FX market development and currency convertibility: Potential and risks
by HervŽ Ferhani, Senior Advisor, Monetary and Financial System Department, IMF
Introduction
Foreign exchange markets are the most important and active financial markets in many developing and transition economies. Yet, their level of development is often low compared to their potential. Country experiences suggest that major advances in capital account liberalization and currency convertibility could significantly boost the speed for foreign exchange market development.
This paper argues that a foreign exchange market can reach its development potential when the domestic currency is fully convertible, the capital account is fully open, and the exchange rate is fully flexible. However care should be taken in moving in this direction. If not properly sequenced, currency convertibility and capital account liberalization may lead to a financial crisis that may reverse the progress achieved in developing the market. It is thus necessary to carefully sequence these reforms and make gradual improvements in the level of market development that can be sustained.
Foreign exchange market development
A foreign exchange market is a network of individuals and institutions connected with each other for voluntarily exchanging, or facilitating the voluntary exchange of, domestic and foreign currencies.1
The foreign exchange market is developed when it satisfies three conditions. First, the network of individuals and institutions willing and able to trade domestic and foreign currencies has established all possible connections.Individuals willing and able to sell get connected to those that are willing and able to buy. Second, transactions are executed safely, quickly, and at low cost. Finally, the market discovers the exchange rate at which foreign exchange demanded is satisfied by those willing to offer foreign exchange. In other words, the market clears.
The most developed foreign exchange markets in the world are the markets for the U.S. dollar/euro and U.S. dollar/yen currency pairs. First, the networks of individuals and institutions trading these currency pairs are enormous and spread all over the world. Second, transactions can take place in real time through very secure settlement systems and transaction costs are very small2 Finally, the markets clear uninterruptedly 24 hours a day. However, the levels of development of the markets for the U.S. dollar/euro and U.S. dollar/yen currency pairs are hard-to-reach objectives for foreign exchange markets in developing and transition economies.
A foreign exchange market develops when the network grows over a period, so that it changes from its original form into one that is larger, more complete or complex, and stronger. The network gets larger by integrating individuals and institutions in more distant locations willing to exchange domestic and foreign currencies. It gets more complete or complex when
-Individuals already in the network establish new channels of communication and trading platforms. Hybrid market structures may arise, incorporating elements of dealer and auction markets. Order-driven, quote-driven, and brokered execution systems may start operating. Order routing systems may go beyond open outcry and telephone systems and include electronic data transmission systems, like electronic dealing and broking systems.
-Foreign exchange trading can take place over an increasing number of dimensions. The number of contracts types expands to fit currency exchange over time and across states of nature. Individuals and institutions in the network trade not only spot contracts, but also forward, and swap contracts. More complex derivative contracts may further expand the possibility of trading currencies across states of nature.
-Product differentiation clearly arises and the different products may be traded in specialized sessions.For example, foreign exchange cash may be traded in a special session, while foreign exchange transfers may be negotiated in wholesale trading (typically at the interbank level) and retail trading sessions.
-The foreign exchange industry becomes more specialized with a pronounced division of labor.
-Trading can take place more frequently. In the extreme continuous markets develop with eventual call markets or periodic auctions to concentrate liquidity at a particular time.
-The private sector plays an increasing role in price discovery. Foreign exchange markets tend to develop when the exchange rate authorities adopt more flexible exchange rate regimes, supported by monetary policy anchors other than the exchange rate, and delegate the process of price discovery to the market.
The market network becomes stronger when the quality and efficiency of the connection among market participants improves. Signal improvements can be achieved through a variety of means:
-Standardization in foreign exchange contracts and trading terminology can go a long way in accelerating signal speed.
-Improvements in settlement systems that reduce or eliminate Herstatt risk increase the likelihood that foreign exchange deals will be carried out as agreed.
-Market information systems become more sophisticated and market transparency increases.
Market connections also strengthen with trust, integrity, and time.
