Al-Ahram Weekly Online   24 - 30 July 2003
Issue No. 648
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A brighter forex future

The way out of the current foreign exchange crisis is a futures market, writes Hossam Omar*


Click to view caption
Average exchange rate for main currencies
The government's decision to float the Egyptian pound so as to minimise the grey market and eliminate speculative activities has resulted in an upward trend for dollar rates and an unprecedented increase in the prices of imported inputs, especially in the food industry. Moreover, illicit currency trading continues to exist, if with a smaller black market differential, while speculators still do a brisk business. Increasingly, Egyptian savers are resorting to the dollar as a reliable hard currency, as evidenced by the fact that US dollar deposits in Egyptian banks amount to almost LE20 billion.

The way out of this vicious circle, in my opinion, is to allow futures contracts on the US dollar to be traded in a futures market. Before going into the pros and cons of the suggested market, it is essential at this point to break down the technical components of the terms "futures contracts on the US dollar" into more comprehensible and less technical terms. This contract is an agreement to buy or sell US dollars in the future, but the exchange rate is stipulated at the initial date of the contract. This contract is simply a position in the futures market and is cancelled by taking the opposite position without actually delivering the US dollars. At the date of this cancellation the trader stands to gain or lose, as the case may be, by the difference between the exchange rate fixed at the initial date of the futures contract and the prevailing market exchange rate.

To achieve the economic goals intended by launching these contracts, they should be traded on a facility or an exchange, usually termed simply a "market".

The advantages arising from trading these contracts on an exchange is that they provide a legal economic mechanism for importers and traders -- who constantly have US dollar obligations to import consumer goods, capital goods and raw materials required for their business -- to reduce the economic deterrent of unpredictability.

Another advantage from establishing and regulating this market is that it provides legal accessibility to dollars for a broad range of importers and traders. Not only businessmen with enormous US dollar obligations or highly sophisticated enterprises benefit from this market, but also small and medium- scale enterprises may take positions in this market to shift their risks and hedge their actual business arrangements quoted in US dollars.

Moreover, a regulated futures market and a traded US dollar contract will provide, for the first time, a legal and acceptable mechanism for speculators to do business. A speculator who does not have a US dollar obligation in the spot market (i.e who is not a trader or an importer), but wishes to engage in profitable speculation on the exchange rate may use the futures market in return for a limited amount of margin paid to the futures market regulator to cover any losses the speculator may assume.

These advantages affect the performance of the Egyptian economy in several dimensions.

A successful futures market will contribute positively to price stability. Prices of both imported goods and domestically-produced goods with imported components will no longer fluctuate substantially. Traders and importers will be able to set prices based on a stable and a previously agreed upon cost due to the prior determination of the exchange rate provided for by the futures contracts.

Futures markets are known to help maintain stability in the foreign exchange market. Since speculators will have another mechanism to speculate on exchange rates, the excess demand on the US dollar will diminish and the US dollar reserves will be preserved. On top of this, losses realised by speculators will be limited to their margins paid to the futures markets at the initiation of their speculative activities, meaning that the losses will not be actually funded by the delivery of US dollars.

If the practice succeeds, this could provide a model for introducing and launching other futures contracts on other commodities, such as the Euro or cotton. This could provide a mechanism for traders to hedge their risks, minimising price fluctuation and hence enhancing economic stability.

However, a futures market is no free lunch, as it bears associated costs, risks and disadvantages. Most problematically, establishing and running a futures market requires a team of knowledgeable regulators well aware of the system and its pitfalls.

Secondly, this market requires also the presence of highly sophisticated main players such as banks and large financial institutions that are willing to take high risks and use their financial capabilities to sustain the market through any crisis.

Thirdly, the market also requires the establishment of a monitoring body comprised of well-trained and highly- educated financial analysts and economists. This regulatory instrument would be able to assess price quotations and decide if such prices represent the actual forces of supply and demand of the spot market and economy at large, or if they indicate the presence of illicit price manipulation. Such a body must also set, monitor, and update margin requirements as well to compensate losses realised by dealers in the market.

Finally, establishing this market requires a campaign to educate businessmen, traders and importers to develop their understanding of the market and the benefits realised from using its mechanism correctly. This market requires full cooperation between governmental agencies such as the Capital Market Authority, the Central Bank of Egypt and the Ministry of Foreign Trade, on one hand, and banks, major financial institutions, the stock exchange and large corporations doing import-related business in Egypt, on the other. There is also a key role to be played by the Ministry of Communications, as this market involves the use of highly sophisticated communications technology.

The cooperation of these players may result in the formation of a commission to investigate the feasibility of a futures market, later selecting experts to regulate and monitor the market, and finally inviting the previously mentioned sponsors to raise funds to establish the host exchange.

* The writer is a securities lawyer and researcher.

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