Annex VI: The ERM Crisis of September 1992
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Abstract

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.

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.

Pre-Crisis Cross-Border Capital Flows

A distinguishing feature of the recent exchange rate crisis in Europe, compared with earlier realignments and speculative attacks, is the magnitude of capital flows precipitated by fears of realignment. In the five years preceding the crisis, cross-border investment flows increased substantially as investors took advantage of new opportunities to diversify their portfolios internationally. Also, in the “convergence play” strategy, institutional investors had sought to exploit the existing interest rate differentials within Europe, given the perception that the macroeconomic performance of ERM member countries would gradually converge. They pursued this strategy, for example, by borrowing funds in the countries with relatively low interest rates such as Germany, and by investing in high-yield countries such as Italy and Spain.

An investor who believed that interest rates would gradually converge toward the levels observed in the low-interest-rate countries without exchange rate realignments on the way, would invest in long-term, high-yielding securities in anticipation of earning significant capital gains as interest rates fell. Even if an investor expected an exchange rate depreciation, he may have viewed the interest differential as sufficient to outweigh the expected depreciation. An investor less confident about convergence prospects could invest in high-yield securities, but hedge against the exchange rate risk or hope to sell the asset before any devaluation occurred.

In many cases, the convergence play was combined with a strategy of proxy hedging—a form of cross-hedging (see Annex II). For example, a U.S. investor purchasing an Italian Government bond could hedge this exposure with a forward contract in lire. However, if he chose to bet on convergence, without taking an open position on the dollar-deutsche mark exchange rate, he could hedge the latter exposure by selling deutsche mark forward; if the lira stayed within the existing exchange rate bands, this would yield higher returns. Obviously, the proxy hedge actually leaves the investor’s position exposed to realignments of the deutsche mark-lira rate.

Some investors also sought to take high-yield exposures through the derivatives markets. This occurrence is illustrated by the increase in trading in Italian Government bond futures on LIFFE, which rose from 483,000 contracts in 1991 to 3.2 million in the first nine months of 1992 alone. Demand for lira interest rate swaps also increased, and their outstanding amount rose by 330 percent during the course of 1991 to reach $34.3 billion (compared with an estimated 33 percent increase in the total volume of interest rate swaps in that year). Italian currency swaps also expanded, with outstanding notional principal in lira swaps expanding by 164 percent to $35.9 billion, compared with an expansion of less than 40 percent for currency swaps as a whole. Swedish interest rate and currency swaps expanded by 58 percent and 185 percent, respectively, reaching $18.2 billion and $17.7 billion, respectively.2

As mentioned above, the convergence play exploits the wide interest rate differentials between some ERM countries. Chart 1 in Section III provides evidence on the magnitude and durability of long-term interest rate differentials for four countries against German rates in the Eurocurrency market. In the United Kingdom, long-term (and short-term) interest rates were approximately 6 percentage points higher, on average, than German rates between 1987 and 1990. The differential came down sharply in the fourth quarter of 1990 following sterling’s entry into the ERM, so that by early summer 1992 the differential was below 100 basis points. In Spain the differentials against German rates hovered around 7 percentage points for 1987-90, before dropping sharply in the first quarter of 1991 to approximately 300 basis points. French interest rate differentials, reflecting France’s strong performance in controlling inflation, were low and declined steadily through 1987-91, increasing only during the third quarter of 1992. In Italy, the interest differential peaked at 8 percentage points in mid-1987 and declined gradually to approximately 200 basis points by mid-1991 before rising sharply in the final quarter of 1991.

From late 1987 to early 1992, the interest rate differential between Germany and the United States rose steadily, becoming consistently positive from mid-1990 onward (Chart 2), so the positive differentials against German interest rates implied even larger differentials against U.S. rates. In the United Kingdom, for example, even though the gap between domestic interest rates and German rates narrowed after the third quarter of 1990, differentials against U.S. rates remained above 4 percentage points until September 1992. By the end of 1991, interest rates in Italy, Spain, and the United Kingdom were all approximately 600 basis points above U.S. rates.

Chart 2.
Chart 2.

Interest Rate Differentials on Eurocurrency Deposits: Deutsche Mark Minus U.S. Dollar

(In percent)

Source: Data Resources, Inc.

Capital flows in major countries in the EMS are shown in Table 4 (in Section III), as well as in Appendix Tables A8, A9, and A10. In Italy, net capital inflows grew from Lit 3.6 trillion in 1986 to Lit 51.5 trillion in 1990 (Table 4). In 1991, net inflows, at Lit 26.6 trillion, were substantially smaller, and interest differentials between Italy and Germany narrowed for the year. The longer-term developments are reflected most prominently in net long-term private loans from foreign residents, which increased from Lit 4.7 trillion in 1987 to Lit 23.5 trillion in 1990 before dropping off in 1991 to Lit 5.7 trillion. Portfolio investment flows reversed from net inflows of Lit 4.7 trillion in 1989 to net outflows totaling Lit 7.6 trillion in 1991. The short-term capital flows show a more pronounced pattern of sudden inflows—mostly reflecting activities of the banking sector—which tripled during 1989-91, reaching Lit 36.2 trillion. The shift from predominantly long-term capital inflows to short-term inflows in 1991 occurred simultaneously with the change in the Italian yield curve, summarized in Chart 3. The differential between long-term and short-term interest rates peaked in mid-1990 at approximately 200 basis points, and by mid-1992 the yield curve had become inverted, with a differential of minus 400 basis points.