As the foreign exchange market develops, market liquidity and depth usually improve, which often reduces exchange rate volatility. Liquidity is the willingness of some market participants to take the opposite side of a trade that is initiated by someone else, at low cost. The more developed and larger is the market network, the more likely it is to find counterparties willing to take the other side of the trade. The increased chances for finding a matching interest and bigger scope for dealer inventory management would generally reduce exchange rate volatility relative to the one that would prevail with the same market participants in a less developed market.3
The private sector and the government could play important roles in the development of the foreign exchange market. Both could develop, and finance the cost of developing, the foreign exchange market.
Private foreign exchange intermediation firms can make the necessary network improvements when investments in market infrastructure are profitable. Profitability, in turn, depends on market size and the width of the intermediation margin. In dealer markets, this margin is the width of the bid-offer spread, while in auction markets the margin is the size of the commission. Because fixed costs and economies of scale are present in developing market infrastructure, private market development may require a minimum size of the market in terms of volume of transactions or number of participants. Otherwise, markets may never develop due to a lack of economies of scale.
Governments also can finance market infrastructure and aid market development, which may be rationalized in the presence of network externalities. The government also could in principle subsidize the infrastructure of the communication networks, the information systems, trading platforms, and settlement systems that are involved in currency exchange to diminishing the transaction costs. Network externalities may result from improvements in market infrastructure that leads to higher liquidity. Enhanced liquidity increases the willingness of traders to participate in that market and traders receive this effect for free (Economides, 1995). Market infrastructure that consolidates order flow over time or place enhances market liquidity, tends to reduce exchange rate volatility, and facilitates surveillance activities.
Given the importance of profitability for market development, foreign exchange regulations should avoid unduly restricting the size of the bid-offer spread charged by dealers or the commission charged by brokers. Central banks should avoid behaving as an intermediary in the market with extremely narrow bid-offer spreads that bring an unfair competition to the rest of the system.
Currency convertibility, capital mobility, and foreign exchange market development
The foreign exchange market can reach its development potential when the domestic currency is fully convertible, the capital account is fully open, and the exchange rate is fully flexible.
Capital mobility and currency convertibility are closely related, but do not always imply one another. On the one hand, capital mobility implies that the domestic currency is fully convertible. Otherwise, the principal and proceeds from domestic currency investments could not be transferred abroad, assuming that the foreign investor does not wish to hold domestic currency assets. On the other hand, currency convertibility does not necessarily imply capital mobility. For example, the currency may be legally convertible, the corresponding foreign exchange transaction may take place, but the ownership of the foreign currency funds may be prevented from being transferred to nonresidents or foreign financial institutions.4
Currency convertibility is essential for leading a foreign exchange market to its full development potential. In its pure form, full currency convertibility grants absolute freedom for foreign exchange transactions. This freedom allows all individuals and institutions willing and able to join the trading network, expanding its size and complexity, as well as increasing the market size that permits further investments in market infrastructure.
Capital mobility can help develop the foreign exchange market on many fronts. An increase in capital mobility can lead to the following:
-Increase the network size by integrating individuals and institutions in more distant locations willing to exchange domestic and foreign currencies. Adding individuals to the network (allowing them to trade foreign exchange) increases the prospects of finding individuals with different endowments, preferences, and information that would lead to trading.
-Improve market infrastructure. It can be expected that communication networks expand and improve, that trading platforms become more sophisticated and include, for example, electronic screen-based dealing or broking systems.
-Increase trading frequency.
-Expand the likelihood that the private sector will play an increasing role in price discovery.
-Typically increase the number of dimensions in which foreign exchange trading takes place. Short term capital flows can add liquidity to the domestic money market and more liquid domestic money markets provide hedging opportunities to market makers in the forward foreign exchange market.
