© 1993 International Monetary Fund

ISBN 1-55775-290-7

ISSN 0258-7440

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Contents

• Preface

• I. Introduction

• II. The Foreign Exchange Market in International Investment Today: Players, Instruments, and Opportunities

• III. Prologue to the ERM Crisis: “Convergence Play”

• IV. Private Sector Behavior During the Crisis

  • Role of Institutional Investors

    • Global Hedge Funds

    • Institutional Investors and Corporations

  • Role of the Banking System

  • Liquidity Problems During the Crisis

• V. Tactics for Defending ERM Parities

  • Official Intervention

    • Existing Stock of International Reserves

    • Borrowing from Private Markets

    • Borrowing from Official Sector

  • Defensive Increases in Interest Rates

  • Capital Controls

• VI. Policy Options in the Aftermath of the Crisis

  • Characteristics of Exchange Arrangements

    • Putting “Adjustable” Back into “Fixed and Adjustable Peg”

    • Wider Margins

    • Move More Rapidly to EMU

    • Leave ERM Design as It Is but Improve Rule Implementation

  • Interest Rate Policy

    • Give Greater Independence to Central Banks

    • Invigorate Coordination More Widely

  • Intervention Policy: Re-examine “Unlimited” Obligation

  • Regulatory and Prudential Framework: Re-examine Position-Taking in Forex Market

• VII. Conclusions

• Annexes

• I. Structure of the Global Foreign Exchange Market

  • Market Participants

  • Instruments Traded

  • Foreign Exchange Payments Systems

• II. Uses of Foreign Exchange Instruments

  • Arbitrage Between the Foreign Exchange and Money Markets

  • Synthetic Money Markets

  • Hedging Foreign Exchange Exposure

• III. Regulatory and Internal Constraints on Foreign Exchange Trading

  • Regulation of Financial Institutions’ Foreign Exchange Positions

  • Margin Requirements on Exchange-Traded Exchange Rate Contracts

  • Internal Risk Management Controls

• IV. Mechanics of Speculative Attacks

  • Bank Covering Operations for Forward Contract Positions

  • Alternative Position-Taking Strategies and Their Costs

• V. Economics of Speculative Attacks

  • Dynamics of Speculative Attacks

  • Multiple Equilibria

  • Lessons from the Literature

• VI. The ERM Crisis of September 1992

  • Pre-Crisis Cross-Border Capital Flows

  • Speculative Attacks and Defenses

  • Financial Market Developments During the Crisis

• VII. Glossary of Financial Terms

• Statistical Appendix

• References

• Tables

• Section

• II.

  • 1. Distribution of Assets Managed by Leading Fund Managers in Europe and the United States, December 31, 1991

  • 2. Foreign Investments of Pension and Open-End Mutual Funds for Selected Industrial Countries, 1991

  • 3. Regulatory Constraints on Foreign-Currency-Denominated Investments by Major Financial Institutions in Selected Industrial Countries

• III.

  • 4. External Net Capital Flows for Selected Countries in the EMS

• Annex

• I.

  • 5. Net Foreign Exchange Market Turnover

  • 6. Distribution of Turnover by Currency

  • 7. Net Foreign Exchange Market Turnover by Counterparty

  • 8. Institutional Investors’ Foreign Securities Investments in Selected Industrial Countries

  • 9. Distribution of Net Turnover by Type of Transaction

• VI.

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

• Statistical Appendix

  • A1. Net Foreign Exchange Market Turnover Handled by Brokers in Selected Industrial Countries

  • A2. Assets of U.S. Institutional Investors by Type of Institution

  • A3. Investments of Japanese Life Insurers

  • A4. United States: Foreign Assets Held in Collective Investment Funds

  • A5. Outstanding Swap Transactions by Currencies

  • A6. Currency Futures and Options: Exchanges, Contracts, and Volume of Contracts Traded

  • A7. Average Daily Settlement Volume on CHIPS and Fedwire

  • A8. Italy: Net External Assets of Credit System

  • A9. Spain: Geographic Distribution of Foreign Investment Flows

  • A10. Germany: Geographic Distribution of Foreign Investment Flows

  • A11. Selected Central Bank Policies, June-December 1992

  • A12. Selected Sovereign Borrowing from Private Sources, June-November 1992

  • A13. Interest Rate Futures and Options: Exchanges, Contracts, and Volume of Contracts Traded

• Charts

• Section

• III.

  • 1. Interest Rate Differentials on Eurocurrency Deposits

• Annex

• VI.

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

  • 3. Interest Rate Spreads (Long-Term Minus Short-Term)

  • 4. Official Overnight Interest Rates, August-November 1992

  • 5. Domestic Short-Term Interest Rates, August-November 1992

  • 6. Ask-Bid Spread on Interbank Rates with Various Maturities, September-October 1992

  • 7. Ask-Bid Spread on Spot Exchange Rates Against U.S. Dollar, September-October 1992

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

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

  • 10. Volumes of Selected Financial Futures Contracts Traded, August-October 1992

  • 11. Margin Requirements for Speculators and Hedgers/Members

Preface

This report was prepared under the direction of Morris Goldstein, Deputy Director of the Research Department of the International Monetary Fund, together with David Folkerts-Landau, Chief of the Capital Markets and Financial Studies Division of the Research Department. The co-authors of the report are Peter Garber, Liliana Rojas-Suárez, and Michael Spencer.

This year’s capital markets report is divided into two parts. Part I examines the implications of the growth and integration of international capital markets for exchange rate management. Part II of the report—to be published later this year—will focus on sources of systemic risk in the international financial system. This report was prepared in connection with the annual surveillance of international capital markets conducted by the Research Department of the International Monetary Fund. It draws, in part, on a series of informal discussions with commercial and investment banks, securities houses, stock and futures exchanges, regulatory and monetary authorities, and the staffs of the Bank for International Settlements, the Commission of the European Communities, the Organization for Economic Cooperation and Development, and the Japan Center for International Finance. These discussions took place in Belgium, France, Germany, Hong Kong, Italy, Japan, the Netherlands, Singapore, Switzerland, the United Kingdom, and the United States between October and early December 1992.

In addition to the authors, other Fund staff members taking part in some of the discussions or making substantive contributions to the study at various stages included Robert Flood, Steven Fries, Zuliu Hu, and Tim Lane of the Research Department, Charles Collyns, Robert Rennhack, and Philippe Szymczak of the Policy Development and Review Department, and Steven Weisbrod, consultant. Kellett W. Hannah and Subramanian S. Sriram prepared the data presented in the report. Norma Alvarado, Maria Orihuela, and Janet Strain provided expert word processing assistance. Elin Knotter of the External Relations Department edited the manuscript and coordinated the production of the publication.

The study has benefited from comments by staff in other departments of the Fund and by members of the Executive Board. Opinions expressed, however, are those of the authors and do not necessarily represent the views of the Fund or of the Executive Directors.