At the Time of the Article VIII Conssultation with, the United Kingdom in the middle of 1966, there was more pessimism than there had been the year before about the United Kingdom’s competitive position. The balance of payments position had not become strong, yet there was not much room in the economy for a release of resources from the domestic sector to the external sector, and costs of production were increasing.
In July 1966, after sterling began to experience pressure in the exchange markets, the U.K. authorities took a number of emergency measures. In the course of the next year the situation improved greatly. Not only was the large speculative capital outflow of the previous year reversed, but the basic balance of payments position was also strengthened. Late in 1966 there was a distinct improvement in the trade balance and a resulting renewed strength of sterling in the world’s financial markets. The outflow of private short-term capital was halted. During the first part of 1967 the United Kingdom’s external accounts even benefited from inflows of short-term capital. By April 1967 the U.K. authorities had repaid all short-term indebtedness to other central banks, and in May they repurchased almost one half of the 1964 drawing from the Fund, six months ahead of schedule.
Prelude to Devaluation
In the second quarter of 1967, however, difficulties did begin to set in. The expected acceleration in the pace of domestic economic activity was not taking place: unemployment was continuing to grow and had reached its highest point since the end of World War II. Likewise, the anticipated improvement in the external trade position was not materializing: imports were high and rising and exports remained sluggish. Consequently, confidence in sterling in world markets was again weakened and the direction of short-term capital flows was once more reversed.
Important developments outside the United Kingdom added to the pressure on sterling in exchange markets. While the United Kingdom was lowering its short-term interest rates to stimulate employment, short-term interest rates in the United States and other financial centers were being raised. The enlarged differential in interest rates stimulated outflows of capital from the United Kingdom. In fact, the main counterpart of capital inflow to the United States in 1967 was a substantial outflow from the United Kingdom. Furthermore, in May and June 1967 the U.K. application for membership in the eec was rejected, arousing more speculation about the immediate and longer-run prospects for sterling in the world economy. The six-day war in the Middle East in June 1967 also adversely affected the outlook for U.K. trade, owing to the closure of the Suez Canal for an indefinite period. The outflow of funds from London accelerated. There were large and growing losses of external reserves, and the resources that the United Kingdom had received from the other central banks and monetary authorities to help support sterling were being used up.
The management and staff of the Fund were closely in touch with the U.K. authorities and were very much aware that these circumstances could precipitate devaluation. Indeed, as has been noted in Chapter 18, the U.K. authorities, during the 1967 Annual Meeting in Rio de Janeiro, alerted Mr. Schweitzer to the seriousness of the United Kingdom’s financial troubles. The staff had already begun to work on calculations of a magnitude of a sterling devaluation and the possible effects on the trade balances of other countries. The previous change in the rate for sterling, a devaluation of 30.5 per cent in September 1949, had been followed immediately by devaluations of the currencies of nearly all sterling area members, of most European countries, and of many other countries.1 Because of the importance of the United Kingdom in the world economy, because of the intense competition in world markets that had developed by the 1960s, and because sterling was a reserve currency, monetary officials, including those in the Fund, were concerned that a devaluation of sterling might again touch off devaluations of other currencies. And this concern in turn made the U.K. authorities most reluctant to consider devaluation.
In September and October 1967 the U.K. trade deficit widened ominously. With the prolongation of a dock strike, expectations concerning exports sagged, and it appeared that the deficit would continue into 1968. Confidence in sterling ebbed further.
As we have seen in Chapter 18, there were intensive discussions early in November between the Fund management and U.K. officials, and on November 17 the Fund was informed of the United Kingdom’s decision to devalue the pound and to request a stand-by arrangement.
Notification to Fund
The message from the Chancellor of the Exchequer that Mr. Maude (United Kingdom) transmitted to the Managing Director on November 17, 1967 sought the Fund’s formal concurrence in a change in the par value of the pound sterling. The message stated that the U.K. Government proposed that, with effect from 4:30 p.m., Washington time, on Saturday, November 18, the sterling exchange rate should be altered from 280.000 U.S. cents per pound sterling to 240.000 U.S. cents per pound sterling, a devaluation of 14.3 per cent in the dollar price of sterling.
The Chancellor of the Exchequer explained that the devaluation was necessary to correct a fundamental disequilibrium in the United Kingdom’s balance of payments. The persistent deficit, complicated by the outflows of capital in 1967, had resulted in extensive borrowing abroad and had weakened the United Kingdom’s reserve position. A point had now been reached beyond which it would be irresponsible for the U.K. authorities to attempt to support the existing rate of exchange by the use of further short-term credits.
The U.K. Government, he continued, had taken all possible steps other than devaluation to restore balance of payments equilibrium. There had been long-term policies to increase productivity throughout the economy and to reform industrial structures and attitudes. Stern measures had reduced domestic demand to such a point that economic growth had been at a subnormal rate since 1964, and abnormally large excess capacity in the economy had developed. Severe price and incomes policies had been applied. Military expenditures abroad had been cut. Restrictions on tourist expenditure and overseas investment had been imposed. These steps had reduced the deficit on current and long-term capital account. But a hoped-for surplus had not materialized.
