VIII Recent Technical Assistance on Exchange Systems, 1994–97

R. Johnston, and Mark Swinburne
Published Date:
September 1999
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This section reviews the IMF’s recent technical assistance on exchange systems and the main elements emphasized during such assistance.

Main Focus of Recent Technical Assistance

Fifty-four countries received IMF technical assistance missions on exchange systems during 1994–97 (see the appendix to this section). The geographical allocation of the recipient countries is as follows: 13 each in European II Department and African Department, 9 in Asia and Pacific Department, 8 in Middle Eastern Department, 6 in Western Hemisphere Department, and 5 in European I Department. Of these, 25 were using IMF resources, and in 19 cases the programs included conditionality on the reform of the exchange system (see Table 38). In a number of cases, including Cambodia, Liberia, Madagascar, Rwanda, Sudan, Tajikistan, Turkmenistan, and Uzbekistan, technical assistance on the exchange system was a critical component of broader efforts to prepare the ground for the programs of macroeconomic adjustment and structural reform, and to pave the way for the recipients to enter into IMF arrangements.

Table 38.Conditionality in IMF Programs and Technical Assistance in Exchange System, 1994–971
AlgeriaRegulatory framework: Adopt obligations of Article VIII. Delegate to authorized dealers specific transactions.

Market development: Establishment of exchange bureaus. Introduction of interbank foreign exchange market, with the commercial banks as authorized intermediaries.
ArmeniaRegulatory framework: Eliminate multiple currency practices and restrictions arising from correspondent accounts with central banks of the Commonwealth of Independent States. Review and revise existing foreign investment law.

Market development: Central bank to withdraw from regular participation in foreign exchange market. Set official rate based on market rate of previous day.
AzerbaijanRegulatory framework: Remove all quotas or licensing requirements for imports and exports. Eliminate current account restrictions. Allow nonresidents to participate in treasury bill market.

Market development: Allow interbank trading in foreign exchange for all banks, and foreign banks to participate in the Azerbaijan National Bank credit auctions market. Increase frequency of foreign exchange auctions.
EthiopiaRegulatory framework: Eliminate negative list at foreign exchange auction; reduce surrender requirements.

Market development: Allow opening of exchange bureaus, permit commercial banks to bid in foreign exchange auctions on their own account, to hold resident foreign exchange deposits; increase frequency of auctions; eliminate the 25 percent cover requirement for auctions.
GeorgiaRegulatory framework: Eliminate surrender requirement.

Market development: Establish interbank credit auction. Widen scope of transactions on the Tbilisi Interbank Foreign Exchange (TICEX) to include non-cash sales/purchases. Increase frequency of TICEX auctions.

Reserve management: Centralize international reserves at the central bank.
GuyanaRegulatory framework: Phase out surrender requirement. Review the Exchange Control Act.
KazakhstanRegulatory framework: Remove remaining restrictions and accept obligations of IMF Article VIII status.

Market development: Establish formal arrangements for interbank foreign exchange market, including code of conduct.
MadagascarRegulatory framework: Accept obligations of Article VIII. Maintain floating exchange rate system.

Market development: Authorize banks to lend in foreign currencies. Reduce minimum capital for exchange bureaus.
MalawiRegulatory framework: Establish new limits on open positions.

Market development: Introduce interbank foreign exchange market.
MauritaniaRegulatory framework: Eliminate surrender requirement for nonmineral export proceeds. Enforce limits on open positions. Unify exchange rate. Eliminate current account restrictions, and agree on calendar for moving to acceptance of Article VIII. Market development: Introduce interbank foreign exchange market. Allow establishment of exchange bureaus. Central bank to intervene in the interbank market.
MongoliaRegulatory framework: Maintain unified exchange rate system. Introduce limits on open positions with daily reporting.

Market development: Develop interbank money market, in line with bank restructuring, so that it can serve as a basis for setting of official exchange rate. Refrain from intervening in foreign exchange market except for smoothing operations.
PakistanMarket development: Liberalize and develop interbank foreign exchange market to increase market determination of the exchange rate and promote the development of private forward cover.
RomaniaRegulatory framework: Amend foreign investment law to facilitate foreign portfolio investment.

Market development: Liberalize the foreign exchange market and ensure a market-determined exchange rate. Eliminate auction market and ensure reliance on fully fledged interbank foreign exchange market.
RussiaRegulatory framework: Maintain market-determined exchange rate.
TanzaniaMarket development: Establish an interbank foreign exchange market.
UgandaRegulatory framework: Facilitate liberalization of capital account. Improve monitoring and enforcement of foreign exchange exposure limits of commercial banks. Submit new Foreign Exchange Law to Parliament.

