Abstract

Forward exchange markets in industrial countries in the 1980s have shown a substantial reduction of government regulation and intervention, and increasing innovations in financial instruments. Forward markets now operate in all industrial countries except Iceland.

Alternative Systems in Industrial Countries

Forward exchange markets in industrial countries in the 1980s have shown a substantial reduction of government regulation and intervention, and increasing innovations in financial instruments. Forward markets now operate in all industrial countries except Iceland.

New markets were established by central banks in Ireland and New Zealand at the beginning of the 1980s, and in Finland in the 1970s. The central banks initially provided backup cover at officially quoted forward rates to commercial banks, enabling these to undertake forward sales and purchases without being left with overbought or oversold open positions. Significant losses on these and earlier operations were experienced by several central banks in this group. The central banks of Ireland and Finland withdrew from the forward market in 1980, and the Reserve Bank of New Zealand from that market in 1983 (Table 4). The Reserve Bank of Australia was the only other central bank in the industrial country group to have provided forward cover in this period to commercial banks at regulated official rates, and it also withdrew this facility in 1983, with the floating of the spot and forward markets.20 These markets have matured rapidly in all three cases, particularly in New Zealand following removal of interest rate and exchange controls in 1984, and floating of the currency in 1985.

Table 4.

Industrial Countries: Chronology of Major Regulatory Changes in Forward Exchange Systems, 1980–87

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Sources: International Monetary Fund, Annual Report on Exchange Arrangements and Exchange Restrictions, 1980–86; and national authorities.

For a detailed description see Appendix I.

Forward markets that were in place before 1980 were also considerably liberalized. Australia and Japan completely removed requirements for an underlying commercial or financial transaction (“real demand principle”), and France has, on balance, expanded the scope of authorized transactions from purely commercial to financial transactions (see Appendix I). The extent of access to the forward market may deviate from an underlying transaction, and the flexibility in terminating or extending contracts has been expanded in France and Spain. Maturity restrictions have been eliminated in France and relaxed in Austria, Denmark, and Italy. Access of financial institutions to forward markets has been expanded in Japan and Sweden, while restrictions on the banks’ net positions have been eased in Japan and Spain. Where restrictions have been retained, they were aimed largely at reducing speculation against the currency. For example, in Australia prior to 1983, an unrestricted parallel exchange market was tolerated alongside the restricted official market because it was limited to directly matched purchases and sales by currencies and maturities and could not lead to pressure against the Australian dollar.

Forward exchange markets, particularly in the less regulated environments, have been marked in recent years by rapidly increasing sophistication of instruments. A major early innovation was the market for foreign currency futures launched in 1972 in Chicago—the International Monetary Market (IMM)—which has since extended to a number of financial centers. The main contribution of the futures market was seen as greater standardization of cover and ease of liquidation compared with the forward market, in which the amount and maturity of the contract must be tailored precisely to customer specifications, at a price quoted in advance, and the customer’s creditworthiness must be established. Spreads, on the other hand, have not differed greatly between the futures and forward markets.21

Currency options introduced in 1978 on the European Options Exchange have given rise to a rapidly broadening range of differentiated financial products. They have also spread in coverage as exchanges in Montreal, Philadelphia, Sydney, London, and Chicago have opened options trading. Although the traditional reliance on forward markets for hedging has necessitated adjustments in corporate financial management systems to accomodate options, growth in the new market has been very rapid. Despite some early objections that currency options were speculative and would increase exchange rate volatility, it is now thought that options may be less speculative than uncovered forwards—in the sense that only the premium paid for the option is at risk in response to exchange rate changes and daily calculations for variation margins through the clearinghouse. In addition, because of the low liquidity involved, credit approval may not be required for standard option purchases as it is for forward contracts.

