Behavior in the forex market has to be seen against the broader trends shaping the growth, integration, and agility of international capital markets. The resources available to the private sector for taking positions in the forex market are now much larger than even those of the Group of Ten central banks. When private markets, led by the increasing financial muscle of institutional investors, reach the concerted view (rightly or wrongly) that the risk/return outlook for a particular currency has deteriorated significantly, the defending central bank could be faced with a run that could easily amount to, say, $100-200 billion or more within a week. Moreover, there is little in the factors underlying the evolution of international capital markets to suggest that the increased clout of private markets (vis-à-vis official reserves) will reverse itself in the future. Quite the contrary, international diversification is still in its adolescence, the pace of financial liberalization and innovation continues unabated in most countries, the pool of savings managed by professionals is growing (as private pension schemes supplement or replace public ones, and savings shift from the banking sector into mutual funds), and the same reforms that reduce systemic risk (such as improvements in payments and settlement systems) often also enhance the private sector’s capacity to redenominate the currency composition of its assets at short notice. For better or for worse—and, given the wide-ranging benefits of integrated capital markets, it is probably better-there is no turning back.

The convergence-play prologue to the ERM crisis, and the crisis itself, should also serve to remind that international capital markets can be prone to sharp shifts in sentiment about the outlook for currencies. The discipline exercised by capital markets over government policies is neither infallible nor is it always applied smoothly and consistently. Nevertheless, the markets eventually decide on what are unsustainable situations, and when they do, their size alone increasingly allows them to force adjustments. The challenge for authorities is to make those policy adjustments in an orderly way before the markets force a more costly resolution. Stronger preventative measures will therefore need to be taken to minimize the probability of future crises, including more timely correction of macroeconomic imbalances, closer monitoring of exchange rate parities to ensure consistency with underlying fundamentals, and renewed efforts to improve the quality of monetary policy cooperation.³⁵

The range of private market participants involved in last fall’s crisis in European currency markets was broad—encompassing banks, securities houses, institutional investors, hedge funds, and corporations. Indeed, that wide participation explains in part why the funds that flooded into central banks were so massive. The role played by each class of participant was different: for the most part, it was simple defensive maneuvering to undo earlier large exposures in certain currencies; for some, it was mainly an intermediary role as both a market maker and a supplier of credit; for others, it was mainly a research and advisory role—pointing out perceived misalignments to their clients and advising them how to alter the currency composition of their portfolios—along with some position-taking on their own account; and for yet others, it was only large-scale position-taking, leveraging to the hilt. The distinction between hedging and speculation is rather blurred when most market participants become convinced—rightly or wrongly—that a large change in exchange rates could well be in the offing, and that this change is likely to be in one direction. Then, everybody gets into the act. This is not to say that it would be unwarranted to conduct an evaluation of whether various types of financial institution undertook excessive risks in their forex activities on prudential grounds. But that is different from attempting to identify “speculators.”

In evaluating the behavior of liquidity during the crisis, markets worked quite well. No major financial firms failed—nor did any of the largest asset markets seize up persistently. A major source of problems during the 1987 crisis in world equity markets was the pressure that price declines put on thinly capitalized broker/dealers. In contrast, forex dealing is almost exclusively by well-capitalized banks and securities houses that, as indicated earlier, generally eschewed large, net open positions. The improvements in back-office processing and risk control systems instituted since the 1987 crash have helped to accommodate the increases in forex and money trading volumes; this progress needs to continue. Just as important (except for the ECU bond market), the crisis remained localized in European currency markets. It did not spread significantly to national debt and equity markets, or to the dollar or yen exchange markets. However, there is little ground for complacency, since this absence of contagion might not pertain in a future currency crisis.

Turning to the tactics of defending ERM parities, the events of last fall made plain the limits of sterilized exchange market intervention when markets are convinced that some existing parities are out of line with fundamentals and when—for a variety of reasons (to be discussed below)—there are tight constraints on interest rate coordination. To expect sterilized intervention to handle massive exchange rate pressures while leaving the domestic monetary policy stance unaltered is unrealistic. This is not to say that sterilized intervention does not have a useful role to play when its mandate is framed (more modestly and) closer to its capabilities. Specifically, it can still be helpful in countering disorderly market conditions in the short term, in sometimes sending a signal about future monetary policy intentions, and in providing a short breathing space while more fundamental policy changes are being made. The relevant question is whether official reserves and other sources of resources for intervention are still adequate to carry out those more limited functions. When official reserves are too large, there is the moral hazard that needed (and often, more painful) policy adjustments can be too long delayed; when they are too small, there is the risk that shocks and political uncertainties can derail policy reforms, which, if sustained, would underpin exchange rate credibility over the longer term. In the run-up to the crisis, as well as during the crisis itself, both types of risk may well have been evident.

Another lesson of the crisis is that whatever the desirability and prowess of aggressive interest rate action to sustain fixed rates in countries with healthy fundamentals and in situations when the disparity between the internal and external requirements of monetary policy is not unusually wide, such tactics are more limited when those conditions are not satisfied. In fact, Germany was not willing to reduce interest rates significantly before it had better assurance that inflationary pressures there were under control, and Italy, the United Kingdom, and Sweden each finally decided that the costs of keeping interest rates above what would otherwise be required on domestic grounds were too high to tolerate. Not that devaluation or floating gives free rein to domestic monetary policy, or that reductions in short-term interest rates will quickly be reflected in long-term interest rates, or that such a loosening of the exchange rate constraint will permit the country to avoid internal/external policy dilemmas, particularly in view of the significant volatility in these recently floated rates after the crisis; here, the differences in regime are more differences in degree than in kind. But recent events do suggest that the scope for using interest rate policy to sustain parities across the EMS cannot be divorced either from the degree of progress in eliminating macro-economic imbalances and financial fragilities in some member countries or from the degree of convergence of economic conditions within the EMS (which inevitably affects prospects for achieving a consensus on the appropriate course of monetary policy). Some countries in the EMS—and, more broadly, in Europe—are already in a position to commit credibly to close coordination of interest rate policy; others are not.

It would be neither desirable nor effective to attempt to deal with capital market pressures on exchange rates by introducing restrictions or taxes on international capital flows. All three countries (Ireland, Spain, and Portugal) that imposed capital controls or tightened existing restrictions during the recent crisis removed them by the end of the year. Prudential concerns, however, about the impact on banks and other institutions of the market risk created by exchange rate volatility are quite different. Those concerns are legitimate and should be addressed in the appropriate multilateral forums, such as the Basle Committee on Banking Supervision; it is expected that the Committee may soon have ready a proposal for extending bank capital requirements to foreign exchange positions. It is important that this effort achieve as wide a geographic coverage as possible to avoid merely moving forex activity from some markets to others. Similarly, as the share of institutional portfolios invested in foreign assets grows, the prudential and fiduciary regulations governing the forex activities of institutional investors (pension funds, mutual funds, insurance companies) may need to be revisited. The regulatory authority over institutional portfolios is divided among jurisdictions in some countries, and it has therefore been difficult to consider sufficiently whether a common standard would be beneficial and practical. Harmonization along the lines of bank capital standards may, for example, pay dividends in improving oversight.