CONTROLS on international capital transactions are usually considered as synonymous with controls designed to prevent an outflow of capital. However, in the years before 1939, a few countries attempted on occasion to restrain the inflow of foreign capital. More recently,1 while restrictions on capital outflows have been steadily relaxed in many countries, in 1960 Germany and Switzerland adopted positive policies designed to limit the inflow of foreign capital.
The Deutsche Bundesbank has intervened in the forward exchange market since early in 1959. The original purpose of this intervention was to encourage the German banks to hold foreign assets. After mid-1960, the authorities also wished to produce the congruent effect of discouraging covered interest arbitrage investment by nonresidents in Germany. Examples of earlier interventions in the forward market by authorities in a number of countries are discussed in the Appendix to this article. On June 3, 1960, the Bundesbank introduced a new group of measures, designed to restrain inflationary pressures in Germany and, at the same time, to discourage the inflow of foreign funds. On August 18, 1960, the Swiss National Bank reached an agreement with Swiss deposit-money banks which, in effect, limited the rights of nonresidents to hold sight deposits with Swiss banks or to purchase Swiss securities, and imposed a charge on short-term deposits owned by nonresidents.
While these German and Swiss policies were similar, they were adopted to meet significantly different situations. Speculation regarding a possible appreciation of the deutsche mark undoubtedly contributed to the flow of short-term funds to Germany. However, at the time that action was taken, interest rates in Germany were higher than in other countries; consequently, simple market forces were attracting short-term investments by nonresidents and discouraging Germans from investing abroad. At the time that Switzerland took action, Swiss interest rates were lower than in any other important capital market. Hence, the flow of funds which these Swiss policies were intended to retard resulted primarily from speculative forces and from fears of political instability in other countries.
In 1959, interest rates in Germany were below those prevailing abroad. Thus, until October, call money rates at German banks were approximately 2½ per cent,2 while the rate on 90-day U.S. Treasury bills was higher throughout the year, rising to 4½ per cent by December. In the United Kingdom, France, and Canada, also, short-term rates exceeded those prevailing in Germany. With nonresident-owned balances in all the highly developed money markets convertible, the spread in interest rates provided an inducement for German residents, particularly the banks, to invest in short-term foreign assets. However, as the holding of claims denominated in foreign exchange involves an investor in an exchange risk, German banks might be expected to invest abroad only if their foreign position could be covered in the forward exchange market. In the normal course of events, this protective action would have resulted in forward exchange falling to a discount in terms of the deutsche mark. The Bundesbank wished, at this time, to restrict the liquidity of the economy, and the high and rising level of the country’s gold and foreign exchange holdings freed the Bank from international liquidity restraints. Hence the Bank was prepared to encourage the deposit-money banks to acquire short-term foreign assets. If the forward exchange rates could be prevented from going to a discount, the interest rate differential could exert its full effect as an inducement to short-term foreign investment by Germans, and a similar discouragement to foreign investment in Germany. The Bundesbank therefore intervened in the exchange market to maintain the forward rate for the dollar at a level close to the spot rate.3
It is impossible to measure the effects of this policy on the decisions of the banks. However, it ensured that Germans were able to obtain most of the benefit arising from the interest differentials between Germany and other countries. German banks took advantage of these differentials. As indicated in Table 1, their short-term foreign assets more than doubled during 1959. There is no information regarding the proportion of these holdings that was covered through forward operations with the Bundesbank. However, as the net foreign exchange position of the banks4 increased from a little over $100 million to over $500 million, it is reasonable to assume that a large part of this investment by the banks was covered against exchange risks.
