Article

The Advantages of Exclusive Forward Exchange Rate Support

Author(s):
International Monetary Fund. Research Dept.
Published Date:
January 1976
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Under the systems of pegged and managed spot exchange rates, short-term capital flows have frequently been disruptive. To relieve pressure on international reserves and the money stock, a policy of supporting both the spot and forward exchange rates has been undertaken occasionally. Experience suggests, however, that such a policy may be costly, as shown by the loss made by the Bank of England after the devaluation of sterling in 1967, and ineffective, as illustrated by the “merry-go-round” effect induced by the policy of the Deutsche Bundesbank.1 Owing to the experiences of the Bank of England and the Bundesbank, countries have become reluctant to give large-scale support to the forward market. Exchange controls and greater exchange rate flexibility have become the preferred means of combating disruptive capital flows.

It is the thesis of this paper that the inflow or outflow of money can be controlled precisely without significant official losses if official support is given exclusively to the forward exchange rate and is accompanied by discretionary purchases or sales of reserves in a free spot market.2 The actual inflow of money—the total currency flow—would equal the difference between maturing official forward sales of domestic currency resulting from the forward support operations and the amount of discretionary official purchases of domestic currency in the free spot market. This mechanism for controlling the total currency flow will be called simply the intervention mechanism.

This paper examines the mechanism, constraints, and costs involved in using the intervention mechanism to reach two target levels for the total currency flow. They are a total currency flow equal to zero and a total currency flow equal to the trade balance. Whether it would be preferable to achieve changes in the reserves and money stock equal to the trade balance or to achieve full insulation of the reserves and the money stock is not discussed.

The structure of this paper is as follows. Section I presents the derivation of the intervention mechanism rules for achieving desired total currency flows. Section II examines the mechanism that induces the required short-term capital flow and assesses the constraints on the magnitude of such capital flows. Section III compares the inherent stability of interest arbitrage capital flows when only the spot rate is supported with its inherent stability when only the forward rate is supported. Section IV examines the official gains and losses that are likely to be incurred by an operation of the intervention mechanism. Section V discusses the question of which of the spectrum of forward rates it is most appropriate to support. Section VI compares the intervention mechanism with the policy of discretionary forward intervention under a supported spot rate. Section VII presents the conclusion.

I. The Intervention Rules for Achieving Desired Total Currency Flows

The notation in this paper utilizes subscripts to distinguish two characteristics of foreign exchange contracts. They are the maturity period of the contract and the date of the contract. Let Di,τ (Si,τ) equal the total ex post demand for (supply of) the domestic currency on the foreign exchange market for delivery after i days contracted on day τ.

Letting day T represent the current period, the value of currently maturing contracts will equal the sum of all i day maturity contracts undertaken i days ago, that is, contracted on day T−i.

Contracts to buy and sell the domestic currency may be classified as being due to trade flows (V), capital flows (C),3 or the intervention of the authorities in the foreign exchange market (G). Let the superscript d represent demand; s represent supply; d−s represent net demand; and s−d represent net supply.

Substituting equations (3) and (4) in equation (2) and rearranging

Equation (5) states that net trade payments flows, hereafter considered to be synonymous with the trade balance, plus net capital inflows equals the net acquisition of official reserves.4

Equation (5) defines the total currency flow, that is, the gap between the demand for and the supply of the domestic currency on the foreign exchange market that is met by official intervention.5 The total currency flow equals not only the acquisition of official reserves but also the increase in the government’s domestic currency financial requirement resulting from its intervention in the foreign exchange market. Assuming that this increase in the government’s financial requirement is met either by an increase in high-powered money or in short-term government debt that both accrues to the banking system and may be used as a reserve asset by the banks, the equilibrium money stock and the total currency flow will be positively related.

In a freely flexible exchange rate system, that is, when

the total currency flow is nil.6 Hence, both the reserves and the money supply are immunized from the external situation. Whenever the exchange rate is stabilized or pegged, however, the authorities become the residual buyers of the domestic currency at a particular price in at least one of the exchange markets for the currency. Hence, it is normally assumed that precise control over the total currency flow is not possible when the exchange rate is stabilized or pegged and that a flexible exchange rate may be necessary to facilitate the maintenance of an independent monetary policy.

To illustrate how precise control over the total currency flow is possible, assume that there are only two exchange markets: the spot market where delivery is immediate and the t-day forward market. When i is constrained to the values 0 and t, equation (5) becomes

From equation (7), it is possible to derive the official foreign exchange intervention rule to secure a total currency flow of any desired size while maintaining a stabilized or pegged exchange rate. Two specific rules will be derived: (1) the intervention rule to secure a zero total currency flow, that is, to secure net capital inflows (outflows) that exactly finance the trade deficit (surplus); and (2) the intervention rule to secure a total currency flow equal to the trade balance, that is, to secure zero net capital flows.

A ZERO TOTAL CURRENCY FLOW

In a freely flexible exchange rate system, both G0,Tsd and Gt,Ttsd are nil. Although this is a sufficient condition for the total currency flow to be nil, it is not a necessary condition. The necessary and sufficient condition is derived simply by making equation (7) equal to zero.

that is,

The interpretation of equation (9) is that official spot purchases of the domestic currency should equal maturing official forward commitments to supply the domestic currency. Such a policy is not possible while supporting a unitary7 spot rate, but it is feasible while supporting the forward rate. When the spot rate is supported, the authorities are the residual buyers of the domestic currency in the current spot market. The value of current official spot purchases of the domestic currency,G0,Tds, equals the total current net supply of the domestic currency on the spot market resulting from trade and capital flows. Only by chance is this equal to the value of past official forward contracts that are currently maturing—be it zero or nonzero. When the forward rate is supported, however, the authorities are the residual buyers of the domestic currency in the forward market on day Tt. The value of currently maturing official forward sales of the domestic currency,Gt,Ttsd, equals the total net purchases of the domestic currency on the forward market on day Tt resulting from trade and capital flows. This magnitude is a historical constant on day T. By buying an equal amount of domestic currency in the current spot market, a zero total currency flow is achieved while a supported forward rate is maintained.8

A TOTAL CURRENCY FLOW EQUAL TO THE TRADE BALANCE

Making equation (7) equal to the trade balance,

the official intervention rule to secure zero net capital flows is

Equation (11) states that official purchases of the domestic currency in the spot market need to be less than maturing official forward sales of the domestic currency by the magnitude of the trade balance in order to achieve a total currency flow equal to the trade balance. Again, such a policy is not possible while supporting the spot rate, but it is possible while supporting the forward rate.

