Gabriel Leandro, MBA
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
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
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:
companies (exporters, importers, etc) or tourists
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.
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
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
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
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
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.
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.
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.
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
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
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
The Costa Rican
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).
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
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
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
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.
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
The Difference between domestic inflation and foreign
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
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.
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.
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
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
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
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
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.
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.
de Negociación Electrónica de Divisas
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,
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