|Million U.S. dollars|
|Billion deutsche mark|
The situation changed radically in 1960. In February, short-term interest rates in Germany rose above comparable rates in the United States. Hence, international interest rate differentials provided the banks with an inducement to realize their foreign investments and sell the exchange proceeds to the Bundesbank, thereby increasing their domestic liquidity. At the same time, nonresidents could profit by switching short-term investments to Germany, thus further augmenting the foreign reserves of the Bundesbank and the liquidity of the deposit-money banks. Table 1 indicates that the German banks reacted to these incentives and reduced their net foreign exchange positions by $450 million in the first half of 1960. Simultaneously, as shown in Table 2, nonresidents purchased more than DM 250 million of German securities. These flows contributed, in part, to the rise in the cash reserves of the German banks from DM 9.1 billion at the end of January I9605 to DM 12.3 billion at the end of June 1960. Despite several increases in the minimum reserve requirements applied to the deposit-money banks, they were willing to increase their credit to the private sector from DM 114 billion at the end of 1959 to DM 122 billion at the end of June.
|Changes in holdings of equities|
|Net purchases by Germans (-)||-252||-223||-413||-105||-347||-63||-232||-90||-44|
|Net purchases by foreigners (+)|
|Net changes in fixed interest securities|
|Net purchases by Germans (-)||-108||-251||-41||-35||-12||23||10||3||39|
|Net purchases by foreigners (+)|
|Other long-term capital1||-50||-100||86||-124||-139||-92||-178||33||51|
|Changes in terms of payment3|
On June 3, 1960, the authorities took action on three fronts to restrict the liquidity of the banks:6 (1) They increased the discount rate and raised the reserve requirements applicable to the deposit-money banks. (2) They took direct action to restrain the inflow of private capital. (3) They intervened in the forward market in an attempt to make covered short-term investment in Germany less profitable. The first of these measures is outside the purview of this article; the second will be discussed later.
Just as, in the absence of Bundesbank intervention, the excess of U.S. interest rates over German interest rates would have driven the forward rate for dollars to a discount in German markets during 1959, so in 1960 the excess of German rates over U.S. rates should have driven the forward rate for dollars to a premium. Such a premium developed in March, April, and May. However, from June, speculation regarding the future of the deutsche mark-dollar exchange rate moved the forward dollar to a discount. That is, nonresidents were able to profit not only from the spread between German and other interest rates, but, on the maturity of their investment, they could acquire more foreign exchange from the reconversion of the deutsche mark proceeds of their original transfer than they had previously converted into deutsche mark. In an attempt to offset the effects of this discount, as a stimulus to foreign investment, and to discourage German importers from financing their requirements abroad, the Bundesbank announced on August 24 that it would buy forward dollars at a premium equivalent to 1 per cent per annum. On September 26, it raised the premium to the equivalent of 1½ per cent per annum, but on November 11 restricted its operations to swap transactions with banks willing to hold foreign balances.
The Bundesbank’s intervention in the forward market was only a part of its program designed to limit the inflow of foreign short-term capital. Its more important measures were direct interventions in the operations of the banks. On June 3, it took the following actions: (1) prohibited the payment of interest on new deposits, with German banks, owned by nonresidents (other than savings deposits held by individuals), and prohibited the payment of interest on the renewal of time deposits owned by nonresidents after their original term had expired; (2) prohibited the sale to nonresidents of short-term securities and of any other securities under repurchase agreements; (3) made all nonresident liabilities of German banks subject to reserve requirements (previously, deposits denominated in foreign currency had been subject to reserve requirements only to the extent that they exceeded the foreign short-term assets of the banks concerned); (4) made the liabilities of the banks arising out of guarantees given for their customers’ borrowings abroad subject to the reserve requirements. The first two of these restrictions were direct attempts to deter the inflow of foreign capital. The fourth was an attempt to limit German borrowing abroad. Since many banks held foreign assets in excess of their foreign currency deposit liabilities, they were free to augment their domestic liquidity by accepting additional deposits in this form (selling the accruing foreign currency to the Bundesbank) without increasing their required cash reserves. Hence, the third restriction was imposed.