Market development: Unify interbank foreign exchange market.
UkraineRegulatory framework: Eliminate restrictions inconsistent with Article VIII. Eliminate surrender requirement.

Market development: Move to daily operations of the foreign exchange market. Allow all licensed banks to participate in the foreign exchange market.
VietnamRegulatory framework: Issue foreign exchange guidelines to commercial banks. Increase transparency of regulatory framework.

Market development: Limit official intervention in foreign exchange market. Formalize interbank foreign exchange market with regulatory framework.

Reserve management: Centralize international reserves at the central bank.
Yemen RepublicRegulatory framework: Unify exchange rate and adopt free floating regime. Eliminate multiple currency practices.

Market development: Allow all commercial banks to participate in interbank foreign exchange market. Achieve full exchange market unification by moving all government and central bank transactions to the freely floating rate.

Reference to the Acceptance of Article VIII means acceptance of the obligations of Article VIII, Sections 2, 3, and 4 of the IMF’s Articles of Agreement.

Reference to the Acceptance of Article VIII means acceptance of the obligations of Article VIII, Sections 2, 3, and 4 of the IMF’s Articles of Agreement.

Technical assistance on exchange systems has focused on three main areas: (1) assisting member countries to liberalize their regulatory framework, including for acceptance of the obligations of Article VIII, Sections 2, 3, and 4 of the IMF’s Articles of Agreement, and for the liberalization of capital account transactions; (2) developing the interbank foreign exchange market; and (3) strengthening central bank’s reserve management.

In providing technical assistance, the IMF draws on the experience of its staff, central banks, and foreign exchange market participants. In the case of the countries of the Baltics, Russia, and the other countries of the former Soviet Union (BRO), 23 central banks have been cooperating with the IMF in an intensive multilateral program for providing technical assistance. In the area of foreign exchange systems, this has focused on establishing the institutional setup for an efficient market-based allocation of foreign exchange; payment and transfers for current account transactions; unification of exchange rates; capital account liberalization; foreign exchange reserve management; and central bank organization and operations. The cooperating central banks are those of Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Iceland, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the United States. Progress in reforms on the exchange system was reviewed in central bank reforms in the Baltics, Russia, and other countries of the former Soviet Union,73 and in the report prepared for the Eleventh Coordination Meeting of Cooperating Central Banks and International Institutions (Basle, Switzerland, May 1998). A number of other central banks have provided assistance to other countries and regions. For example, Tunisia assisted Rwanda in establishing a market-based system; Korea and Chile assisted China on capital account liberalization; the Czech Republic assisted several BRO countries, and Ghana assisted Ethiopia and Malawi in foreign exchange market development.

Liberalization of the Regulatory Framework

Technical assistance has assisted with reviewing and reforming regulatory framework for current international transactions and capital movements.

Assistance in Acceptance of the Obligations of Article VIII, Sections 2, 3, and 4

Substantial assistance was provided in assisting member countries to accept the obligations of Article VIII. Twenty-six countries receiving IMF technical assistance accepted the obligations of Article VIII, Sections 2, 3, and 4 during the period, including Algeria, Armenia, China, Croatia, Georgia, India, Kazakhstan, the Kyrgyz Republic, Kenya, Latvia, Lithuania, Madagascar, Malawi, Malta, Moldova, Mongolia, Pakistan, Paraguay, Poland, Russia, Slovenia, Sri Lanka, Tanzania, Uganda, Ukraine, and the Republic of Yemen.74 In addition, assistance from headquarters in reviewing legislation was provided to the 13 member countries of the African CFA franc zone, which accepted the obligations of Article VIII, Sections 2, 3, and 4 on June 1, 1996.

Assistance in Capital Account Liberalization

The substantial progress achieved in current account convertibility encouraged increased emphasis on capital account liberalization. IMF advice is typically structured within the context of a broader program of macroeconomic adjustment and structural reform, especially financial regulatory reforms and operational procedures. For example, the liberalization of capital account transactions has been linked to the reform of the foreign exchange system (e.g., Bangladesh, Guyana, India, and the Republic of Yemen), to improvements in monetary control, including the introduction of indirect monetary policy instruments (e.g., Bangladesh, Fiji, Guyana, Russia, the Slovak Republic, and the Republic of Yemen), and to the strengthening of domestic financial systems and markets (e.g., Bangladesh, India, Russia, and the Slovak Republic).

