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For the latest thinking about the international financial system, monetary policy, economic development, poverty reduction, and other critical issues, subscribe to Finance & Development (F&D). This lively quarterly magazine brings you in-depth analyses of these and other subjects by the IMF’s own staff as well as by prominent international experts. Articles are written for lay readers who want to enrich their understanding of the workings of the global economy and the policies and activities of the IMF.

AFRICAN countries experimenting with interbank floating exchange markets are discovering the significant benefits these markets provide, such as realistic exchange rates for domestic currency and an increased flow of foreign exchange through the official market But numerous institutional and regulatory issues still need to be resolved to help the new markets operate smoothly.

In industrial countries, billions of dollars change hands daily in the interbank markets for foreign exchange. These markets are the deepest, most liquid, and most resilient of all global currency markets. But, only in recent years have interbank foreign exchange markets begun to emerge in developing countries, in many cases spurred by the need to reform exchange rate systems. Since the mid-1980s, for example, a number of African countries have moved to floating exchange rate systems, often through interbank market arrangements.

Under an interbank market arrangement, the exchange rate is determined in negotiations between commercial banks (or other licensed dealers) and their clients, and in transactions between the banks. The exchange rate may vary from day to day and even from minute to minute. In some instances, foreign exchange bureaus are allowed in an interbank market, although there may be specific regulations governing their participation. Bureaus usually concentrate on retail transactions (such as those involving foreign bank notes and traveler’s checks) rather than on wholesale transactions in foreign funds. Some countries that are constrained by institutional considerations have opted for an auction rather than an interbank system. While an interbank arrangement closely approximates a free market, in an auction system, the central bank conducts a one-sided market by auctioning off given quantities of foreign exchange to eligible bidders.

Establishing an interbank market system is not easy. The process takes time, and its success depends upon the sustained pursuit of sound macroeconomic policies. While some studies have already devoted attention to the relationship between macroeconomic policies and interbank markets, less attention has been paid to microeconomic concerns that relate to the institutional and operational structures within which these markets operate. To address this latter issue, a recent IMF study examined the experiences of six African countries—The Gambia, Ghana, Kenya, Mozambique, Nigeria, and Sierra Leone—that have created interbank markets. The study shows that while these countries have made a good start—increasing the efficient allocation of their foreign exchange resources and narrowing the exchange rate differentials in the parallel and official markets—they still need to resolve many operational and institutional issues that threaten to hinder further development of these markets.

How interbank markets work

In the ideal case, interbank transactions take place in a market sufficiently competitive so that participants can respond freely to price signals. Further, demand and supply would reflect prevailing macroeconomic conditions, such as movements in interest rates, inflation, and trade flows. At the same time, electronic exchanges or exchanges through any other medium allow a central bank instant access to the prevailing rates, which can then be influenced, as necessary, through market interventions.

In general, interbank rates from such a market would result from transactions of a standard minimum size and be conducted between professionals with sufficient market expertise to ensure that the prevailing rates truly reflect market conditions. To avoid distortions caused by retail transactions, such as those involving foreign bank notes and traveler’s checks, the interbank transactions used for determining the central exchange rate would typically include only wholesale transactions.

The African connection

In practice, interbank systems in Africa are in their early stages, with many practical and operational issues still to be addressed. Only two of the countries surveyed—The Gambia and Mozambique—adopted an interbank system from the start and maintained it thereafter. The other four countries first experimented with various auction schemes as well as with legal parallel markets operated by foreign exchange bureaus. Except for Nigeria, which abolished the interbank market in January 1994, the countries surveyed still have functioning interbank markets. Nigeria’s interbank experience until the end of 1993 is still valid for purposes of this discussion, however.

Market transactions. In these African countries, most transactions are made not among banks but between banks and their clients. Nonbank dealers, including foreign exchange bureaus, may also play an important role. Interbank transactions are relatively limited for several reasons. Shortages of foreign exchange have created a situation where few, if any, dealers find themselves with the excess foreign exchange balances necessary for transactions with other dealers. Furthermore, the spread between the buying and selling rates applicable in transactions between dealer and client is typically higher than the spread in interbank transactions, so that the latter are not viewed as profitable. Given the newness of market arrangements, dealers are not comfortable with carrying out transactions with each other, owing partly to a lack of experience and the pressures of competition to gain market share and partly to the lack of comprehensive prudential regulations limiting the foreign exchange exposure of dealers.

