In the discussion of economic questions, even in the nonspecialist press, many terms are used which until quite recently were employed only by economists or others professionally concerned. This series of articles is designed to explain the economists’ shorthand.
FORWARD EXCHANGE MARKETS deal in current commitments to buy and sell currencies for delivery and payment at some prescribed time in the future. They may be considered as markets distinct from (though directly connected with) normal foreign exchange markets which deal in current, or “spot,” transactions, because they have their own prices, and their own methods of determining them, which are different from those in spot exchange markets. For simplicity, let us assume that there are only two currencies in existence, A and B, which have a “pegged” rate of exchange for each other which has no variation unless the government concerned changes the peg. The spot rate for currency A measures the number of units of currency B which one A can buy on the spot (in practice for settlement within two days of the transaction in most markets) and the forward rate for A measures the number of units of B which one unit of A can buy at a given time in the future for a contract concluded now. Though in reality there are various periods of maturity for forward contracts, from three days onward, let us assume that there is only one period of three months being used. The forward rate for currency A is said to be at a premium with respect to the spot rate when it buys more of currency B than the spot rate, and the premium is expressed as the difference between the two rates as a percentage per annum of the spot rate. Conversely, it is said to be at a discount when it buys fewer units of currency B, and the discount is expressed in the same way.
Why should such a market for buying and selling in the future exist at all? Its existence is due to the fact that export and import transactions usually involve periods of waiting for payments and receipts, and the amount of currency which may be received for or paid for a foreign currency in the future is not completely certain. A slight change in the spot exchange rate may involve traders in profits or losses unrelated to the normal flow of business. There is, therefore, an exchange risk involved for anyone who is holding a foreign currency or a foreign debt without the protection that is given either by a present sale or purchase of the domestic currency or by a forward deal which would offset the risk. Anyone in this situation is said to be holding a net position; and as he is unprotected “forward” his position is described as “uncovered.” Thus, any trader who wishes to avoid an exchange risk must either deal entirely in current transactions with no uncovered positions in foreign currencies or cover himself entirely in the forward market. Since most traders and short-term investors are involved in transactions which by necessity involve future payments or transfer, they must enter into forward contracts unless they deliberately choose to assume the exchange risk of an uncovered contract. For instance, an exporter who expects payment some months from now in foreign currency can sell that currency forward now; or an investor who buys foreign currency now to invest in bonds in a foreign country can sell the proceeds of his investment forward until the time at which he anticipates repatriation of his funds; and so on, so that the demand for and supply of different currencies in the forward market establishes a price for forward exchange related to the spot market but not entirely determined by it. This forward market should not be thought of merely as an ancillary of the spot market; it is a significant part of the total exchange market and handles the bulk of normal international trade.
It is possible to distinguish three types of private dealings in forward exchange markets: for interest arbitrage, for speculation, and for commercial purposes. For a full understanding of this it is important to know something of the nature of the parties involved. Only “authorized dealers” can actually deal, and such authorized dealers are generally institutions, most characteristically banks, with large financial resources. The clients who trade through such dealers are businesses, small or large, or private individuals. When the authorized dealers deal on their own account they may be acting as “speculators” (see below); such speculation is systematic and highly sophisticated and backed by great resources of expertise and experience. There may be individuals who (through authorized dealers) speculate as though they were playing a kind of financial roulette, but these are not characteristic of the speculators, whether institutions or not, whose informed views and careful judgment might move the market in such a way as to influence financial authorities.
Interest arbitrage means the shift of funds by an investor from an asset offering a low interest rate in one country to one offering a higher rate in a different country. It is part of the normal process of maximizing earnings from investment. An investor who wishes to buy assets in money markets abroad has, however, first to buy the requisite foreign currency; and then, when he wishes to repatriate his funds at the maturity of his investment, he has to sell the foreign currency. Anyone who invests abroad exposes himself to an exchange risk as long as he holds an uncovered position in the foreign currency; to rid himself of this risk, he can sell the foreign currency on the forward market at the time that he buys it on the spot market, thus entering into what is called a swap. In this way, he can benefit from higher interest rates abroad without bearing the risk of a change in exchange rates. Such transactions may be described as “pure arbitrage.”