The direct restrictions on the inflow of foreign capital and the Bundesbank’s intervention in the forward market were approximately coincident. It is therefore impossible to assess their separate effects. However, as Table 1 shows, the foreign assets of the deposit-money banks fell only slightly after the end of June 1960, and rose in the last quarter of the year. It is significant, however, that the premium on forward exchange did not encourage the banks to rebuild their foreign assets to levels close to those prevailing at the beginning of the year. Their reluctance to do so is readily understandable. Short-term interest rates in Germany were at least 2 per cent per annum higher than in the United States from June onward, and almost 3 per cent higher in October. But in January 1961 this spread narrowed, and even though the Bundesbank lowered its swap premium to the equivalent of 1 per cent per annum on January 20, the difference between U.S. and German rates became marginally smaller than this premium. During this month, the German banks almost doubled their foreign assets. Between the end of June and November 1960, the liabilities of these banks to nonresidents remained relatively stable: the increase in the first half of the year was not continued. However, in December, nonresident-owned deposits rose markedly.
Further, the data in Table 1 probably overstate the net effect of the Bundesbank’s action. It is likely that the decline in the foreign assets of the deposit-money banks would have decelerated in any event. Having large foreign liabilities, these banks would be expected to maintain some foreign assets. It is difficult to know if total foreign assets at the end of June were much more than adequate cover for the outstanding liabilities. The statistics, as recorded, cannot indicate any evasion of the ban on interest payments to nonresidents by the transfer of nonresident-owned deposits to the nominal ownership of German intermediaries.7 Finally, as suggested by Table 2, the Bundesbank’s action probably changed the form taken by the capital inflow. Nonresident purchases of German longer-term securities increased markedly in the third quarter of 1960, and continued at higher levels in the fourth quarter. It is significant that the private capital transactions recorded in Table 2, other than “leads and lags,” which had absorbed almost DM 200 million of the capital outflow from Germany in the first six months of 1960 (i.e., approximately the period prior to the Bank’s action), contributed DM 1.8 billion of capital inflow in the last half of the year.
This inflow of capital, plus Germany’s continued surplus on current account, resulted in an increase in the Bundesbank’s foreign assets from DM 27.8 billion at the end of June 1960 to DM 31.3 billion at the end of October. The increase in foreign assets in the last half of the year was equal to nearly half of the total of its domestic assets (viz., DM 9.1 billion) at the end of June 1960. That is, the Bank was, in fact, unable to offset the increase in the deposit-money banks’ liquidity arising from the inflow of foreign exchange. In an attempt to regain control over the liquidity of the economy, by stemming the inflow of foreign capital, the Bundesbank acted on November 11, and again on January 20, 1961, to make German interest rates less attractive to foreign investors. In order to restrict the liquidity of the economy, the Bank lowered its discount rate from 5 per cent to 4 per cent, and then to 3½ per cent.
In the period prior to 1939, when “hot money” was flitting between major capital markets, the Swiss authorities attempted to stem the inflow of short-term funds, most of which were likely to be withdrawn with the next change in the winds of speculation. Between 1937 and 1939, nonresident holders of short-term balances were charged a percentage fee on their holdings; this was equivalent to charging a negative rate of interest. This policy was adopted again in 1950 and 1951, and from 1955 to 1958. In some respects, the imposition of a negative rate of interest on nonresident balances is comparable to intervention to maintain the forward foreign exchange rate at a discount. In the past, these policies proved relatively unsuccessful in halting the inflow of short-term capital. As the inflow of foreign funds to Switzerland has been motivated primarily by speculation, fears of war, or fears of political instability in other countries, the relative ineffectiveness of these policies is not surprising.
In mid-1960, the Swiss authorities were faced with a problem similar, in some respects, to that facing the Germans. For the previous few years, there had been a net flow of capital from Switzerland. In the first half of 1960, this outflow continued. In July, the movement was reversed, and capital, particularly funds for investment in short-term assets, started to move to Switzerland. Whereas official holdings of gold and foreign exchange had declined by a little over $100 million in the 12 months ended June 1960, they rose by more than $400 million in the last half of the year. This inflow was reflected in an increase in the liquidity of the deposit-money banks. The cash reserves of the banks that publish accounts rose by almost 20 per cent in July and by almost 5 per cent in August, despite contractionary open market operations by the National Bank.