Setting the rate. Given the low volume of true interbank transactions in the countries studied, central banks for the most part rely on dealer/client transactions to determine the “interbank” rate in the market. In Mozambique, the market, or “secondary,” rate is calculated as a weighted average of all transactions reported by dealers to the central bank each day. Similar situations exist in The Gambia, Kenya, and Sierra Leone, where the rates are determined freely in the market as a weighted average of the rates posted. In contrast, the Bank of Ghana has attempted to use “moral suasion” to hold the exchange rate down, though with limited success; and in Nigeria, rates in the inter-bank market were subject to a 1 percent spread between buying and selling rates.

In contrast to the “ideal case,” however, reliance on dealer/client transactions to determine the interbank rate can present some problems. Transactions between dealers and clients tend not to be homogeneous; because transactions are generally large in number and of different sizes, processing reports and calculating average rates is difficult. Further, mixing transactions in bank notes or traveler’s checks with foreign funds deposited in accounts increases the chances for distortions. Last, the lack of double reporting on the buyer and seller sides of transactions makes it difficult to verify the accuracy of the reports provided by banks and other dealers.

Level of expertise. It is only natural that in the early stages of the development of interbank markets, dealers lack experience in information gathering. The result can be an excessive divergence of rates among dealers, uncertainty about how to set rates, and even a reluctance to change rates frequently.

In addition to this, dealers in most of these countries operate with an inadequate communications infrastructure, leading to a limited flow of “real time” information about the foreign exchange markets, especially exchange rates quoted by different institutions. The problem is more pronounced in the bureau sector of the market, where variations in quoted exchange rates can be more significant. Such variations reduce efficiency and competitiveness and allow the larger dealers to develop collusive practices. For many clients, the transaction costs are still too high to force a greater convergence of rates among dealers, and in none of the countries has the development of foreign exchange brokerage services been apparent.

At this stage, none of the dealers in African markets actively manage their foreign exchange positions internationally, although countries have made an attempt to keep abreast of developments in the international markets through various media. Dealers have also not yet reached a level of sophistication that would allow them to develop forward markets for hedging exchange risks.

Institutional and regulatory issues

In most of these countries, market entry seems to be guided by concerns about maintaining competition, ensuring appropriate prudential regulations, and reducing illegal transactions in the parallel market. But to develop the markets and make them function smoothly, other institutional features and forms of official involvement need to be addressed.

Market concentration and size. In order for an interbank market to operate competitively, countries need to have a sufficient number of commercial banks and foreign exchange dealers. African interbank exchange markets, however, are dominated by a relatively small number of players. This oligopolistic market structure has resulted in the practice of setting rates by “following the big banks.” Market concentration is greatest in The Gambia and Mozambique (see table).

Although the number of dealers is limited, it appears as though there is a large dealer presence in the market, judging from transactions turnover. For example, total transactions in the interbank market of Nigeria amounted to $4 billion in 1992, equivalent to about 50 percent of all merchandise imports. About the same ratio was expected for 1993. For Mozambique, approximately $400 million was traded in the interbank market in 1992, compared with about $900 million in imports.

In these countries, the central bank is generally the main source of foreign exchange. The relative importance of central bank sales of foreign exchange, as against private sector primary sales of foreign exchange, differs from country to country. For example, in Nigeria, about 60 to 70 percent of all funds supplied to dealers were supplied by the Central Bank of Nigeria either through allocations based on the size of the dealer’s capital base or, at various times, through auctions. In Kenya, the central bank auctions small amounts of foreign exchange to dealers several times a week.

Fixing sessions. In a fixing session, the central bank brings dealers together, face to face, to trade exclusively with each other and possibly with the central bank itself. In The Gambia, weekly fixing sessions are held at the central bank, with the participation of the commercial banks and foreign exchange bureaus. The rates determined at these sessions are used mainly for statistical and customs valuation purposes and apply only to interbank transactions taking place at that time.

Although transactions settled by the fixing rate tend to be small relative to overall transactions in the market, the fixing sessions serve some useful purposes. First, for dealers who are hesitant to trade with each other, these sessions provide an opportunity for genuine interbank transactions to take place, with the central bank playing a pivotal role. Second, the fixing sessions provide a unique forum for the central bank to discuss and resolve operational problems affecting the market. Third, the sessions offer the central bank an opportunity to intervene with full information regarding dealers’ positions. For all these reasons, fixing sessions can prove highly useful in the development of the interbank foreign exchange market, especially in its early stages.

