Abstract

As a group, the Baltics, Russia, and other countries of the former Soviet Union have achieved substantial progress in the areas of convertibility, foreign exchange market development, and central bank foreign exchange operations over the last six years. The institutional arrangement for an efficient market-based allocation of foreign exchange is in place in most countries; payments and transfers for current account transactions are free of restrictions, except in a limited number of countries; and several countries maintain a liberal system for capital account transactions, or interpret liberally the restrictions in place. Nominal exchange rates have begun to stabilize in most countries (Figure 3.1). The ratio of gross international reserves to imports also indicates that countries are moving to macroeconomic stabilization (Table 3.1). Foreign exchange markets are usually shallow, however, with banking unsoundness often an obstacle to market deepening.

As a group, the Baltics, Russia, and other countries of the former Soviet Union have achieved substantial progress in the areas of convertibility, foreign exchange market development, and central bank foreign exchange operations over the last six years. The institutional arrangement for an efficient market-based allocation of foreign exchange is in place in most countries; payments and transfers for current account transactions are free of restrictions, except in a limited number of countries; and several countries maintain a liberal system for capital account transactions, or interpret liberally the restrictions in place. Nominal exchange rates have begun to stabilize in most countries (Figure 3.1). The ratio of gross international reserves to imports also indicates that countries are moving to macroeconomic stabilization (Table 3.1). Foreign exchange markets are usually shallow, however, with banking unsoundness often an obstacle to market deepening.

Figure 3.1.
Figure 3.1.
Figure 3.1.

Nominal and Real Effective Exchange Rates

(Indexed to 1980)

Source: IMF staff estimates.
Table 3.1.

Ratio of Total Reserves to Imports

(In months)

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Source: IMF staff estimates.

Preliminary.

Recent Developments

Out of the group, only four countries—Belarus, Tajikistan, Turkmenistan, and Uzbekistan—had not yet achieved current account convertibility (see Chapter 8, Table 8.4) by the end of 1997. During the past year, Armenia acceded to Article VIII of the IMF’s Articles of Agreement, and Russia and Ukraine removed remaining restrictions on current account transactions.1 Belarus, Turkmenistan, and Uzbekistan maintain a multiple-currency practice (subject to the jurisdiction of the IMF). Azerbaijan has virtually eliminated all restrictions, and plans to accede to Article VIII. In Tajikistan, political instability in late 1996 and early 1997 led to a disruption of foreign exchange reform and resulted in the reintroduction of import and export duties and of administrative mechanisms for allocating foreign exchange. The peace agreement in June 1997 allowed the authorities to eliminate all of the reintroduced restrictions. While most of the countries continued to require the repatriation of current account proceeds to domestic commercial banks (except for Armenia, Azerbaijan, the Baltics, and the Kyrgyz Republic), much progress was made in reducing or eliminating surrender requirements. In 1997, Belarus and Turkmenistan reduced, and Ukraine eliminated, surrender requirements.

Concerning capital account transactions, the Baltics, Georgia, and the Kyrgyz Republic had abolished controls on capital transactions prior to 1997, while Kazakhstan, Moldova, and Russia maintained limited controls. Only moderate progress was made in other countries during 1997, although Ukraine lifted the conditions for residents to borrow in foreign exchange from nonresidents.

Most of the countries have a unified exchange rate, except for Belarus and Uzbekistan, where different exchange rates still apply to different transactions, and those that maintain multiple-currency practices as mentioned above. Moreover, in some countries attempts to maintain overvalued official exchange rates and to restrict access to foreign exchange have caused cash/noncash spreads to rise substantially and have induced parallel exchange market activities in general with substantial spreads between official and parallel market rates.2 The introduction of market-determined exchange rates, supported by monetary and fiscal discipline, eliminated the spread between these two markets in the other countries.