Chart 3.
Chart 3.

Interest Rate Spreads (Long-Term Minus Short-Term)

(In percent)

Sources: IMF, International Financial Statistics and World Economic Outlook data base.

Table A8 identifies the principal sources of these capital inflows to Italy. Net liabilities of the Italian credit system to OECD countries increased from Lit 20.8 trillion in 1986 to Lit 77 trillion by the end of 1991. The principal claimants are residents of Belgium, France, Germany, Luxembourg, Switzerland, and the United Kingdom. In 1991 alone, net liabilities increased by Lit 24 trillion, and the net position against U.S. investors changed from a net asset of Lit 3.9 trillion in 1990 to a net liability of Lit 2.9 trillion in 1991.

The data for Spain reported in Tables 4 and A9 reveal a similar, although less pronounced development. Net capital inflows increased from Ptas 1.4 trillion in 1987 to Ptas 3.2 trillion in 1991, and have since slowed considerably. Net inflows in the first three quarters of 1992 were only Ptas 1.2 trillion. As with Italy, most of the inflows during 1987-90 were in long-term instruments. In contrast to Italy, however, no significant shift from long-term to short-term capital inflows was observed in Spain. This coincides with a much flatter yield curve in Spain (Chart 3). In line with the speculative attack against the Spanish peseta, data for the first three quarters of 1992 reveal that short-term capital flows were directed out of Spain. By far the most significant source of capital in recent years has been U.K. investors. Net inflows from the United Kingdom rose from Ptas 429 billion in 1990 to Ptas 1.1 trillion in 1991. In 1992, however, U.K. investors withdrew from Spain, causing outflows of Ptas 66 billion.

The French data in Table 4 do not show a strong trend. Also, interest differentials between France and Germany were relatively small and stable. There was, however, a large outflow in 1992 reflecting, in particular, reduced foreign holdings of franc assets in the third quarter. In Germany, there were large net capital outflows from 1986 to 1990, but these subsequently turned positive in 1991 and increased in the first half of 1992, during which capital inflows were almost twice the level of the whole of 1991. In the United Kingdom, net capital flows declined steadily from 1990 onward, coincident with a steady narrowing of interest rate differentials against Germany. Indeed, during the first nine months of 1992, net capital flows were negative, and interest rate differentials were low and even negative.

Table A10 identifies the major sources and destinations of German cross-border investment flows in securities from 1986 to the end of the third quarter of 1992. Over most of this period, Germany was in a surplus position. These data show that the most important source, and the most variable, of foreign net investment in German securities was U.K. resident investors. In 1990 these investors purchased DM 2.5 billion of German securities. In 1991 this figure rose to DM 28.3 billion, and the rate has increased in 1992, with inflows of DM 25.2 billion through the first three quarters alone. German investors’ holdings of U.K. securities, however, have increased by only DM 1,500 million from 1990 to the third quarter of 1992.

Overall, net German investment in five of the countries whose currencies were devalued in the recent crisis fell to only DM 1.8 billion in the first three quarters of 1992, down from DM 5.4 billion in 1991.3 During that time, purchases of German securities by residents in these countries rose to DM 33.5 billion in 1991 before falling to DM 24.2 billion in 1992.

The data presented above suggest that the large positive interest differentials between the high-inflation countries vis-à-vis Germany and the United States were associated with large net inflows of capital to the high-inflation countries by the end of 1991. The evidence also suggests that in early 1992, as prospects for realignment increased, sizable amounts of this capital were repatriated as investors sought to protect themselves against realignment.

Speculative Attacks and Defenses

Central bank policies aimed at either stemming the speculative attacks or supporting other ERM central banks are presented in Table A11.4 In most countries subject to speculative attacks, the central bank engaged in large-scale market intervention, which also involved shifts in central bank lending rates. The classical interest rate defense of squeezing short sellers of the currency under attack was widely used by central banks. In taking a short open position in a currency, speculators generally enter into a contract—either with banks or with organized exchanges—to deliver such currency sometime in the future. To cover this delivery, they will have to borrow short-term funds for which they may eventually have to pay a high price in a squeeze.

