Floating Exchange Rates in Developing Countries : Experience with Auction and Interbank Markets

Kyong Huh, Benedicte Christensen, Peter Quirk, and Toshihiko Sasaki

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 1987
• ISBN:
  9780939934898

NONE

Contents

Prefatory Note

I. Introduction

II. Experience with Instituting and Operating Market Arrangements for an Independent Float

Reasons for Floating

Choice of Floating Market Arrangements

Interbank System

Auction Markets

Issues that Have Arisen in the Choice and Implementation of Floating Arrangements

Role of the Fund in Floating Arrangements

III. Accompanying Measures In Members’ Exchange Markets

Development of Forward Exchange Market

Role of Exchange and Trade Liberalization in Floating Arrangements

IV. Developments Under Floating Exchange Rate Regimes

Exchange Market Developments

Bilateral and Effective Exchange Rates

Capital and Reserve Movements

Absorption of Black Markets

Macroeconomic Performance

Output and Trade

Inflation Effects

Comparison of Performance Under Floating with Managed Flexibility

V. Summary

Appendix

TABLES
Section

II. 1. Independently Floating Unitary Exchange Rate Arrangements in Developing Countries: Summary Characteristics

2. Fund-Supported Programs Incorporating Flexible Exchange Rate Policies, January 1983–December 1986 16

3. Independently Floating Exchange Rate Arrangements in Developing Countries, Including Elements in Fund-Supported Economic Programs, January 1983–December 1986 18

III. 4. Floating Unitary Exchange Rate Regimes in Developing Countries: Exchange and Trade Liberalization

IV. 5. Comparison of Macroeconomic Performance in Developing Countries with Independently Floating and Managed Flexible Exchange Arrangements Under Fund-Supported Programs Compared with Year Before Program

Appendix

6. Indicators of Economic Structure in Selected Developing Countries, 1985

7. Exchange Rate Arrangements as of September 30, 1986

8. Floating Exchange Rate Regimes: Exchange Rate Variability in Selected Developing Countries in the Pre-Float and Floating Periods, January 1976–June 1986

9. Floating Exchange Rate Regimes: Variability of Exchange Rates in Selected Developing Countries, January 1976–June 1986

10. Floating Exchange Rate Regimes: Exponential-Trend-Corrected Variability of Exchange Rates in Selected Developing Countries, January 1976–June 1986

11. Floating Exchange Rate Regimes: Net Capital Flows, 1980-86

12. Floating Exchange Rate Regimes: International Reserves, External Debt, Arrears, and Foreign Currency Deposits, 1980-86

13. Growth and Foreign Trade Performance in Developing Countries with Floating Exchange Rates and Fund-Supported Programs, 1981-86

14. Comparison of Average Retail Prices for Selected Goods in Uganda, Zaïre, and Sierra Leone, First Quarter 1984

CHARTS
Section

IV. 1. Floating Exchange Rate Regimes: Exchange Rate Developments in Selected Developing Countries, January 1976–June 1986

2. External Current Account Developments in Selected Developing Countries, 1981-86

3. Consumer Price Developments in Selected Developing Countries, January 1981-September 1986

The following symbols have been used throughout this paper:

… to indicate that data are not available;

— to indicate that the figure is zero or less than half the final digit shown, or that the item does not exist;

– between years or months (e.g., 1984–85 or January–June) to indicate the years or months covered, including the beginning and ending years or months;

/ between years (e.g., 1985/86) to indicate a crop or fiscal (financial) year.

“Billion” means a thousand million.

Minor discrepancies between constituent figures and totals are due to rounding.

Choice of Floating Market Arrangements

Experience with different forms of free exchange markets is as yet relatively limited, being for the most part of recent origin. The authorities must nevertheless choose the institutional arrangements that are best suited to their economic structure and financial institutions. An important concern in designing a market arrangement and in deciding on the role that the authorities themselves will play in instituting the market and monitoring its performance is to prevent the emergence of destabilizing monopolistic or collusive behavior.

Members contemplating floating exchange rates are faced with essentially two forms of market arrangements (Table 1). In most of the countries under discussion in this paper (The Gambia, the Dominican Republic, Lebanon, the Philippines, Sierra Leone, South Africa, Uruguay, and Zaïre), as in all developed countries with floating exchange rates, members have opted for a market that is operated within the private sector by commercial banks and licensed foreign exchange dealers. In other countries, the authorities have felt constrained by institutional or social considerations to use an auction system to ensure a sufficiently competitive market. Foreign exchange is then surrendered to the central bank for auction to the highest bidders (Bolivia, Ghana, Guinea, Jamaica, Uganda, and Zambia). In an auction market, the central bank conducts the market and serves as the channel for the auction process. The system recently instituted by Nigeria is a composite of both forms, as an auction is used by the authorities to price and distribute foreign exchange receipts from oil to an interbank market.