Similarly, a total currency flow equal to any other magnitude, such as the “basic” balance of payments or the non-oil deficit, can be ensured while maintaining a stabilized or pegged forward rate by making official purchases of the domestic currency in the spot market that are less than maturing official forward sales of the domestic currency by the magnitude of the particular total currency flow that is desired.

II. Securing the Required Short-Term Capital Flows: Mechanism and Constraints

Assuming that trade payments and long-term capital flows are exogenous, the intervention mechanism achieves the desired total currency flow by inducing short-term capital flows of the required size.9 This section examines the mechanism whereby the desired short-term capital flows are induced and the constraints on the magnitude of such capital flows. To simplify the understanding of the basic mechanism and constraints, it is first assumed that all capital flows are the result of spot operations and not of maturing forward operations.

CAPITAL FLOWS THROUGH THE SPOT MARKET ONLY

On the assumption that no capital flows are the result of maturing forward contracts, the authorities are required on day T−t to sell a quantity of domestic currency in the forward market equal to the net demand from traders in order to stabilize or peg the forward rate, that is,

when Ct,Ttds=0

On day T, the actual amount of domestic currency that the authorities need to buy or sell in the spot market depends upon the particular total currency flow that they desire.

A zero total currency flow

When a zero total currency flow is desired, the intervention rule is equation (9). Substituting equation (12) in equation (9), official purchases of domestic currency in the spot market on day T equal

The total net demand for domestic currency in the spot market on day T by traders and the authorities is therefore

The total net demand for spot domestic currency by traders and the authorities equals the trade balance. If the trade balance is in surplus, this positive net demand will tend to appreciate the spot rate. The premium of the spot rate over the unchanged forward rate will tend to rise, that is, the implicit interest rate of the forward premium will tend to fall. Given that the money stock is immunized from the external situation when a zero total currency flow is maintained, it may be assumed that the uncovered interest rate differential is also immunized.10 The sum of the implicit interest rate of the forward premium plus the actual uncovered interest rate differential will therefore tend to fall, that is, the covered interest rate differential will tend to fall. The covered interest rate differential will fall sufficiently to induce an interest arbitrage outflow (and/or any other type of capital outflow) exactly equal to the trade surplus. If the trade balance is in deficit, there will be a total net supply of spot domestic currency by traders and the authorities equal to the deficit. This will tend to depreciate the spot rate, increase the forward premium, and induce an arbitrage inflow exactly equal to the trade deficit.

In a world in which international short-term capital movements were neither penalized nor prohibited by banking regulations or exchange control regulations, the relationship between the spot rate and forward rate and the constraints on the ability of the authorities to maintain a continuing zero total currency flow would depend, essentially, upon a single factor—the risk associated with covered interest arbitrage. For an arbitrageur who borrows the currency of a trade surplus country for a given time period and relends on a covered basis for the same period in the currency of a trade deficit country, there is no capital or income risk, no exchange risk, only default risk. The default risk is the risk that the forward currency claim of the arbitrageur will be dishonored or frozen, however temporarily. The risk of default on the arbitrageur’s forward claim is mirrored in a risk of default by the arbitrageur on his liability. The aversion of banks to default risk is expressed in the limits that banks impose on their claims on other individual banks; in the limits on their aggregate claims in particular currencies; and on the interest rate premium, actual or implicit, charged on such claims.

Provided that it were believed with certainty that the default risk was nil, banks would adjust their limits as necessary to enable their dealers to take any arbitrage profits that become available.11 Only a minimal intrinsic premium (discount) would be necessary to induce inward (outward) interest arbitrage. The authorities would be able to maintain a zero total currency flow with the relationship between the spot and forward exchange rates being held at interest parity.

Although some risk of default would always face the interest arbitrage operations induced by an application of the intervention mechanism, in at least two important situations it is likely that a sufficient number of banks would consider the risk of default to be so small that a zero total currency flow could be maintained with the relationship between the spot and forward rates being held at interest parity. They are (a) the use of the intervention mechanism by trade surplus countries to secure offsetting capital outflows, and (b) its use by trade deficit countries to secure offsetting capital inflows when the overall deficit to be financed does not represent a significant proportion of total reserves.

(a)The authorities of à trade surplus country who use the intervention mechanism to secure offsetting covered capital outflows will build up forward liabilities denominated in their own currency. Since the supply of their own currency is under their own control, no risk of default owing to economic considerations need be assumed. By definition, no risk of default for political reasons will exist on liabilities to residents of politically favored countries.

(b) The authorities of a trade deficit country who use the intervention mechanism to secure offsetting covered capital inflows will build up a forward liability on the reserves—albeit one that can be rolled over. Provided that the deficit is either small and known to be temporary, or is confidently expected to be offset by a surplus in the foreseeable future, it is likely that a sufficient number of banks would consider the risk of default to be sufficiently small that they would allow their dealers to take any profits that became available on inward interest arbitrage.

The main situation in which default risk may constrain the ability of the authorities to maintain a zero total currency flow is one in which the deficit that is being financed by covered capital inflows is large in relation to the reserves and where there is no prospect of a turnaround in the trade balance in the foreseeable future. When the risk of default is thought to be significant, banks will retain effective limits on the total size of their foreign currency claims that are known or believed to be claims directly or indirectly on the country, and/or charge higher actual (implicit) interest rates on such spot (forward) claims. Hence, it is possible that the authorities of the deficit country would experience increasing difficulty in finding banks with whom they could undertake currency swaps, and/or that the spot rate would depreciate to create a rising intrinsic premium on the currency.

Many factors would influence the amount of inward interest arbitrage that an individual deficit country could actually induce before the assessment of the default risk by arbitrageurs would significantly influence the availability and price of spot foreign currency to the authorities in the afore-mentioned manner. There are reasons for believing that the figure would be large for certain countries.

