VI Developments in the ECU Markets
- International Monetary Fund
- Published Date:
- January 1993
The Maastricht agreement of December 1991 generated a surge of activity in the ECU securities market. This market had become symbolic of confidence in convergence to monetary union and the creation of a European central bank (ECB), and the ECU was viewed as more likely to have a stable real value as it would become the unit of account in a monetary union.96 At the end of 1991, the market included ECU 193 billion of banking liabilities, ECU 124 billion of bonds, and ECU 17 billion of Euro-notes and treasury bills; in the first half of 1992, ECU primary bond issues totaling ECU 26 billion (compared with ECU 33 billion in the whole of 1991) were brought to the market (Bank for International Settlements, 1993, p. 62).
The defeat of the Maastricht treaty in the Danish vote of June 2, 1992 brought this expansion to a temporary halt. Secondary ECU bond markets became less active as a number of ECU bond dealers withdrew from the ECU market, and no significant ECU primary issues were brought to market from the end of July 1992 through mid-January 1993. At the end of January 1993, however, primary issues resumed with the issue of ECU 680 million of a ten-year French OAT ECU bond and of an ECU 1.1 billion three-year U.K. ECU note. These were followed with an issue of ECU 2 billion of five-year French BTANs in March 1993. Further ECU issues by Sweden and Denmark in May and June added to the recovery of the primary market.
During the ERM crisis, the exchange rate between the private ECU and the official ECU’s basket of currencies deviated up to 250 basis points from par because of a combination of exchange controls in some of its component currencies, large sales of ECUs from official reserves as official holders made “substantial withdrawals of deposits,” and a general flight from ECU securities.97 The market did not operate for a week after September 16, 1992—that is, holders of ECU claims found that they were inconvertible with the basket. Not until the end of October 1992 did the private ECU begin once more to exchange at close to par.
As a background to the events in the ECU markets, this section will describe the development and institutions of the ECU bond and banking markets before the crisis. Next, it will describe the reduced activity in the ECU markets in the eight months from July 1992 through February 1993 and the nature of the recovery that began in February 1993.
Primary and Secondary ECU Securities Markets
With the active support of European institutions and national governments, the ECU securities market has grown rapidly from the time of the first ECU-denominated issue in 1981. In 1984, international ECU bonds outstanding reached ECU 7 billion in face value, mostly in small, retail-oriented issues. Outstanding international ECU issues grew to ECU 40 billion by the end of 1989 and to ECU 72 billion by the end of 1991. Domestic issues were also substantial, reaching ECU 52 billion at the end of 1991.98
Initial investors bought ECU securities to gain exposure to the basket of European currencies under the assumption that the ECU denomination of bonds was similar to that of the official ECU basket. Institutional involvement generated a secondary market whose liquidity was accentuated as large-sized issues were brought to the market starting in 1988. Banks also acquired ECU securities to balance ECU-denominated liabilities to customers. In 1989, central banks began to employ the ECU to manage reserves, thereby adding to the demand for ECU securities.99 Central banks began to acquire such large amounts of private ECU-denominated claims that, by September 1991, total official holdings of private ECUs amounted to ECU 34.1 billion.100
The bulk of the ECU securities are issued by European governments, institutions (European Atomic Energy Community (EURATOM), European Coal and Steel Community (ECSC), European Economic Community (EEC), and European Investment Bank (EIB)), or supranationals. Financial institutions also account for a large proportion of the number of ECU securities issues. Commercial corporations currently account for less than 20 percent of the number of issues. The issues of both commercial corporations and financial institutions are almost entirely concentrated in issues that have no more than two years to maturity. The large benchmark issues listed by market makers are almost entirely government, EEC, or EIB issues. For example, large ECU issuers in February 1993 included the United Kingdom with ECU 6.05 billion in bonds outstanding, France with ECU 11.8 billion in ECU OATs, Italy with ECU 26.5 billion in certificates (CTEs) and ECU 4.9 billion in bonds, and the EEC with ECU 3.6 billion in bonds.
In addition, Italy and the United Kingdom had treasury bill programs with ECU 4.3 billion and ECU 3.9 billion, respectively, outstanding in February 1993. The U.K. ECU treasury bill program is noteworthy in that it was explicitly intended to aid the development of a liquid London money market in ECUs and to add to the flexibility of U.K. reserve management, since ECUs acquired in treasury bill sales could be counted as foreign exchange reserves.101
The ECU Banking Market
The rapid growth of the ECU securities market has been matched by that of the ECU banking market. ECU-denominated bank assets grew from ECU 64 billion at the end of 1985 to ECU 184 billion at the end of 1991. During the same period ECU-denominated liabilities grew from ECU 58 billion to about ECU 193 billion. Of these 1991 liabilities, however, ECU 152.8 billion were interbank claims; other liabilities consisted of ECU 7.7 billion identified in official deposits and ECU 32.8 billion in other customer deposits. In September 1991, approximately three-fourths of ECU bank assets were interbank claims, and loans to nonbanks were dominated by Italian residents, including banking holdings of Italian ECU treasury securities.102
Almost all the ECU banking activity is undertaken by members of the ECU Bankers Association (EBA) with 44 clearing banks. The BIS, as agent for the EBA, operates an ECU clearing and settlement system, which functions on an end-of-day net settlement basis. Average daily turnover on this system grew from ECU 21.4 billion in January 1990 to ECU 43.2 billion in May 1992, reaching a peak of ECU 156 billion in September, and declining to a more normal ECU 45 billion in October 1992.
