I Introduction

International Monetary Fund
Published Date:
January 1993
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This report examines the implications of the growth and integration of international capital markets for the management of exchange rates, with particular attention to the inferences that can be drawn from the currency turmoil that shook the European Monetary System (EMS) last fall and winter.

In examining the main factors behind the September crisis, the International Monetary Fund’s January 1993 World Economic Outlook concluded that the crisis “… reflected an unusual combination of divergent economic forces and important political events that raised doubts about countries’ commitment to control inflation and to reduce excessive budget deficits and about the prospects for monetary cooperation in Europe” (p. 26). This paper focuses on the currency crisis from the perspective of international capital markets. It rounds out previous analysis in three respects. First, it provides a fuller picture of how the liberalization of capital flows, the growing imbalance between the resources of private market participants and those of central banks, the ascendancy of institutional investors with a global horizon, and the rapid progress in the technology of financial transactions have combined to increase the challenges associated with the management of exchange rates. Second, the paper discusses the activities of, and several of the tactical issues that faced, some key players during the crisis itself. And third, it identifies the types of policy options available to authorities for managing (fixed) exchange rates in today’s world of global capital markets.

Section II outlines the changing landscape in international capital markets—with emphasis on the main features of the global foreign exchange market (including existing regulatory constraints). Section III introduces an important prologue to the currency crisis, namely, the substantial capital inflows into high-yielding currencies in the exchange rate mechanism (ERM). Section IV then discusses the roles of institutional investors and of banks during the turmoil, as well as assessing the behavior of liquidity in that period. The tactics of defending ERM parities—with a focus on official intervention and on defensive increases in interest rates—are taken up in Section V. Section VI introduces some of the policy options for managing exchange rates in the aftermath of the ERM crisis. A series of annexes examine the foreign exchange markets in greater depth; topics include their structure; foreign exchange hedging strategies; the regulatory constraints facing traders; the mechanics and economics of speculative attacks, together with the defense against these attacks; and case studies of some countries’ experience during the ERM crisis.

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