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COSTA RICAN EXCHANGE-MARKET

By Gabriel Leandro, MBA
Economist

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Along time ago, men performed transactions through barter, but nowadays money is involved in almost every negotiation carried out. This situation does not represent any problem when residents of the same country are involved in such negotiations because they share the same currency so they accept it as a payment method.

However, each sovereign nation has the right to have its own currency and manage it. So what happen when dealers come from diverse countries where different currencies are used?

For example, the income of a Costa Rican importer that buys cars from a North American company is in colones but the foreign company demands the payment in dollars. So the national businessman would have to acquire the North American currency to perform the transaction, in other words he would have to resort to the currency market also known as foreign-exchange-market.

The currency market is where different foreign currencies are traded. This market is constituted by a great variety of dealers all around the world, who sell and buy foreign currencies, thus making possible any international transaction.

This market, as Riehl (1987) sates, is not a “physical location” it is constituted by a variety of dealers, buyers and sellers of currencies, who are communicated by phone, networks and other technological means. According to Calvet (1995) in this market around nine hundred thousand millions of dollars are traded daily. The main trading centers are in London, New York, and Tokyo.

The currency market represents a mechanism that makes possible the purchase of currencies in an impersonal and efficient way. This market favors international trade because it transfers purchasing power from one currency to another, in this way dealers are able to sell and buy or carry out any kind of business with brokers of other countries.

In this way, Costa Rican tourists in other countries as well as foreign tourists in Costa Rica, exporters, importers, investors and also people who need to send money to other country, resort to this market.

Role of the Exchange Market

The exchange market plays an important role in the appropriate performance of dealers when carrying out any transaction and also in the development of the economy in general.

In this sense, the main role is to be a mechanism by which dealers can have purchasing power in a foreign currency. In other words, dealers have the possibility to make foreign currency payments. Such a role allows that importers, like the one in the previous example, be able to buy products manufactured in other countries and sold in different currencies.

In this way the importance of this market to external economic relations can be perceived. As Spencer (1976) says regarding to currency markets: without them international trade would be limited to barter.

The currency market also connects currency buyers and sellers, which allow them to perform transactions quickly and efficiently.

On the other hand, the currency market also provides credit; a great number of the international transactions are performed making use of the credit facilities that the currency market offers. Products or merchandise requires time to be transferred from one country to another that’s why some mechanisms like letters of credit and bills of exchange, among others have been implemented.

Structure and Organization of the Exchange Market

The currency market is constituted by a variety of dealers but who are they? What’s their role? Some experts agree that these dealers may be classified into the following categories:

  • Non-financial companies (exporters, importers, etc) or tourists and immigrants.
  • Commercial Banks.
  • Central Banks.
  • Some others like, Chacholiades, also consider the exchange brokers as a category.

In this way, businessmen, tourists and the rest are the end currency buyers and sellers. Commonly, these dealers do not trade with each other and not even get into touch but they sell and buy currencies, as the case may be, to commercial banks, primarily. These commercial banks are the main agents of the currency market.

In this way every commercial bank has a number of currencies to trade. In addition, banks have accounts in other banks from different countries to perform the transactions of their customers.

In the case of the Costa Rican importer of the last example, this businessman do not send the money to the North American company but makes a deposit in a Costa Rican bank or buys a banker's bill for the sum of the transaction. So, the bank is the one that credits the money to the account of the North American company in a North American bank. Actually in International trade, money deliveries are unusual. There are some documents considered as money substitutes that people use for such transactions.

Commercial banks play a very important role as intermediaries between sellers and buyers of foreign currencies, however; it is possible that a bank accumulates more currencies than the ones it sells or it can face a huge demand that its reserves cannot satisfy. In such a situation is when exchange brokers have an important function in the market because banks do not trade with each other so exchange brokers are the ones who equilibrate such imbalances, in this way they function as commercial banks with regards to the end buyers and sellers of currencies.