1. Although foreign banks may place limits on their foreign currency claims with the domestic central bank, it is most unlikely that domestically owned banks would place any such constraints. Given that domestically owned banks place no such constraints, the only limitation on inward arbitrage is the ability of these banks to borrow foreign currency in the Euro-currency interbank market. Foreign banks will not know whether domestically owned banks are borrowing foreign currency in order to swap into domestic currency or in order to relend in the same currency or in another foreign currency as part of their normal Eurocurrency operations.12 This ignorance as to the eventual final use of funds lent in the interbank Euro-currency market means that countries whose commercial banks are normally active operators in the Eurocurrency market could expect to induce large-scale covered interest arbitrage inflows by an application of the intervention mechanism. The most important beneficiary on this score would be the United Kingdom.

2. It is likely that the assessment by banks of the propensity of an individual country to default in a given economic situation would depend upon such noneconomic factors as the color of the political party in power and the independence and standing of the central bank. Default on official forward commitments is known to be unprecedented and it may simply be considered unthinkable that, say, the Bank of England would default on its foreign currency liabilities as long as it was able to roll over its commitments or have access to official international credit. For many noneconomic reasons, however, not all claims on central banks would be thought to be as free of default risk.

3. The assessment of the propensity to default is likely to depend upon the future economic implications for the particular country if it defaulted. Official default would be resisted by most countries, since it would seriously reduce both the effectiveness of any future policy designed to attract private capital inflows and the availability of official international credit. It is also likely to increase the future instability of the exchange rate and/or reserves owing to a resulting increased “nervousness” of short-term capital flows. For any international banking center, a further economic reason why default would be resisted is that the repercussions of default on the international interbank mechanism would be such that the center’s invisible earnings potential would be curtailed.

The preceding reasons for suggesting that certain countries could induce large-scale interest arbitrage inflows without disturbing interest parity are backed up by the empirical evidence on interest parity. Numerous studies demonstrate that interest parity always holds for Euro-currency interest rates even during turbulent periods on the foreign exchange market.13 The departures from interest parity when measured in terms of national interest rates are an expected result of exchange controls and/or banking regulations that prohibit or penalize resident lending to or borrowing from nonresidents. The relaxation of such controls could be expected at least to result in a closer approximation to interest parity for national interest rates.14

A total currency flow equal to the trade balance

When a total currency flow equal to the trade balance is desired, the intervention rule is equation (11). Substituting equation (12) in equation (11), official purchases of domestic currency in the spot market on day T are

The total net demand for domestic currency in the spot market on day T by traders and the authorities is therefore

Given that the total net demand for spot domestic currency by traders and the authorities is zero, maintaining a total currency flow equal to the trade balance will not itself lead to a continuous appreciation or depreciation of the spot rate. Since spot purchases of domestic currency by the authorities equal the net spot sales by traders, total net capital flows are necessarily zero. The actual relationship between the spot rate and the forward rate will reflect the attractiveness of investing in the currency. Interest parity will hold at least during times when speculative activity in the spot market is not intense.15

The only constraint on maintaining a continuing total currency flow equal to the trade balance would be the availability of foreign currency reserves.

CAPITAL FLOWS THROUGH BOTH THE SPOT AND FORWARD MARKETS

The foregoing analysis of the mechanism whereby the required short-term capital flow is induced assumed that all current capital flows were the result of current spot operations and not of maturing forward operations, that is, that Ct,Ttds=0. Removing this assumption, maturing official forward sales of domestic currency are greater than equation (12) by the magnitude of the capital outflow through the forward market, Ct,Ttds. Hence, when a total currency flow equal to zero or equal to the trade balance is maintained, the total net purchases of domestic currency in the spot market by traders and the authorities are greater than equation (14) or equation (16), respectively, by Ct,Ttds The induced net capital outflow through the spot market is therefore greater than that derived earlier by the magnitude of the net capital inflow resulting from maturing forward contracts. Although, overall, the same total net capital flow is necessarily induced, the impact of the intervention mechanism on the spot rate will depend upon the quantity and type of capital flows occurring through the forward market.

Current capital outflows resulting from maturing forward contracts may be of two types. They may be undertaken by individuals who had existing spot domestic currency balances and whose purpose in taking out a forward contract was to remove exchange risk; or they may be undertaken by individuals who did not have existing spot balances and whose purpose in taking out a forward contract was purely speculative. In the former case, securing the same overall capital inflow requires a movement in the covered interest rate differential sufficient either to induce the individuals to roll over their contracts or to secure a new spot inflow to offset maturing contracts that are not rolled over. In the latter case, the individuals have to buy spot domestic currency to meet their forward commitments, and these spot purchases of domestic currency exactly offset the higher official spot sales of domestic currency called forth by the higher official forward commitment.

Two important conclusions emerge. First, if the authorities wish to maintain a total currency flow that is greater than the trade balance, the intrinsic premium on the currency will need to improve sufficiently (i.e., the spot rate will need to depreciate sufficiently) to induce not only a capital inflow equal to the trade deficit but also an ever-increasing quantity of funds to be rolled over regularly. Second, purely speculative forward market operations have no impact whatsoever on the covered interest differential, regardless of the size of the total currency flow that is maintained.

III. The Stability of Arbitrage Flows

When the exchange rate is supported and there is excess supply of the domestic currency by traders and speculators in the spectrum of spot and forward markets, it can be shown that destabilizing arbitrage outflows are induced when only the spot rate is supported, whereas stabilizing arbitrage inflows are induced when only the forward rate is supported. In the former case, it is likely that the covered interest differential will tend to weaken, whereas in the latter the covered interest differential will certainly tend to improve. The arbitrage flows tend to occur automatically, owing to the normal practice of banks of offsetting changes in their open foreign currency positions by spot purchases or sales of foreign currency.

When only the spot rate is supported, excess supply of domestic currency by traders and speculators in the spectrum of spot and forward exchange markets produces weakness in the forward market. Any depreciation of the forward rate reduces the forward premium. The reduction in the forward premium is accompanied by an improvement in the uncovered interest rate differential that is due to the tighter domestic monetary situation. Whether or not the covered interest differential rises or falls depends upon the magnitude of spot speculation in relation to forward speculation and the thickness of the forward exchange market in relation to the money markets. If the covered interest rate differential deteriorates, as is most likely, an arbitrage outflow will be induced. In fact, a given excess supply of domestic currency by traders and speculators in a free forward market has to induce an approximately 16 equal arbitrage outflow in order that supply and demand in the forward market shall be equated. The arbitrage outflow is destabilizing in the sense that it reduces the reserves and hence reduces the ability of the authorities to stabilize or peg the exchange rate. If the reserve loss is seen as a danger signal, further speculative forward sales of the domestic currency may be induced. These will again decrease the forward premium sufficiently to induce an approximately equal arbitrage outflow. If the confidence of speculators is significantly affected by reserve losses, the interaction of speculation and arbitrage may develop into a currency run.