Within the forward foreign exchange markets there has been a recent influx of variations on the basic instruments (cylinders, collars, zero premium options, G-hedges, compound options, break forwards, participating forwards, and extra, scout, and pooled options), all tailored to particular risk situations and customer preferences.22 However, with this degree of sophistication, many participants now prefer to tailor their own specific instruments from combinations of forwards, futures, and options. In this connection, there has been a concern, as cited recently in the 1987 Annual Report of the Bank for International Settlements (BIS), that new techniques and facilities in the financial markets in general have not been tested over the business or interest rate cycles and may be causing prudential and management difficulties for the banks concerned. One concern noted by the BIS is that of “short-termism,” whereby liberalization is seen as shortening planning horizons. Bankers also reportedly view the availability of longer-term (over one year) forward contracts as having become more limited.

However, despite the innovations of recent years, according to a recent survey of market participants by the Group of Thirty, the traditional “FOREX products” —spot and forward contracts—are expected to remain the markets’ staple diet.23 Currency risk is covered on a selective basis, mostly by forward contracts and options; options are a more frequent alternative than futures to forward contracts, and markets for both options and futures are still regarded as thin. If the new instruments have reduced the demand for forward contracts at all, the reduction has been very small and confined to U.S. dollar forwards, not between nondollar currencies. Corporations also reported to the Group of Thirty that they have experienced good results from the cover.

Alternative Systems in Developing Countries

Systems of forward exchange cover involving exchange rate guarantees and officially managed cover at noncommercial terms have been prevalent in developing countries, and the major feature of the experience has been the heavy losses imposed in a number of instances on the central banks administering them. The response of the authorities to these losses has varied from country to country. In some countries they have been absorbed by budgets and monetized, with a severe impact on monetary growth and inflation. In other cases, the current losses have been reduced gradually by transition to a more market-related approach, involving closer observance of the covered interest parity condition, and in some cases, transition to a freely market-determined system of rate determination.

Available data for the magnitude of losses experienced by governments in meeting official cover guarantees show them to have been extremely large in some countries. In Costa Rica, which introduced an exchange rate guarantee scheme in mid-1981, the Central Bank was unable to make any payments of amounts due, and at the end of 1983 potential losses amounted roughly to the equivalent of the Bank’s total liabilities to the private sector (Appendix II). In addition, the losses stemming from exchange subsidies paid in 1981–82 are estimated to have been equivalent to total outstanding currency issued at the end of 1982. The subsequent interest costs of stabilization bonds issued by the Central Bank to sterilize these effects resulted also in continuing operating losses for the Central Bank after 1982. A cover scheme introduced in 1981 by Israel for domestic value added in exports led to operating losses that in 1985–86 amounted to 1.3 percent of GNP, and were charged to the budget. In the Philippines, swap arrangements between the Central Bank and commercial banks played an important role in 1982–83 in defending official reserves. However, as the peso depreciated sharply in this period and in following years, the Central Bank’s accumulated losses amounted to more than the equivalent of 6 percent of GNP at the end of 1984.

South Africa has also absorbed large official losses on forward cover facilities provided by the Reserve Bank since 1980. These losses arose primarily from the provision by the Reserve Bank of South Africa of long-term forward cover to public enterprises on very favorable terms; by end-March 1986, the cumulative losses amounted to about 150 percent of the stock of reserve money outstanding. Partly to avoid further losses, the Reserve Bank discontinued the provision of forward cover facilities to public enterprises effective December 1986.

In one instance, namely the FERIS scheme in Turkey (for World Bank-financed lending by a domestic development bank), a minimum contribution from the budget was established at the outset of the scheme at 7 percent of value added from a government sinking fund. In principle, additional costs could have arisen from this arrangement, had the depreciation of the Turkish lira over time exceeded the interest differential between the foreign loan and the respective domestic credits. In practice, only very few transactions were conducted under these arrangements.