Table 1. Independently Floating Unitary Exchange Rate Arrangements in Developing Countries: Summary Characteristics

Source: Data provided by national authorities.

¹ One of the four commercial banks operating in the market at the inception of floating has since ceased operations.

² Intervention has in practice pegged the Jamaican dollar vis-à-vis the U.S. dollar since October 1985.

³ Arrangements in place prior to reintroduction of dual exchange rate in September 1985.

⁴ Arrangements in place prior to reintroduction of managed floating arrangements in November 1985.

Interbank System

The participants in an interbank market are commercial banks and, in some instances, foreign exchange dealers (if these are licensed for the purpose). Individuals and firms are permitted to bid through the commercial banks or dealers acting as their agents. Of the developing countries that have adopted an interbank system, most already had a sufficient number of commercial banks and foreign exchange dealers operating in the economy to ensure a competitive environment. In other instances, major considerations in the choice of an interbank system were the absence of sufficient manpower and expertise at the official level to conduct auction arrangements and the belief that, with sufficient freedom of entry into the newly created market, the necessary institutions would develop quickly.

Under this system, the exchange rate is determined in negotiations between banks and their clients and in transactions between the banks. The exchange rate is free to vary from hour to hour and day to day. However, to ensure the competitive operation of the market, in all instances except the Philippines and Uruguay there are maximum or minimum limits imposed on commercial bank holdings of foreign exchange. The purpose of such regulations is twofold: first, to prevent major dealers from cornering the market or from using inside information to speculate on their foreign exchange operations; second, to prevent imprudently large exposure of banks to exchange risk. Such limits on stocks may be important particularly in the initial stages of the market when a minimum volume of trading is necessary to establish confidence. The size of the limits may be established initially by reference to the previous behavior of commercial banks’ working balances, and then adjusted in the light of experience with the market. Such limits may also be seen as assisting the responsibility of the central bank for managing accumulation of international reserves from the low initial levels generally prevailing in these countries. A second type of regulation on the market would involve an upper limit on the volume of foreign exchange surrendered to each commercial bank, to prevent any bank from cornering the market in a flow sense. Such a limit, as introduced in Sierra Leone, could be necessary in countries where the foreign exchange receipts of the economy accrue to one or a few major transactors who could then direct all of their foreign exchange earnings to one exchange dealer. If constrained by the stock or flow limits, banks must either buy or sell from other banks or, if other banks were also at their limits, transact with the central bank.

Another important form of official involvement in the interbank market is the periodic fixing session, at which the central bank has representatives present, who may also transact.⁹ At the rate-fixing sessions, held at least once a week, the commercial banks trade in foreign exchange, and an exchange rate is fixed taking into account the outcome of the previous fixing and subsequent transactions between banks and their customers during the week. The fixing exchange rate is usually set at a level which allows the largest volume of purchase orders to be transacted, and in the course of the fixing session commercial banks trade short and long positions according to their needs at this rate; a minimum volume of transactions may be specified by the central bank. Except for customs valuation and other official statistical purposes, the fixing rate normally does not apply to transactions other than in the fixing session; it is immediately superseded by rates in the interbank market. Particularly in economies marked by a relatively small number of transactors, or by other political or institutional tendencies toward collusion, the fixing session is an important means of providing the authorities with a view into the operation of the system, and thus preventing abuses. In countries where there are inadequately defined budgets for foreign exchange expenditures by the government itself, there may also be rules concerning the entry of the government or government enterprises into the interbank market, either in the course of the week or at the time of the fixing. Such rules may be especially relevant where the floating arrangements are introduced ahead of fiscal adjustment measures.