When the authorities are supporting only the forward rate, the excess supply of the domestic currency by traders and speculators in the spectrum of spot and forward exchange markets produces weakness in the spot market. Any depreciation of the spot rate increases the forward premium. Combined with the improvement in the uncovered interest rate differential that may again tend to occur, the covered interest rate differential tends to increase unequivocally. An arbitrage inflow is induced. In fact, a given excess supply of domestic currency by traders and speculators in a free spot market has to induce an equal arbitrage inflow in order that supply and demand in the spot market shall be equated. The arbitrage inflow is stabilizing in the sense that it improves the total currency flow of the weak currency.

When there is a net demand for spot and forward foreign currency by banks’ clients, the foreign currency position of banks is shortened. Banks normally restore their foreign currency positions by buying foreign currency in the spot market. Hence, pressure in the forward market is automatically transmitted to the spot market. Although it is possible for banks to offset the effect on their foreign currency positions of a net demand for or supply of forward foreign currency by repurchasing or reselling foreign currency forward instead of spot, this is not normally undertaken. In this context, Pierre Prissert has stated:

… it is conceivable that, in order to avoid the spot sale or purchase of foreign currency, the bank could simply resell or purchase it forward. Let us, once and for all, recognize that foreign exchange dealers generally abstain from such operation which are in effect a rejection of their professional ability … Such a practice … boils down to simply passing on one’s own business to a competitor.17

To the extent that banks do cover changes in their open foreign currency positions by spot operations, the destabilizing or stabilizing arbitrage flows that were just described will occur automatically. If the spot rate is supported and pressure in the forward market is transmitted by banks to the spot market, official reserve losses will reflect the excess supply of domestic currency by traders and speculators, both spot and forward. However, if only the forward rate is supported and pressure in the forward market is transmitted by banks to a free spot market, the excess supply of domestic currency by traders and speculators, both spot and forward, will be reflected by an offsetting capital inflow through the spot market.

If the authorities were to support only the forward rate, it is less likely that banks would continue to offset changes in their open foreign currency positions by spot rather than forward operations. Repurchasing foreign currency forward from the authorities does not represent the passing on of one’s business to a competitor and is more profitable than purchasing foreign currency spot when an intrinsic premium on the domestic currency exists. However, if all banks were to retain a constant open foreign currency position by spot operations only, the situation would arise in which a pegged forward rate would automatically be accompanied by fully stabilizing capital flows without the need for the authorities to actually buy or sell currency in either the forward or spot markets.

IV. Official Gains or Losses

This section examines the official gains or losses that occur owing to an operation of the intervention mechanism. The section has two parts, the first of which examines the official gains or losses that are due to the activity of arbitrageurs. It is found that, for as long as interest parity holds, there are only minimal official losses owing to the use of the intervention mechanism to secure the desired interest arbitrage flows. The second part examines the official gains or losses that are due to activity by speculators. It is found that the official loss (gain) that occurs because of a given depreciation of the exchange rate is likely to be less (greater) when the forward rate has been supported prior to the depreciation than when only the spot rate has been supported.18

GAINS OR LOSSES TO ARBITRAGEURS

Under the intervention mechanism, the required arbitrage inflow is secured by official spot sales of domestic currency of the appropriate magnitude. It may be assumed that the induced spot purchase of domestic currency by the arbitrageur is accompanied by a forward sale of domestic currency directly or indirectly to the authorities. One part of the gain or loss to the authorities of securing the arbitrage inflow is therefore the cost of the swap, that is, the forward premium. If there is a positive forward premium, the inducement of arbitrage inflows by official spot sales and forward purchases of domestic currency will result in an official loss. If there is a negative forward premium, that is, a forward discount, there will be an official gain. To the extent that a trade deficit is associated with a relatively high rate of inflation, a relatively high nominal rate of interest, and therefore a forward discount, gains will be made on the swaps by a trade deficit country that is inducing stabilizing arbitrage inflows. Similarly, gains will be made by a trade surplus country that is inducing stabilizing arbitrage outflows.

The gains or losses on the swaps are not the total gain or loss to the authorities of securing the required arbitrage flow. An arbitrage inflow increases both the size of the reserves and the size of the government’s domestic currency financial requirement above what they would otherwise have been. The gain or loss here is the difference between the rate of interest received on the reserves and the rate of interest payable on official debt, that is, the uncovered interest rate differential in favor of the foreign currency.

Provided that interest arbitrage flows are perfectly elastic, the forward premium on the domestic currency will need to be only minimally greater than the uncovered interest rate differential in favor of the foreign currency in order to induce arbitrage inflows. Only a minimal loss is therefore incurred by the authorities. Any official losses on the swaps are all but offset by the interest rate gain on the increase in spot foreign currency claims and domestic currency liabilities. The official loss equals the profit made by arbitrageurs.19

The size of the arbitrage inflows that have been induced has no impact on the total official gain or loss that will be incurred if the exchange rate is allowed to depreciate. Each official forward commitment to supply foreign currency to arbitrageurs will have been accompanied by an official spot purchase of foreign currency. The official net open foreign currency position, spot and forward, is unaffected by the size of arbitrage flows induced. Although a devaluation brings a loss on maturing forward contracts to supply foreign currency to arbitrageurs at the predevaluation rate, this is offset by the larger profit on the revaluation of the reserves owing to the arbitrage inflows.

GAINS OR LOSSES TO SPECULATORS

Given that the official open foreign currency position, spot and forward, is unaffected by the volume of interest arbitrage flows induced, the exposure of the authorities to exchange risk under the intervention mechanism depends only upon the operations of traders and speculators. Past deficits in trade payments flows plus outstanding covered commitments by traders to supply foreign currency shorten the official foreign currency position whether the spot rate or the forward rate is supported.20 Therefore, assuming that physical trade flows are independent of the exchange rate that is being supported, the relationship between the official exposure to exchange risk under a supported forward rate and under a supported spot rate depends only upon the impact of speculation—defined to include the open position held by traders.