In a number of countries with fixed and managed forward exchange rates, significant one-way divergences between uncovered interest rate differentials and forward premiums have been consistently maintained; these have generally implied losses on the arrangements. Charges levied by Bank Indonesia on swap contracts (2.5 percent per annum) have been small in relation to two step movements of the spot exchange rate (of about 30 percent each) in recent years (Appendix II, Chart 1). Forward cover provided to authorized dealers by the Central Bank of Pakistan was at forward margins which were kept unchanged in absolute terms for more than twenty years until May 1987. There have also been discontinuities in the yield structure of forward rates in Pakistan—in early May 1987 the buying rate for U.S. dollars between 6 and 12 months forward implied a forward discount on the dollar of 3 percent per annum at 12 months, while the selling rate for 6–12 month maturities implied a forward premium on the U.S. dollar of 3 percent per annum. Meanwhile, there was an uncovered interest differential in favor of rupee bank deposits vis-à-vis Eurodollar deposits of about 7 percent per annum.

Chart 1.
Chart 1.

Forward Exchange Rate Differentials versus Realized Spot Exchange Rate Changes Against U.S. Dollar, 1983–87

Sources: International Monetary Fund, International Financial Statistics; data provided by the authorities; and Fund staff calculations.1 End of quarter six-month forward differential (percent per half year) advanced by six months. Negative value indicates forward discount.2 Change of spot rate over preceding six months. Negative value indicates depreciation of the currency vis-á-vis the U.S. dollar.3 Percent from third quarter 1983.4 End of quarter three-month forward differential (percent per quarter) advanced by three months. Negative value indicates forward discount.5 Change of spot rate over preceding three months. Negative value indicates depreciation of the currency vis-á-vis the U.S. dollar.6 Percent from second quarter 1983.7 End of quarter three-month forward differential (percent per quarter) advanced by three months. Negative value indicates forward discount.8 Change of spot rate over preceding three months. Negative value indicates depreciation of the currency vis-á-vis the U.S. dollar.9 Percent from first quarter 1983.10 Change of spot rate over preceding three months. Negative value indicates depreciation of the currency vis-á-vis the U.S. dollar.11 End of quarter (last month’s average) three-month forward differential (percent per quarter) advanced by three months. Negative value indicates forward discount.12 Percent from first quarter 1985.

Prior to February 1987, Sri Lanka had changed the forward quotations of the Central Bank infrequently so that they did not reflect international interest differentials, and losses were incurred. As of end-1986 the Central Bank’s buying rate for dollars one month forward was the same as the spot middle rate, while the selling rate for dollars one month forward represented a forward premium of 1.4 percent per annum over a spot selling rate. Its corresponding buying and selling rates for three-month forward dollars represented forward premiums on the dollar of 0.04 percent and 2.7 percent per annum, respectively.

In other situations, the potential for adverse effects on central bank and fiscal budgets has not been as clear. Premiums charged by the Bangladesh Central Bank (as low as 0.3 percent) were in 1985 markedly smaller than prevailing interest rate differentials, and also realized movements in the spot exchange rate. However, the official exchange rate, to which the forward cover applies, is used for only a small portion of imports, and forward purchases of foreign exchange by the Bank have predominated. A forward cover scheme for certain transactions provided by the Reserve Bank of India implied, as of end 1986, a forward discount on the rupee of approximately 2.1 percent per annum, between the spot selling rate and the three-month forward buying rate. As for realized movements in the spot exchange rate, there was little movement on balance in the U.S. dollar exchange rate in the first half of 1986, but an average depreciation of some 8 percent in 1986.

Mauritius provides forward exchange facilities for certain purposes, with forward rates based on a uniform margin of 3 percent per annum. However, losses have not been realized, and the interest differential has generally been maintained at close to covered parity. The market-determined systems (which do not involve losses to the central bank and subsidization) have generally led to forward premiums closely approximating interest differentials over time in the absence of strong impediments to capital movements (Malaysia, Singapore, and Thailand).