Chart 4 displays the movements in official central bank lending rates during the crisis. The chart indicates that the use of the interest rate to defend the currency varied in intensity across countries—almost unused in the United Kingdom, and used most aggressively in Sweden. As will be discussed below, however, most central banks limited the increase in interest rates that would have occurred as a result of an unsterilized intervention, and provided liquidity to the banking system by at least partly sterilizing the contractionary monetary effects of their foreign exchange intervention.

Chart 4.
Chart 4.

Official Overnight Interest Rates, August-November 1992

(In percent)

Source: Bloomberg Financial Services.Note: France (repo rate—5 to 10 days); Italy (discount rate); Sweden (marginal rate—paid on last tranche of borrowed reserves); United Kingdom (base rate).1The vertical line is drawn over September 16.2The vertical line is drawn over November 19.3Gap indicates that data are not available.

Table A11 indicates that several countries had arranged or subsequently arranged international syndicated loans to provide resources for their interventions. Table A12 reports a detailed breakdown by country of loans for both weak- and strong-currency borrowers.

Italian Lira

Although Italy had been losing reserves gradually since the beginning of the year, the first manifestation of the foreign exchange crisis in Italy can be traced to June 1992, when lira bond prices started to fall first in the futures markets and then in the cash markets.5 Investors’ pessimism about lira-denominated securities was apparently fueled by several developments, including lack of progress in achieving convergence in public finances; the Danish referendum; the delay in forming a government; the wealth tax on deposits included in the July budget package; the announcement in July that the bankrupt state holding company, Ente Partecipezione e Finanziamento Industria Manifatturiera (EFIM), would be liquidated but that the government would not be fully responsible for its debts; and the downgrading by Moody’s of Italian debt from AA1 to AA3 in July. Foreign investors began to sell lira securities in June and July, driving up yields on interbank deposits by at least 300 basis points. In August and September, there was a general portfolio shift from domestic government bonds toward foreign assets. Additional pressure came from the Italian banks, which had funded themselves in the low-cost deutsche mark bloc currencies, and sought to reduce their foreign indebtedness with sales of lire to cover their foreign positions.

Some market participants may have viewed the first devaluation on September 13 as a signal that the authorities were not determined to maintain the exchange rate parity at all costs, and that further depreciation of the lira was likely. Accordingly, investors moved to diversify out of the lira. Fund managers sold lira securities, bought spot foreign exchange, and bought deutsche mark securities.

Simultaneously, the forward market became illiquid and precluded other means of closing lira exposures. Banks’ depositors exchanged a substantial volume of lira deposits for deutsche mark deposits in the same institution, which could be done instantly because the bulk of deposits were in the form of current accounts. In addition to funding the domestic sellers of the lira, Italian banks provided credit to foreign sellers by lending to foreign banks through lira credit lines and prearranged overdraft facilities.

These outflows were met with substantial intervention by the Bank of Italy, which was funded by sales of foreign exchange reserves and borrowing through the very short-term financing facility (VSTFF) from the Bundesbank. At the end of August 1992, Italian gross foreign exchange reserves were valued at $20.4 billion (Table 10).6 On September 17, the Italian Government withdrew the lira from the ERM. By the end of September, gross foreign exchange reserves had risen to $25 billion.

Table 10.

Official Foreign Exchange Reserves of Central Banks of Selected Industrial Countries, 1992

(In millions of U.S. dollars, end of period)

article image
Source: IMF, International Financial Statistics.

The Bank of Italy actively engaged in interest rate policy as a defense mechanism throughout the attack on the lira, gradually raising its discount rate (from July 5 through September 4) from 12 percent to 15 percent; see Table A11 and Chart 4.7 Repurchase (repo) rates—the rates used most directly to control overnight interest rates—were raised from 14.75 percent to 16.5 percent on September 4.

In the event, the interbank rate rose higher than the repo rate: on September 16, the interbank overnight rate reached 36 percent (Chart 5), and three-month rates hit 20 percent. The Bank of Italy also limited the amounts of repo funding that it offered to banks.

Chart 5.
Chart 5.

Domestic Short-Term Interest Rates, August-November 1992

(In percent)

Sources: Bloomberg Financial Services; IMF.Note: France (overnight rate); Italy (overnight rate); Sweden (one-week STIBOR); United Kingdom (one-week rate).1The vertical line is drawn over September 16.2The vertical line is drawn over November 19.

A problem faced by the Italian authorities in their defense of the lira was that, owing to the composition of the government paper, rises in money market interest rates rapidly affected the Government’s finances. Specifically, 29 percent of its debt is in the form of treasury bills (BOTs), 48 percent is in floating rate securities (CCTs), and the remainder consists primarily of medium- and long-term bonds (BTPs).8 Moreover, as interest rates rose and the price of government securities declined, the Government faced a significant increase in the costs of marketing new issues during the crisis. The Bank of Italy increased its holdings of government bills and bonds by Lit 14.2 trillion in September, largely through its use of the secondary bond markets for open market operations to sterilize reserve outflows. At the bi-monthly treasury bill auction, the Bank of Italy bought Lit 1 trillion at an interest rate of 17.9 percent. The Government also had to fund itself by drawing down its current account at the Bank of Italy by Lit 17.5 trillion in September.