Whether the forward rate or the spot rate is supported and whether speculation occurs in the forward market or the spot market, a shortening in the domestic currency position of speculators will be transmitted to the officially supported market and will bring a corresponding shortening in the official foreign currency position. If the spot rate is supported, speculative forward sales of domestic currency will induce interest arbitrage outflows that transmit the speculative pressure to the spot market; if the forward rate is supported, speculative spot sales of domestic currency will induce interest arbitrage inflows that transmit the speculative pressure to the forward market. The relationship between the official exposure to exchange risk under a supported forward rate and under a supported spot rate therefore depends upon the magnitude of speculation, both spot and forward.

At a time when the trade balance is weak and speculators consider a depreciation of the exchange rate to be possible, there are two reasons why it is likely that the magnitude of speculation will be less if the forward rate is supported rather than the spot rate.21

(a) It seems reasonable to assume that, for a given trade deficit, speculators will believe that a depreciation of the exchange rate is more likely the less able they feel that the authorities are to maintain the rate. It has been shown in this paper that, when only the spot rate is supported, arbitrage flows may be destabilizing. Excess supply of the weak currency in the forward market induces interest arbitrage outflows. The reduction in reserves caused by the arbitrage outflows may be seen by speculators as reducing the ability of the authorities to maintain the exchange rate. As a result, speculative forward sales may occur that induce further arbitrage outflows, a further reduction in the reserves, and a further loss of confidence. Hence, when capital flows are destabilizing, the magnitude of speculation is likely to be greater than it would have been if capital flows had been stabilizing. Many changes in spot exchange parities have been preceded by large-scale destabilizing capital flows. When only the forward rate is supported, however, interest arbitrage flows are not only stabilizing but also precisely controllable by the authorities. Speculation can never force the authorities to depreciate the exchange rate. Current speculation will not encourage future speculation whose hope of profit lies in the anticipation that the total quantity of speculation will have such an effect on the reserves that a depreciation of the exchange rate will be forced on the authorities.22

(b) Whenever the domestic currency is weak, speculators may believe that a possible alternative to a depreciation of the exchange rate is a deflationary policy that includes higher domestic interest rates. When only the spot rate is supported, a future increase in domestic interest rates is reflected in a depreciation of the future forward rate. Such a depreciation has no influence on the profitability of current speculation. When only the forward rate is supported, however, the higher domestic interest rates are reflected by an appreciation of the future spot rate. Speculators who are holding a short position in the currency are penalized. The possibility that the authorities of a weak currency will raise domestic interest rates rather than depreciate the exchange rate is therefore likely to be a stronger deterrent to speculation when only the forward rate is supported than when only the spot rate is supported.

The preceding arguments suggest that the scale of speculation against a weak currency is likely to be less when only the forward rate is supported than when only the spot rate is supported. If depreciations of given size and timing occur, the official losses (gains) are therefore likely to be less when the authorities are supporting only the forward rate.

When only the forward rate is supported, however, the financing of trade deficits by short-term capital flows is facilitated. Hence, it is possible that countries would use the facility to maintain an overvalued exchange rate for a longer period than they would otherwise. If such were the case, official losses could be greater. In this context, however, a quotation from Aliber is relevant: “To fault forward intervention because the authorities may use its advantages to delay a devaluation is to assert that the authorities cannot be trusted with the additional freedom that forward intervention may afford.” 23

V. Which Forward Rate to Support

It has so far been assumed implicitly or explicitly that there exists a single forward market. In reality, there is a spectrum of forward markets of different maturities. This section considers the problem of which of the spectrum of forward rates is most appropriate to stabilize or peg.

When the authorities support a single forward rate, the spot rate is determined by the interest differential on debt with the same maturity as the supported forward rate. Other forward rates are determined by the term structure of money market interest rates domestically and internationally. It seems more appropriate to confine large-scale support to a single forward rate for two reasons. First, the greater is the rigidity with which the structure of forward rates is supported, the greater will be the rigidity placed on the term structure of money market interest rates. Second, if large-scale support is given to more than one forward rate, there will be the danger of official losses owing to straddling operations by speculators.

The arguments concerning which individual forward rate is most appropriate to support are divided into three categories: those relevant to (1) trade; (2) speculation; and (3) interest arbitrage.

THE IMPACT ON TRADE

If all trade contracts required payment after the same length of time, it would obviously be appropriate to stabilize or peg the forward rate of that maturity period. The stabilized or pegged forward rate would reduce the risk associated with the possibility of a change in the forward rate during the search and negotiation period before the exchange of contracts. However, trade contracts require payment after periods of time varying from very short to long. The interests of traders are best satisfied by stability in a wide range of maturity availabilities. When only one forward rate is stabilized or pegged, however, traders will benefit from the point of view of stability if the maturity period of the supported forward rate best reflects the average credit period. From the point of view of maturity availability, traders will benefit if the supported forward rate is as long as possible; whichever forward rate is supported, thick forward markets can be expected to exist for all shorter round-period maturities but only for longer maturities of a limited period in excess of the maturity period of the supported forward rate. The greater is the dispersion in trade credit practices, the more beneficial it will be to traders for the choice of the maturity period of the supported forward rate to be determined by the desire to secure a wide range in maturity availabilities rather than by the desire to achieve stability in a particular forward rate.

THE IMPACT ON SPECULATION

The maturity period of the supported forward rate will influence both the magnitude and stability of speculation.

If the authorities maintain an overvalued or undervalued exchange rate, it is likely that the magnitude of speculation in the supported forward market will be greater the longer is the supported forward rate. The conjectured probability of an anticipated depreciation or appreciation occurring within a given period will be greater the longer is the period. Hence, a speculator will consider the possibility of being able to close his position at a profit to be greater the longer is his forward contract.

The maturity period of the supported forward rate will have an important influence on the time horizon of speculators and, as a result, on the stability of speculation. If the one-month forward rate is supported, many speculators are likely to anticipate the state of the balance of payments in one month’s time; if the one-year forward rate is supported, however, the time horizon of many speculators may be lengthened to one year. There is a lag before the full impact is felt of any expenditure-switching or expenditure-reducing policy. Believers in the J curve suggest that the short-term impact of an exchange rate change may be perverse. Even when the authorities are pursuing appropriate policies in relation to the exchange rate, speculation may be destabilizing if the time horizon of speculators is shorter than the period required for policies to become effective. By supporting the forward rate of maturity equal to the time period necessary for the effectiveness of the particular policies that are being pursued, countries pursuing appropriate policies in relation to the exchange rate could expect speculation to be stabilizing, that is, to ease the burden of the authorities in supporting the forward rate.