In each of the countries incurring large losses relative to the monetary base, the impact on inflation rates and the balance of payments has been severe, and has contributed to delays in needed exchange rate adjustment, which was held hostage to the budgetary consequences of the exchange rate guarantee.

Adjustments to forward systems that have taken place in response to losses incurred have included shifts toward the application of either covered interest parity to determine the forward premiums or more market-approximating forward rates. Costa Rica has withdrawn the official cover schemes that led to the large losses in 1982–83. Indonesia in 1986 moved to a closer approximation of interest rate differentials in the provision of forward cover by its central bank, and more recently to a market among the commercial banks. Israel reacted to losses from its export insurance scheme by limiting the provision of subsidies to 11 percent of value added and by adopting, in principle, a transition to self-financing for the scheme. Fees in Pakistan have been raised recently for official cover, and South Africa limited the Treasury’s risk arising from the provision of forward cover by allocating a quota to each authorized exchange dealer for the maximum amount that a dealer can buy from the central bank by means of swaps.24 Turkey has effectively eliminated the subsidy in the FERIS scheme.

In several developing countries market-determined rates have emerged in forward and options markets. Following the large losses in Argentina, the official cover market for medium- and long-term external borrowing has generally not been used, while an unrecognized parallel forward market providing short-term cover for traders and investors gained in depth. Chile shifted from a system of a managed forward rate in 1986 to a freely floating forward market, while in the Philippines increasing reliance has been placed on the free market determination of forward rates following sharp losses. Sri Lanka effected such a transition in February 1987 with the application of market principles for the official cover scheme for unbalanced commercial banks’ positions. Thailand in July 1985 introduced an options market for foreign exchange, operating alongside a traditional market for forward contracts.

Schemes for handling exchange risks associated with rescheduling country debt have generally themselves been subject to ongoing revisions. As a consequence of losses incurred, the Argentine schemes have been replaced by successive arrangements. The Mexican FICORCA scheme appears set to yield significant losses, but these have not yet been realized because further restructuring of the eligible debt has recently been agreed with lead commercial bank creditors. Schemes for guaranteeing debt repayments raise some special considerations. If external arrears are involved, equity considerations may sometimes suggest the application of the exchange rate prevailing at the time that the obligation should originally have been serviced. (Provided, for example, that the imports, payment for which is in arrears, were not sold at the equivalent of the parallel spot market exchange rate.) However, such considerations do not point to the same (“old”) exchange rate for newly maturing obligations. To the degree that subsidization is implied by the provision of guarantees for maturing obligations, this represents a delay in the supply-side effects of programs for rationalizing the exchange rate and domestic price structure.

In summary, the typical response to losses from fixed or managed forward exchange rates has been either to limit the cover of the schemes or to shift toward more market-oriented and self-financing arrangements for forward cover. Narrowing the range of eligible transactions to avoid loss has not been the course generally taken—because it would negate the important benefits of cover, even relatively expensive cover to importers. In some instances, parallel exchange markets have developed to fill the gaps created by the absence or withdrawal of official cover for certain transactions. However, the parallel markets tend to relate to parallel spot transactions, and are not useful for import transactions for which sufficient customs and exchange documentation is available to police illegal activities.

Perhaps the most significant development in forward market operations in developing countries has occurred in Singapore, where banks are free to deal on the spot and forward markets in all currencies and with no limits on maturities of underlying transactions. The full menu of foreign currency futures and options is now traded on the Singapore International Monetary Exchange. Singapore’s role as a financial center was deliberately promoted by government policies, including the complete liberalization of exchange controls in 1978.

