The foreign exchange market is the world’s largest financial market by virtually any measure. It is the only truly global financial market: currencies are traded in financial centers around the world, connected by communications systems that allow nearly instantaneous transmission of price information and trade instructions. The market has grown rapidly over the last decade since cross-border capital flows have been liberalized and the regulatory constraints on institutional investments relaxed. The increased liquidity of securities markets, particularly in the industrial countries, which has resulted from privatization and from larger and more efficient markets for government debt securities, has also increased the range of foreign assets available to investors and made foreign investment easier. This expansion of cross-border capital flows has been actively promoted by governments seeking broader investor bases for their own debt and for securities issued by domestic firms. Improvements in trading and settlement practices and in technology have increased the liquidity of secondary markets for foreign exchange instruments and allowed participating financial institutions to handle larger volumes of transactions safely.
Trading in the foreign exchange markets takes place for a variety of motives. This annex discusses three aspects of foreign exchange transactions: first, the arbitrage that links the forward and spot markets; next, the use of foreign exchange markets as “synthetic money markets”; and then the use of foreign exchange instruments to hedge foreign currency risk, which covers first the basic hedging techniques typically used by individuals and investors and then the dynamic hedging strategies typically used by banks to hedge exposure associated with issuing currency options. The consequences of these various strategies for foreign exchange market behavior are also examined.
The relaxation of capital and exchange controls and the acceleration of financial innovation have clearly encouraged competition among financial institutions and improved efficiency in financial services worldwide. Increased competition has also presented financial institutions with new risks-including those associated with losses on open positions and with losses resulting from settlement failures. These risks are increased by the speed with which prices change, by the delays inherent in covering exposures and settling trades, and by the extension of credit to counterparties with non-zero bankruptcy probabilities.
The increasing sophistication of foreign exchange markets offers investors a wide range of liquid assets. In normal times, this enables participants to manage their risks and lower their costs of transacting, and is therefore conducive to a more efficient allocation of funds in the world economy. But these same features have also expanded the range of opportunities available to speculators who believe that a currency’s sudden depreciation is impending, and have increased the private sector’s ability to marshall large resources on very short notice. Of course, during a foreign exchange crisis, when most market participants become convinced—rightly or wrongly—that a large change in the exchange rate could well be in the offing, the line between speculation and hedging becomes rather blurred.
A system of fixed exchange rates, or a system of exchange rate bands like the ERM, is usually maintained through the central bank’s foreign exchange market intervention using its foreign exchange reserves. Such regimes are subject to periodic speculative attacks, however: speculators take a position against a currency if they believe that the exchange rate is likely to devalue from its current parity soon enough to compensate them for the costs of speculation; high capital mobility has lowered these costs by greatly expanding the speculators’ range of alternative means of taking positions in the foreign exchange market.1
This annex focuses on the financial aspects of the currency crisis and complements the more detailed discussion of macroeconomic developments presented elsewhere.1 The first section describes the pattern of cross-border capital flows into and out of some of the countries most affected by the recent currency crisis, elaborating on the discussion of convergence plays in Section III of the paper. The next section describes the methods by which the speculative attacks against some of the weaker currencies were launched and the tools used by central banks to try to defend their exchange rate parities. The role of the commercial banks in providing credit to those that took positions against the weak currencies is described, illustrating the mechanics of speculative attacks characterized in Annex IV. The final section examines activity in the financial markets during the crisis.
Beginning in the late 1970s, and extending to the present, a large number of industrial countries initiated a process of financial deregulation and liberalization. The gains from this have been substantial, including increased access to credit markets by households and enterprises, higher rates of remuneration on deposits, and a more market-determined allocation of resources. Major economic sectors have been affected by this process and the responses of these sectors have contributed to important economic developments in the 1980s and early 1990s.
Adams, Charles, Fenton, Paul R., and Larsen Flemming
The deterioration in labor market performance in most of the industrial countries since the early 1970s remains one of the most serious economic problems confronting policymakers. Even though a broad range of measures has been implemented to tackle this problem, unemployment has continued to rise in a large number of countries, particularly in Europe.
Recent developments in the sphere of international economic policy coordination produced an agreement at the May 1986 Tokyo Summit that the major countries should focus on a set of economic indicators as a means of strengthening the degree of cooperation in macroeconomic policymaking already in existence. The Fund was given the formal responsibility for carrying this suggestion forward. In the subsequent development of this idea (see. in particular, Crockett and Goldstein (1987)), emphasis has been given to a taxonomy of indicators of current economic developments, distinguishing those which are signals of policy posture from those which measure intermediate variables, and which in turn are distinguished from those measuring economic performance. Indicators may be used in a number of ways. On a rising scale of increasing international interdependence, they may provide individual countries with a checklist of variables against which to monitor the short-run progress of their economies; they may provide information on the medium-run sustainability of policies; and they may signal in a formal way the need for multilateral discussion of policies.