The failure of the balance of payments to move into surplus despite the low level of domestic economic activity and the restrictions in force, in the U.K. authorities’ view, revealed that the balance of payments was in fundamental disequilibrium. Hence, a devaluation was necessary. To delay it any longer would run the risk of having to devalue by a larger amount later, and that in turn might cause a major dislocation in the international monetary system.
The degree of devaluation proposed was, in the opinion of the U.K. authorities, sufficient to establish a strong pound sterling and to enable the United Kingdom to generate a much needed balance of payments surplus. It was not large enough, however, to disrupt world trade and payments or to require changes in the parities of other major currencies. Finally, the message spelled out that additional measures, including severe credit restraints, curtailment of government expenditure, continuation of the price and incomes policies, tightening of hire-purchase restrictions, and increases in taxation in the next budget, would accompany the devaluation.
The Fund’s Deliberations
Behind the Scenes
A change in the par value of a major reserve currency had far-reaching repercussions on the work of the staff and of the Executive Directors that were little known outside the closely knit financial circles of the world. Communications via telex, cable, and telephone took place between the Managing Director, Executive Directors, and staff in Washington and monetary officials in member countries all over the globe. Inquiries were made as to what action for its own currency each member intended to take in the light of the change proposed for this major reserve currency. Staff papers were then prepared, usually within a matter of hours, analyzing each proposed par value change, including its justification and adequacy. In order to take decisions while the exchange markets were closed, the Executive Directors met in emergency sessions, often late at night or on weekends. All these activities had of course to take place in the strictest possible secrecy, in order to avoid the speculation in exchange markets that could be extremely costly for a member’s exchange reserves. Then, once decisions had been taken by the Executive Board, they had to be communicated to all members so that the new par values and exchange rates for various currencies could go into effect as soon as the exchange markets opened.
On the occasion of the second devaluation of sterling, the operation went unusually smoothly. On instructions of the Managing Director, the Directors or Acting Directors of the five Area Departments were alerted late in the day on Thursday, November 16, 1967, that there was every reason to expect a devaluation of sterling over the weekend and that they should review the situations of all members for which they were responsible in order to sort out those likely to follow suit or to consider doing so. They had, in effect, one business day in which to make this review before reporting back to the Managing Director late on Friday, November 17, 1967. By early Saturday morning, when exchange markets were closed, the staff of the Area Departments was permitted to firm up its information by communicating with Executive Directors, with the monetary officials of member countries, and with staff representatives stationed in a number of countries.
Because of its familiarity with members’ circumstances, the staff was able to compile in advance a list of all of the member countries that did in fact devalue following the devaluation of sterling. In addition, during the days just before and after the devaluation of sterling, close contact was maintained with a large number of member countries so that the monetary officials in those countries could be given firsthand reports of what was going on as well as advice on their own situations. This experience was in contrast to that of 1949, when the Fund had been criticized for not playing an effective role.
Staff Paper and Executive Board Discussion
In the paper on the devaluation of sterling, circulated to the Executive Directors at 8:00 a.m. on Saturday, November 18, the staff indicated its agreement with the U.K. authorities that the proposed change in the par value of the pound sterling was necessary to correct a fundamental disequilibrium. The staff cited the cumulative deficit in the United Kingdom’s balance of payments of more than £1,300 million over the previous four years, the apparent incompatibility of external equilibrium and satisfactory economic growth, the failure of exports to grow at a rate adequate to meet the import demands of a full-employment economy, and the failure of imports to decrease despite the disinflationary measures that had been imposed. These last two phenomena suggested to the staff the existence of disparities between U.K. prices and costs and those elsewhere. The staff further noted that, although demand pressures at home had been excessive and domestic financial management had been expansionary, an improvement in the balance of payments could have been possible. But that improvement had not developed. Moreover, the reduction in the balance of payments deficit that had taken place in 1966 had rested in part on the use of capital controls.
As far as the magnitude of the proposed devaluation was concerned, the staff had made calculations that showed that, on the basis of reasonable assumptions for trade elasticities, a devaluation of roughly 15 per cent could, after some time, yield an improvement in the U.K. trade balance of more than £500 million a year, provided that the associated rise in domestic prices was kept to a moderate amount and the devaluation of sterling was not accompanied by devaluations of other currencies. Moreover, according to the staff’s analysis, an improvement of this magnitude in the U.K. trade balance was unlikely to cut seriously into the export market of any other individual country.
The Executive Directors, meeting three hours after the staff paper was circulated, expressed sympathy with the U.K. authorities in the painful decision that they had had to take, and agreed that the change in the par value of sterling was justified.
Mr. Dale (United States) recognized that determining a new par value involved a very difficult set of judgments, but thought that the U.K. authorities had chosen well in deciding to propose a rate that represented a substantial change but yet would avoid major disruptive effects on the majority of other countries and on the international monetary system itself. He commended the U.K. authorities for the accompanying measures, which, he thought, generated confidence that the new rate was to be supported with great determination. Mr. González del Valle (Guatemala), Mr. Lieftinck (Netherlands), Mr. Plescoff (France), and Mr. Ungerer (Federal Republic of Germany) underscored the need for strict domestic measures, particularly since the degree of devaluation was modest.