The environment provided by the exchange systems in developing countries has been important in promoting, although not in determining, the flexibility of forward rate arrangements. Among the countries with market-determined forward exchange rates, Indonesia, Malaysia, Singapore, and the United Arab Emirates maintain no restrictions on outward capital transfers, and permit residents to hold foreign currency accounts (Table 5). The exchange system of Korea is also relatively free; although there are general restrictions on capital transactions, residents are permitted to hold foreign currency accounts. On the other hand, there are capital controls and limits on bank and nonbank foreign exchange positions in several other countries with market forward rates (Brazil, Chile, Jordan, Sri Lanka, and Thailand). In this latter group of countries, some resident foreign currency deposits are permitted. It is noteworthy that in all countries with market-determined forward rates, with the exception of Brazil, there has been no substantial ongoing parallel market for spot exchange (as indicated by a spread exceeding 10 percent between quotes in the official and parallel spot markets).

Table 5.

Summary Features of Exchange Systems of Selected Developing Countries, End-1986

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Source: International Monetary Fund, Annual Report on Exchange Arrangements and Exchange Restrictions, 1987.

Member maintains system of dual exchange markets involving multiple exchange arrangements. The arrangement shown is that maintained in the major market.

The exchange rate is maintained within margins of 5 percent on either side of a weighted composite of the currencies of the main trading partners.

The exchange rate is maintained within margins of ± 2.25 percent.

Policies for Developing Forward Markets

The institutional characteristics and the pre-existing stage of development of forward markets in individual developing countries are important in the choice of techniques for the establishment of forward market arrangements. Nevertheless, experience indicates that there are several general considerations that will bear on this decision.

Central in such considerations is the role of the central bank. Although forward markets have developed more or less spontaneously in one or two developing countries, in most instances free forward markets have evolved from more limited arrangements in which central banks have played a key role. However, it is also clear that the form of central bank involvement has differed from country to country, and certain forms of arrangements have been associated with highly adverse developments, as discussed in the previous section. The experience with the assumption of exchange rate risk by central banks has provided support for the principle that this should be as limited as possible, both in its coverage and in its role in the incipient stages of the development of the forward market.

In countries which do not already have market-determined arrangements (this group includes Iceland and most developing countries), as a first step the central bank may set up a small fund for providing exchange cover to importers which would be replenished by purchases of forward foreign exchange from exporters. In the case of pre-existing cover, all official support would be channeled through this fund and other arrangements would be terminated. At the outset, the willingness of exporters and importers to transact in the market would no doubt be highly sensitive to the rates charged by the central bank. In establishing the market, the central bank would have to search for rates that would not only provide cover to importers but would also activate forward sales by exporters. The operation of other than market-determined forward arrangements has thus far focused most commonly on the provision of cover to importers—which has deterred the creation of a market by failing to disseminate information on the market to exporters, who supply the foreign exchange to the markets and are, in some ways, the more important sector. In principle, the search for market-clearing rates could involve a temporary “reverse spread” between buying and selling rates, in order to enhance the probability of striking such rates, but the experience with losses by central banks providing subsidized fixed rates suggests that this should be avoided.

It is most important that the exposure of the central bank in making the market be limited a priori, and that a clear plan should exist for phasing it out over a specific brief period (say, one year), if the central bank’s participation did not lead to a viable market that could be transferred to the commercial banks. Reference was made to biases that could exist at the outset in the evaluation of risk by potential participants. Presumably, with the ongoing operation of the market and the focus that it would receive, expectations would become quickly more rational. Should the central bank exposure limit be reached before a market-clearing rate had been established (with little but transactions costs separating the buying and selling rates), then the viability of the market would be reassessed and a decision could be made whether or not to continue the arrangements.

A key institutional reason in many developing countries for the little attention paid to hedging export receipts is that export proceeds are channeled through an official marketing board. Decisions on producer pricing at the outset of the planting season must take into account several uncertainties, of which exchange rate risk is one. In a number of developing countries, producer prices have been kept at levels that have been too low to stimulate investment in export industries, in part through maintenance of an overvalued spot exchange rate. When the rate is expected to be adjusted, often to correct such overvaluation, it is important that exporters’ implicit forward sales of receipts to the marketing board reflect what in many instances will be a forward premium payable to the exporters. Export prefinancing arrangements, often through the marketing boards, should also take into account such premiums.

