Experience With Floating Interbank Exchange Rate Systems in Five Developing Economies


WP/93/36-EA

Experience With Floating Interbank Exchange Rate
Systems in Five Developing Economies by Vicente Galbis

This paper examines the experiences under floating interbank exchange
rate systems of five developing countries--The Gambia, Guyana, Jamaica,
Nigeria, and Sri Lanka--which employed a variety of institutional and
regulatory arrangements in the interbank market. It describes their
prefloat economic conditions and exchange arrangements and the factors
affecting their choice of an interbank system. The role of financial
institutions and the official regulatory framework in making the transition
to the interbank exchange rate system are also discussed, along with the
macroeconomic adjustment framework and the exchange and trade system reforms
adopted. The paper assesses the performance of the interbank floats in
terms of both exchange market and macroeconomic developments.

All five countries introduced an interbank floating exchange system to
provide a more efficient, noninterventionist mechanism for determining the
official rate and allocating scarce foreign exchange resources. However,
some phased in the new system, removed exchange and trade restrictions, and
liberalized interest rates more gradually than did others; in several
countries, too, remaining regulations constrained banks and other authorized
exchange dealers in negotiating the exchange rate between themselves and the
public. The interbank floats and the accompanying exchange and trade
liberalizations generally resulted in convergence between the official and
parallel exchange rates; an appropriate flexibility and movement of nominal
and real exchange rates; and spreads between the buying and selling rates
that stayed within reasonable limits. Economic gains from the floating
interbank systems also appear to have accrued more visibly to the countries
that moved early and decisively to abandon previous restrictions--The
Gambia, Guyana, Jamaica, and Sri Lanka.

The paper concludes that interbank exchange rate markets can operate
relatively well with minimal banking infrastructure (for example, The
Gambia and Guyana); licensing of nonbank foreign exchange dealers can
provide additional market competition. However, the paper argues, these
markets can operate well only if the authorities remove trade barriers and
exchange restrictions on both current international transactions and capital
transfers, liberalize interest rates, and introduce prudential regulations
and supervision over exchange transactions. Segmented exchange markets may
persist if regulations prevent the free flow of resources across market
participants (as shown by the experience of Nigeria with a composite
exchange rate system--an official auction and an interbank market).
Moreover, any residual official restrictions that remain are likely to
foster the continued existence of parallel, informal markets. Finally, the
paper concludes, floating exchange rates and liberalized exchange and trade
systems--although they are helpful in balancing the external sector--are not
substitutes for sound macroeconomic policies.