The authorities, fearing that the economy would be subjected to excessive inflationary pressures, decided to stem the inflow of capital by administrative methods. On August 18, 1960 the National Bank and the commercial banks reached a one-year agreement which provided, among other things, that the banks would act as follows:8 (1) refuse to accept sight deposits from foreigners and require that all foreign deposits received after July 1, 1960 be held for at least three months; (2) convert any time deposits into foreign exchange, or into Swiss francs for the purchase of foreign securities, on demand; (3) pay no interest on any foreign deposit accounts, and subject all deposits for terms of less than six months owned by nonresidents to a commission of ¼ per cent for each quarter, i.e., short-term foreign-owned deposits in Swiss banks were to carry negative interest of 1 per cent per annum; (4) refuse to sell Swiss securities to nonresidents, and discourage these transactions from taking place through other channels.
In spite of this agreement, the flow of foreign capital to Switzerland persisted. The monetary system added to its foreign exchange holdings each month. In part, this inflow may have reflected evasion of the regulations. In part, nonresidents may have taken advantage of the right to acquire time deposits, maturing in more than six months, which were not subject to the commission, but which could be converted, on demand, into foreign exchange or foreign securities. Further, no restrictions were imposed on the repatriation of capital by Swiss residents. Between June and September 1960, U.S. short-term liabilities to Swiss residents declined from $939 million to $806 million (the total holdings of foreign exchange by Swiss authorities were stable in this period, at $130 million).
As a result, the liquidity of the banking system continued to increase, after the agreement was effected. The impact of the resulting inflationary pressures was evidenced by the 8 per cent rise in the money stock between August 1960 and the end of the year, and by continued very low interest rates in Swiss capital markets. On September 18, in a further attempt to reduce the liquidity of the economy, the authorities announced an issue of Sw F 400 million of special securities for sale to the banks, as an action to absorb their excess reserves. The 1960 experiment does not appear to have been any more effective in limiting short-term capital movements than were attempts in earlier years.
The German authorities may have achieved a modicum of success in their attempts to stem an inflow of capital, which was primarily motivated by the opportunity to earn a higher income on investment in Germany than in other countries. In effect, the actions of the authorities reduced the profitability of some forms of investment in Germany and thereby lessened that part of the flow which was directly affected by the regulations. The major effect of this policy may have been to change the form of, rather than to bring about the desired reduction in, the flow of capital to Germany. The Swiss, in attempting to halt a flow motivated largely by fears of political or monetary instability, appear to have been even less successful. Both experiments suggest that the problem of controlling movements of short-term funds among developed capital markets with convertible currencies cannot be solved by relatively simple measures.
The German experience suggests that short-term funds, moving in response to interest differentials, may easily produce a liquidity effect on the economy contrary to that which domestic monetary policy intended to create. In the absence of international action, the possibility of flows of interest-sensitive short-term capital between countries with convertible currencies may limit the freedom of national authorities to implement monetary policy.
Official intervention in the forward exchange market antedates the international financial crisis of 1907. In earlier years, the Austro-Hungarian Bank had intervened in the forward market on a small scale, but in 1907 it engaged in large operations to support the forward value of the krone, thereby guaranteeing potential speculators against loss. This action was taken to discourage capital outflow and, if possible, to encourage capital inflow.9 Between 1923 and 1925 the Austrian National Bank,10 from the mid-twenties11 until the present12 the Bank of Brazil, during 1935 and 1936 the Swiss National Bank,13 in 1936 the Bank of France,14 and in 1957 the National Bank of Belgium15 and the Netherlands Bank16 all engaged in forward operations. These central bank actions were intended to provide investors with direct incentives so that capital outflows would be discouraged and, perhaps, some inflow encouraged, at times when the national reserves were under pressure.