THE IMPACT ON INTEREST ARBITRAGE

The intervention mechanism secures the required capital flow through movements in the covered interest rate differential on assets of the same maturity as the supported forward rate. The shorter is the supported forward rate, the less likely it will be that interest parity will hold and the greater will be the resulting fluctuations in the spot rate. Owing to fixed transactions costs, especially of time, arbitrageurs will require a higher percentage per annum profit for moving funds around on a covered basis for short periods rather than longer periods. The shorter is the supported forward rate, the more frequently will the authorities have to induce arbitrageurs to roll over their positions and the more costly it will therefore be to the authorities.

The maturity of the supported forward rate need not necessarily be equal to a maturity period—such as three months—for which there already exists a wide range of money market assets. Whatever forward rate is supported, it is likely that an interbank market would develop for that maturity.

Although interest arbitrage in itself is riskless, the inducement of interest arbitrage flows by the intervention mechanism may increase the risks or strains on the world banking system. For example, if the maturity period of the supported forward rate of a trade deficit country differed significantly from the maturity period of the newly created liabilities of the world banking system to the trade surplus countries, stabilizing interest arbitrage inflows to the trade deficit country would involve a lengthening or shortening of the maturity spread between the claims and liabilities of the world banking system. Since risk needs to be compensated for by return, such a change in the maturity spread might result in a change in the term structure of international interest rates that was unfavorable to trade deficit and/or trade surplus countries. A corollary to this, however, is that the intervention mechanism may reduce the risk or strains on the world banking system by creating investment opportunities—covered against exchange risk—of similar maturity to the newly acquired liabilities of the world banking system. If, for example, the revenues of the oil exporting countries were all held in the world banking system on one-month maturity and other countries wished to use the intervention mechanism to finance their oil deficits, it would be appropriate to support the one-month forward rate.

The arguments concerning the impact of the maturity period of the supported forward rate on trade, speculation, and interest arbitrage lead to the conclusion that one should be pragmatic in arriving at a recommendation concerning which forward rate to support. The lack of a decisive argument in favor of supporting a particular forward rate does not detract from the case for forward intervention. Rather, the many arguments in favor of supporting forward rates with different maturities bring home the importance or potential benefits of forward intervention.

VI. The Intervention Mechanism Versus Discretionary Forward Intervention Under a Supported Spot Rate

This paper has examined the intervention mechanism in which official support is given exclusively to the forward rate and is accompanied by discretionary intervention in a free spot market. This policy is in contrast to the conventional policy in which official support is given exclusively to the spot rate and is accompanied by discretionary intervention in a free forward market. The object of this section is to highlight some major differences between these two policies. In particular, it will be shown that whereas conventional forward interventional policy encourages adverse speculation that undermines the effectiveness of the policy, the intervention mechanism encourages stabilizing speculation.

Under conventional policy, the spot rate is supported. To improve the total currency flow, the authorities enter the forward market and buy domestic currency. The objective of the policy is to encourage (discourage) covered arbitrage inflows (outflows). The effectiveness of the policy can be judged on two criteria: (1) the impact on the total currency flow; and (2) the impact on the official open domestic currency position and the consequential impact on the official profit or loss that will be made in the event of a depreciation of the domestic currency. When the only impact of the official forward purchases is an equal increase in forward sales of domestic currency by arbitrageurs, the policy is fully effective; the total currency flow improves by an approximately equal amount and the official open domestic currency position remains unchanged. It is unlikely, however, that only arbitrage flows will be affected. The official forward purchases of domestic currency are likely to induce forward sales of domestic currency by speculators and/or traders. Even with perfectly elastic arbitrage flows, the forward rate will tend to appreciate owing to the impact of the improved total currency flow on the domestic rate of interest. Any appreciation in the forward rate will, first, increase the expected profitability of speculative forward sales of domestic currency, provided that the elasticity of expectations of the future spot rate with respect to the forward rate is less than unity; and, second, increase (decrease) the profitability of imports (exports) covered in the forward market. Furthermore, any improvement in the total currency flow that is due to arbitrage inflows will decrease the cost and increase the availability of funds for speculation against the currency in the supported spot market. The effectiveness of the policy is reduced by the magnitude of induced domestic currency sales, both spot and forward, by speculators and traders; the total currency flow improves by a correspondingly lesser amount than the value of official forward purchases of domestic currency; the official open domestic currency position lengthens by the corresponding amount.

There are two situations in which the effectiveness of conventional forward intervention is completely eliminated by adverse speculation. First, if speculators expect with certainty that the future spot rate will be less than (that is, more depreciated than) or equal to some magnitude, such as the upper spot support limit, forward intervention will become ineffective as the forward rate approaches this point. Official forward purchases of domestic currency at this point will simply lengthen, the official open domestic currency position and will not improve the total currency flow. The “Keynes Plan” has been criticized on the grounds that the authorities of a weak currency cannot use conventional forward intervention to accommodate relatively low interest rates without the danger of significant official losses.24 Second, if actual speculation through the spot market against the domestic currency by nonresidents is less than desired speculation owing to exchange controls that prohibit the lending of domestic currency by residents to nonresidents, arbitrage inflows by nonresidents will simply be borrowed by other nonresidents and will be converted back into foreign currency. In the case of sterling, for example, conventional forward intervention policy may induce arbitrage inflows that are lent in the Euro-sterling market and are then borrowed by speculators.

Under the intervention mechanism, the forward rate is supported. To improve the total currency flow, the authorities enter the spot market and sell domestic currency. By definition, the total currency flow must improve by an equal amount. The official sales of domestic currency in the spot market will tend to depreciate the spot rate. This is likely to encourage not only arbitrage inflows but also spot purchases of domestic currency by speculators and traders. Any depreciation in the spot rate will, first, increase the expected profitability of spot market speculation in favor of the domestic currency, provided that the elasticity of expectations of the future spot rate with respect to the current spot rate is less than unity; and, second, increase (decrease) the probability of exports (imports) channeled through the spot market. Other things being equal, the official open domestic currency position is shortened by the magnitude of induced spot purchases of domestic currency by speculators and traders.