Also, while stopping short of recommending full convertibility, the IMF staff noted in its assessment of India’s regulatory framework that capital account liberalization would be important for the development of the interbank foreign exchange market, as banks’ foreign exchange transactions were hampered by existing capital controls. In Bangladesh, the staff noted that it seemed to be relatively easy to circumvent existing capital controls through the unofficial market and suggested that capital account liberalization should be undertaken concurrent with the strengthening of indirect monetary controls. In the Slovak Republic, it was emphasized that there were no particular impediments preventing a relatively rapid pace of liberalization. In discussing the liberalization of China’s exchange system, the staff emphasized the importance of anticipating the future liberalization of the capital account in preparing new foreign exchange legislation and of coordinating reforms with the strengthening of the banking sector, and the introduction of indirect monetary instruments. Initially, technical assistance to China had been directed at assisting the authorities in unifying its exchange rate (January 1994) and liberalizing current account transactions. China accepted the obligations of Article VIII, Sections 2, 3, and 4 in December 1996. In 1998, discussions focused on the development of the foreign exchange market and the orderly liberalization of the capital account. In Fiji, it was recommended that further capital account liberalization be viewed as an integral part of the authorities’ overall economic reform program: liberalization of foreign direct investment should go hand in hand with reforms aimed at strengthening the real sector, and liberalization of portfolio flows should be coordinated with reforms in the domestic financial sector.

Interbank Foreign Exchange Market Development

With respect to interbank foreign exchange market development, official policies have been emphasized as having an important role in this process. In particular, the authorities need to eliminate barriers that may hinder foreign exchange dealings and exchange controls arising from official regulations and practices. Below, the core issues relating to the establishment of an interbank foreign exchange market are discussed (Box 8 lists the key institutional and operational reforms involved).

Exchange Control Laws and Regulations

To foster development of the interbank foreign exchange market, authorities need to identify and remove barriers that prohibit authorized dealers from providing foreign exchange to their customers. For example, dealers may not be allowed to maintain open foreign currency positions overnight. Foreign exchange receipts may have to be surrendered to the central bank. Foreign exchange transactions may have to be conducted through the central bank or exchange transactions at an official exchange rate. This restriction would have to be modified as part of the development of the foreign exchange market.

Furthermore, to be able to operate in the interbank exchange market, banks need to be able to deal in the international currency markets for the purpose of converting customers’ demands for third currencies into the intervention currency, and vice versa. To engage in hedging forward operations banks should be able to borrow and lend, subject to prudential limits, both domestically and internationally. Where capital controls restrict this activity, forward transactions may be limited to matching purchases and sales of foreign exchange between customers, hindering the development of a liquid forward foreign exchange market. The experiences among IMF member countries show that it takes some time to develop a well-functioning forward market, partly because this requires a liquid and relatively free market for spot transactions and a functioning interbank market for domestic currency.

To ensure efficient foreign exchange allocation in the customer market, foreign exchange should be freely available for various external transactions. Therefore, the IMF has emphasized that the introduction of interbank foreign exchange markets has often gone hand in hand with a move toward convertibility of the currency. This may necessitate that exchange control laws and regulations be liberalized, and that the authority to provide foreign exchange and verify the compliance with exchange controls, where these are still relevant, be delegated to authorized dealers.

Box 8.List of Key Institutional and Operational Reforms for Foreign Exchange Market Development

Some of the key international and operational reforms in the development of a foreign exchange market are outlined below.

Exchange System and Market Arrangements

  • Modify exchange control laws and regulations.
  • Delegate exchange control authority to the authorized dealers.
  • Establish a code of conduct.
  • Improve information technology to facilitate interbank dealings.
  • Use market exchange rates for all foreign exchange transactions.
  • Transfer all private transactions to the interbank market.
  • Facilitate the market-making role of authorized dealers.
  • Establish transparent criteria for licensing dealers.
  • Strengthen payments and clearing arrangements.

Central Bank’s Own Operations

  • Develop dealing and back-office arrangements.
  • Establish adequate internal controls for foreign exchange operations.
  • Streamline central bank’s organization and operations.
  • Establish foreign exchange cash-flow projections.
  • Improve central bank’s information technology.
  • Strengthen central bank’s supervisory capacity.
  • Increase dialogue with the market and disseminate information.
  • Improve central bank’s external reserve management operations.

Supporting Measures

  • Introduce prudential guidelines for banks’ currency exposure.
  • Establish reporting arrangements for authorized dealers.

When the interbank foreign exchange market is introduced, exchange controls and regulations guiding foreign exchange dealings in the market should be modified so that they do not impede the role of market forces in determining the allocation and pricing of foreign exchange in the market; regulations that apply to foreign exchange trading between dealers should not unduly limit dealers’ operations in the interbank foreign exchange market and their access to exchange transactions at any exchange rate they quote. However, prudential controls may be imposed on dealer banks’ foreign currency open positions to safeguard the soundness of the banking system.