The primary interest of the Executive Directors was to prevent a chain reaction to the devaluation of sterling. They praised the U.K. authorities for proposing a degree of devaluation that should not set off many other devaluations, at least by industrial members. On the occasion of this second devaluation of sterling, the stance of the U.S. authorities in particular was much in contrast to their position at the time of the 1949 currency adjustments. Whereas in 1949 they had been advocating devaluations, they were now eager to prevent devaluations that would worsen the U.S. balance of payments deficits. Mr. Dale said that this was “an historic moment of testing whether the system of par value exchange rates under the Fund’s Agreement” could “withstand strain and adversity.” He emphasized that the United States did not want other members to respond automatically to the devaluation of sterling by devaluing their own currencies: such devaluations should be limited to those necessary for correcting fundamental disequilibria. Mr. Lieftinck indicated that the major Western European members ought to be able to live with this adjustment of the rate for sterling without devaluing their currencies, although some other members might have to make adjustments. Mr. Suzuki (Japan) confirmed that Japan would not be changing its par value.
As we have seen in Chapter 18, the Managing Director had explored informally the reactions of some of the major countries and again prior to the Saturday morning meeting had been in touch with a number of Executive Directors and with a number of Governors to see whether their governments would or would not devalue. At the Executive Board meeting, Mr. Schweitzer, expressing views which he hoped would prevent a round of devaluations, said that the international payments situation was quite different from that in 1949 and that widespread currency adjustments were not justified at this time. It was, he said, in the interests both of the success of the U.K. action and of the international monetary system in general that this devaluation of sterling not touch off a series of exchange rate changes. He announced that he understood that none of the rest of the countries participating in the General Arrangements to Borrow would be devaluing. Nevertheless, he realized that a number of members whose economies were closely dependent on the U.K. market or who had been contemplating exchange rate changes but had not yet made them might wish to devalue their currencies.
So, on November 18, 1967, the Fund concurred in a change in the par value of the pound sterling to 240.000 U.S. cents per pound sterling (or 2.13281 grams of fine gold per pound sterling) and issued a press release to coincide with the official announcement in London. To help restore confidence in sterling, the Managing Director also gave the press a statement to the effect that the Fund was likely to act favorably within a few days on the United Kingdom’s request for a very large stand-by arrangement with the Fund.
On Monday, Mr. Maude brought to the attention of the Executive Directors a number of measures announced by the U.K. Government on Sunday evening. Among these was a rise in the bank rate to 8 per cent, a level which Mr. Maude observed had been exceeded only once in the past fifty years or so.
Limited Devaluations of Other Currencies
The second devaluation of sterling since World War II, unlike the first one, did not precipitate a round of devaluations of other currencies. There were, in fact, only a limited number of immediately subsequent devaluations.
The statements to the Executive Board by Mr. Lieftinck and Mr. Suzuki on November 18, 1967 were taken as official indications that the major Western European members and Japan would not devalue. The U.S. Government issued a public statement to the effect that the par value of the U.S. dollar would be maintained.
Some Executive Directors, including those for Argentina, Australia, Austria, Canada, and South Africa, reported within the next few days that these members would not be changing their par values. Similar communications of decisions to maintain their par values unchanged were received very shortly afterward from Afghanistan, Burma, Ghana, Kenya, Liberia, the Malagasy Republic, Malaysia, Nigeria, Portugal, Singapore, Somalia, Tanzania, Thailand, Uganda, and Zambia.
There were, however, some countries that did devalue. Within ten days of the devaluation of sterling, 13 members altered their par values in agreement with the Fund. These are listed in Table 15. Nine of these changes, those for the currencies of Cyprus, Guyana, Ireland, Israel, Jamaica, Malawi, Sierra Leone, Spain, and Trinidad and Tobago, were of the same degree as the U.K. devaluation, that is, 14.3 per cent. Except for Israel and Spain, the economies of these members were very closely linked with the U.K. economy. The nature of Israel’s fundamental disequilibrium was considered to be somewhat long term. Israel had been gaining reserves in recent years but needed to retain its competitive position and was also acting to counter a slowdown in the domestic economy. In the instance of Spain, the devaluation of sterling provided the authorities with an opportunity to correct a previously existing fundamental disequilibrium.
Changes in Par Values, November 18–27, 19671
Does not include changes in the par values for the separate currencies in the non-metropolitan territories of the United Kingdom; see text, pp. 439–40.