In most instances, there are official requirements for surrender of exchange to the official market. All countries in this group, except Lebanon and Uruguay, have surrender requirements for foreign exchange. In Nigeria, the Philippines, and Sierra Leone, all receipts from exports of goods and services are required to be surrendered to commercial banks (except oil receipts in Nigeria, which are surrendered to the central bank). Receipts of the marketing board in The Gambia and receipts of mining companies and oil companies in Zaïre are required to be surrendered to the central bank. In the Dominican Republic, foreign exchange earnings of traditional exports of goods and services previously subject to an exchange surcharge (sugar, cocoa, coffee, tobacco, most metals and minerals, and services other than tourism) are required to be surrendered to the central bank. The significance of the surrender requirement to government authorities is that, although the government uses the exchange rate determined in the market, it may seek to guarantee the provision of foreign exchange for certain purposes. The surrender requirements are therefore a consequence of official intervention in the allocation of foreign exchange by nonprice methods, for example, import licenses or exchange restrictions.

In some cases, portions of the supply and demand of foreign exchange are allocated outside the market, although at the same exchange rate. Such extra-market transactions occur when the central authorities retain exchange surrendered to them for their own use or when private sector exchange earners are granted retention privileges to use or sell the retained amounts outside the market. This results in less information on transactions being channeled through the market, and a consequent loss of efficiency in the floating arrangements. As will be seen below, this has led on occasion to severe instability of the exchange rate, especially when the information is ultimately made available to market transactors, and expectations are corrected suddenly.

Demand for foreign exchange by the public sector, including public enterprises, is met at the prevailing exchange rates either through the commercial banks or through the central bank. In Nigeria and Uruguay the central bank acts as an agent when it is requested by the government to purchase on its behalf foreign exchange from commercial banks (or at the auction also in the case of Nigeria). In the Dominican Republic, the central bank sells foreign exchange to the government from receipts surrendered to it. In The Gambia and Zaïre, debt service obligations of the public sector are paid from exchange surrendered to the central bank. However, the government may obtain foreign exchange from commercial banks for other purposes. In most countries severe shortages of foreign exchange for building up depleted reserves and meeting external debt service obligations, including the elimination of arrears, make it very difficult for the central bank to become a net seller to the interbank market. On the other hand, excessive purchases by government would tend to overdepreciate the domestic currency, leading to political and social difficulties. Intervention will therefore usually be limited to very short-run smoothing or seasonal operations and to purchases for gradual reconstitution of international reserves.

For the efficient and competitive operation of the interbank market, it is important that exchange rates determined in these transactions be widely and openly published so that the possibility of collusive practices by commercial banks is reduced and that the regulations set specific requirements to this effect. The central bank may in addition set maximum commissions or spreads between buying and selling rates that may be charged by commercial banks. Purchasers of foreign exchange may also be required to provide documentation that the purchase is for transactions in accordance with prevailing exchange and trade controls and income tax regulations.

An important question in setting up a competitive market is the degree of freedom of access to the market. In several countries, exchange transactions are limited to certain groups. In Zaïre, foreign exchange dealing licenses are granted only to commercial banks and hotels. There is no specific information on the network of informal foreign exchange dealers, but it is thought to be small and scattered. In the Dominican Republic, the foreign exchange market is a very broad one owing to the openness of the economy and the prior existence of a secondary market in which some 16 commercial banks and more than 90 foreign exchange houses participated. Nigeria also has a large number of commercial banks (over 40), and other dealerships may be licensed. At the other end of the spectrum is the market in The Gambia, in which only 3 commercial banks participate, and nonbank foreign exchange dealers are not permitted to participate in the fixing session. Generally speaking, the easier are entry requirements into the market, the more competitive and stable it will be.

Auction Markets

The role of the authorities in an auction system (as conducted by Bolivia, Ghana, Guinea, Jamaica, Uganda, and Zambia) is a more central one than in an interbank market. Receipts from specified exports and services are surrendered to the central bank at the prevailing exchange rate and are auctioned by the authorities on a regular basis. The central bank decides the amount of exchange to be auctioned and the minimum reserve price below which it will not accept bids. The minimum amount of the sales may be predetermined as part of a macroeconomic program. The central bank may decide to auction foreign exchange in minimum amounts (say, US$50,000), allowing banks to bid on behalf of their customers. Where licensing requirements are retained, all bidders with a valid import license are required to lodge an advance deposit, either partial or equivalent to 100 percent of the foreign exchange they intend to purchase, before the submission of bids. The bids submitted to the auction are then examined, and all bids in excess of the highest bid which fully exhausts the available supply of foreign exchange (i.e., the market-clearing price) are accepted, providing they exceed any reserve price established by the central bank. The market-clearing marginal rate (the average exchange rate in Bolivia) becomes the market exchange rate. After the auction, the market exchange rate, the total number of bids received, and the number of successful bidders are announced. The auction-determined exchange rate applies until the next auction date to all exchange transactions, including surrenders for the next auction and any transactions that may not be required to be channeled through the auction market (e.g., transactions of the government).¹⁰ Advance deposits lodged by unsuccessful or partly successful bidders are returned in whole or in part, respectively, but bids are normally not permitted to be withdrawn. If a successful bidder fails to make full payment for his foreign exchange within a specified period, he may be subject to a fine that may be collected from the deposit he has lodged. Spreads between buying and selling rates of individual commercial banks and any limits on commercial bank foreign exchange positions are closely monitored by the central bank to ensure that collusive practices are not involved and that they reflect reasonable profit margins.