In the interbank foreign exchange market, foreign exchange proceeds are sold directly to authorized dealers at freely negotiable exchange rates while the central bank typically acquires foreign exchange from the dealers. If capital controls are retained, the requirement to repatriate foreign exchange proceeds to the local interbank market is normally also retained, while the central bank could require that foreign exchange be surrendered to the interbank market (rather than to the central bank) or allow it to be retained in foreign currency accounts with local banks.

The IMF has also recommended that the provision of foreign exchange by the central bank directly to the nonbank private sector should be terminated and these transactions should be transferred to the interbank market; this will both enhance the transparency of foreign exchange allocation and improve liquidity in the interbank market.

Finally, the IMF has recommended that market-determined exchange rates should be used for all foreign currency transactions, including official transactions, so that distortions are avoided. In the case of a fixed exchange rate regime, a “market-determined” rate is one that clears the market, even if it is directly set by the authorities. In other words, a fixed rate is considered to be market-determined when the central bank absorbs excess market supply or demand through its own transactions, without recourse to rationing, and when such excesses sum to zero over some time horizon. All taxes and surcharges related to foreign currency transactions should be abolished. The central bank may, nevertheless, calculate a reference exchange rate based on a weighted average exchange rate of transactions in the interbank market, usually for customs and statistical valuation purposes.

Buying and Selling Quotations

In the interbank foreign exchange market, dealers need to be free to establish their buying and selling exchange rates for transactions between themselves and with their customers. Brokerage fees and prices for customer services should be negotiated between dealers and their customers competitively. The IMF staff’s recommendation has been that to foster competition, the spread between buying and selling exchange rates in the interbank market should not be limited. Maximum spreads—although nonbinding—often become a norm in the market, while free competition tends to drive the spreads down. Nevertheless, information about the spreads should be monitored by the central bank to help detect the emergence of noncompetitive behavior, as well as to potentially provide information about market sentiment and uncertainty. Publishing information about spreads would also help improve the transparency of the market.

Mutual Trust

An essential element that facilitates the smooth operation of an interbank foreign exchange market is the mutual trust among market participants. This forms the critical basis for interdealer transactions. To facilitate the building of trust, dealers would need to be able to evaluate the credit risks of their counterparties, based, for example, on published balance sheets and reports on profits and losses. In countries where lack of mutual trust is likely to hinder direct dealings between banks, an interbank fixing arrangement may facilitate interdealer transactions; however, participation in the fixing sessions should be optional, and no limits should be imposed on dealings taking place outside these fixings. Collateral could be introduced to safeguard against possible payments defaults.

In addition to counterparty risk, settlement risk due to inadequate clearing and payments systems can impede interdealer transactions. Improvements in the domestic payments and clearing systems would help eliminate the settlement risk due to insufficient funds in the local currency leg of the transaction.

Code of Conduct

To facilitate the development of an interbank market for foreign exchange, a code of conduct for foreign exchange trading should be adopted, which would be established as a form of self-regulation and would therefore need to be fully accepted by market participants. It would provide participants with a set of rules and guidelines that would govern their dealings in the interbank market, but it would also educate them on issues related to accepted trading practices, such as instruments and procedures that are typically used in foreign exchange dealings, and market terminology. The sample code of conduct provided by the Association Cambiste Internationale would be a basis to develop local codes.

Market Making

To enhance market liquidity, the IMF has advised that some dealers be permitted to assume the leading role in “making the market.” The market-making process creates liquidity in the foreign exchange market as the dealers constantly adjust their portfolios on the basis of the flows of market orders and their expectations about the market, while competition forces exchange rate quotations to converge to a narrow range.

Experience suggests that in emerging markets there may be significant obstacles that prevent the emergence of continuous two-way quotations, associated with instability in foreign exchange flows, lack of trust, inefficiencies in the payments systems, and lack of adequate communication technology and computer systems. In the early stages of market development, the number and the size of currency transactions in the interbank market may be limited. However, the experience also suggests that the initial problems are likely to dissipate as market reforms take hold and market participants become more comfortable in dealing among themselves.

In an emerging interbank foreign exchange market, the nature of the central bank’s participation in the market may be critical since this can both facilitate market making and provide liquidity to the market. The IMF staff has recommended that the central bank should avoid undermining the market-making role of banks by exchange control regulations or by providing services that can and should be provided by market participants. However, it could encourage the banks to become market makers by limiting its dealings to banks that provide firm two-way quotations for a set minimum amount; it can also assist by undertaking transactions through broader market operations (where there can be some variations in prices, even under a fixed or pegged regime), as opposed to an on-demand window for individual banks. Such methods can have a strong enforcement effect, particularly when transactions with the central bank are significant. The IMF has also sometimes recommended that a requirement to provide two-way quotations be imposed as part of the licensing process.

