depend very much on the financial environment of the particular country. In countries with interest rates and spot exchange rates in significant disequilibrium it would be necessary to proxy the covered interest parity condition with shadow pricing of interest rates and, possibly, spot exchange rates. (The forward premium could be set, for example, at the present domestic rate of inflation minus the Eurodollar interest rate.) Both the rate and the margin payable from the fund would be adjusted continually to attract customers to both sides of the market. However, where there is a large spread between the official and parallel exchange rates, it would be necessary to increase the premium beyond the calculated level to reflect the risk that large exchange rate adjustments could occur. It would be important to limit the extent to which this could be done to avoid signaling an impending devaluation of the spot exchange rate.

In developing the market, it would clearly be preferable to have commercial banks handle transactions as much as possible, and have the central bank withdraw both its support for, or regulation of, the rate as early as possible. In the initial stages, the training requirements would probably be considerable because of the technology required. Experience in the industrial countries suggests that outright forward contracts for commercial cover would be the most desirable point at which to commence operations. In any event, options often involve forward contracts, and both options and futures markets require a large volume of transactions to be efficient. Futures and options markets may well emerge later, as in some of the more advanced developing country markets.

As the last stage of its development, the market could be extended from underlying commercial transactions to forward transactions of a purely financial character, a process that is taking place in most of the few industrial countries that have retained regulated forward systems. Such development would parallel the liberalization of remaining restrictions on international capital transactions. Benefits of these purely financial transactions, in addition to those mentioned above for commercial transactions, are that they permit stabilizing speculation and allow domestic financial institutions to retain market share in the international financial markets. Otherwise, there would be a tendency for this form of transaction, and also some of the more sophisticated money market transactions that they accommodate, to move abroad.

Development of a forward market is not a panacea for incorrect financial policies. In fact, cultivation of the market will require the adoption and maintenance of realistic financial policies.