Settlement of a day’s balance, however, does not occur in the national currencies belonging to the ECU basket; rather, banks that are net debtors on a day’s payments must borrow ECUs from banks that are net creditors for the day. Because there is no final settlement medium from outside the ECU banking system, the private ECU is a unit of account detached from the official ECU as defined by the EC for its own accounts and for denomination by such entities as the European Monetary Cooperation Fund (EMCF).103
If a creditor proved reluctant to extend further credit, the day’s clearing operation could be jeopardized. To prevent this and potential manipulation of overnight ECU interest rates, the EBA has implemented a system of brokering overnight lending and administratively setting overnight ECU interest rates.104
Exchange Rate Between the Private ECU and the Basket
The touchstone of the private ECU was an agreement among the members of the EBA to permit delivery of the basket for settlement of the day’s clearing balance, which guaranteed that the ECU’s value would not deviate from its theoretical basket value. This means of validating the private ECU’s value was eliminated in October 1987 when the basket could no longer be delivered as settlement.105 As its value was not pinned down by a use as a medium of exchange, the ECU then became a unit of account whose value depended on the anticipation that it might one day be exchangeable at some fixed rate for the basket or vice versa. Such an event might occur in stage III of EMU. Until that time, however, the ECU would have to float against the basket, with its spot value determined by speculation on the prospects for EMU, movements of cross-exchange rates, or potential redefinitions of the basket.106 Nevertheless, for the next year, banks continued to make a market in ECUs by quoting an exchange rate around par with the basket, but later they discontinued this practice and let the ECU float against the basket. The ECU continued to hover near par with the basket, based on a market view that there was some arbitrage possibility that prevented it from moving far away. The exchange rate with the basket might appreciate as much as 90 basis points or depreciate as much as 60 basis points from par (in a market with normal bid-ask spreads of 3 to 5 basis points),107 but this phenomenon was interpreted optimistically as the ECU separating itself into an independent currency preparatory to the advent of EMU.108
Changes in belief about the probability of EMU or the possible future conversion rate would then move the current exchange rate between the private ECU and the basket. Chart 20 depicts the exchange rate between the private ECU and the basket for the 15 months from December 1991 through February 1993. At around the time of Maastricht, the private ECU traded at a discount of up to 50 basis points with the basket, but for the first eight months of 1992 it traded at close to parity. The ERM crisis drove the exchange rate as much as 250 basis points from par; but by November 1992, the private ECU traded at close to parity once more.
Chart 20.Private ECU/Basket Exchange Rate
The Hiatus of the ECU Markets
With about 500 separate issues outstanding, the average size of an ECU security issue is about ECU 200 million. There are 22 benchmark issues, however, of ECU 1 billion or more, and these had considerable liquidity. Notable among these benchmarks were French OAT issues, U.K. Treasury note and bond issues, and some EIB issues.
After the Danish vote, however, the benchmark ECU issues became less liquid, as did bond markets in the individual currencies. Two indicators track the ensuing one half year of activity in the ECU market—the shifts in the ECU yield curve relative to the theoretical ECU yields and the amount of turnover in the secondary ECU securities market.
ECU Versus Theoretical Yield Curves
Panels A through D in Chart 21 compare the evolving relationship between the actual ECU yield curve and the theoretical ECU yield curve immediately after Maastricht, at the end of summer 1992, in the aftermath of the ERM crisis, and after the introduction of the new French and U.K. issues. The actual ECU yield curve consists, for each maturity, of a composite of benchmark ECU bond yields based on quotes of market makers. The theoretical ECU yield curve is constructed by taking the weighted average, for each maturity, of benchmark securities in each of the ERM currencies, using each currency’s weight in the basket.
Chart 21.ECU Yield Curve and Spreads
Source: Bloomberg Financial Services.
Various explanations have been advanced for why ECU securities might trade at prices higher or lower than the theoretical price. First, the markets may reflect an anticipation of a future weight shift in the basket over the life of the security, so that the weights used in calculating the theoretical price and yield may be inappropriate. Second, the liquidity of the benchmark ECU securities may differ from that of issues denominated in individual ERM currencies. Third, different credit risk is associated with the issuers of benchmark ECU securities and with those of securities denominated in ERM currencies. Fourth, there are differential effects from taxes and exchange controls.
The spreads between the ECU curve and the theoretical curve in December 1991 in Panel A of Chart 21 are typical of the yield curves after Maastricht and before the Danish referendum. Across the maturity spectrum, ECU benchmarks traded at yields up to 50 basis points below theoretical yields. After the Danish referendum, the ECU yield curve shifted substantially above the theoretical curve, as indicated in Panel B—the ECU yield for ten-year benchmarks reached 70 basis points above the theoretical yield. This pattern continued from the time of the ERM crisis through the end of December 1992, as indicated in Panel C.