Central banks also participate in the currency market. On these banks depends the exchange rate and exchange rate system a whole.

Exchange Rates

When one currency is converted into another an exchange rate is applied. In other words, it is the price of one country's currency expressed in another country's currency. For example if the exchange rate of Costa Rican colones against US dollars is ¢191 per dollar, this means that 1 American Dollar can be exchanged for ¢191. So, if you buy US$5 you have to pay ¢955 (in other words 5 x ¢191). On the other hand the US dollar exchange rate against Costa Rican colones would be reciprocal to the last relationship colon/USD, US$0.0052 per colon.

Exchange Rate Systems

There are many methods to set exchanges rates in an economy. Throughout time these systems have been evolving, the most popular are:

  • Fixed Exchange Rate System or Pegged Exchange Rate
  • Pegged but adjustable exchange rate
  • Floating Exchange Rate System

Fixed Exchange Rate System

In a fixed exchange rate system the central bank sets the exchange rate according to its policies and criteria. In this way the monetary authority has the right to devaluate and revaluate the currency depending on the appreciating or depreciating value of such currency against a standard that can be another currency or the gold standard like in the past. The gold standard system prevailed for many years and throughout the history it had many different manifestations.

The gold standard prevailed until the outbreak of World War I. The gold Standard system was a monetary system that maintained a fixed exchange rate and imbalances were equilibrated through gold imports and exports. Bills were exchangeable for gold. Central banks exchanged currency for gold and vice versa. In addition international trade of gold required freedom, as a result gold exports and imports were free.

This system had a variety of weaknesses and limitations, first it brought about inflation and deflation problems due to variations in gold quantity that produced increases and decreases in the money supply of nations. In addition the gold standard allowed big changes in economic activity. After World War II countries adopted a new system, the pegged but adjustable exchange rate.

Pegged but adjustable exchange rate

In 1944 the Breton Woods conference was held, to come up with an international monetary system to assure stability in exchange rates and international cooperation. In this way the International Monetary Fund (IMF) was created and the Articles of Agreement of the International Monetary Fund obligated countries to establish a parity of their national currencies in terms of gold or US dollar. Nations had to maintain parity in terms of the US dollar or gold and preserve or defend it by selling or buying dollars or gold. They could adjust the exchange rate to correct disequilibrium, but IMF had to authorize such fluctuations. In addition the IFM was willing to cooperate by credits to stabilize the exchange rate.

Throughout time and mainly since 1960 Bretton Woods System entered a period of crisis because the quantity of gold of USA had decreased in relation to the liabilities of the country. In addition the disequilibrium in the balance of payments of USA increased every year. All this brought about doubts and distrust in the system giving way to speculations.

Authorities of IMF realized the urgency to modify the system and to stabilize it. For this purpose, the first amendment to the Articles of Agreement was introduced in July 1969. It reflected the creation of a new reserve asset called Special Drawing Right (SDR), independent and complementary to gold production and to monetary issue.

In spite of all the efforts distrust was not eradicated. In 1971 the obligation of Federal Reserve to exchange dollars for gold is suspended, and countries looked for new system. With The Second Amendment countries had the right to choose the exchange rate system that they considered convenient for them. Most of the countries chose a floating exchange rate.

Floating Exchange Rate

A floating exchange rate is determined by foreign exchange market through supply and demand. The central bank neither sets the exchange rate nor intervenes in any way nor manipulates any variable to achieve any parity.

In this system, the free game of the market, the role of supply and demand and the floating of currency determine the exchange rate. Appreciation and depreciation- of exchange rate correct the disequilibrium or imbalances.

Thus, for example, the colon depreciates against USD when due to market reasons a dollar is worth more colones. On the other hand, the colon appreciates against USA currency when a dollar is worth fewer colones.

As a matter of fact, Countries develop what is called dirty float, which is actually a system where currencies float but not completely free because monetary authorities can intervene when they wish, with the purpose of keeping stability and correcting disequilibrium. However, central banks intervene in the market through procedures that modify the quantity of offered and demanded currencies but not by setting parities.