The differential between forward rates for two currencies tends to reflect the difference between the domestic interest rates of the countries concerned. When then will “pure arbitrage” occur? Clearly, if the forward rate is equal to the spot rate, then any difference in interest rates between two countries would make arbitrage profitable. Thus, if the return to an investor from investing for three months in country B were 5 per cent higher than the yield in country A, and if the forward rate for three months were equal to the spot rate, then the profit from arbitrage would be 5 per cent (minus the cost of the actual transaction). If the forward rate for currency A were at a discount to the spot rate, then the profit to be made by country A’s investor would be higher than 5 per cent. If the forward rate were at exactly a 5 per cent premium with respect to the spot rate, there would be no profits from arbitrage because the gain from higher interest would be canceled by the higher cost of the domestic currency in the forward market. Conversely, if the forward rate were lower than the spot rate, the arbitrage profits would be larger than that yielded by the interest differential.
Put more generally, if the difference in interest yields between two countries is exactly matched by a diametric difference between the forward and spot rates of exchange for their respective currencies, then there is no profit in covered interest arbitrage in either direction. This may be called the “neutrality condition.” If the forward rate differs from its value in the neutrality condition, assuming that interest rates are unchanged, pure arbitrage becomes profitable because the gain from the difference in interest rates is not completely offset by the cost of forward cover. Given the interest rate differential, arbitrage would tend to affect forward rates in such a way that the neutrality condition is achieved.
The fact that arbitrage of fully covered funds is determined not only by interest rates but also by the condition of the forward market is of significance to economic policy. The authorities in a country usually prefer to have their interest rates determined by long-term economic considerations and are loath to change them to suit the needs of short-term international monetary flows. The forward market provides a convenient way of affecting covered arbitrage funds while maintaining an independent domestic monetary policy. The use of the forward market as an instrument of policy is not, however, free from difficulties, as we shall see later.
It is important to distinguish between arbitrage and speculation. While arbitrage involves the renunciation of exchange risk, speculation is in essence the conscious assumption of such a risk in the expectation of a capital profit. The speculator in forward exchange takes a definite view of future events in the foreign exchange markets and deliberately adopts an uncovered position in some currency so as to benefit from a change in exchange rates. For instance, if a speculator believes that currency A is shortly to be devalued, he will try to buy and hold currency B so that after the devaluation he can convert back into A and get more than he paid initially. He can, as an alternative, operate in the forward market with substantially the same results; he can sell A (buy B) forward at the present rate ruling in the forward market. Let us assume that this rate equals the spot rate. After three months his contract matures and he obtains B at a rate equal to the previous spot rate. Meanwhile, currency A has been devalued in terms of B, and he can now sell the units of B he had contracted for at the new spot rate and obtain a larger quantity of A than he originally paid for. Thus, speculative profits are made by simultaneous entry into spot and forward markets at the time of maturity of the forward contract, by the difference between the two rates. If the speculator belongs to country A, then the government of A loses domestic currency to him; if he belongs to country B, then the government of A loses reserves to the extent of his profits.
It is possible for a speculator, who has to be an authorized dealer in the exchange market (a bank or similar institution) to operate in the forward market without possessing ready funds, since he can enter into forward contracts now on the surety of his signature or fixed assets in anticipation of finding funds three months hence by liquidating some of his assets or by borrowing for a single day, at a time when (he hopes) he will be assured of a profit. In fact, he may not even borrow on the day of maturity of the contract, but just collect his profits or pay for his losses; the actual borrowing and repayment of the principal become implicit. If he wishes to continue speculating he can contract forward for another three months. Such a transaction may be called “pure speculation,” in contrast to speculation which is backed by ready funds. The significance of “pure speculation” is that it creates pressures in the forward market which affect the flows of arbitrage funds, and thus it indirectly influences reserves. To revert to the example of a devaluation of A’s currency; speculative pressure to sell currency A forward will lower the forward price of A, and if previously the neutrality condition obtained (that is, there was no arbitrage of covered funds either way and if interest rates are not raised) there will now be an inducement to covered arbitrage out of country A into country B. This will reduce the foreign exchange reserves of A’s authorities (assuming a basic deficit in the balance of payments) and create the impression that the crisis is worsening. Such speculative pressure may so accentuate loss of confidence in the currency that in the extreme case devaluation is forced upon the authorities. Thus, pure speculation can have effects more powerful and dramatic than its eventual effect on reserves, and as such is a potential danger whenever a currency’s future value is in doubt.