In the move toward market-oriented and liberal exchange systems, the market structures for foreign exchange trading have been organized as both interbank and auction-type arrangements, depending on the initial institutional circumstances. Although most countries under review made the development of an interbank foreign exchange market a priority, actually building a functional market has generally proved to be a challenging task.3 Auction mechanisms were implemented at the start of the reform process, but they are gradually being phased out.4 In a number of cases the auctions took the form of interbank exchanges and were a voluntary part of the overall exchange system. Establishing interbank foreign exchange markets is a priority because these markets allow a more decentralized allocation of foreign exchange than auctions. At the same time, interbank markets support a variety of exchange rate regimes, as indeed is the case in the countries represented, including both fixed and freely floating exchange rate regimes. The three Baltic countries formally peg their currencies (Estonia to the deutsche mark and Lithuania to the U.S. dollar through currency board arrangements; and Latvia to the SDR). Five others, including Russia and Ukraine, which both use exchange rate bands, and Georgia, Tajikistan, and Turkmenistan, de facto peg their exchange rates. The remaining seven countries operate regimes with varying degrees of flexibility—from allowing the interbank market to determine the exchange rate with negligible official intervention to having the central bank be the market-maker and set the rate.

The soundness of the banking system has been a key determinant of the development of interbank trading. This is evidenced in particular by the experience of Georgia, where the turnover on the interbank market represents 16 percent of total foreign exchange transactions on an aggregate basis, but reaches 50 percent for banks with good financial standing. Interbank trading has become relatively deep and competitive in the Baltic countries, Armenia, Georgia, Kazakhstan, the Kyrgyz Republic, Moldova, Russia, and Ukraine.5

In parallel with the development of interbank foreign exchange markets, there has been a general trend toward a shift of foreign exchange interventions by central banks from auction arrangements to interbank trading. This trend was reinforced in 1997 when the Central Bank of Armenia discontinued its interventions at the auction. Other countries in which the central bank intervenes exclusively in the interbank market include Latvia and Ukraine. The central bank continues to intervene exclusively at the auction in Belarus, Georgia, the Kyrgyz Republic, Tajikistan, Turkmenistan, and Uzbekistan. These dissimilarities in central banks’ operating procedures reflect to a large extent the level of development of the countries’ foreign exchange interbank markets, or, as in the Kyrgyz Republic, the need to channel donor funds to the market.

In most of the countries, central banks have attained an adequate organization of their foreign exchange departments, including achieving the separation of front and back offices (except in Azerbaijan, Tajikistan, and Uzbekistan), the adoption of settlement procedures in line with international standards and adequate reporting and accounting standards, and the use of suitable equipment. Refinements may be needed in some cases, however—for example, better reporting and coordination between front and back offices, and more back-office training, as is needed in the Kyrgyz Republic.

Most of the countries have also made significant progress in centralizing foreign exchange reserves at the central bank and in managing these reserves. A small portion of Russia’s official reserves, however, is still held by the Ministry of Finance and by former Soviet trade banks. Presidential control over the country’s official reserves continues in Turkmenistan; and in Uzbekistan the state-owned National Bank of Economic Activity administers a significant portion of the official reserves. In addition, some official reserves of Belarus are still held in domestic banks.

In the Baltics, the Kyrgyz Republic, Moldova, Russia, and Ukraine, foreign exchange reserve management has been relatively advanced for some time. Substantial progress has been made recently in developing adequate guidelines in a number of countries, including Armenia, Azerbaijan, Belarus, Georgia, Kazakhstan, and Turkmenistan. Further work is needed in Tajikistan and Uzbekistan to introduce meaningful guidelines and reporting procedures.

Country Rankings

Based on the level of development that has been achieved since the beginning of reforms, Table 3.2 groups countries into three categories. Countries in Group III (the Baltics, Armenia, Georgia, Kazakhstan, Kyrgyz Republic, Moldova, Russia, and Ukraine) have made substantial progress in most or all areas of foreign exchange reform. Ukraine has joined this group through the notable progress made in 1997. There is now only limited need for further reforms in this group, although specialized advice may still be needed in several of these countries to refine interbank market development, international reserve management policies, and coordination with monetary policy. Azerbaijan, the only country in the moderate category, has also shown reasonable progress, although the need for farther reforms continues in a number of broad areas, including reserve management policies. Foreign exchange reforms in Group I—Belarus, Tajikistan, Turkmenistan, and Uzbekistan—have been slow, or have even been reversed. Slow progress in implementing structural and economic reforms and limitations in implementation capacity (Tajikistan and Turkmenistan) appear to be major impediments to progress. Likewise, a cautious approach to adopting market-oriented reforms, and even a lack of conviction as to the merits of such reforms constitutes an important impediment in Turkmenistan and Uzbekistan.