Concerning technological requirements for establishing and operating the interbank foreign exchange market, these need not be extensive. If a functioning telephone network exists and dealers have access to telex or fax machines, then it is possible to conduct interbank dealings. Sometimes it is feasible to establish a computer network linking authorized dealers together in the market; this network system may be used as a bulletin board to give information about bids and offers to other dealers while trading is still conducted by phone.

Payment and Communication Systems

In view of the critical importance of effective domestic payments and clearing systems to allow for smooth operation of the interbank foreign exchange market, an adequate domestic payments system is an essential element of a functioning interbank market arrangement. In the early stages of market development a separate clearing facility for the domestic leg of the transactions may be required.

To ensure the dissemination of information—an essential element for efficient pricing of foreign exchange—a suitable information network is needed. While actual dealings may be conducted via telephone lines and confirmed through secured telex or other arrangements (such as SWIFT),75 bids and offers can be provided via a computer system where information is displayed on screens accessed by dealers. In addition, such an information system will effectively spread information on exchange rate quotations and enhance competition between the dealers in the market.

Market Participants

To enhance market liquidity and competitions, the IMF has recommended licensing a wide range of authorized dealers to trade in the interbank foreign exchange market, including additional banks, domestic and foreign, as well as entities other than deposit-taking banks, such as merchant banks and nonbank dealers. Also, allowing the participation of exchange bureaus has been advocated in countries where collusion between banks has led to nonmarket pricing or allocation of foreign exchange.

Role of the Central Bank

As already noted, when the central bank participates in the interbank foreign exchange market, it should not become a market maker. To avoid doing so, it can buy and sell foreign currency at its own discretion by contacting one or more market participants, usually banks, and requesting firm buying and selling quotations for amounts of foreign exchange that it is willing to deal. This does not mean the central bank should deal with large numbers of banks in countries where there are many of them. For greater effectiveness, it may be preferable to limit the number of institutions with which the central bank has transactions. These banks would assume “primary dealer” status and become agents of the central bank in intervening in the foreign exchange market. Brokers may also be used for interventions. These transactions are then effected at rates agreed by the central bank and the participating dealer(s). These same principles should be applied whether the central bank transacts in the foreign exchange market on its own behalf, for example, to accumulate foreign exchange reserves, as an intervention in the market in accordance with exchange rate policy objectives, or on behalf of a customer, normally the government. The central bank should cease all other commercial activities.

The central bank should also discontinue the provision of exchange rate guarantees, and in particular forward cover. The role of the central bank in this area should be one of assisting indirectly in the development of a forward interbank market by helping to educate market participants, through seminars and the like, about the technology associated with forward market trading and especially about management of the risks involved. It may also have a role in developing appropriate information technology.

Dealers in the interbank foreign exchange market must learn how to manage their foreign currency positions and ensure that their end-of-day open positions conform with prudential standards. In principle, the central bank should not participate in settling the excess end-of-day balances of dealer banks; sometimes, however, it may need to use its discretion to support the market when sales or purchases of foreign exchange by commercial banks make it difficult for the banks to comply with the prudential open position limits, or could result in sharp exchange rate fluctuations. Experience suggests that the need for such intervention may decrease as the regulatory framework for exchange transactions is liberalized.

More important, intervention policy must have a clearly defined goal, whether to maintain a fixed exchange rate or to smooth out short-run exchange rate fluctuations in a more flexible regime. Otherwise, the central bank’s interventions can confuse and destabilize the market. In any event, interventions by the central bank are likely to have a major impact on the emerging interbank market; therefore, the interventions should not be used to undermine the market’s role in pricing foreign exchange. An assessment of daily foreign exchange cash flows can be helpful in indicating the likely volume of central bank intervention that may be needed, or alternatively the movement that may be needed in the exchange rate.

The central bank’s own dealing operations should be properly organized. In particular a clear separation between the back-office and front-office functions is needed. Also, the central bank’s top management should provide written guidelines to its dealers to control risks involved in foreign exchange dealings. These guidelines should, at a minimum, include the list of traded currencies and the counterparties with whom the central bank dealers are allowed to deal, and the procedures for reporting and recording executed transactions; the responsibilities of dealers, what they can do and to whom they must report daily, monthly, or periodically; authorized dealing limits; the amounts above which approval of the senior management is required; and the procedures for proper internal supervision.

It is important for the central bank to maintain a continuous dialogue with the market through its trading desk. This would include contacts between the central bank and the dealers in the interbank market, regular meetings between the senior representatives of the central bank and market participants, and so on. The aim would be to prevent any misunderstandings about economic policies that could result in increased uncertainty, and thus volatility of the exchange rate, and to increase market transparency.