If the assumption on which speculation is undertaken proves false, it of course carries its own penalty. To illustrate, if large numbers of speculators buy currency B forward and sell A forward in the belief that the currency A is about to be devalued, and there is in fact no devaluation, they find themselves holding currency B which they bought at a very expensive rate and which they have to convert at an unchanged, and relatively unfavorable, spot rate. The fear of this may deter speculation after the forward rate for currency A falls (and that for B rises) to some level below which the potential loss outweighs the gain anticipated from the devaluation. In a situation of this kind, much depends on what action may be expected from the monetary authorities; a strong stand taken by A’s authorities on the stability of the currency may well quell speculation by causing the speculators to incur substantial losses.
The destabilizing effect of speculation comes into play only in times of crisis of confidence in a currency’s external value; in normal times the effect of speculation is the opposite. It keeps the forward rate from fluctuating unduly by providing a strong link between the spot and forward markets, and thus makes for unity and continuity in the foreign exchange market as a whole.
Commercial Forward Exchange
Traders of all kinds can be placed in one of three classes: (1) those who never cover in the forward market, (2) those who always cover in the forward market, and (3) those who sometimes cover forward and at other times do not. The first two types are affected neither by the cost of forward exchange nor by expectations of changes in exchange rates, and are, therefore, of no relevance to our analysis. The third class of traders can be subdivided into trader arbitragers and trader speculators.
Trader arbitragers are those who cover sometimes from one country and at other times from another in order to minimize the cost of forward coverage; they are governed by the same factors which affect the pure arbitragers. Trader speculators are those who hold definite views on the future of the spot rate and sometimes carry out their transactions in the spot market and at other times in the forward market in such a way as to have uncovered positions in a currency that will benefit from a devaluation. Their behavior is similar to that of the pure speculators, but there is a significant difference between pure and commercial speculators insofar as the former do not possess ready funds and the latter do. For instance, importers in country A who have to make payment to country B in the future have the right and the means to convert to currency B through the spot market if they so desire; the only condition when they will stay in the forward markets is when the forward rate does not decline but is maintained at a high value. If the forward rate declines sharply, then, of course, it is more profitable for a speculator with ready funds to buy units of currency B spot and hold them until devaluation occurs. This has important implications for policy.
Policy for Forward Markets
In recent years some controversy has ranged round the desirability of official intervention in forward exchange markets. The case for intervention rests on two different grounds. The better known one is the support of the forward rate in times of crisis, in order to prevent outflows of arbitrage funds and thus to protect reserves. The other is the raising of the forward rate during normal times in order to enhance reserves; this has till now remained an academic suggestion and has received relatively little attention.
Support During Crisis
We have seen how a crisis of confidence in a currency (let us continue with currency A) causes speculative activity in the forward market that causes losses in reserves by outflows of arbitrage funds. As long as speculators persist in keeping the forward rate for currency A low by selling A and buying B forward, country A’s reserves will suffer losses and worsen the initial crisis. The loss of reserves will intensify speculation by institutions with surplus balances of currency A selling them in the spot market, and further worsen the currency’s reserve standing. If this occurs over a long enough period of time and other preventive measures fail to restore confidence, a devaluation may be forced upon the authorities when otherwise the crisis would have been weathered without devaluing. If, however, reserves are large enough to bear the temporary outflow of funds, it may be better, by not intervening, to let the forward rate decline below the spot rate and thus punish the pure speculators, and then, as the balance of payment situation improves and speculation declines, let the forward rate rise and arbitrage funds flow back in. Whether or not intervention is desirable depends partly on whether or not reserves are adequate and the crisis short-lived enough to let events take their natural course, and penalize harmful speculation at the same time. Clearly it also depends on whether intervention in the forward market will have positive or negative effects on confidence in the authorities’ capacity to maintain the currency’s par value.