Perhaps the basic differences between interbank and auction system arrangements are the treatment of the supply of foreign exchange to the market and the frequency or continuity of adjustment of the rate. An essential feature of an auction market arrangement is that it requires the surrender of foreign exchange to a centralized unit, which to date has been the central bank of the country organizing the market. In contrast, in an interbank arrangement the ownership of foreign exchange may remain diffused in the private sector. In some auction arrangements (as with the interbank arrangements described above) the surrender requirement is less than complete, and retention allowances have been kept for certain export or other foreign exchange earners. Similarly, the supply by the central bank of foreign exchange it has collected may be less than complete, as the central bank retains a certain portion of foreign exchange from the market for the use of government.

In Bolivia, Ghana, Jamaica, and Uganda, all export proceeds are required to be surrendered to the central bank. In Guinea, joint ventures in the mining sector pay a special export tax in foreign exchange, and partial surrender requirements apply to other major exports. In these five countries, all sellers of foreign exchange to the central bank are entitled to receive local currency at the auction market exchange rate for all foreign exchange surrendered. In Bolivia, in order to stimulate surrender, those surrendering foreign exchange were for a short time able to obtain an exchange reimbursement certificate in an amount equivalent to 10 percent of the foreign exchange surrendered. In Zambia, the authorities have accepted, on a transitional basis, retention privileges for the mining company and exporters of nontraditional products, reflecting concerns about the availability of foreign exchange. For example, in the latter case, about 50 percent of total export proceeds are estimated to be retained by exporters. However, the Zambian and the Ugandan authorities have introduced policies whereby the source of foreign exchange earnings is no longer subject to declaration, in order to encourage capital inflows into the system.

Once the central bank obtains the foreign exchange, it may put some portion aside for its own uses— reduction of external arrears, accumulation of reserves, and payments of external debt obligations. In Guinea, Jamaica, Ghana, Uganda, and Zambia, payments for official imports, such as petroleum and some other payments, are made by the central bank from the surrendered foreign exchange, and the other available foreign exchange is auctioned. The foreign exchange requirements of public enterprises may also be provided at the official exchange rate, or the enterprises may be required to purchase foreign exchange in the auction market (Bolivia, Ghana, Jamaica, and Uganda). Most of these requirements are, in practice, met outside the auction in Jamaica. The net effect of these arrangements under which government needs are met outside the auction at the market rate is to limit severely the proportion of overall foreign exchange earnings that is channeled through the auction market.¹¹ In Uganda and Zambia, the amount supplied to the market has been largely prespecified in absolute terms, although subject to some variation according to the balance of payments performance. In Jamaica, the amount supplied to the market has been larger and has naturally fluctuated with overall balance of payments developments. The retention and sequestering of exchange for official purposes, although undertaken to ensure availability, has often created problems both for the flow of information to the auction market and for the provision of sufficient exchange for the orderly discharge of current demands, by reducing confidence in the operation of the market and thus sales to it.

The other aspect of the supply side of the market, namely the exchange rate applying to sales to the central bank, in part for the auction, also marks an important difference from the interbank market system. Under the interbank system the exchange rate may be determined directly and may vary continuously during business hours by negotiation between buyers and sellers, but under the auction system, which functions discretely, surrender occurs in practice at the exchange rate determined in the preceding auction. This may create uncertainty for market participants, and a risk of exchange loss in the interim for participants engaged in both purchases and sales in the market. Of course, the more frequently the auctions are conducted, the less inefficiency in the market-clearing process will result from this source. In addition to adding to exchange risk, infrequent auctions could also cause delays in the availability of exchange. Further delays will result if participants’ difficulties in assessing the clearing price cause them to make one or two unsuccessful bids before finally obtaining exchange. Auctions take place daily in Bolivia, twice a week in Jamaica, and weekly in Ghana, Guinea, Nigeria, Uganda, and Zambia.