Diversity in implementing market arrangements

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Surrender requirements were not formally abolished in The Gambia but de facto ceased to be implemented.

Data are not available.

Foreign exchange surrender requirements. With the exception of The Gambia, Mozambique, and Sierra Leone, the countries surveyed have official requirements for surrendering foreign exchange to the official market (see table). But these requirements raise some issues: (1) how to determine the appropriate surrender requirements for the repatriation of foreign exchange earnings and the surrender of such earnings to the central bank and the interbank foreign exchange market; and (2) whether allowing exporters or other holders of foreign exchange to establish foreign exchange accounts in the domestic banking system facilitates the development of an interbank market.

In general, as the market develops, the forced surrender of foreign exchange earnings should become less necessary. In some countries (e.g., The Gambia and Ghana), greater reliance on appropriate macroeconomic policies has fostered voluntary sales of foreign exchange earnings to authorized dealers. The establishment of foreign exchange accounts can facilitate the development of the market by providing an opportunity for private earners of foreign exchange to determine, in tandem with purchasers, the most efficient allocation of a country’s scarce foreign exchange resources. Nevertheless, if macro-economic conditions remain unfavorable, holders of these accounts may choose instead to keep the retained foreign exchange as a hedge against the risk of adverse foreign exchange rate movements, restricting the flow of foreign exchange to the interbank market.

Official involvement. The ability of a central bank to regulate and participate in the domestic interbank foreign exchange market is linked closely to (1) its capacity to know what is happening in the market in “real time,” and (2) its weight in the market as a buyer and seller of foreign exchange. Central banks that participate actively in international markets tend to have relatively well-organized foreign exchange departments with separate sections for dealing, research, and control and payments in order to ensure effective “checks and balances.” As a result, these central banks are more adept at playing a constructive role in the development of an efficient foreign exchange market.

A major constraint continues to be the absence of an electronic exchange or other medium to carry out transactions and receive quotes instantaneously. To obtain quotes, most of the African central banks rely primarily on frequent informal calls to commercial banks. In the six countries, central bank intervention has varied from the use of occasional auctions to open market sales and purchases.

More important, most of these countries have yet to develop a set of comprehensive prudential guidelines to govern the foreign exchange market. The paucity of prudential regulations on issues such as open position exposure (foreign exchange holdings or contracts subject to exchange rate risk) and working balance limits may not only put the operation of interbank markets at excessive risk but may also hinder interdealer transactions. In cases where ceilings on working balances exist, the limits are often not binding, given the excess demand for foreign exchange in these countries.

Assessing interbank markets

An efficient, well-functioning interbank market arrangement can typically be assessed by:

  • the market’s ability to reduce segmentation and, consequently, to reduce exchange rate differentials;

  • the increased allocation of foreign exchange through the official market and a market exchange rate that reflects demand and supply conditions as closely as possible;

  • the ability of market participants to collect, analyze, and transmit information at the lowest possible cost, as well as to minimize transaction costs; and

  • the central bank’s ability to monitor the market through effective information gathering, market intervention, and regulations. In general, it is fair to say that the six countries surveyed have made some progress in these areas. The differences between parallel and official rates have narrowed in all six countries since the introduction of interbank markets to between 2 percent and 13 percent from as high as 58 percent.

The available data on transactions turnover in the foreign exchange markets in these countries suggest that since the introduction of interbank markets, more funds are being allocated through official channels. But markets could be made wider and deeper by further eliminating surrender requirements and encouraging more direct transactions in the interbank market.

Much more, however, needs to be done to improve the operation of the market. In the future, central banks have to be more active (without necessarily being interventionist) in educating participants about the market’s operations, alternative approaches to managing foreign exchange resources and open positions, and the need to turn to other dealers, instead of to the central bank, to reduce open positions. To improve their own effectiveness in the market, central banks need to continue to develop their capacity to monitor, intervene, and provide sound guidance through regulation and dialogue.

In all of these economies, exchange markets are still new, and countries are “learning by doing.” Despite the existence of distortions in the interbank foreign exchange markets, these six countries have taken a positive step forward to ensure that exchange rates are more flexible and responsive to the forces of supply and demand. By facing up to the challenges presented by the practical and operational aspects of the market, the interbank exchange markets in these countries can be further developed to play a pivotal role in determining exchange rates.

For further detail, see “Operational Issues Related to the Functioning of Interbank Foreign Exchange Markets in Selected African Countries,” by the authors, IMF Working Paper (WP/94/48).

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