Abstract

To understand why the sales of certain ERM currencies in the summer and fall of 1992 were so huge, the story has to go back at least five years. Specifically, over 1987-91, large, cumulative inflows of capital into the higher-yielding ERM currencies occurred (see Table 4). These inflows are examined in more detail in Annex VI. One of the important factors motivating these inflows was the growing perception by international investors that the member countries of the EMS were on a continuous convergence path toward European Monetary Union (EMU), under which interest rate differentials in favor of the high-yielding ERM currencies would increasingly overestimate the actual risk of exchange rate depreciation. As one portfolio manager recalled the prevailing view, “why settle for the yield on a deutsche mark bond when you can get the higher yield on a peseta or lira bond without a compensating exchange risk?” This came to be known in major financial centers as the “convergence play.”

To understand why the sales of certain ERM currencies in the summer and fall of 1992 were so huge, the story has to go back at least five years. Specifically, over 1987-91, large, cumulative inflows of capital into the higher-yielding ERM currencies occurred (see Table 4). These inflows are examined in more detail in Annex VI. One of the important factors motivating these inflows was the growing perception by international investors that the member countries of the EMS were on a continuous convergence path toward European Monetary Union (EMU), under which interest rate differentials in favor of the high-yielding ERM currencies would increasingly overestimate the actual risk of exchange rate depreciation. As one portfolio manager recalled the prevailing view, “why settle for the yield on a deutsche mark bond when you can get the higher yield on a peseta or lira bond without a compensating exchange risk?” This came to be known in major financial centers as the “convergence play.”

Table 4.

External Net Capital Flows for Selected Countries in the EMS

(In billions of local currency)

article image
Sources: Bank of Spain, Statistical Bulletin (November 1992); Banque de France, Bulletin Mensuel (December 1992); Direction du Trésor and Banque de France, La Balance des Paiments de la France (various issues); Monthly Report of the Deutsche Bundesbank (various issues); and United Kingdom, Central Statistical Office, Financial Statistics (December 1992) and Press Release CSO (92) 187 (December 18, 1992).

Excluding changes in official foreign exchange reserves and errors and omissions.

For the first three quarters of the year.

For the first half of the year.

Private capital includes capital movements in the banking sector.

As shown in Chart 1, the average spread during the last five years of the one-year lira yield over the corresponding deutsche mark instrument was nearly 5 percent (so too with the yield differential over U.S. dollar instruments); the attraction of peseta instruments (over 1989-92) is likewise apparent. When the United Kingdom entered the ERM in October 1990, it too became a candidate for convergence plays. Based on the same convergence scenario, the financial sector and the larger corporate issuers in the high-yield currency countries increasingly funded themselves in the lower-interest ERM currencies (mainly the deutsche mark and to a lesser extent the Dutch guilder).6 In yet another reflection of the fixed exchange rate assumption, the exchange risk of positions against non-ERM currencies was frequently “proxy-hedged,” for example, a hedge of a deutsche mark position against the U.S. dollar was emplaced when lira securities were acquired. As the period since the last realignment in the ERM lengthened and as the political commitment toward EMU solidified—culminating with the signing of the Maastricht Treaty in December 1991—the strategy of riding the high nominal interest rate seemed secure. Without pretending too much precision,7 estimates suggest that the total of such convergence plays could have been as high as $300 billion.8

Chart 1.
Chart 1.

Interest Rate Differentials on Eurocurrency Deposits1

(In percent)

Source: Data Resources, Inc.1 Labels indicate maturity of both components of the differential.2 Daily data for the Spanish peseta are not available before July 1989.

The problem of course was that actual achievements in convergence among ERM countries—although significant—were neither durable nor deep enough to justify assuming complete fixity of exchange rates. Losses of competitiveness, large fiscal deficits not yet under control, weaknesses in financial sectors, sharp cyclical differences, and divergent mixes of monetary and fiscal policy across countries (in the wake of German unification) were each vulnerable elements. Those vulnerabilities became more important once the negative outcome of the Danish referendum and uncertainties about the outcome of the French referendum challenged both the certainty of the EMU treaty ratification and the ability of some countries to deliver enough convergence (without EMU) to sustain existing exchange rate parities. In short, the markets “rediscovered” exchange risk. A massive shift out of certain currencies and the beginning of the recent crisis in the ERM followed.