It is also clear from experience that the level of the forward exchange rate would be crucial in the initial stages. Here again, the optimal starting point for development of a forward market would depend very much on the financial environment in the particular country. In countries with interest rates and spot exchange rates in severe disequilibrium, it would be necessary to proxy the covered interest parity condition with shadow pricing. For example, a simple approximation to parity might be made by setting the forward premium on the U.S. dollar at the present domestic rate of inflation minus the Eurodollar interest rate. (A premium higher than this might be warranted by the greater scarcity of capital in developing countries.) In any event, both the rate and the margin payable from the fund would be adjusted continuously to attract customers to both sides of the market. In countries with equilibrium spot exchange rates and interest rates, the covered interest parity condition could be used directly as a reference for setting a start-up value for the mid-point forward rate. In most developing countries, charging forward premiums (and paying premiums on forward surrender of exchange receipts) would lessen, but not remove, the possibility of heavy continuing losses to the budget. Interest parity alone, proxied or used directly, may not provide an adequate indication for this purpose. Where the spot exchange rate disequilibrium is large, as evidenced by the parallel market exchange rate or by extensive restrictions that are also effective, the premium may need to be increased beyond the calculated interest parity level (the so-called “peso problem”). However, there may be limits on the extent to which this can be done without signaling an impending devaluation of the currency. In such circumstances, the underlying disequilibrium would need to be corrected before an attempt is made to re-introduce the forward cover arrangements on a more realistic basis, or, optimally, to go directly to a forward market in the private sector.

Another question is whether the central bank should take a direct role in making the market or should operate the scheme through the commercial banks as agencies. It would be important that the central bank allow only a small margin to the commercial banks to operate the scheme because, through the funding arrangements, it would initially be taking the risk itself. Transactions costs are relatively low, and in countries where the demand for forward contracts is small, the central bank’s forward transactions with the commercial banks might be restricted to one or two business days per week to minimize such costs. (The commercial banks would be free to transact among themselves at any time.) At the outset, the market might also be made only against the intervention currency and further hedging be performed in the major markets against that currency.25 In time, more currencies could be introduced depending on the volume of transactions that developed. Toward the end of the transition period, when the use of the funding as an interim device has finally established an equilibrium rate at which transactors are attracted to both sides of the market (and any reverse spread has been eliminated), the central bank could withdraw from the arrangements and leave them to the commercial banks to operate. As was noted above, the very adverse experience with forward guarantee schemes operated and funded through central banks argues that this step should be taken as soon as possible.

An alternative arrangement to having the central bank make the markets would be for the central bank to operate the fund through the commercial banks, who would then set the rates and administer the market directly themselves. The central bank would play only a funding and advisory role under this approach. While it would enable the commercial banks to assume more quickly a pivotal role in making the forward market, the feasibility of such an approach would differ from country to country. In some countries, the potential for abuse of the transitional government funding might be such that extensive official monitoring of each individual transaction would be required, and the arrangements would become essentially those described in the preceding paragraph. In others, the absence of the necessary expertise in the private banking sector might require relatively strong official participation in the initial stages.

Another alternative would be for the central bank simply to broker forward transactions between nonbank participants, with or without subsidization. Here again, the issue would be one of feasibility. With subsidization, this would be the strongest form of centralization of the forward arrangements—one that would help little in bridging to market arrangements, because the commercial banks would not have a role, and the government would also be exposed to risk. Without subsidization, the commercial banks would continue to have no role, but the government would not be exposed to exchange risk because it would simply match transactors for a small fee. It is unclear that the latter form of arrangement would “spark” development of a forward market in many countries, but it could warrant introduction on an experimental basis in some.