Changes in Par Values, November 18–27, 19671
| Effective Date | Member | New Par Value in U.S. Cents per Currency Unit | Date Previous Par Value Became Effective |
|---|---|---|---|
| November | |||
| 18 | United Kingdom | 240.000 | September 18, 1949 |
| 18 | Ireland | 240.000 | May 14, 1958 |
| 19 | Israel | 28.5714 | February 9, 1962 |
| 20 | Cyprus | 240.000 | July 25, 1962 |
| 20 | Guyana | 50.000 | February 13, 1967 |
| 20 | Malawi | 240.000 | May 27, 1966 |
| 20 | New Zealand | 112.000 | July 10, 1967 |
| 20 | Spain | 1.42857 | July 17, 1959 |
| 21 | Ceylon | 16.8000 | January 16, 1952 |
| 21 | Denmark | 13.3333 | September 18, 1949 |
| 21 | Jamaica | 240.000 | March 8, 1963 |
| 21 | Sierra Leone | 120.000 | August 6, 1965 |
| 22 | Trinidad and Tobago | 50.000 | February 10, 1965 |
| 27 | Iceland | 1.75439 | August 4, 1961 |
Does not include changes in the par values for the separate currencies in the non-metropolitan territories of the United Kingdom; see text, pp. 439–40.
Changes in Par Values, November 18–27, 19671
| Effective Date | Member | New Par Value in U.S. Cents per Currency Unit | Date Previous Par Value Became Effective |
|---|---|---|---|
| November | |||
| 18 | United Kingdom | 240.000 | September 18, 1949 |
| 18 | Ireland | 240.000 | May 14, 1958 |
| 19 | Israel | 28.5714 | February 9, 1962 |
| 20 | Cyprus | 240.000 | July 25, 1962 |
| 20 | Guyana | 50.000 | February 13, 1967 |
| 20 | Malawi | 240.000 | May 27, 1966 |
| 20 | New Zealand | 112.000 | July 10, 1967 |
| 20 | Spain | 1.42857 | July 17, 1959 |
| 21 | Ceylon | 16.8000 | January 16, 1952 |
| 21 | Denmark | 13.3333 | September 18, 1949 |
| 21 | Jamaica | 240.000 | March 8, 1963 |
| 21 | Sierra Leone | 120.000 | August 6, 1965 |
| 22 | Trinidad and Tobago | 50.000 | February 10, 1965 |
| 27 | Iceland | 1.75439 | August 4, 1961 |
Does not include changes in the par values for the separate currencies in the non-metropolitan territories of the United Kingdom; see text, pp. 439–40.
The magnitudes of devaluation by other members were 7.9 per cent for Denmark, 19.45 per cent for New Zealand, 20 per cent for Ceylon, and 24.6 per cent for Iceland. The last three, it is to be noted, were of greater magnitude than that of sterling. New Zealand was the first member to propose (on November 20, 1967) that it would devalue its currency by more than sterling had been devalued: the par value was to be changed from 139.045 U.S. cents per New Zealand dollar to 112.000 U.S. cents per New Zealand dollar. Initially, this degree of devaluation caused concern to some Executive Directors. After discussion, however, they agreed with Mr. Stone (Australia) that the new rate was needed to eliminate the existing disparity between domestic and external prices and costs. They hoped that the devaluation would lead to a better allocation of resources; improve the competitive position of domestic industry against imports, thereby reducing import demand; encourage tourism; and stimulate the inflow of capital, including the repatriation of capital held abroad by New Zealand residents. Mr. Stone further defended New Zealand’s action by noting that the measures previously taken by the authorities during 1967 had had noteworthy effects on the domestic economy; hence, the economic environment was one in which the introduction of a more realistic par value could be expected to yield maximum benefits.
Each member proposing a change in par value customarily explained its action as necessary to correct a fundamental disequilibrium. The Fund, as required by the Articles of Agreement, used the concept of fundamental disequilibrium in examining proposals to change par values. In this context, devaluation of the Ceylon rupee was presented by the member as being necessary to correct a fundamental disequilibrium. Mr. Suzuki explained that the disequilibrium had existed since the time of the devaluation of the Indian rupee in June 1966, but had been intensified by the U.K. devaluation.2 The Executive Directors agreed that a fundamental disequilibrium existed. But the proposed devaluation raised an old issue that had first come up in 1948, that is, what the Fund should do if it considered that a devaluation proposed by a member might not be adequate to correct the fundamental disequilibrium. The staff had some doubts that a 20 per cent devaluation of the Ceylon rupee was sufficient to encourage new exports, reduce leakages through the exchange controls, or make possible any relaxation of controls. Mr. Saad (Egypt) called attention to a decision by the Executive Board in 1948 to the effect that the Fund would give a member the benefit of any reasonable doubt about the size of its proposed devaluation.3 Hence, the Fund concurred in Ceylon’s proposal to change the par value of the rupee from 21.0000 U.S. cents per rupee to 16.8000 U.S. cents per rupee.
Iceland proposed an even greater degree of devaluation than those proposed by New Zealand and Ceylon. The nature of Iceland’s fundamental disequilibrium had been considered by the Executive Directors only two weeks earlier at the conclusion of the 1967 consultation under Article XIV. They had noted that Iceland had high domestic costs and difficult market conditions abroad. At that time, the Icelandic authorities had publicly rejected devaluation on the ground that such a step would be undesirable at a time when the labor market had begun to show an increasing understanding of the need to rationalize production. However, the devaluation of sterling, Mr. Friis (Denmark) stated, had completely changed the situation. The United Kingdom was such an important trading partner that the Icelandic authorities had no choice but to take steps to correct Iceland’s fundamental disequilibrium. The Fund concurred in the proposal for a change in the par value of the Icelandic króna from 2.32558 U.S. cents per króna to 1.75439 U.S. cents per króna. Mr. H. M. H. A. van der Valk (Netherlands, Alternate to Mr. Lieftinck), as he had in the past when Iceland had devalued, questioned the extent of the devaluation from the point of view of whether it possibly involved competitive exchange depreciation.