Pound Sterling

The attack on the pound sterling gathered momentum in the days preceding September 16. During the few days of the attack on sterling, the Bank of England sold foreign exchange in its market intervention and borrowed from the Bundesbank through the VSTFF. Gross foreign exchange reserves, which had totaled $40.2 billion at the end of August 1992, dropped to $37.1 billion by the end of September and stabilized at $35.9 billion by end-November (Table 10).

The Bank of England used interest rate policy only on the last day of the attack. In the U.K. financial system, any rise in the Bank of England’s minimum dealing rate would have spread quickly throughout the financial markets, particularly the retail markets.9 The Bank of England raised its minimum dealing rates only on September 16 from 10 percent to 12 percent and announced a rise to 15 percent for the next day. Chart 5 indicates that short-term market interest rates also moved very sharply. Instantly, however, it was obvious that these interest rate changes had no impact on the selling of pound sterling assets. The exchange rate did not move from its floor value in the ERM band. The Government then formally suspended participation in the ERM, and the Bank of England rescinded the announced rise in the minimum dealing rate from 12 percent to 15 percent on September 16. After a sequence of reductions, the minimum dealing rate reached 6 percent on January 26, 1993.

As mentioned above, the announcement of the increase in minimum lending rates did not lift the exchange rate from its floor value; instead, a simultaneous surge of selling materialized. One explanation for this result is that the markets may have interpreted the raising of rates as a signal that the Bank of England would soon stop intervening, since it was generally believed that high interest rates could not be sustained for long. An additional contributory factor may have arisen from the operation of the derivative markets: holders of foreign currency securities may hedge them by acquiring or synthesizing currency put options. In addition, banks create synthetic puts to hedge their over-the-counter derivative positions.10 If they create a synthetic put, as do many pension funds and wholesale banks, they commit themselves to a dynamic trading strategy that mandates a forward or spot sale of the currency when the spread between the attacked currency’s interest rates and domestic interest rates rises. Thus, raising the interest rate in the usual manner could perversely induce net sales of the currency being defended if the dynamic trading strategies required by synthetic puts are widespread enough. Although the volumes involved in such operations are unknown, it is estimated that currency sales from dynamic hedging ranged from 5 percent to 10 percent of the overall selling volume stemming from the crisis.

French Franc

After the withdrawal of sterling from the ERM on September 16, the French franc came under heavy attack, which initially was met mainly through intervention. The exchange rate was kept somewhat above the floor value that would trigger obligatory Bundesbank lending through the VSTFF.

On Monday, September 21, the day after the French referendum narrowly approved the Maastricht Treaty, the opening of business in New York brought an unexpectedly sharp attack on the French franc. The turning point came on the morning of September 23, after the Bank of France raised the short-term repurchase rate by 250 basis points to 13 percent. This action was reinforced by a joint statement from the French and German central banks and finance ministries that declared that the franc/deutsche mark central parity did not need to change. The statement was backed by heavy intramarginal intervention in the foreign exchange market by the Bank of France and the Deutsche Bundesbank—the first time the latter had intervened to defend an exchange rate that was above its compulsory intervention level. The market finally stabilized on Wednesday afternoon with a decline in pressure from New York and with the direct intramarginal intervention of the Bundesbank.

Private buying of the French franc resumed on Monday, September 28, and much of the lost foreign exchange reserves were recovered. Since positions taken by speculators were often for one month, however, most of the lost reserves poured back into France one month later. By the end of October 1992, gross foreign exchange reserves totaled $30.9 billion, reflecting a small increase from $28.5 billion (Table 10) at the beginning of the crisis.

After initially relying only on intervention, the Bank of France shifted to an interest rate defense on September 23. The Bank of France normally provides liquidity to the money markets through two outlets: a low-priced auction facility, which carried a rate of 9.60 percent during the month of September; and a higher-priced 5- to 10-day repurchase facility. The interest rate on these repurchases was increased from 10.5 to 13.0 percent on September 23. To isolate the effects of an interest rate squeeze on perceived speculators, banks could get relatively inexpensive funding if their demand for funds arose from normal commercial requirements. These funds would then be passed through to commercial customers at a base rate that was kept unchanged although money market rates had increased markedly.