Box 9.Decision-Making Hierarchy in Reserve Management

This box lists the main elements in a decision-making hierarchy for international reserve management.

Level of Decision: Governor, Board of Directors

  • Defines overall objectives and principles of reserve management.
  • Approves principles of currency distribution.
  • Approves optimal currency distribution, range of permissible deviation.
  • Approves benchmark portfolio durations, permissible range of deviation.
  • Approves principles for assets selection.
  • Approves principles for managing credit exposure and for establishing limits for banks.
  • Sets maximum limit on credit exposure of total reserves.
  • Defines nature of liquidity requirement.
  • Reviews (annually) reserve management performance.

Level of Decision: Investment Committee

  • Defines investment strategy to be pursued within framework determined by board’s decision.
  • Sets operational guidelines for managing currency exposure.
  • Approves principles for determining composition and maintenance of benchmarks.
  • Reviews bank limits and credit exposure regularly (semiannually, quarterly).
  • Approves dealing counterparties.
  • Sets limits for individual bank counterparties, approves increases in limits, approves new bank counterparties.
  • Defines and approves assets categories.
  • Approves custodian agreements and arrangements.
  • Approves other needed contracts and agreements.
  • Evaluates liquidity of assets.
  • Reviews investment performance (monthly).

Level of Decision: Manager, Reserve Management Unit

  • Decides on operational strategy to be followed.
  • Responsible for monitoring and reporting on observance of all risk limits.
  • Approves individual securities within framework of approved asset categories.
  • Responsible for maintaining liquidity of assets.

Level of Decision: Chief Dealer/Dealers

  • Responsible for ensuring that dealing takes place within approved framework and with accepted counterparties.
  • Make individual investment decisions in line with approved investment strategy.
  • Responsible for ensuring that all information needed for settlement of deals is made available to settlement/back office unit.

Foreign Exchange Risk Regulations

In the area of foreign exchange risk regulations, controlling these risks is the primary responsibility of the management of each bank. The management must identify the types and the amounts of unhedged risks it is willing to assume and put in place appropriate procedures for monitoring individual risk exposures and for detecting any deficiencies in compliance with management’s directives. The role of the supervisory authority is to assess the adequacy of the internal procedures set up by banks, while establishing uniform minimum standards to monitor the banks’ risk taking. While banks should be allowed to maintain adequate foreign exchange reserves—otherwise the interbank market may not develop—prudential limits on banks’ foreign exchange positions are intended to contain banks’ risk taking in foreign currencies, not to limit their activities in the interbank market.

To enable the supervisory authority to monitor banks’ risk taking and enforce compliance with the established prudential limits, the IMF has recommended implementing the prudential regulations put forward by the Basle Committee of Banking Supervision. These include reporting arrangements to the central bank and limits on the ratio of the net open position to the bank’s capital base.

Reserve Management

In a number of countries, assistance was provided to help central banks strengthen their reserve management. It is the task of the top management of the central bank to define the overall objectives and principles of reserve management. On the basis of these guidelines, an Investment Committee may be established to define the investment strategy, and the manager of the reserve management unit would decide on the operational investment strategy, to be followed. Box 9 summarizes a model decision-making hierarchy in reserve management for a central bank.

No investment alternative is available to the central bank that would simultaneously negate all types of risks to which it is exposed to (i.e., liquidity risk, credit risk, and market risk). Thus, the central bank has to determine the appropriate trade-offs between the different types of risks, reflecting the central bank’s relative aversion to them. However, as a matter of principle, the IMF staff has advised against investing the international reserves with domestic banks and emphasized that the central bank should not play a lender-of-last-resort role in foreign exchange. Reserves should be invested in marketable government securities or short-term deposit accounts with overseas central banks and, sometimes, the most creditworthy commercial banks.

Concerning the organization of the reserve management function, a clear separation between front office (those who deal) and back office (those who make and authorize settlements on the basis of the deals) is needed. The division would minimize fraudulent collusion to embezzle funds. No transaction type or instrument should be approved for investment purposes unless the back office can handle the settlement and accounting for it.

Appendix. Main Instances of Technical Assistance on Exchange Systems, 1994–97

The table below provides a summary of technical assistance presented by the IMF to its members in the period 1994–97.