The U.K. Government also proposed changes, in which the Fund concurred, in the par values of most of the separate currencies of nonmetropolitan territories for which the United Kingdom had accepted the Articles of Agreement. The territories for which changes in par value were made were areas in the East Caribbean (Antigua, Dominica, Montserrat, St. Christopher-Nevis-Anguilla, St. Lucia, and St. Vincent), British Honduras, the Federation of South Arabia, Bermuda, the Falkland Islands, Gibraltar, Fiji, Hong Kong, Mauritius, and Seychelles.4 The degree of devaluation for the currencies of these territories was 14.3 per cent, the same as that for sterling. A few days later, however, adjustments were made so that the Hong Kong dollar was devalued by only 5.7 per cent and the Fiji pound by 9 per cent. No changes in par values were proposed for the Bahamian dollar, the Bahrain dinar, the Brunei dollar, the Rhodesian pound, and the Tongan pound.
The Gambia, which had not yet established a par value, proposed to the Fund a depreciation of 14.3 per cent in its exchange rate, to which the Fund agreed, effective November 20, 1967. That rate, 240.000 U.S. cents per Gam-bian pound, was agreed with the Fund as the initial par value for the currency of The Gambia later, on July 8, 1968. The initial par value agreed by Nepal with the Fund on December 11, 1967 represented a devaluation of 24.75 per cent from the previous official exchange rate.
Thus the sterling devaluation of 1967 was carried out with relatively few subsequent devaluations. Including the United Kingdom, the countries devaluing accounted for only 12 per cent of world trade and only 12 per cent of the exports of industrial countries. Excluding the United Kingdom, they accounted for less than 4 per cent of the world’s exports and only 2 per cent of the exports of industrial countries, and their share of U.K. exports was only 16.5 per cent. These amounts of trade were very much smaller than those affected by the 1949 devaluations. The countries that devalued at that time accounted for almost half of the world’s exports and about 60 per cent of the exports of industrial countries. Excluding the United Kingdom, they accounted for about 40 per cent of the world’s exports and about 50 per cent of the exports of industrial countries, and their share of U.K. exports was more than 75 per cent.
U.K. Economy Fails to Respond
After the sterling devaluation and the stand-by arrangement of November 1967, the Fund kept in close touch with officials of the U.K. Treasury and the Bank of England. In February, July, and November 1968 staff teams returned to London, as agreed under the terms of the stand-by arrangement, to review the domestic economy and the balance of payments. The second and third visits were after the United Kingdom had drawn the full amount of the stand-by arrangement in June 1968. In mid-July the Article VIII consultation became the basis of another discussion of the U.K. economy in the Executive Board, and in January 1969 the Board again reviewed the U.K. economic and financial picture.
Improvement in the balance of payments position following the devaluation of November 1967 was disappointingly slow. Because of widespread expectations of price increases and higher indirect taxes in 1968, consumers’ expenditures in late 1967 continued upward even after devaluation. Imports increased and inventories of imported goods were drawn down.
In January 1968 the U.K. authorities went ahead with the additional measures to restrain public expenditure that had been planned at the time of devaluation. Cuts in spending on education, health and welfare, housing, and roads for the next two years were announced. Planned expenditure was to be reduced by about £300 million for the financial year 1968/69 and by over £400 million for 1969/70. On March 19, 1968 the Chancellor of the Exchequer, in presenting the 1968/69 budget estimates, announced a still greater tightening of fiscal policy. Higher duties were imposed on alcoholic beverages, tobacco, and mineral oils. Purchase taxes, excise taxes on vehicles, and the rates for the selective employment tax were increased.
Nonetheless, in the second half of 1968 private consumption and imports were still high and rising, and the U.K. authorities took more measures to reduce aggregate demand and to curb imports. A surcharge of 10 per cent was imposed on the purchase tax and on the duties already applied to tobacco, beer, wines, and mineral oils. An import deposit scheme was introduced, under which importers were obliged to deposit with the customs authorities in advance of imports a sum equal to 50 per cent of the value of their imports, such deposits to be refunded after six months. An exchange restriction was also imposed, with the approval of the Fund, on the normal short-term banking and credit facilities in sterling made available by residents to nonresidents to finance trade between nonresidents.
Despite these measures, imports increased by 8 per cent from the second half of 1967 to the second half of 1968. The volume of exports increased by 18.5 per cent, but at the new exchange rate their value as a percentage of world exports declined. The deficit on visible trade account actually worsened by about $200 million. This widening of the trade deficit was largely offset by an increase in the surplus on invisibles, so that the current account worsened only marginally. The long-term capital outflow was reduced, but the short-term capital outflow (including errors and omissions) exceeded $1.8 billion. Consequently, the overall deficit for the calendar year 1968 turned out to be more than twice the 1967 deficit of $1.3 billion.