Paper eligible for discounting (government securities and eligible trade paper) at the Bank of France was not available in sufficient amounts during the crisis to provide for all liquidity demanded at the increased refinancing rate, so money market overnight rates rose to between 25 and 30 percent for several weeks. Chart 5 displays the impact of this policy on French overnight rates. A comparison with Chart 4 indicates the increase in the spread between the overnight rate and the official 5- to 10-day repurchase rate. Discountable paper is held mostly by money market SICAVs, funds that are mainly managed by the banks, which are limited in the amount of paper that they can lend from their portfolios. Such SICAVs must maintain a certain percentage of their holdings in such paper, and banks are limited in the amount of their own paper that they can place with their money market SICAVs. Through this system of interest rates, the Bank of France was able to increase the cost of funds to speculators without access to appropriate paper or preferential access to the repurchase facility—while keeping the prime rate low and avoiding a higher general level of interest rates.11

Swedish Krona

The Swedish defense was the most drastic squeeze implemented during the exchange rate crisis. Swedish officials had strongly emphasized the policy primacy of maintaining the parity with the ECU. The three-month attack on the krona began on August 21 and was met with an increase of the Riksbank’s marginal lending rate, which rose from 13 percent to 75 percent by September 9 (Table A11).12 On September 9, the Riksbank announced its plans to arrange private funding for its interventions. After the marginal rate was lowered to 20 percent on September 15, it was increased to 500 percent on September 16. This increase was followed by a series of reductions that lowered the rate to 11.5 percent on November 10. On November 19, faced with a resumption of the attack (after initially raising the marginal rate from 11.5 percent to 20.0 percent), the Riksbank allowed the krona to float, and dropped its marginal rate back to 12.5 percent.

The pass-through of the marginal rate increases to other rates was rapid. For example, the ask rates for interbank 1-month, 3-month, and 12-month funds jumped from 16.15 percent to 33 percent, 15.05 percent to 23 percent, and 13.8 percent to 16 percent, respectively, between September 7 and September 11. These same rates jumped from 25 percent to 70 percent, 22.5 percent to 34 percent, and 16.5 percent to 20 percent, respectively, between September 15 and September 17. Chart 5 indicates the impact on one-week Stockholm interbank offered rates (STIBOR).

These increases in interest rates affected the overnight funding of the banking system and also indirectly increased the pressures on an already troubled banking system by exacerbating the problem of nonperforming assets on bank balance sheets.13

From September to December, the Riksbank borrowed approximately ECU 12.5 billion from private banks (Table A12) to augment its foreign exchange reserves, which totaled $16.6 billion at the end of August 1992.

Deutsche Bundesbank

Although the Bundesbank reduced its discount rate from 8.75 percent to 8.25 percent and the Lombard rate from 9.75 percent to 9.5 percent effective September 15, the main thrust of its role in the defense of the ERM was in providing credit for intervention by other central banks through the VSTFF or bilateral lending.14 In the September attacks, the Bundesbank was the major lender of foreign exchange reserves. Given the operating rules of the VSTFF, with the deutsche mark at or near the top of the band, the Bundesbank was called upon to provide the funding for further intervention. Through the VSTFF and the Bundesbank’s own direct lending and interventions, a substantial volume of foreign exchange was sold to the Bundesbank. This put pressure on the Bundesbank’s monetary policy.

In September 1992, inflows as a result of intervention were about DM 92 billion—considerably smaller than the Bundesbank’s sterilization capabilities.15 Nevertheless, additional sterilization might have been disruptive to individual markets. For example, swaps of non-ERM currencies were marketed at rising deutsche mark interest rates, which, in the context of the run into the deutsche mark, was an unstable outcome because increasing interest rates might attract even larger inflows.

Sterilization was carried out on a gross level through repurchase agreements for securities; the amount of outstanding repos was reduced as expiring contracts were not renewed. Repurchase offerings were speeded up from biweekly to weekly intervals. The repos issued were aimed at extracting sufficient liquidity to eliminate the interest rate effects of the expected inflows of foreign exchange between repurchase operations. Between weekly offerings, the Bundesbank used bill sales, the movement of government funds on its balance sheet, and currency swaps, to expand and contract liquidity as necessary to meet unanticipated foreign exchange inflows. The currency swaps were for maturities of from one to three days.

The Bundesbank did not completely sterilize the impact of the foreign reserve inflows on the monetary base, as deposits of domestic credit institutions in the Bundesbank increased from DM 65 billion to DM 91 billion, and total Bundesbank liabilities increased from DM 367 billion to DM 380 billion between September 23 and September 30. Short-term interest rates fell on average during September compared with August by 40 basis points for overnight funds, 37 basis points for one-month FIBOR, and 38 basis points for three-month FIBOR.

Capital Controls

Capital controls, if introduced suddenly, can assist in the defense of a currency by limiting the speculators’ and hedgers’ ability to take a short position in the currency. Such controls essentially isolate the would-be seller of the domestic currency from the domestic banking system. Capital controls played significant roles in the defenses of three currencies: the Irish pound, the Portuguese escudo, and the Spanish peseta. The Spanish central bank introduced new controls, while the Portuguese and Irish central banks tightened existing ones.16

The Bank of Spain introduced three new controls on the foreign exchange activities of domestic banks on September 23. To discourage speculation by domestic banks, they were required to deposit an amount equal to the peseta value of new long positions in foreign currencies (with maturities at or before the spot value date) in one-year, non-interest-bearing deposit at the Bank of Spain. To discourage speculation by foreign banks, domestic banks were required to deposit an amount equal to the value of new peseta-denominated loans to nonresidents other than those related to commercial activities. Finally, a cash reserve equal to 100 percent of new peseta liabilities in branches and subsidiaries of Spanish banks abroad or in domestic branches of foreign banks was required.