The spreads began to shrink in all maturities with the issue of the French ten-year ECU OATs and the U.K. three-year ECU treasury notes in January 1993, though they had not returned to their post-Maastricht levels. At the three-year maturity the ECU yield fell below the theoretical yield by the end of February, as shown in Panel D. Part of this movement could be associated with new primary issues alone: the lack of issuance of new securities in the previous six months had caused the existing ECU benchmark issues to become seasoned, with the usual loss of liquidity. The ECU yield curve would then tend to be higher than the theoretical because of the more recently issued, and therefore more liquid, ERM currency issues. Part of the movement was associated with a revival in momentum toward EMU.
Turnover in Secondary Markets
In the first six months of 1992, the monthly average turnover on Euroclear and Cedel of straight ECU Eurobonds was ECU 91 billion, a large increase over the ECU 65 billion monthly average for all of 1991. Monthly turnover surged to ECU 106 billion in July and then fell steadily to about ECU 30 billion by December 1992.109 A similar pattern emerged in the turnover for domestic ECU issues. Domestic turnover increased from a quarterly average of ECU 86 billion in 1991 to ECU 149 billion, ECU 176 billion, and ECU 169 billion in the first three quarters of 1992, respectively. Turnover in domestic issues then declined to ECU 89 billion in the fourth quarter of 1992 but increased to ECU 108 billion in the first quarter of 1993. Much of the decline in 1992 can be traced to the fall in wholesale trading among market makers. In turn, the decline of the wholesale market made primary issues problematic; since new issues typically generate much trading among market makers, the dearth of new issues also contributed to the decline in turnover.
The dollar exchange rates of the ECU at year-end 1991 and 1992 were $1.36 per ECU 1 and $1.34 per ECU 1, respectively.
Domestic ECU bonds are targeted by governments at domestic residents seeking to invest in securities not denominated in the national currency.
Bank for International Settlements (1992a), pp. 17 and 19. The BIS reports that from end-1987 to end-September 1991 identifiable ECU liabilities of the banking system to official monetary institutions jumped from ECU 1 billion to ECU 9 billion. It further reports that this number substantially underestimates official ECU holdings because data from banks in the United Kingdom do not report such funds separately from other nonbank funds and because its data do not include official ECU holdings with the domestic banking systems. It estimates that in September 1991 central bank deposits in the ECU market were about ECU 30 billion and that ECU 4–5 billion more was held in ECU securities (ibid., p. 20).
For a description of this program, see Bank of England (1992). The United Kingdom had little interest cost from operating this program: U.K. ECU treasury bills yielded as much as 30 basis points below the London interbank bid rate (LIBID), so if the proceeds were held as ECU bank deposits, the program would yield positive net interest revenue.
Of total lending to non-EC nonbanks 60 percent was to Swedish residents. See Bank for International Settlements (1992a), pp. 17–18.
The emergence of the private ECU as a unit of account in its own right temporarily generated a lack of clarity in the meaning of a promise to deliver ECUs contained in ECU securities. The typical prospectus of an ECU security initially defines the ECU as the official basket, but then promises delivery in private ECU bank deposits. If these two units of account trade at par until the maturity of the security, no problem can arise. When they cease to trade at par, however, the promise of the securities becomes less clear.
Nevertheless, because of growing recognition of the risk of difficulties in clearing a day’s payment operation, several lending facilities have recently been established to provide credit to net debit banks. The BIS Intermediation Facility can lend funds to a bank short of funds by taking up to ECU 5 million from each of the clearing banks and lending to banks that are short. In this way, it can spread the risk of the overnight credit among the clearing banks. The Bank of England, the Banque de France, and the Banca d’Italia have also introduced separate liquidity recycling facilities. These operate either as collateral management facilities, with the pledging by short ECU clearing banks of ECU sight balances held at the central bank as collateral for lending by a long ECU clearing bank, or as credit management facilities, with direct intermediation between long and short banks by central banks’ lending against ECU or national currency securities held in centralized securities depositories.
As agent for the EBA, the BIS does maintain “small change” sight accounts for final settlement purposes in which private ECU claims of the banking system are backed by basket assets. These accounts are used for ease of settlement of small, odd amounts at the end of the day, and they are specifically not used to exchange ECUs with the basket.
Specifically, together with the exogenous mechanism for setting overnight private ECU interest rates agreed among the members of the EBA, future convertibility at par is sufficient to determine the current value of the private ECU.
These observations are based on data provided by Kredietbank, Brussels, a major market maker in ECU exchange.
Folkerts-Landau and Garber (1992) describe the institutional factors that impart real value to the private ECU and the deviation of the exchange value between the private ECU and the basket that would occur with a loss in confidence in emergence of the ECU as the European currency.
In discussing overall ECU bond turnover in 1992, Bank of England (1993), p. 226, states, “Although the value of ECU turnover was unchanged between the first and second halves of the year, this reflects heavy selling by market-makers attempting to unload unprofitable positions in the second half of the year, rather than genuine ‘end user’ investment.”