Some Restrictions Are Approved
A continued lack of confidence in sterling during 1968 was further evidenced when members of the sterling area began to run down balances of sterling accumulated as foreign exchange reserves. Even before the November 1967 devaluation, they had begun to alter the composition of their reserves in order to reduce their relative holdings of sterling. This trend increased significantly in the second quarter of 1968, rendering it necessary for the U.K. authorities to make some arrangements to meet or forestall such diversification of reserves. To help in dealing with this problem, the U.K. authorities announced in July 1968 that provisional agreement had been reached with the bis and 12 industrial countries—the Basle Group—for a medium-term stand-by credit of $2 billion; by September the facility was established.5 At the same time, members of the sterling area agreed to keep certain minimum proportions of their reserves in sterling for three (or in some instances for five) years in return for a guarantee of the U.S. dollar value of the bulk of their sterling balances.
The Fund regarded this requirement as a limitation on the use and convertibility of the sterling holdings of sterling area countries, and therefore a requirement of some consequence. There were 64 participants in these sterling agreements, many of which were also members of the Fund. The Fund considered that the United Kingdom was applying a measure subject to the Fund’s approval under Article VIII. The Executive Board, recognizing that the Basle facility and the sterling agreements would have a salutary effect on the stability of sterling and on the entire international monetary system, agreed on November 18, 1968 to such features of the agreements as required the Fund’s approval.
By September 1971 all but two of the agreements that were to last for three years and were then due to expire had been renegotiated; like the agreements that were originally designed to last for five years, they would continue until September 1973. After September 1971 there was also a reduction in the proportion of sterling that countries in the sterling area agreed to hold as part of their total reserves.
The Fund Urges More Stringent Policies
The Fund’s discussions concerning the United Kingdom’s situation, both with the U.K. authorities and within the Executive Board, during 1968 centered on the reasons why the member’s progress toward external surplus was so slow and on the question whether the domestic policies introduced were adequate. By mid-1968 the staff and several Executive Directors had come to believe that the measures taken were not fully effective and that, while the authorities had imposed strong fiscal measures, they had not made enough use of monetary and credit restraints. Bank credit to the private sector of the economy was growing much more rapidly than had been anticipated and was stimulating a boom in consumer spending, including spending on imports.
The general question of the effectiveness of monetary and credit policy for stabilizing a domestic economy and restoring external equilibrium had for years been a subject of debate between officials of the U.K. Government and senior members of the Fund staff. Consultations revealed differences of view about the effectiveness of aggregate monetary restraints. To consider these differences at greater length and on a technical level, an informal seminar was held in London in October 1968 between officials and technicians from the Treasury and the Bank of England, and the Economic Counsellor and other members of the Fund staff. The seminar did not entirely resolve these differences of view, but a much greater tightening of U.K. credit policy nevertheless did occur, and as we shall see in the next section of this chapter, the situation of the United Kingdom began to improve.
In presenting the 1969/70 budget on April 15, 1969, the Chancellor of the Exchequer not only announced the imposition of still more taxes but also, significantly, referred to the importance of monetary policy in providing essential support to fiscal policy. He stated that the increase in bank credit in 1968 had been too large, and said that in the coming year the needed balance of payments improvement should be accompanied by restraint on the provision of domestic bank credit to both the public and private sectors of the economy. Steps were then taken to restrict bank credit and to ensure that other financial operations, including debt management, did not make the amount of credit actually extended exceed the intended limitations on credit extension.
Evaluation of Improvement in U.K. Economy
Under the terms of the 1969 stand-by arrangement, there were to be quarterly reviews with the Fund. In both the periodic reports of the staff and the Executive Board discussions pertaining to these reviews, efforts were made to pinpoint the reasons for the eventual turnaround in the U.K. balance of payments and why it had been delayed until nearly two years after devaluation.
The evaluation was directed in part to ascertaining the effectiveness of a change in par value and of demand management policies for solving the external financial problems of the United Kingdom. For nearly a decade the United Kingdom’s external disequilibrium had been a recurrent theme in international economic discussions, and many economists had come to regard it as basically structural in character. They attributed it to a relative lack of modernization and investment by British industry and, consequently, to an insufficient increase in productivity. It was often said, for instance, that British manufacturing had fallen behind American, European, and Japanese manufacturing, which had made impressive strides since World War II. But it was also important to assess the usefulness of exchange rate, fiscal, credit, and monetary policies in the U.K. economy of the late 1960s. In addition to ascertaining the effectiveness of exchange rate changes and of demand management policies, this evaluation was motivated by the desire to give the Fund management and the Executive Directors some way to judge how long the U.K. authorities would be advised to continue their stringent domestic policies.