Aspects of the Exchange Market

The Exchange market is not a physical location, as previously mentioned it is an international market where the dealers are communicated constantly through technological means.

The main trading centers of the currency market are in London, New York, and Tokyo, all of them operates 24 hours a day. Agents from these centers and from all around the world take advantage of sophisticated technological tools to have constant communication.

Arbitrage

Since it is an international market, it gives way to arbitrage. Many times a currency in terms of another is more expensive in one place than in another. So dealers can buy a currency in a country where it is cheaper and sell that currency in another country where it is more expensive to get profits, that is called arbitrage. It also can be defined as the simultaneous buying and selling of foreign currency to get profits (Chacholiades, 1992).

There are two types of arbitrage opportunities, first when there is currency pricing discrepancies between markets and also when there are inconsistent exchange rates.

Types of arbitrage

As mentioned before, there are two types of arbitrage, two-point and three-point arbitrage. The two-point arbitrage consists in exchange rates discrepancies in two different markets. For example, let the exchange rate be 1USD= ¢190 in New York and 1USD= ¢192 in San Jose, so arbitrageurs would attempt to exploit, and hence profit from, the differential (¢2 per dollar) by selling colones for dollars in New York and reselling the dollars in Costa Rica. However, soon prices will be equal.

On the other hand, three-point arbitrage is when exchange rates among different currencies may be mutually inconsistent even when all the prices are the same in all the markets there is arbitrage. For example, in San Jose as well as in New York 1USD = ¢190 or 1USD = 2 Deutsche Marks (DM) and 1DM = ¢100, then to buy 1USD for 2DM, to sell 2DM for ¢100 each and get ¢200 to buy dollar again for ¢190 and get a profit of ¢10.

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The Costa Rican Currency Market

Below, a brief explanation of the evolution of the Costa Rican exchange rate system prior the incorporation of Costa Rica in the International Monetary Fund until now, is provided. The main bibliographical sources were Picado (1993) y Peralta (1994).

Costa Rican Exchange Rate Systems

Even prior the incorporation of Costa Rica in the International Monetary Fund, the country was facing a difficult situation regarding its trade balance which got complicated in 1946 leading authorities to handle the situation to stabilize the economy and to reduce currency market pressures.
At that time, gold standard was prevalent, when countries had to maintain a fixed exchange rate and the International Monetary Fund was created in 1945 whose goal was to monitor the fixed exchanged rate of the members, among them was Costa Rica.

During the years when the gold standard was prevalent, the country had relative stability because even when the exchange rates did not fluctuate drastically authorities made big efforts to reach such stability. Since 1947 the country’s authorities resorted to advance deposits, currency rationing, overcharges in addition, a multiple exchange rate system was maintained since 1967 until 1969.

There were many difficult times, but through some mechanisms like spending in only essential goods like medicines and oil, etc. and even through the modification of the Organic Law of Central Bank of Costa Rica, the situation was stable. In spite of the strong fluctuations in international markets during that time, in this country the main fluctuation took place in 1974 when the exchange rate fluctuated from ¢6, 65 to ¢8, 54 and also in 1979 when the exchange rate was ¢8, 57 and ¢8, 60 per dollar, the ask and bid respectively.

However to maintain this exchange rate and to assure convertibility, the central bank faced big losses of its international monetary reserves which was compensated with the foreign debt and a number of restrictions regarding currency acquisition and mainly non-essential goods imports.

As a result f such situation, In 1980 some significant changes in the exchange rate system took place. Costa Rica adopted a floating exchange rate system so that market determined the exchange rate. In this sense Picado (1993) stated the following: there is no doubt that fluctuation of the colon exchange rate against the US dollar since December 26 in 1980 determined the beginning of an important change in the Costa Rican exchange rate system.