Appendix. Main Instances of Technical Assistance on Exchange Systems, 1994–97
CountrySummary of Technical Assistance
AlgeriaFollow-up assistance to implement a comprehensive reform of the foreign exchange system, including a floating rate regime in the context of an interbank market and liberal exchange system. Technical assistance was also provided to strengthen the intervention policy of the central bank. Algeria is using IMF resources.
ArmeniaFollow-up assistance to further develop the foreign exchange interbank market, the capacity of the central bank to intervene in the market, and to coordinate intervention with monetary operations. Interbank trading is expanding while the role of the foreign exchange auctions is decreasing. Assistance in reserve management and internal controls. Armenia is using IMF resources.
AzerbaijanFollow-up assistance to further develop foreign exchange auctions and introduce an interbank foreign exchange market; enhanced coordination of monetary and foreign exchange operations; reserve management; and liberalization of exchange system. Azerbaijan is using IMF resources.
BangladeshVisit of a short-term expert to advise on the establishment of a foreign exchange dealing room; also remaining foreign exchange restrictions were reviewed in view of acceptance of Article VIII on April 11, 1994.
BoliviaDesign of a plan to phase out surrender requirements; review of intervention policy and procedures, including a phasing out of current auction arrangement. Bolivia is using IMF resources.
CambodiaMission and long-term expert to develop a comprehensive reform program to enhance effectiveness of the foreign exchange market, including auctions of foreign exchange, and develop expertise at the central bank.
Cape VerdeAdvice to reform the foreign exchange regime and move toward current account convertibility.
ChinaFollow-up assistance to unify the exchange rate, achieve current account convertibility, develop an interbank foreign exchange market, strengthen payment and settlement systems, and better coordinate monetary and foreign exchange operations. Discussions on the liberalization of the capital account have already started. The exchange rate was unified in January 1994.
CroatiaAssistance on foreign exchange market development, strengthen reserves management, enhance coordination of monetary and exchange policies. Croatia is using IMF resources.
Dominican RepublicReview operations of the foreign exchange market and advise on coordination of intervention with monetary operations.
EthiopiaAssistance in foreign exchange market development (unification of the auction market and official exchange rate; establishment of foreign exchange bureaus; liberalization of restrictions on payments for invisible transactions; reduction of surrender requirement; and establishment of limits to open foreign exchange positions for commercial banks). Ethiopia used IMF resources (the first annual enhanced structural adjustment facility (ESAF) arrangement under a three-year ESAF lapsed in October 1997 without completion of the midterm review).
FijiReview appropriateness of Fiji’s exchange rate arrangement and discuss possible alternatives; assess scope for further easing of capital controls.
Gambia, TheReview foreign exchange market and operations and advise to enhance market liquidity.
GeorgiaFollow-up assistance for coordination of monetary and exchange policies, improve the operations of the foreign exchange auctions, strengthen reserves management. Georgia is using IMF resources.
GuatemalaReview of regulatory framework for foreign exchange operations and implications for supervisory oversight.
GuyanaReview progress in foreign exchange market development; design strategy for intervention in the interbank market; review remaining exchange controls on capital transactions. Guyana is using IMF resources.
HondurasReview foreign exchange market and central bank intervention, including coordination between intervention and monetary operations.
IndiaReview foreign exchange market operations, intervention policy, and regulatory framework for capital account transactions.
Iran, Islamic Republic ofReview reserve management policy in view of enhancing market risk monitoring, strengthen internal controls, and propose guidelines for investments.
KazakhstanFollow-up assistance for interbank foreign exchange market development; enhance intervention policy; coordinate monetary and exchange operations; strengthen reserves management. Kazakhstan is using IMF resources.
KenyaAdvise on coordination of monetary and foreign operations, to increase reliance on indirect monetary policy instruments. Kenya is using IMF resources.
Kyrgyz RepublicFollow-up assistance to further develop interbank foreign exchange market; enhance intervention capacity; coordinate monetary and foreign exchange operations; strengthen reserves management. The capital account is also free of restrictions. The Kyrgyz Republic is using IMF resources.
LatviaReview foreign exchange market and operations, reserves management policy and operations. The capital account is free of restrictions.
LesothoBroad efforts to develop foreign exchange market and enhance reserves management (benchmark portfolio).
LiberiaComprehensive reform of the foreign exchange system, including unification of exchange rate, phasing out exchange controls, developing foreign exchange market, and enhancing intervention policy.
LithuaniaReview foreign exchange system, design exit strategy in view of integration into the European Union. The capital account is free of restrictions.
MadagascarReview interbank foreign exchange market, advise on intervention policy and coordination of monetary and foreign exchange operations.
MalawiFollow-up assistance to develop interbank foreign exchange market, exchange bureaus, review restrictions on current account transactions. Malawi is using IMF resources.
MaldivesReview foreign exchange operations, trading band for authorized dealers, introduce limits on open position, establish dealers’ association, strengthen reserves management, establish dealing room at the central bank.