These controls were rescinded on October 5 and replaced by a requirement for non-interest-bearing deposits at the Bank of Spain for the peseta counterpart of same-day or next-day peseta sales to nonresidents. Similar deposits were required for the peseta counterpart of new forward short positions in foreign currency contracted with nonresidents. These added restrictions were rescinded on November 22.

The Central Bank of Ireland introduced no new capital controls but enforced existing ones, which had apparently not been strictly enforced. Credits to nonresident Irish pound-denominated accounts exceeding £Ir 250,000 had to be reported to the Central Bank of Ireland unless the credit was trade related. Forward foreign exchange transactions of less than 21 days, and all nontrade-related forward transactions were prohibited. Swaps and loans to nonresidents for periods of less than one year had to have permission of the Central Bank of Ireland. These restrictions were rescinded on January 1, 1993.

The central bank of Portugal likewise introduced no new controls. In August 1992, it announced that the existing foreign exchange controls would be eliminated by the end of the year. However, since most were to be phased out after the end of October they were still in effect during the crisis in September. Therefore, in mid-September, the central bank reminded domestic banks of their obligation to obtain its approval before taking open foreign exchange positions. Although such approval had previously been easily forthcoming, in September the central bank began refusing applications. In addition, prohibitions against short-term escudo lending to nonresidents and nonresident purchases of domestic money market instruments were enforced. The remaining foreign exchange and money market controls were eliminated on December 16.

Financial Market Developments During the Crisis

During the currency crisis, and particularly during the period of greatest activity in the last two weeks of September, unprecedented volumes of transactions took place in foreign exchange cash and derivatives markets. The sudden increase in exchange rate and interest rate volatilities caused problems for the pricing of financial derivatives and resulted in declining liquidity in many markets. The most interesting development in these markets during this period was the shift of activity from the OTC markets (generally the largest segment of the derivatives markets) to the exchanges. The bid-ask spreads in the forward foreign exchange, currency swap, and OTC options markets in the currencies under attack widened significantly at the height of the crisis.

These sporadic illiquidities in the cash and derivatives markets caused the breakdown of some assumptions underlying most hedging strategies. For example, once it became clear that a dynamic hedging strategy could not be maintained in an environment in which funds could not be moved at low spreads, portfolio managers and traders shifted away from the partial hedging indicated by these strategies to 100 percent hedged positions. Thus, market illiquidities themselves triggered additional selling of the weak currencies.

Cross-Border Flows

A rough indication of cross-border activity during the crisis is given by the volume of transmissions through payments systems such as CHIPS. The data on CHIPS transmissions is given in Table A7. The average daily value of transmissions for the first eight months of 1992 was $911 billion, 4.5 percent higher than the $872 billion recorded for the same period in 1991, although virtually the same number of payment instructions were sent during both periods. But in September 1992, the average daily value of transmissions increased by 20 percent over the August average, to $1,063 billion. Transmissions remained above $1 trillion per day until December, when the average fell to a level comparable to earlier months.

Most of the increased volume of CHIPS transmissions can reasonably be attributed to developments in the foreign exchange market.17 The timing of the increased volume coincides with the period of greatest activity in the foreign exchange markets. Moreover, the volume of transmissions through the U.S. domestic payments system, Fedwire, did not change significantly during these three months compared with earlier months of 1992 or with the same period in 1991, suggesting that the cause of increased CHIPS activity was not domestic in origin.

Money and Foreign Exchange Markets

Several central banks defended the currencies under attack by squeezing market participants who were short in these currencies. Inevitably, these high interest rates were charged to all parties with short positions in these currencies, regardless of their motivation. The large fluctuations in overnight rates generated by the squeeze, along with the heightened risk of being unable to obtain funds at all in such an environment, increased the risks of making markets in money market instruments and foreign exchange. In such circumstances, dealers widen their bid-ask spreads and lower the volumes in which they offer to trade. Ultimately, if interest rate levels and volatility increase sufficiently, markets may close, or traders may post only nominal prices.

In fact, the variability in official and market interest rates shown in Charts 4 and 5 did cause liquidity in some money and bond markets to suffer. Chart 6 shows the evolution of ask-bid spreads in interbank lending markets in France, Germany, Sweden, and the United Kingdom. In France, one-month interbank spreads widened to 100 basis points from a norm of 12 basis points during the last week in September and the first week in October. The spread on one-month rates in Sweden peaked at 20 percentage points in late September, while German and U.K. spreads, although particularly variable on short-term deposits, remained significantly lower. Unlike the other markets, however, the peak spreads on one-month and overnight deposits in the United Kingdom did not coincide. One-month rates peaked during the week of greatest activity in mid-September, while the spread on overnight rates peaked in mid-October.