There were two different exchange rates:

  • The Official Exchange Rate, that was ¢8,60 and remained stable until December 10, 1981 when the Devaluation Law changed it to ¢20,00 per dollar.
  • The floating Exchange Rate that was determined by the market. This was the exchange rate involved in most of the transactions. The central bank decided the percentage and also decided in what economic activities one or another exchange rate was involved.
  • Then the interbank exchange rate was introduced but later unified with the floating exchange rate system.

During that time, this country faced a strong crisis characterized by inflation and devaluation, as a result of a variety of factors, at great extent external. There were big problems regarding the trade balance. The price of oil increased significantly while the prize of coffee decreased. The relations with the International Monetary fund were suspended as well as with some international creditors, which represented one of the main causes of the crisis.

In 1982 some reforms to the Organic Law of Central Bank of Costa Rica were implemented. The most important one was to restrict dollar negotiations to the central bank, to commercial banks and to other organizations under the supervision of the central bank. This reform brought about the eradication of exchange offices and who negotiated dollars without authorization were severely punished.

When all this mechanisms and reforms previously explained and some others were implemented and put into practice, Costa Rican currency market enjoyed a better atmosphere.

System of Mini-devaluations

After the situation faced during the last years, the government implemented a monetary stabilization program and a Stand-by Agreement with the International Monetary Fund to control foreign debt, public expenditure, net international monetary reserves and to reunify the exchange rate only prevailing the official exchange rate of ¢20,30 and ¢20,00, bid and ask respectively and the Floating Interbank Exchange Rate , which was involved in most of the transactions.

Since 1984 the central bank adopted a new exchange policy, the system of mini-devaluations. This system consisted in small devaluations of the colon against dollar to adjust the exchange rate to different situations. Mainly, the following aspects were taken into consideration:

  • The Difference between domestic inflation and foreign inflation.
  • Competitiveness of domestic exports in foreign markets, which encourages exports.
  • Capital Account Behavior.
  • Balance of Payments Results.
  • Regulation for the use of currency.
  • Currency supply and demand in the domestic currency market.

It was intended to maintain the exchange rate close to equilibrium, so that it was adjusted to the economic situations. These mechanisms allowed agents to make their decisions easily but the negative aspect was that devaluations were subjected to the criteria of the central bank, so the real conditions of the market and economy in general were not reflected.

Dirty Float System

In March, 1992 the central bank decided to put into practice a system of floating currency, as part of the modernization process, in this way the market determined the equilibrium exchange rate that had to prevail in an economy (I recommend to read Guardia, 1993; Di Luca, 1994 where information regarding this topic is provided).

This foreign exchange liberalization brought about many doubts because there were speculations regarding the behaviour of the exchange rate and in fact this variable fluctuated during the days following to liberalization. Thus, for example in March 20, 1992 there was a decrease of ¢0.82 along with many other decreases, in that period the currency tended to revaluation.

For many this happened as a result of the drastic devaluation of the domestic currency (colon). Some believed that this was a market mechanism to set the equilibrium exchange rate of the domestic currency against the US dollar. All this situation brought about uncertainty in the economic environment even some people feared the possibility that Costa Rica faced a similar situation to the one suffered during the early 80’s. In addition, exporters felt threaten because revaluation affected them.

Before revaluation got close to 12%, little by little the exchange rate became stable and then the currency began to depreciate because in June the dollar began to appreciate even when some believed that the colon was overvalued.

In spite of these situations, according to Zuniga (1994) there were some factors that improved the performance of this system such as the fiscal and monetary policies, the increase of tourist activity, the depreciation of the real exchange rate, a significant reserve accumulation of the central bank and the difference between domestic inflation and foreign inflation that along with other factors brought about capital flows to the country.

In the Dirty Float System, the central bank is not the one that sets the exchange rate but the market. The market determines the equilibrium exchange rate. The central bank will intervene only when strong short-term fluctuations take place and mainly if such fluctuations are result of speculations.

One of the goals of this system was to introduce important changes because there were reforms to the prevailing regulations and some other legal reforms.