International Capital Markets: Part I
  • A.M. Best Co., Best’s Aggregates & Averages—Life/Health (Oldwick, New Jersey: A.M. Best Co., 1992).

  • Association of Reserve City Bankers, Report on the Payment System (Cambridge, Massachusetts, 1982).

  • Bank for International Settlements, International Banking and Financial Market Developments (Basle: Bank for International Settlements, August 1991).

    • Search Google Scholar
    • Export Citation
  • Bank for International Settlements, Recent Developments in International Interbank Relations (Basle: Bank for International Settlements, October 1992).

    • Search Google Scholar
    • Export Citation
  • Bank of Italy, Annual Report (Rome: Bank of Italy, 1991).

  • Bank of Spain, Statistical Bulletin (Madrid: Bank of Spain, November 1992).

  • Deutsche Bundesbank, “The Latest Exchange Rate Realignments in the European Monetary System and the Interest Rate Policy Decisions of the Bundesbank,” Monthly Report of the Deutsche Bundesbank, Vol. 44, No. 10 (October 1992).

    • Search Google Scholar
    • Export Citation
  • Deutsche Bundesbank, “The Impact of External Transactions on Bank Liquidity, the Money Stock and Bank Lending,” Monthly Report of the Deutsche Bundesbank, Vol. 45, No. 1 (January 1993).

    • Search Google Scholar
    • Export Citation
  • Flood, Robert P., and Peter M. Garber (1984a), “Gold Monetization and Gold Discipline,” Journal of Political Economy, Vol. 92, No. 1 (February 1984), pp. 90107.

    • Search Google Scholar
    • Export Citation
  • Flood, Robert P., and Peter M. Garber (1984b), “Collapsing Exchange-Rate Regimes: Some Linear Examples,” Journal of International Economics, Vol. 17 (August 1984), pp. 113.

    • Search Google Scholar
    • Export Citation
  • Goldstein, Morris, and others, International Capital Markets: Developments, Prospects, and Policy Issues (Washington: International Monetary Fund, September 1992).

    • Search Google Scholar
    • Export Citation
  • Healey, Juliette, “The Foreign Exchange Market in London,” Bank of England Quarterly Bulletin, Vol. 32 (November 1992), pp. 408415.

    • Search Google Scholar
    • Export Citation
  • International Monetary Fund (1992a), Balance of Payments Statistics Yearbook (Washington: International Monetary Fund, 1992).

  • International Monetary Fund (1992b), Report on the Measurement of International Capital Flows (Washington: International Monetary Fund, September 1992).

    • Search Google Scholar
    • Export Citation
  • International Monetary Fund, World Economic Outlook: Interim Assessment (Washington: International Monetary Fund, January 1993).

  • International Monetary Fund, International Financial Statistics (Washington: International Monetary Fund, various issues).

  • Krugman, Paul, “A Model of Balance-of-Payments Crises,” Journal of Money, Credit, and Banking, Vol. 11 (August 1979), pp. 31125.

  • Life Assurance Association of Japan, Life Insurance Industry in Japan 1990-91 (Tokyo, 1992).

  • Mathieson, Donald J., and Liliana Rojas-Suárez, Liberalization of the Capital Account: Experiences and Issues, IMF Occasional Paper, No. 103 (Washington, March 1993).

    • Search Google Scholar
    • Export Citation
  • Posen, R., and S. Nada, “U.S. Institutional Investors and International Equity Trading,” (unpublished; Boston: Fidelity Investments, September 1992).

    • Search Google Scholar
    • Export Citation
  • Salant, Stephen W., and Dale W. Henderson, “Market Anticipations of Government Policies and the Price of Gold,” Journal of Political Economy, Vol. 86 (August 1978), pp. 62748.

    • Search Google Scholar
    • Export Citation
  • Turner, Philip, Capital Flows in the 1980s: A Survey of Major Trends, BIS Economic Papers, No. 30 (Basle: Bank for International Settlements, April 1991).

    • Search Google Scholar
    • Export Citation
  • Walmsley, Julian, The Foreign Exchange and Money Markets Guide (New York: Wiley, 1992).