The distinction between pure and commercial speculators is important because the former cannot directly affect reserves before maturity of contract while the latter can, by switching to the spot market. If the number of speculators with ready funds at a particular time is large enough to have a really damaging effect on reserves it is obviously important to prevent them from wholesale conversion to B in the spot market, which would occur if A’s forward rate declined sharply. For this reason it may be advisable to support the forward rate for A at its neutrality-condition value during a crisis, to restore confidence by stemming an outflow of arbitrage funds and prevent commercial speculators from converting en masse. Of course, supporting the rate may itself encourage speculation by removing the penalty contained in the forward rate falling below the spot rate, but if the crisis is expected to be short-lived and devaluation is definitely not considered desirable such a price may be worth paying. Though it is difficult to know the identity of forward exchange dealers, since contracts change hands very often, the authorities can make a well-informed guess about how much hard cash is backing up speculation by their intimate knowledge of the market. The effectiveness of intervention depends to a great extent on its timing and manner. It is difficult to predict which way speculation will go—at one time massive intervention may restore confidence, at another it may destroy it completely; announcement of intervention or its secrecy may similarly have opposite effects.
Keynes proposed, long before the forward market gained notoriety for its speculative outbursts, the use of official intervention to raise the forward rate and induce arbitrage into a country during normal times as a means of freeing internal interest rates from the external trade and reserve situation. The forward exchange rate instrument was seen as securing the best of both worlds—an independent domestic monetary policy and controllable external capital movements.
Manipulation of the forward rate for this purpose is, however, subject to limitations. First, it is not feasible to raise forward rates by intervention in the market over a long period. If the knowledge of large official commitments spreads, it may create a fear that authorities would be unable to meet all their commitments, and may cause a crisis and lead to undesirable speculation. Second, the supply of short-term funds for international arbitrage is limited, and after a stage may cease to respond to further increases in the forward premium. The authorities would then have to pay out larger and larger premiums to attract to the arbitrage channels funds which are normally invested elsewhere. After some time the costs may outweigh the benefits. Third, forward exchange costs are a part of the normal costs of exporting and importing for those traders who always fully cover their transactions. A rise in the forward rate makes it more expensive for domestic exporters to cover, thus increasing the price of their goods abroad while making it cheaper for importers and thus lowering the domestic price of imports. The effect is the opposite of a devaluation of the domestic currency, and makes for a rise in imports and a fall in exports—certainly not an outcome desired by most countries.
All this implies that an active forward exchange policy for enhancing reserves should be used deliberately only as a short-term, restricted policy, which would work well if the amount of intervention were small and confidence in the currency strong. Otherwise the Keynesian method may prove harmful in the long run. This proposal has not, in any case, been tried out as a long-term policy, and intervention has been confined to fighting speculation.
It is by now a matter of history that official intervention in forward markets has been carried out by various governments with some measure of success—for instance by the Bank of England in 1965 and 1966, the Canadian Government in 1962, and the U.S. authorities since 1961. Such intervention in forward markets should be distinguished from official forward exchange dealings between different central banks which are part of swap transactions. These transactions usually take place outside the actual markets (perhaps even at different exchange rates), and their purpose is to provide convenient additions to reserves during difficult periods at very short notice. A country which is backed by central banks of other countries has more confidence in its ability to survive a short-term crisis without devaluation, and this confidence may encourage it to intervene directly in forward markets more promptly. All these measures have somewhat lessened the speculation which is the bane of the present international monetary system.
DIRECTION OF TRADE
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