At the time of the 1967 devaluation of sterling it had not been expected that the benefits of the devaluation would be so slow to materialize or that they would come only after the U.K. payments position had worsened. To describe the aftermath of the devaluation, economic journalists in the United Kingdom, as well as economists and government officials, began to use the term J-curve—a shorthand way of denoting that devaluation at first produces a deterioration in the external account (the short downward shaft of the J), and later produces an improvement in the external account that is considerably in excess of the initial deterioration (the long upward shaft of the J). The initial deterioration comes about because the immediate impact of devaluation is a worsening of the country’s terms of trade while the effect on trade volumes takes longer to come about. The price effect of devaluation is offset by the quantity effect only after time lags of considerable duration.
Essentially what happens is that, if exporters maintain their prices in terms of local currency, the lower cost to foreign customers in terms of their own currencies should stimulate buying and in time raise the volume of exports enough to produce some increase in export values in terms of foreign currencies and a considerable increase in terms of local currency. On the import side, if foreign exporters hold their export prices in their currencies unchanged, the local currency cost to the customers in the devaluing country rises; eventually the lowering of the volume of purchases will reduce aggregate local currency expenditures on imports. Thus, as current receipts are enlarged and current payments are reduced, the current account position improves.
These effects, however, take some time to materialize. Shifts in demand, both at home and abroad, and changes in resource allocation are required before the quantity of exports of goods and of outgoing services increases and the quantity of imports of goods and of incoming services decreases. Meanwhile, the quantities of exports and imports may well remain substantially unchanged, and the increase in the aggregate local currency value of imports is likely to outweigh any favorable impact on exports. Hence, the current account position worsens immediately following a devaluation.
Increasingly, officials in the United Kingdom and in the Fund took cognizance of the J-curve effects on the United Kingdom’s balance of payments after the 1967 devaluation. The United Kingdom’s experience, moreover, revealed to many economists who customarily differentiated short-term effects (when price elasticities of demand and supply were small) from long-term effects (when such price elasticities were larger) that for other countries, too, the first effects of devaluation might even be negative and that the long-term effects of changes in exchange rates might take much longer to materialize than had previously been assumed. New interest was generated in both the theory of the effectiveness of exchange rate changes and the empirical study of such changes.6
Gradually—by late in 1969—there was sufficient statistical and circumstantial evidence to support the view that strong overall financial policies, persistently applied, were bringing about the necessary shift in resources from the domestic economy to export production and hence were bringing about a marked improvement in the external payments position of the United Kingdom. The U.K. authorities, by applying such policies after the devaluation, had managed in 1969 to bring about a trade and balance of payments surplus, to rebuild foreign exchange reserves, and to repay much short-term indebtedness.
At the same time, the Fund, noting signs of rising labor costs and only small gains in productivity, cautioned against relaxation of stabilizing policies lest an inflationary wage-price spiral ensue. Several Executive Directors, as well as the staff, also drew attention to a number of circumstances that had benefited the U.K. balance of payments in 1969 but that could not be counted on in the future. U.K. imports had fallen and U.K. exports had expanded substantially partly because the growth of the economy had been held down during 1969 to a rate lower than normal while the rest of the world had enjoyed unusually rapid growth. But had demand conditions at home and abroad moved in greater cyclical unison, such a favorable trading situation for the United Kingdom might not have developed. Furthermore, during 1969 the U.K. economy had been able to rely on inventories of imported products; the utilization of such stockpiles could obviously be only temporary. In addition, when the import deposit scheme was removed, the pound sterling would lose an artificial prop. Finally, long-term capital imports might be more difficult to achieve as the interest rate differential between money markets in the United Kingdom and those on the European continent diminished. In any event, it was an anomaly for the United Kingdom to be achieving balance of payments equilibrium by being an importer of long-term capital; one would expect the United Kingdom, a major industrial country, to be an exporter of capital.
In April 1970 in Washington, in a follow-up to the seminar held in London in October 1968, U.K. officials and technicians and members of the Fund staff discussed once more their views about the efficacy of monetary policy. There was a much greater harmony of opinions than at the earlier seminar, and very few areas of difference now remained.
U.K. Surpluses in 1970 and 1971
By July 1970, at the time of the 1970 Article VIII consultation, it was apparent that, after lagging initially, the results of the U.K. devaluation and financial programs had far exceeded expectations. Mr. Derek Mitchell (United Kingdom) reported that the new Government, which had taken office following the general election on June 18, was examining all policies with a view to strengthening the U.K. economy further and especially to curbing inflation. In the opinion of both the U.K. authorities and the Fund, the problem of inflation was becoming critical.
In December 1970 and January 1971, the Fund held consultations with the U.K. authorities in accordance with the provision of the stand-by arrangement that, while any of the Fund’s holdings of sterling above the first credit tranche included currency resulting from purchases under the stand-by arrangement, the United Kingdom would consult the Fund from time to time concerning its balance of payments policies. The dramatic improvement in the United Kingdom’s external accounts that took place late in 1969 had continued into 1970. The overall balance for 1970 was in surplus by $3 billion, three times the surplus of 1969. Stringent policies had been maintained, dampening any rise in imports and attracting large inflows of short-term capital. The terms of trade had also moved favorably. The potentially serious damage to the United Kingdom’s national competitive position that might have resulted from the rapid advances in domestic prices and costs was averted by continuing inflation in other industrial countries.