An essential difference that emerges between the conventional policy and the intervention mechanism is that official action to improve the total currency flow will lead, in the former case, to an appreciation in the unsupported rate and, in the latter case, to a depreciation in the unsupported rate. Although it is possible that, under the conventional policy, an appreciation in the unsupported rate could encourage stabilizing speculation because of the effect on confidence and could improve the trade balance because of perverse trade elasticities, the experience of the United Kingdom and the Federal Republic of Germany suggests that it would be dangerous to assume such stabilizing effects. Although, under the intervention mechanism, a depreciation in the unsupported rate could similarly lead to adverse speculation and a worsening in the trade balance, such results do not weaken the impact of the intervention mechanism on the total currency flow but only influence the official open domestic currency position. Any adverse effects on the demand for spot domestic currency by speculators and traders are offset by stabilizing interest arbitrage flows in the manner described in Section III.

Three other differences between the conventional policy and the intervention mechanism are discussed briefly, as follows.

(1) Under the conventional policy, only the spot rate is supported; under the intervention mechanism, only the forward rate is supported. Switching support from the spot to the forward market will have an impact on the welfare of traders and capital transactors. Sohmen has argued that, for most commercial traders, absence of exchange risks requires stability of forward rather than spot exchange rates.25 In contrast, the exchange risk associated with speculative capital movements is reduced by stability in the spot rather than the forward exchange rate. Switching support from the spot to the forward market is therefore likely to reduce the risk associated with commercial trade and to increase the risk associated with speculative capital movements.

(2) Exchange controls are used by many countries to prohibit purely speculative forward market operations. To prohibit spot market speculation, however, would require restrictions on the convertibility of nonresident deposits. It is possible to prohibit speculative operations taking place at an officially supported exchange rate without constraining the free flow of capital internationally only if it is the forward rate that is supported.

(3) A difference between the conventional policy and the intervention mechanism lies in the likelihood of obtaining political agreement between countries on the coordinated use of the two policies to control short-term capital movements. With the conventional policy, the impact on the total currency flow is imprecise. There could never be certainty of the extent to which intervention in the free forward market would influence the total currency flow or would merely accommodate speculation. It is unlikely that a country would agree to undertake whatever scale of forward intervention was necessary to obtain an agreed total currency flow. With the intervention mechanism, however, the impact on the total currency flow is precise. The intervention mechanism rules derived in this paper determine the exact amount of intervention in the free spot market that is necessary to obtain a given total currency flow.

VII. Conclusion

This paper has examined the official foreign exchange intervention mechanism of supporting only the forward exchange rate while maintaining control over the inflow or outflow of money by buying or selling reserves in a free spot market. The main findings of the paper are as follows:

(1) The necessary and sufficient condition for achieving a desired total currency flow is to make official purchases of domestic currency in the spot market that are less than maturing official forward sales of domestic currency by the magnitude of the desired total currency flow.

(2) There is no constraint on the ability of a country to use the intervention mechanism to maintain zero net capital flows except for the availability of reserves.

(3) There is no constraint on the ability of trade surplus countries to achieve offsetting capital outflows.

(4) Trade deficit countries can secure offsetting capital inflows without disturbing interest parity for as long as the risk of official default is considered to be nil.

(5) Interest arbitrage flows are inherently destabilizing when only the spot rate is supported but inherently stabilizing when only the forward rate is supported.

(6) Securing the required interest arbitrage flows will induce only minimal official losses for as long as interest parity holds.

(7) Provided that the intervention mechanism is not used to prolong the maintenance of an overvalued or undervalued exchange rate, it is likely that official losses owing to exchange rate depreciations or appreciations will be less than they would have been if only the spot rate had been supported.

(8) Trade will be encouraged by a lengthening and thickening of forward markets.

(9) If appropriate policies in relation to the exchange rate are pursued, speculation can be expected to be stabilizing if the maturity period of the supported forward rate reflects the time period necessary for the policies to become effective.

(10) The strains on the world banking system would be reduced if the maturity period of the supported forward rate of a trade deficit country was such that it created investment opportunities—covered against exchange risk—of similar maturity to the newly acquired liabilities of the world banking system to trade surplus countries.

(11) Conventional forward intervention policy under a supported spot rate has an imprecise effect on the total currency flow; the effectiveness of the policy is likely to be reduced by adverse speculation. The impact of the intervention mechanism on the total currency flow is precise; the effectiveness of the policy is likely to be enhanced by stabilizing speculation.

The foregoing findings indicate that the intervention mechanism can achieve important advantages over a pegged or managed spot exchange rate system without significantly greater official losses provided, first, that significant departures from interest parity do not occur and, second, that the maintenance of an overvalued or undervalued exchange rate is not prolonged. These two conditions are not violated if the intervention mechanism is used only to combat or to finance stochastic or temporary disturbances to the balance of payments, such as disequilibrating hot money flows; cyclical balance of payments disturbances; and the adjustment periods during which the trade balance is responding to expenditure-switching or expenditure-reducing policies. The intervention mechanism will be especially suitable for (1) retaining immunity of the reserves and the money supply while stabilizing the path of a flexible exchange rate toward its medium-term norm; and (2) securing stabilizing capital flows between countries that have coordinated economic objectives and policies and that wish to maintain an area of internally fixed exchange rates.26

REFERENCES

Mr. Day, economist in the Financial Studies Division of the Research Department, is an external graduate of the University of London and received his doctorate from the University of Birmingham. He taught at the University of Manchester before joining the Fund.

The author acknowledges the benefit of discussions with members of the University of Manchester Inflation Workshop, and W. Allen, D. Aston, M. Miller, and D. Sheppard, as well as colleagues in the Fund. The views expressed remain those of the author.

The Bundesbank’s operations in the forward market are described by D’Erwin Blumenthal, “Forward Interventions of the Deutsche Bundesbank,” in Coulbois (1972), pp. 140–50. The “merry-go-round” effect here refers to the phenomenon of short-term capital being recycled outward by official swaps and then returning through the supported spot market. A theoretical explanation for both the merry-go-round effect and the possibility that the net effect of a policy of forward intervention on the flow of capital may even be perverse is given in Prissert (1974).

The first advocate of abandoning support of the spot market and restricting intervention to the forward market seems to have been Sohmen (1961).

The category of capital flows (C) includes autonomous public sector capital flows and pure speculation. Pure speculation is defined as a forward purchase or sale of the domestic currency that, on the date of maturity, is exactly offset by a spot contract or another maturing forward contract to sell or purchase an equal quantity of the domestic currency. It is therefore represented by two equal but opposite maturing capital flows.