The reforms that affected the Reglamento para las Operaciones Cambiarias were basically the decentralization of the buying and selling of dollars for common transactions in the central bank, and at the same time capital restrictions were suspended. All these resulted in the merger of and black market with the free market that allowed that any person to buy or sell currencies at the price quoted in the currency market.

There were also legal reforms. This new system included a number of changes in the sense of assuring free currency convertibility for all people and under equal conditions. In other words, not only the National Banking System was able to do so but also all the financial organizations had the right of free currency convertibility. In addition all people were able to buy and sell currencies for licit purposes, without having to resort to illegal activities, and at the same time there was freedom to deal with freeing currencies. On the other hand the gold parity of the colon was suspended and it was not necessary to recourse to the Legislative Assembly to set the official exchange rate because the Central Bank was able to set it or to set the price determined by the market.

In addition to the reforms previously mentioned, there were other attempts to encourage the participation of the private banking sector by providing them opportunity to take risks and to grant loans in foreign currency.

The fact that the Central bank was not the one in charge of setting the exchange rate, it did not mean that it would not play an important role in the functioning of the currency market. It did intervene but not like in the previous regime.

Now, the intervention of the central bank was totally different, it was able to regulate the functioning of the market and to buy and sell dollars in situations where strong fluctuation or fluctuation result of speculations took place and also it could increase or decrease the supply and demand of colones as it considered it convenient.

Regarding the regulations, the organizations authorized by the law, the central bank and the regulation could participate in the market. According to the regulation, public banks as well as private, non-bank financial institutions regulated by the Auditor General of Financial Entities could participate actively in the market. In addition the Board of Directors of the Central Bank authorized other institutions such stock exchange seats and exchange offices.

In this sense, the duty of the Central Bank as well as the Auditor General of Financial Entities and The National Securities Commission was not only to ensure a greater participation but also to supervise and control the participant organizations to assure stability, security and solvency of the market and its participant agents.

Current Regime

According to the Organic Law of Central Bank, approved at the end of the year 1995, the determination of the exchange regime corresponds to the Board of Directors of the Central Bank and the exchange rate can be set by the central bank, which has the opportunity to participle as stated by this law in the articles 28 and 85, or the exchange rate can be determine by the market as well.

In this sense the central bank, recently, has readopted the mini-devaluations policy, devaluating the currency daily according its criteria regarding the evolution of the market and the different factors that affected it. In addition, there is no regulation for currency acquisition like in the previous law and people have access to currency convertibility (article 82). Nowadays the colon depreciates against the dollar between 10 and 14 cents daily.

Some rules were implemented, according to the article 86 of the Organic Law, concerning who may deal currencies in the exchange market, and how these negotiations should be conducted. Articles 92 and 93, respectively, stated the corresponding sanction and punishments for those who violate this law.

Mercado Organizado de Negociación Electrónica de Divisas (MONED)

Recently, the Bolsa Nacional de Valores (Costa Rican Stock Exchange or BNV) implemented the MONED which actually is an electronic market, where computer systems are linked to each other via modem. In this way, every user has access to information concerning supply and demand and to other data that is displayed in the screen as well and he or she can trade making use of this system.

MONED shows data regarding currency supply and demand at a specific time and also the prices without showing the entities involved allowing users to trade from their computer impersonally. Information and data concerning transactions carried out during the day and statistics relative to such transactions like average prices, the last transaction carried out, etc.

In this way, in the MONED every participant is able to offer or acquire, as well, currencies at the price more convenient to them because in this system the prices are set by the supply and demand.

This is a very efficient system and to use it the only requirements are: to request the authorization of the Central Bank, to have the appropriate computer equipment, a telephone line exclusively for this purpose and to have current accounts in colones and dollars in the Central Bank. In addition, other requirements are: to pay the affiliation fees and a commission of 0.05% to the Bolsa Nacional de Valores per transaction, payable in colones.

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