Chart 6.
Chart 6.
Chart 6.

Ask-Bid Spread on Interbank Rates with Various Maturities, September-October 19921

(In percent)

Source: Data Resources, Inc.1 Gaps indicate that data are not available.

The spot foreign exchange markets never ceased operating, and continued to transact in large volumes, although by September 16, the Bank of England was almost the only significant purchaser of sterling. Ask-bid spreads in these markets also widened, however, to five or ten times their normal values for most intra-ERM exchange rates (see Chart 7). Spreads in forward markets widened also, reflecting the greater volatility in interest rates from which forward contracts are priced.18 Liquidity suffered more in the forward markets than in the spot markets. Market makers in lira and sterling forwards and swaps stopped making two-sided quotes in mid-September, and on the eve of these currencies’ withdrawal from the ERM, interbank activity had essentially come to a halt. The forward sterling market recovered by the end of the week, but the lira market remained inactive for up to two weeks, although notional prices are available (see Charts 8 and 9).

Chart 7.
Chart 7.

Ask-Bid Spread on Spot Exchange Rates Against U.S. Dollar, September-October 19921

(In percent)

Source: Data Resources, Inc.1 [(ASK-BID)/BID] x 100.2 Gaps indicate that data are not available.
Chart 8.
Chart 8.

One-Month Forward Exchange Rates Against Deutsche Mark, August-November 1992

Source: Data Resources, Inc.1The vertical line is drawn over September 16.2The vertical line is drawn over November 19.
Chart 9.
Chart 9.

Three-Month Forward Exchange Rates Against Deutsche Mark, August-November 1992

Source: Data Resources, Inc.1The vertical line is drawn over September 16.2The vertical line is drawn over November 19.

Futures Exchanges

The demand for futures contracts expanded because of the increased hedging activity and because of the loss of liquidity in the OTC forward exchange and swaps markets. In addition to the effects of increased interest rate volatility that made the pricing of forward contracts difficult, the forward market could not expand to meet the increased demand because banks cut or did not expand credit lines to many of their customers. Consequently, these customers had to move their operations to the organized exchanges. These exchanges are more liquid because they offer uniform products and require participants to post liquid margin deposits to guarantee settlement.

Data on the history of trading in the major currency futures are presented in Table A6. Data on interest rate futures are presented in Table A13. As with currency futures, the principal exchanges on which interest rate futures are traded are CBOT, LIFFE, and MATIF. The market for interest rate futures is broader and more active than the market for currency futures. Indeed, turnover in the CBOT’s U.S. Treasury Bond futures contract is the highest for any financial security anywhere. Moreover, between end-1987 and end-1991, the number of interest rate futures contracts traded increased by 61 percent, while the number of currency futures increased by only 41 percent. In 1991, 234 million interest rate futures contracts were traded, while only 29 million currency futures contracts changed hands.19

Chart 10 shows the daily volume of currency and interest rate futures in the early fall of 1992. Trading in each of the three currency futures contracts peaked just before the withdrawal of the pound sterling and lira from the ERM. Trading in the deutsche mark contract greatly exceeded trading in Swiss franc or pound sterling contracts, reflecting the greater use of that currency in hedging European exposures. LIFFE’s Eurodollar contract and the CME’s dollar LIBOR contract showed no significant changes, which illustrates that this episode was largely confined to European currencies. However, trading in sterling, deutsche mark, and Paris interbank offered rate (PIBOR) futures showed furious activity before and immediately after September 16. At the CME, 28,173 pound sterling futures contracts were traded on September 16 alone, more than twice the daily average for the first eight months of 1992.

Chart 10.
Chart 10.

Volumes of Selected Financial Futures Contracts Traded, August-October 19921

(Number of contracts)

Source: Reuters.1Missing dates indicate the official holidays. The vertical line is drawn over September 16.

Trading for the week of September 14-18 reached record levels on many exchanges. Average daily turnover of short sterling futures at LIFFE was 148,454 contracts that week, up from 66,488 the previous week. Volume fell to 68,508 the week following sterling’s withdrawal from the ERM. Average daily turnover in Euromark futures likewise jumped to 132,112 contracts, from 59,968 the previous week, and remained at an elevated level for the rest of the month. On September 16 alone, 886,100 contracts were traded on LIFFE, 38 percent more than the previous record daily turnover. This represented a notional volume of £254 billion. For the month of September, a record 1.7 million Euromark futures contracts changed hands on LIFFE, and volume fell only slightly, to approximately 1.5 million in each in October and November. On MATIF, average daily turnover of contracts on notional bonds rose from 160,264 contracts during the week of September 7-11, to 263,118 during the week of September 14-18. For the month of September, almost 1 million PIBOR contracts were traded on MATIF, compared with January 1992, with a turnover of 484,462.20