Each unit of foreign currency is valued here at the domestic currency price at which it is bought or sold.

The total currency flow, in fact, differs from the gap between the demand for and supply of the domestic currency on the foreign exchange market by the extent to which autonomous public sector borrowing, lending, and transfers are not passed through the foreign exchange market.

Modes of official intervention considered in this paper are assumed to have been in operation on day T−i as well as on day T.

It is possible, theoretically, to maintain precise control over the total currency flow under a dual exchange market by supporting only the commercial market and undertaking discretionary purchases or sales of domestic currency in the free financial market. The author compares the intervention mechanism with such a dual exchange market system in Day (1975 b).

The intervention mechanism for ensuring that a balance of payments deficit is financed by borrowing (i.e., by the attraction of short-term capital) while stabilizing the forward rate is analogous to the mechanism whereby a budget deficit can be financed by borrowing while stabilizing long-term interest rates. Stabilizing long-term interest rates results in official purchases or sales of long-term debt that, other things being equal, increase the government’s residual financial requirements and results in offsetting sales or purchases of treasury bills. In the same way that offsetting net purchases of long-term debt by net sales of short-term debt means that the budget deficit can be financed by borrowing while stabilizing long-term interest rates, the offsetting of maturing net forward purchases of domestic currency by spot sales of domestic currency means that the balance of payments deficit can be financed by borrowing while stabilizing the forward exchange rate. This analogy between stabilizing long-term interest rates and stabilizing the forward exchange rate is not appropriate to the impact on the money stock if the banking regulations are such that the equilibrium money stock is a function not only of the quantity of high-powered money but also of the quantity of treasury bills.

A second and related analogy exists between the impact of the intervention mechanism to secure a zero total currency flow on the forward premium and the impact of a funding or attempted twist operation on the term structure of interest rates. A funding or attempted twist operation alters the relative supplies of short-term and long-term debt. If the expectations hypothesis holds, there will be no effect on the term structure of interest rates. The intervention mechanism for securing a zero total currency flow alters the relative supplies of spot and forward currency. If the interest parity hypothesis holds, there will be no effect on the relationship between the spot and forward exchange rates. The interest parity hypothesis is more likely to hold than the expectations hypothesis insofar as the forward price, that is, the forward exchange rate, on which arbitrage depends in the former case is a known variable, whereas the forward price, that is, the expected future short-term rate of interest, on which arbitrage depends in the latter case is stochastic.

The achievement of the required short-term capital flow is, in fact, facilitated by the dependence of leads and lags in trade payments flows on the covered interest rate differential, that is, by the operation of trader arbitrage. For a description of trader arbitrage, see Spraos (1959).

Given that the use of the intervention mechanism to secure a zero total currency flow leaves the currency composition of the spot claims of the world banking system unchanged, it may be assumed that the general level of short-term interest rates, domestically and internationally, remains unchanged. If, however, the maturity period of the supported forward rate of a trade deficit country differs significantly from the maturity period of the newly created liabilities of the world banking system to the trade surplus countries, it may be assumed that the required capital flow to the trade deficit country will involve a change in the term structure of money market interest rates to compensate the world banking system for the risk involved in the lengthening or shortening of the maturity spread between its claims and liabilities. In Sections II-IV, it is assumed that the intervention mechanism neither lengthens nor shortens the spread between the claims and liabilities of the world banking system, and that the term structure of money market interest rates therefore remains unchanged.

Einzig (1973), p. 74, has stated that during the late 1960s some first-rate banks got into the habit of lending to each other without any limits.

The following statement by Einzig is relevant in this context: “In the [Eurodollar] market itself, where the same amounts may be lent and re-lent a dozen times, no lender knows even whether the immediate borrower wants to use it for granting credits, short or long, to finance foreign trade or domestic trade, whether he wants it for arbitrage or speculation. He has no idea to which country and to which firm his Euro-dollar deposits will be re-lent. As for the use made of the Euro-dollars by the ultimate borrower the original lenders cannot even hazard a guess, considering that they have no means of knowing his identity …. The safeguard by limits is purely illusory,” Einzig (1973), pp. 65-66.

After the relaxation of controls on capital inflows in the Federal Republic of Germany in early 1974, that country’s interbank rate moved into line with the Euro-mark rate, which remained at interest parity. See Herring and Marston (1974), p. 29.

For a currency with a supported forward rate, speculation may be expected to give rise to a significant intrinsic premium or discount on the currency only if there are constraints on speculation in the forward market or a risk of default on forward contracts. It is possible to demonstrate that when there are no constraints on forward market speculation and no risk of default, speculation through the spot market becomes inefficient as soon as an unfavorable covered interest rate differential develops on the currency being acquired in the spot market. See Day (1975 c).

The actual arbitrage outflow is less to the extent that arbitrageurs cover their future interest earnings by forward sales of foreign currency.

Prissert (1974), p. 6.

In a separate paper, the author considers official gains or losses that are due to the activity of speculators during normal market periods when a fixed or moving forward rate peg is maintained—Day (1975 a).

Assuming that the authorities undertake swaps with only resident banks, the arbitrageurs’ profits are reflected in the profits made by resident banks and are therefore subject to local taxation.

When only the spot rate is supported, such forward covering by traders induces interest arbitrage outflows that shorten the official open foreign currency position.

It is here assumed that the officially supported forward rate is not longer than the longest thick forward market existing in the absence of forward intervention, that is, that the time horizon of speculators—and therefore the magnitude of speculation—is not affected by the maturity period of the supported forward rate. The impact on speculation of the maturity period of the supported forward rate is considered in Section V.

In the context of a pegged spot rate, Aliber has argued in favor of forward intervention even when a devaluation of the spot rate is envisaged by the authorities. Owing to the stabilizing effects of forward intervention on arbitrage flows and hence on market confidence, he argues that the loss (gain) on the official foreign currency position, both spot and forward, is less (greater) in the presence of forward intervention, Aliber (1962), (1963), and (1967). See also Goldstein (1966).

See, for example, Spraos (1959).

Egon Sohmen, Flexible Exchange Rates: Theory and Controversy (University of Chicago Press, Second Edition, 1969), p. 126.

The intervention mechanism could be applied by a group of countries such as the European Economic Community by maintaining a snake for their cross forward rates. The nondomestic currency acquired through a support operation would then simply be sold in the unsupported spot market.

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