On the other hand, signs of renewed difficulty were beginning to show. Relatively weak demand in the domestic economy was accompanied by rising unemployment, which by the spring of 1971 had reached the highest level in many years. To stimulate domestic activity, the authorities undertook, in the budget announced at the end of March 1971, to reduce fiscal restraint somewhat and to ease monetary policy. But there was a danger of inflation and of a cost-price spiral, which could have adverse consequences for the competitiveness of British goods in world markets.
Despite these areas of weakness, the United Kingdom had an even larger balance of payments surplus in 1971—$6.5 billion—and the United Kingdom, as well as several other industrial countries, absorbed the counterpart of a U.S. deficit on an official settlements basis that reached $30 billion.
Sterling Devaluation as Seen at the Time
At the time of the devaluation of sterling in November 1967, it was not expected that this devaluation would be only the first of many alterations in the exchange rates of major currencies to take place over the next several years. But in fact, by the end of 1971 the par values of the French franc and the deutsche mark had been changed, the dollar had been devalued in terms of gold for the first time since 1934, the exchange rate relationships among all the major currencies had been realigned, and a regime of “central rates” had been introduced as a temporary substitute for the par value system, which had, indeed, collapsed.
Most monetary officials and expert observers did not, in November 1967, regard the collapse of the par value system as imminent. True, they were very well aware that the international monetary system was under severe stress. Disequilibrium in international payments continued to involve deficits for the United States and the United Kingdom and surpluses for the industrial countries of continental Europe as a group. Speculative movements of capital were becoming larger, and harder to counteract by official action. But the elimination of the deficits of the United States and the United Kingdom, on which major emphasis had been placed, seemed to be in process. As far as the United Kingdom was concerned, sterling was being devalued. Although the United States had a large overall deficit in 1967 because of an increase in capital outflows, still it had a sizable current account surplus, and the trade balance was showing improvement. During the first three quarters of 1967, the steep upward trend of Europe’s exports to the United States that had taken place in 1965 and 1966 was abruptly reversed. Also, U.S. exports to Europe (to the eec countries as well as to the United Kingdom) were on the rise. In addition, Japan’s exports to the United States had not increased as rapidly in 1966 as they had earlier, and, during the first half of 1967, they actually declined. Japan’s overall payments position was close to being in balance.
Moreover, after years of deliberation, an outline for a special drawing rights facility in the Fund had finally been agreed upon less than two months before the devaluation of sterling, and considerable optimism existed that the international monetary system would be bolstered. A new mechanism for reserve creation was anticipated that could substitute for the cessation of reserve increases or for the reserve losses entailed in the elimination of the U.S. and the U.K. deficits.
In these circumstances, the devaluation of sterling was looked upon as a move that would strengthen the international monetary system. This was the view, for instance, of the Managing Director. In a televised interview on Sunday, November 19, the day after sterling was devalued, in response to a direct question about the effect of the devaluation on the U.S. dollar, he replied that the United Kingdom’s move should not have an unfavorable impact on the dollar. The situation of the United States was completely different from that of the United Kingdom. The United States had a substantial surplus on current account in its balance of payments. Mr. Schweitzer added that he welcomed President Johnson’s statement that there would be no change in the willingness of the United States to continue buying and selling gold freely (that is, without limit) at $35.00 an ounce. Mr. Schweitzer went on to say that, contrary to the belief held by some that devaluation of sterling was harmful to the position of the dollar and indicative of weakness in the monetary system, the devaluation of sterling was “good” both for the dollar and for the monetary system.
History, 1945–65, Vol. I, pp. 238–41, and Vol. II, pp. 99–100.
See History, 1945–65, Vol. II, pp. 93–95.
Mauritius became an independent country on March 12, 1968 and a member of the Fund on September 23, 1968. It had not agreed an initial par value for the Mauritian rupee by the end of 1971.
The 12 countries were Austria, Belgium, Canada, Denmark, the Federal Republic of Germany, Italy, Japan, the Netherlands, Norway, Sweden, Switzerland, and the United States.
Among these studies were several by the staff of the Fund. See, for example, Jacques R. Artus, “The 1967 Devaluation of the Pound Sterling,” Staff Papers, Vol. 22 (1975), pp. 595–640, and “The Behavior of Export Prices for Manufactures,” ibid., Vol. 21 (1974), pp. 583–604; Michael C. Deppler, “Some Evidence on the Effects of Exchange Rate Changes on Trade,” Staff Papers, Vol. 21 (1974), pp. 605–36; and Avinash Bhagwat and Yusuke Onitsuka, “Export-Import Responses to Devaluation: Experience of the Nonindustrial Countries in the 1960s,” Staff Papers, Vol. 21 (1974), pp. 414–62. Also see Helen B. Junz and Rudolph R. Rhomberg, “Price Competitiveness in Export Trade Among Industrial Countries,” The American Economic Review (Papers and Proceedings of the Eighty-Fifth Annual Meeting of the American Economic Association), Vol. 63 (1973), pp. 412–18.