Table 3.2.

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

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Priorities for Future Reform

Most of the countries of the Baltics, Russia, and the other countries of the former Soviet Union have implemented the key reforms required for an efficient market-based allocation of foreign exchange. Countries lagging behind are those that either did not consider such an approach to be appropriate given the country’s specific circumstances, or that, in the wake of political instability, could not implement the necessary reforms. For these countries, one of the first priorities will be to implement the necessary measures for the acceptance of IMF’s Article VIII.

In some of the countries, interbank foreign exchange markets have not yet begun. Others face the challenge of further enhancing market liquidity and depth so that the interbank market becomes the main channel for allocating foreign exchange. In both cases, central banks must intervene in a way that provides incentives for participants to start trading among themselves. This intervention can occur by trading through either an interbank exchange (i.e., a two-sided auction and with the market as a whole), or selected and reliable banks. Central bank intervention should evolve in phase with market development. Transitional arrangements, such as an interbank exchange, may well be used in tandem with over-the-counter interbank trading, depending on a country’s circumstances and its objectives, and until the interbank market has reached a level of development that will allow reliance on interbank trading.

The pace for phasing out auction mechanisms and relying exclusively on interbank trading will depend on the circumstances of individual countries, and in particular on the stability of foreign exchange flows, the liquidity and solvency of some banks, the degree of trust between dealers, and the effectiveness of payment and communication systems. Progress in two areas appears to be critical: first, enhancing the soundness of the banking system so that banks are willing to trade with each other; and, second, eliminating surrender requirements. Technical refinements are also called for, including tightening or strengthening the enforcement of open position limits, improving settlement systems and correspondent relations, training dealers, and establishing codes of conduct.

As a consequence of macroeconomic stabilization and the return of investor confidence, a number of countries benefited from sustained capital inflows during much of 1997 (Armenia, Kazakhstan, Kyrgyz Republic, Moldova, Russia, and Ukraine). Large and volatile capital flows call for effective coordination between money and foreign exchange operations, as well as for the development of strategies for a smooth transition between alternative monetary and exchange arrangements. This is an area in which well-targeted technical assistance may be required in the near future. Some countries (Ukraine most recently), however, experienced sudden reversals of capital inflows. Such a situation calls for the design of contingency strategies to deal with such reversals.

Finally, the most advanced countries that have not yet fully liberalized capital account transactions—Kazakhstan, Moldova, Russia, and Ukraine—need to develop a strategy for an orderly liberalization of these transactions, consistent with macroeconomic stabilization and financial system reform. Achieving this kind of strategy may also call for well-targeted technical assistance. In Chapter 8, Table 8.5 provides details on where further work is needed in individual countries.

1

Article VIII, Sections 2, 3, and 4 define the obligations of convertibility that IMF members are required to undertake. Under Section 2 members may not, without 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. Russia eliminated one exchange restriction resulting from the inconvertibility of interest income on foreign holdings of government securities on January 1, 1998. In May 1997, Ukraine removed the last two remaining restrictions on payments and transfers for current account transactions.

2

By the end of 1997, in Tajikistan the spread was brought down to about 13 percent while it reached about 30 percent in Belarus and Turkmenistan and about 110 percent in Uzbekistan.

3

Azerbaijan was the last country to lift the prohibition on interbank trading (August 1997).

4

The change in the auction format in the Kyrgyz Republic in February 1997 gave rise to a multiple-currency practice, which the IMF’s Executive Board approved until December 1998.

5

The share of interbank trading in total foreign exchange transactions has grown to 65 percent in Kazakhstan, 39 percent in the Kyrgyz Republic, 98 percent in Moldova, and to more than 80 percent in Russia.