Eligibility for participating in the auction on the demand side of the market is basically determined by the restrictive system of the particular country (see next section). In addition, there may be technical requirements that must be satisfied in order to establish the ability of a participant to make the local currency payment and to otherwise consummate a successful bid. Bids in the Ghanaian auctions must be accompanied by a deposit equivalent to 100 percent of the bid amount. In Bolivia, any individual or legal institution that wishes to obtain foreign exchange is permitted to submit a bid in the auction, although each bid must have a minimum value of US$5,000 and must be accompanied by a banker’s check in domestic currency equivalent to the bid. In Jamaica, private participants in the market comprise all bona fide importers with valid due or outstanding payments and other nonbank applicants holding foreign exchange approvals of the central bank. Bids for transactions below US$50,000 are aggregated and presented by Jamaican commercial banks (US$500 for Ghanaian banks) on behalf of their clients. In Bolivia, all public sector institutions must also validate their participation by producing a banker’s check. In Guinea, all transactions of the public sector are conducted at present in the primary exchange market (first window) which handles, inter alia, external debt service obligations and official petroleum imports. Transactions of the mining companies are also conducted at this window, while all other trade transactions are conducted at the second market window. Authorized Nigerian foreign exchange dealers are free to participate in that country’s auction for a portion of foreign exchange receipts, without provision of documentation regarding end-use of exchange; for the purpose of capital controls they act as agents of the government in their sales in the interbank market. In the initial stage of operation of the Ugandan market, bids for foreign exchange were limited to imports (excluding oil and essential spare parts and capital goods), to invoices made out by foreign airlines for transportation, and to private sector service and transfer payments. In Zambia, all public enterprises, except the mining enterprise, must bid for their foreign exchange requirements in the auction. Advance deposits, amounting to 30 percent of the kwacha offered at the auction have been required of all participants since November 1986; in effect this has constituted a restriction on access to the auction.

Some of these countries have penalties for the successful bidder who fails to take the bid within a certain period, even though he has deposited with his commercial banks checks against the full local currency value of his foreign exchange application. In Zambia, for example, a penalty not exceeding 10 percent of the amount of the bid will be imposed on the bidder if the Foreign Exchange Committee finds a blatant abuse of the foreign exchange arrangements. A bidder found persistently abusing the arrangements may be placed by the Committee on a black list for up to 12 months, during which time the individual is disqualified from participation in the market. In countries with floating systems that have retained import or capital controls, pre-existing legal penalties for contravention of these regulations may also continue to apply.

Another aspect of auctions is the choice of arrangements for determination of the exchange rate between a “Dutch auction” and a “marginal pricing” approach. Under the Dutch auction system, each bidder whose bid is accepted must pay his bid price for foreign exchange. This system has been applied recently by Bolivia, Ghana, Jamaica, and Zambia. Participants in this type of auction may pay a price for foreign exchange that is significantly higher than the market-clearing price if they assess demand conditions in the market incorrectly but their bid is successful. Guinea, Nigeria, and Uganda operate marginal price auctions. Under the marginal price system, a single rate—the most appreciated bid price at which the available foreign exchange is exhausted, which is the market-clearing price—is applied to all successful bidders. Bidders who have offered rates more depreciated than the market-clearing rate will receive all the foreign exchange they have bid for at the clearing rate. Those who have offered a rate more appreciated than the clearing rate will not receive foreign exchange and those who have offered the marginal rate will receive only part of what they have bid for, on the basis of an allocative rule. In Jamaica and Zambia, the authorities switched to a Dutch auction from a marginal pricing auction mainly because they were concerned that speculators would act on the belief that the local currency would depreciate sharply against foreign currencies and that these speculators should pay the full price of their bid. In practice, however, participants in the Jamaican auction have been able to obtain sufficient information regarding each other’s bids for the spread between buying and selling rates to remain very narrow. Similarly, in Bolivia, following a settling down period of a month or so after introduction of the Dutch auction, the successful bids in the auction also converged within a narrow...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• Prefatory Note
• I. Introduction
• II. Experience with Instituting and Operating Market Arrangements for an Independent Float
• III. Accompanying Measures In Members’ Exchange Markets
• IV. Developments Under Floating Exchange Rate Regimes
• V. Summary
• Appendix
• TABLES
• Footnotes