In 1925 and 1926, both the Bank of France and the Italian Treasury intervened in their respective forward markets to maintain the spot rates.17 By selling exchange forward, the authorities hoped to lower the demand for spot exchange and in this way to support the exchange value of the franc and the lira. Part of this support was provided by permitting speculators to take options for future capital payments, thereby reducing the present demand for exchange on the part of owners of short-term capital. The Bank of France took similar action again in 1936.18 For a short period in 1931, the British attempted to defend the parity of the pound by similar intervention.19 There is a hint, in an answer to the Radcliffe Committee, that the U.K. Exchange Equalization Account has engaged in similar action in recent years.20 From 1939 until 1950, the Canadian Foreign Exchange Control Board pegged the forward rate, i.e., intervened in the forward market, as part of its policy of pegging the spot rate.21 In 1958, the Central Bank of Argentina also intervened in the forward market to protect the spot rate, by providing exchange guarantees to importers.22
Other central banks have intervened in the forward market for reasons different from those discussed above. Thus, it is thought that, in the years prior to 1939, the National Bank of Czechoslovakia intervened to even out seasonal variations in the forward rate.23
Insofar as these operations were intended to influence short-term capital movements, they were, on the whole, designed to minimize capital outflows. In 1935, the Netherlands Bank acted to curb an inflow. At that time, the Bank discouraged the commercial banks from entering into forward sales contracts for noncommercial transactions when the guilder stood at a discount. As a result, the forward guilder rose to a point where covered capital exports by Dutch residents became relatively profitable. Consequently, there was an outflow of short-term capital from the Netherlands.24
Mr. Dorrance, Chief of the Finance Division, has been a lecturer at the London School of Economics and a member of the staff of the Bank of Canada.
Mr. Brehmer, economist in the Finance Division, is a graduate of Kiel University and was formerly a member of the staff of the Deutsche Bundesbank; he is the author of Struktur und Funktionsweise des Geldmarktes der Deutschen Bundesrepublik seit 1948.
This article was completed in February 1961. It takes account only of events preceding the appreciation of the deutsche mark and Netherlands guilder.
Unless stated otherwise, all the data in this article are taken from International Monetary Fund, International Financial Statistics.
See, for example, Deutsche Bundesbank, Monthly Report, January 1960, p. 5.
Defined as the excess of their assets denominated in foreign currencies over their liabilities denominated in foreign exchange.
The figure of DM 11.0 billion for the end of 1959 is obviously a “window dressed” total.
See International Monetary Fund, International Financial News Survey, Vol. XII, pp. 382-83 and 488.
Transactions of this type may account for part of the large size of the “errors and omissions” entries for the last half of 1960, which are recorded in Table 2 as “Changes in terms of payment.”
See International Monetary Fund, International Financial News Survey. Vol. XII, pp. 470-71.
For a discussion of this incident, see Paul Einzig, The Theory of Forward Exchange (London, 1937), pp. 329-40.
Ibid., pp. 341-47.
Ibid., p. 348.
International Monetary Fund, Summary Proceedings of the Fifteenth Annual Meeting of the Board of Governors (Washington, 1960), p. 62.
Einzig, op. cit., p. 374.
A. E. Jasay, “Forward Exchange: The Case for Intervention,” Lloyds Bank Review (London), October 1958, p. 42.
De Nederlandsche Bank N.V., Report for the Year 1957 (Amsterdam), p. 149.
Einzig, op. cit., pp. 369-70.
Ibid., p. 374.
Ibid, pp. 371-73.
Committee on the Working of the Monetary System, Minutes of Evidence (London, HMSO, 1960), Question 3212.
When the Canadians ceased to peg the exchange rate at the end of September 1950, the Exchange Fund was committed to buy US$412 million at the pre-existing rates. The official spot holdings were $1,790 million. Bank of Canada, Statistical Summary, Financial Supplement 1955 (Ottawa), p. 52.
Banco Central de la República Argentina, Memoria Anual (Buenos Aires, 1958), p. 119.
Einzig, op. ext., pp. 347-48.
Ibid., pp. 375-76.