An important aspect of the central bank’s activities in the interim period, and perhaps continuing beyond that period, would be to disseminate information to all potential participants and to conduct training courses in the uses and operation of the forward markets. To the extent necessary, this could involve technical assistance from international organizations, such as the International Monetary Fund, or from banks in major financial centers through their local branches. The central bank may also take a lead in establishing a technical committee of market makers to enhance market arrangements and promote training and professional standards (which was the function of the Singapore Foreign Exchange Market Committee established in 1966). An important feature of the transition is that it would involve the active monitoring of domestic monetary and financial conditions relative to the international markets, in order to maintain the continuous realism of the forward premiums or discounts.

The institution of such a forward market will also have some implications for the operation of domestic monetary and spot exchange rate policies. Sudden and large step movements in these instruments would be destabilizing to the forward markets and could abort them in their early stages of development. A more stable approach to monetary and exchange rate policy would therefore be necessary to provide a suitable environment for the arrangements. However, from the experience it is also clear that exchange rates and interest rates that are significantly out of equilibrium preclude transition to forward exchange rates on commercial terms. The conclusion must be, therefore, that the central bank would need to establish quickly, and to maintain, broad realism of both interest and exchange rate policies for the market to be viable.

There is the further question of the particular form of instruments that are appropriate in the early stages of development of a forward market in a developing country. The sequence of events to date in both developed and developing countries suggests that traditional forward markets would be the most appropriate starting point. The experience in industrial countries has been that futures markets have taken longer to develop than forward markets, requiring a relatively large volume of transactions maturing on each day of the financial year. Futures may also be more expensive to operate, being generally used as a “warehousing” device in advance of a swap transaction.

Options markets are relatively complex arrangements, and some of the dealer strategies required to utilize them optimally require a substantial technological input. Options have the advantage of including information on exchange rate volatility in addition to the expected exchange rate; but, because exchange rates in developing countries have typically been subject to one-way adjustment, the concept of volatility has had little meaning, and the expected rate dominates the calculation of the forward exchange rate. Options transactions also involve standard forward contracts in many of their variant forms. Following the cultivation of depth in the forward market, an options market could be developed (as has been the case in Singapore and Thailand).

Because of the resources that will be required for training in the early stage of the market, it may be preferable to focus available resources on the more important cover transactions, namely the trade-related transactions. This would also help to ensure that the availability of foreign exchange corresponds to any restrictions on its use, either through the import licensing system or exchange restrictions on current international transactions. It would generally imply restrictions on available maturities to within six months. Margin requirements against the opening of forward contracts depend on the arrangements for checking creditworthiness that exist in the individual countries. An indication of the appropriate margins may be had from requirements for the opening of letters of credit, which also reflect the creditworthiness of the applicant and the availability of institutional checks.

Development of a forward market is not a panacea for inappropriate financial policies. In some instances, the authorities have wished to promote access to available foreign credits to support the overall balance of payments. Domestic importers eligible for such trade credits have not wished to use them, because domestic currency interest rates are relatively low, taken in conjunction with the perceived exchange risk attached to the repayments. Removal of the risks with the provision of a forward cover scheme might move the effective interest rates into rough competitiveness. However, lower-than-equilibrium interest rates generally go hand in hand with rising inflation and depreciating spot rates, and the central bank must therefore charge a fee for the provision of the cover to reflect the likely future depreciation. Although it might appear that the competitiveness of the foreign financing could be retained by the subsidization of the forward cover, this is an illusion if the subsidy is then monetized, worsening the disequilibrium.

Such a strategy for developing forward arrangements is open to any developing country whose arrangements do not already involve a market-determined forward rate. Either fixed or managed forward arrangements could evolve in this way; with the managed market-approximating arrangements, the transition might be quicker. As has been examined above, the existence of moderate exchange controls does not preclude the formation of a forward market; the evolution of markets to date also points to the need for a realistic spot exchange rate policy.

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    Forward Exchange Rate Differentials versus Realized Spot Exchange Rate Changes Against U.S. Dollar, 1983–87