MaltaReview development of interbank foreign exchange market, widen trading band for authorized dealers, liberalize forward market, establish limits on open positions, adopt code of conduct for foreign exchange market.
MauritaniaFollow-up assistance to further liberalize current account transactions, develop interbank foreign exchange market, introduce exchange bureaus, limit open position for authorized dealers, develop intervention capacity in the market, establish code of conduct for authorized dealers. Mauritania is using IMF resources.
MoldovaFollow-up assistance to develop interbank foreign exchange market, intervention capacity in the market, strengthen reserves management and internal controls. Moldova is using IMF resources.
MongoliaFollow-up assistance to enhance interbank foreign exchange market, intervention capacity in the market, strengthen reserves management, and liberalize current account transactions. Mongolia is using IMF resources.
OmanReview current exchange system with the view of assessing the pros and cons of a peg to a single currency versus a peg to a basket of currencies.
PakistanReview foreign exchange operations in view of designing a strategy to reduce Pakistan’s reliance on short-term capital inflows and enhancing market determination of the exchange rate in the context of a gradual liberalization of exchange controls. Pakistan is using IMF resources.
ParaguayReview of foreign exchange reserves management (enhance risks controls, internal controls including a separation of front office and back office).
PolandReview exchange arrangements, recommendations to the effect of introducing crawling peg arrangement. Also review of restrictions on current account transactions.
RomaniaFollow-up assistance to enhance the foreign interbank market, establish exchange bureaus, enhance coordination of intervention with monetary operations. Romania is using IMF resources.
RussiaFollow-up assistance to enhance the interbank foreign exchange market, and develop intervention in the interbank market. Review of restrictions on current account transactions. Russia is using IMF resources.
RwandaComprehensive reform of foreign exchange system: establish interbank foreign exchange market, develop intervention capacity in the market, establish exchange bureaus, establish limits on open positions, coordinate intervention and monetary operations, and liberalize current account transactions.
São Tomé and PríncipeShort-term expert assisted the authorities in improving monitoring and supervision of authorized dealers and formulating policies and regulations to strengthen the foreign exchange market and unify the exchange rate.
SloveniaBroad effort to strengthen foreign exchange system with the view of developing the interbank foreign exchange market, developing intervention policy supportive of market development.
Sri LankaReview of strategy for achieving capital account convertibility, including enhancing coordination of monetary and exchange policies.
SudanComprehensive reform of foreign exchange system and development of a strategy to unify the exchange rate, reform intervention policy, develop limits to open positions for authorized dealers, and liberalize current account.
TajikistanFollow-up assistance to improve operations of foreign exchange auction, and enhance reserve management.
TanzaniaReview foreign exchange market reform, reserve management, and payment systems issues, including clarification of the role of exchange bureaus, and strengthening intervention policy in the interbank market. Tanzania is using IMF resources.
TurkmenistanFollow-up assistance to further liberalize current account transactions, unify the exchange rate, improve the operations of auction mechanism, reduce surrender requirements, centralize reserve management and strengthen internal controls at the central bank, and establish limits on open position for authorized dealers.
UgandaFollow-up assistance to design a strategy for moving to full convertibilty. Uganda is using IMF resources
UkraineFollow-up assistance to develop interbank foreign exchange market; remove remaining restrictions on current account transactions. Ukraine is using IMF resources
UzbekistanFollow-up assistance to amend current regulations with a view to liberalizing the current exchange regime, unifying the exchange rate, and paving the way for acceptance of Article VIII. Also strengthen reserve management, including centralization of international reserves at the central bank.
VietnamComprehensive reform of foreign exchange system to establish an interbank foreign exchange market within the context of managed floating, liberalize current account transactions in view of acceptance of Article VIII, and enhance reserves management at the central bank. Vietnam is using IMF resources.
West Bank and GazaDevelop the capacity of the Monetary Authority to implement a sound reserves management policy.
Yemen, Republic ofComprehensive reform of foreign exchange system to establish an interbank foreign exchange market, develop intervention capacity in the market, establish exchange bureaus, establish limits on open positions by authorized dealers, coordinate intervention and monetary operations, and liberalize current account transactions. Yemen is using IMF resources.
ZambiaReview foreign exchange system with a view to strengthening the interbank foreign exchange market and intervention capacity in the market, and remove multiple currency practices. Zambia is using IMF resources.

Note: This section was prepared mainly by Bernard Laurens.


It is noteworthy that among the countries of the Baltics, Russia, and the other countries of the former Soviet Union, only five, Azerbaijan, Belarus, Tajikistan, Turkmenistan, and Uzbekistan, have not yet accepted the obligations of Article VIII, Sections 2, 3, and 4.


SWIFT is a nonprofit, cooperative organization that facilitates the exchange of payment messages between financial institutions worldwide; it is not a payment system.

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