Partial progress in developing the foreign exchange market can nevertheless be achieved when capital controls are in place. Such controls may be necessary given political constraints, for instance, to maintain the consistency of the monetary policy framework. In these circumstances, legal currency convertibility can play a useful role. Legal currency convertibility is a narrow concept that refers to the ability of residents and nonresidents to exchange freely the domestic currency for foreign currencies for making and receiving payments and transfers for all legally permitted underlying transactions.5 Legal currency convertibility could promote capital account openness and foreign exchange market development. Nonresidents may be more willing to undertake cross-border investments knowing that they can freely convert their domestic currency returns into foreign currency, even if during an eventual crisis the corresponding transfers may be temporarily prohibited.
Fund membership promotes legal current account convertibility and limits the scope for taxing currency exchange. The Articles of Agreement establish that Fund members cannot impose exchange restrictions that affect the making of payments and transfers for current international transactions.6 Indirectly, this requires legal current account convertibility because without the currency conversion the payment and transfers for the legally permitted current international transaction cannot be completed. The Articles also establish limits to the taxation of currency exchange. In particular, exchange taxes cannot exceed two percent because it creates multiple currency practices, subject to Fund jurisdiction.7
Foreign exchange market development can be seriously undermined and drastically reversed if the capital account liberalization and movements toward capital account convertibility are not properly sequenced and end up in a financial crisis. The liberalization of the capital account can bring about many benefits, but also entails risks. Several countries have suffered financial crises (banking, currency, and debt) when sudden large capital outflows took place after a period of large capital inflows. The outflows could cause a liquidity shortage, an increase in interest rates or sharp currency depreciation, depending on the exchange rate regime. As a result, the financial conditions of many banks may deteriorate drastically. A full-scale banking crisis could follow, further exacerbating macroeconomic instability. The macroeconomic and financial weaknesses could reinforce each other, worsening the crisis. Under these conditions, many central banks have reintroduced controls reversing capital account liberalization and redesigning the microstructure of the foreign exchange market (Ariyoshi and others, 2000). Many countries in crisis have even abandoned legal currency convertibility, restructured the foreign exchange market, and their central banks taken the role of main foreign exchange intermediary in the country.
Macroeconomic and financial sector reforms are crucial for operating in a more liberalized environment. The reforms to the macroeconomic policy framework need to aim at making the monetary, exchange rate, and fiscal policies consistent with an open capital account on a sustainable basis, for which they need to be political feasible. They also need to address the sources of macroeconomic and external vulnerability that could result in large capital flow volatility. To maintain financial sector stability in an environment with high capital mobility, countries should address the vulnerabilities in their financial sectors and modify their macroeconomic and financial sector policy frameworks to adapt them to operate in a more liberalized environment. Financial sector reforms should aim at making the financial sector resilient to shocks that could trigger capital movements. They may be supported by four pillars: (i) a strong capital base, (ii) adequate risk management, (iii) financial sector discipline, and (iv) well designed schemes for systemic liquidity management and support (Ingves, 2001).
Proper sequencing could help reduce the risks of financial sector instability. Yet, simple rules for sequencing do not exist. It is necessary to assess individual country circumstances before designing an operational plan for sequencing and coordinating capital account liberalization with other policies. This assessment inevitably requires judgment, discretion, and flexibility.
To prepare an operational plan for capital account liberalization, country authorities could follow three steps. First, analyze the financial sector, the macroeconomic policy framework, and the effective degree of capital account liberalization to identify the reforms necessary to operate within a more open capital account. Second, devise a broad reform strategy by grouping, sorting in order of priority, and phasing reforms according to feasibility, taking account of the principles described in Box 1. Finally, work out the tactics by preparing a detailed plan for scheduling and implementing each reform.
Conclusion
The appropriate speed for making progress in foreign exchange market development varies with country circumstances and is generally associated with the feasible speed in adopting financial sector reforms. While the foreign exchange market may speed up its development in a sudden liberalization of the capital account and a sharp increase toward currency convertibility, a rush in adopting these reforms could end up in a financial crisis that ends up reversing the development process. Thus, countries should liberalize their capital account gradually, and accompany the reforms with legal capital account convertibility that gives full foreign exchange access to domestic currency obtained for legally approved capital account transactions.
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