One of the responses to the turmoil in the foreign exchange markets was an increase in the margins required for purchases of some futures contracts. For example, on September 17, the initial and maintenance margins on the pound sterling futures contract on the CME were at least doubled, to $4,050 and $3,000 from $2,700 and $2,000, respectively (see Chart 11). Likewise, the margins on deutsche mark, Swiss franc, and Canadian dollar futures were increased on the same day. The margins on the deutsche mark/yen contract on the CME were increased by a similar proportion, to ¥371,250 and ¥275,000, on October 6.

Chart 11.
Chart 11.

Margin Requirements for Speculators and Hedgers/Members

(In U.S. dollars per contract)

Source: Chicago Mercantile Exchange.

The London Clearing House (LCH) made an additional margin call on Monday, September 14, of £298 million, the largest ever. The LCH too increased its margin requirements, doubling most of them, effective September 18. The margins on the short sterling, Euromark, ECU interest rate, and Euro-Swiss futures doubled to £1,250, DM 1,500, ECU 1,500, and Sw F 1,500, respectively. The margins on the Eurolira and BTP futures increased by Lit 1 million to Lit 5 million and Lit 6 million, respectively. On December 23, MATIF raised the initial margin on PIBOR futures from F 10,000 to F 12,500.

Options Exchanges

Just as the forward foreign exchange market dried up during the crisis, necessitating a shift to the futures exchanges, the OTC options market also became illiquid.21 This happened for a number of reasons. First, as the increased realignment risk meant that historical exchange rate volatility was no longer a reliable estimator for future volatility, options writers had to raise the implicit volatilities of their contracts, increasing their prices. Implied volatilities in the sterling/deutsche mark options rose steadily from July onward from a low of 5 percent.

Second, options pricing models broke down during the crisis when their underlying assumptions were violated. For example, interest rate volatility increased to approximately five times its post-1987 levels. Even those options pricing models designed to allow for discontinuities in interest rates could not cope with such volatility. Also, options pricing became difficult because the strike price is compared with the current forward exchange rate to determine how far in or out of the money the option is, and therefore to determine its price. Since banks were not quoting forward prices, it was impossible to price options. As a result, by September 17, the interbank currency options market had dried up. Except for the dollar/deutsche mark option, only very few customers were able to get quotes of currency options from their banks. Those quotes that were given carried large implicit volatilities, of about 25 percent, and bid-ask spreads had widened to 10 percent. The market for interest rate options fared better, although implied volatilities and bid-ask spreads remained unusually high.

Third, because of the huge volumes of turnover leading up to the middle of September, credit lines for interbank market participants filled up. Without credit they had to move to the exchanges to hedge their positions. In addition, creditworthiness concerns forced banks to be more careful about counterparty risk, and credit watches were initiated.

Consequently, although the exchange-traded options market has historically been dominated by the OTC market, investors wanting to buy or sell financial options had to do so on exchanges. The history of the turnover for exchange-traded currency options is given in Table A6 and for interest rate options in Table A13.

Currency options turnover on PHLX in September was an average of 77,877 contracts a day, up 76 percent from the average of approximately 44,000 contracts a day in January-August. Open interest at the end of September exceeded 1 million contracts, compared with an average of only 689,000 during the previous eight months. Currency options on CBOT showed somewhat smaller increases in activity. For example, turnover of the deutsche mark option on the CME was 610,000 contracts in September, up 20 percent from the monthly average for the previous eight months.

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International Capital Markets: Part I
  • Chart 2.

    Interest Rate Differentials on Eurocurrency Deposits: Deutsche Mark Minus U.S. Dollar

    (In percent)

  • Chart 3.

    Interest Rate Spreads (Long-Term Minus Short-Term)

    (In percent)

  • Chart 4.

    Official Overnight Interest Rates, August-November 1992

    (In percent)

  • Chart 5.

    Domestic Short-Term Interest Rates, August-November 1992

    (In percent)

  • Chart 6.

    Ask-Bid Spread on Interbank Rates with Various Maturities, September-October 19921

    (In percent)

  • Chart 7.

    Ask-Bid Spread on Spot Exchange Rates Against U.S. Dollar, September-October 19921

    (In percent)

  • Chart 8.

    One-Month Forward Exchange Rates Against Deutsche Mark, August-November 1992

  • Chart 9.

    Three-Month Forward Exchange Rates Against Deutsche Mark, August-November 1992

  • Chart 10.

    Volumes of Selected Financial Futures Contracts Traded, August-October 19921

    (Number of contracts)

  • Chart 11.

    Margin Requirements for Speculators and Hedgers/Members

    (In U.S. dollars per contract)

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