Chaphekar, Prem, Giles Keating, and Richard Mason, “ECU Recomposition and the True Synthetic Yield,” CSFB Research (September 1988).
Committee of Governors of the Central Banks of the Member State of the European Economic Community, “Recent Developments in the Use of the Private ECU: Statistical Review” (February 1991).
Folkerts-Landau, David and Peter Garber “The ECU: A Currency Floating on Gossamer Wings,” NBER Working Paper No. 4017 (March 1992).
Goldstein, Morris, and David Folkerts Landau, “International Capital Markets. Part II. Systemlc Issues in International Finance,” World Economic and Financial Survey, (Washington, D.C.: International Monetary Fund, 1993).
Jean, Alain, “The ECU Clearing System,” translated from “L’ECU, le SME et les Marches Financiers,” Les Editions d’Organisation (Paris, 1990).
Louw, A., “The ECU and the Basket: Exchange Rate Premium/Discount and Interest Rate Differential,” ECU Banking Association (draft, 1991).
Patinkin, Don, “Financial Intermediaries and the Logical Structure of Monetary Theory,” American Economic Review (March 1961), pp. 95–116.
This paper has benefitted from comments of participants at seminars held at the Research Department of International Monetary Fund, the Federal Reserve Board, Princeton University, University of Pennsylvania, Harvard University, the University of Chicago, the OECD, and the European Commission. We are particularly in debt to Bennett T. McCallum, whose comments helped us correct several errors in an earlier draft. The authors are grateful for information and data received from the Kredietbank N.V., the Bank for International Settlements, Eurostat, and the Bank of England. The views expressed are the authors’ alone and do not necessarily represent the views of the International Monetary Fund. An early draft of this paper
Typical bid-ask spreads between the ECU and the Basket are four to five basis points, while deviations from parity have exceeded 200 basis points.
The official ECU, created in a definition contained in a resolution of the European Council of December 5, 1978, is a unit of account consisting of fixed amounts of the currencies of all 12 member states of the EU. Its value in terms of another currency can be calculated by converting the fixed amounts of constituent currencies into a common currency at prevailing bilateral exchange rates. The official ECU is created as a liability of the European Monetary Cooperation Fund (EMCF) by swapping such ECUs for gold and international reserves held by central banks participating in the EMS. In July 1993, the EMCF had about ECU 51 billion in liabilities outstanding through swap operations. Official ECUs can be used only in transactions with EU central banks and a limited number of monetary institutions designated as Other Holders of ECUs. Official ECUs are also created through Very Short Term Financing Facility (VSTF) established in the Basle-Nyborg agreement to provide inter-central bank credit in the defense of the bands of the European Exchange Rate Mechanism.
Since the exchange rate crisis of September 1992, ECU bank assets have been flat and securities issuance has declined substantially.
A real economy is without a pure nominal commodity or unit of account to serve as numeraire, instead prices are stated in terms of a real good numeraire, e.g., in terms of steel ingots.
It should be noted that in order to get a determinate real value of currency or reserves, it is necessary for the monetary authority to fix exogenously the interest rate on currency and reserves. Otherwise, no determinate price of reserves in terms of goods emerge, since a continuum of own currency interest rates and price levels could serve to equate demand and supply in the market for reserves (Patinkin, 1961).
In actual practice, the monetary authority controls the sum of currency and reserves, allowing banks to exchange currency for reserves on demand at a fixed price.
The ability to settle interbank clearing balances in either private ECUs or Baskets also meant that banks with short or long positions in private ECU did not incur much exchange risk and could make a two-way market in ECU against the basket with low risk.
A further technical difficulty contributed to the breakdown of the clearing arrangements. The delivery of some component currencies occurred too late during the clearing day to be lent out overnight.
Two banks make a two-way market in ECU against the Basket and a further three banks make a two-way market in ECU against single currencies. We will refer to these as core banks. Most other banks have a matched ECU book.
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 back to a more normal ECU 45 billion in October 1992, a level that persisted through September 1993.
In national currencies settlement of end-of-day balances in the banking system is usually done in claims on the central bank, i.e., in a good funds medium from outside the private banking system.
As an example of the belief in the professional market literature that the ECU value was pinned down by arbitrage, see J.P. Morgan (April 1991). Starting in 1991, the literature on the ECU produced by major market institutions started to discuss the divergence between the ECU and the Basket and began to argue that there was no means of effecting an arbitrage, although some hinted that there might be some central bank intervention to stabilize the exchange rate. See, for example, ECU Banking Association (June 1991); Paribas (1991b); Louw (1992), Bishop (1991, 1992). Nevertheless, in assessing the divergence, there was still a frequent misuse of the word “arbitrage”. See, for example, Paribas (1991a).
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 ECU 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. The exchange rate uncertainty can be removed quite easily from the market for nonbank securities if issuers were prepared to service such debt either in ECU or in Basket according to the demands of the holder. This would implicitly fix the ECU/Basket exchange rate applicable to nonbank markets but would add a multiple currency option risk to the security issuer. Since the official sector is the main issuer of ECU-denominated bonds, notes, and bills such an initiative could easily be implemented by amending the prospectuses for such issues.
The Maastrich Treaty formally provides for this in Article 109g and Article 1091(4).
The Maastricht agreement of December 1991 generated a surge of activity in the ECU securities market. This agreement made the convergence to monetary union and the creation of a European Central Bank (ECB) more likely, and with that the private ECU was more likely to become the unit of account in a monetary union. 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 to ECU 33 billion in all of 1991) were brought to the market. The currency turmoil put nearly a complete halt to new issues from August 1992 until February 1993. New issues have revived somewhat in 1993, but they remain far below the levels attained in the first half of 1992.
Prior to Maastricht, the ECU was reconstituted every five years. The Maastricht Treaty froze the composition of the Basket, but since it is generally accepted that many of the countries will not meet the convergence criteria by 1997 or 1999, there is some doubt in the markets about how the ECU will be defined for those core countries that may satisfy the criteria.
Instead of explicitly discounting the expected future DM value of one ECU by the risk-adjusted DM interest rate to obtain the present DM value of an ECU deliverable at time T, we could have replaced E (e(T) W(T)) with the ECU/DM Forward exchange rate and discounted by the observable DM interest rate of appropriate maturity. In this case, the risk-premium generated by the uncertainty about e(T) and W(T) would have been embedded in the forward rate.
If the time of fixing is uncertain, then
The uncovered interest parity condition is given by
The daily ECU clearing operation proceeds in three separate stages. Until the preliminary cut-off time of 2 p.m. (Brussels time) all payments messages between the clearing banks go through the SWIFT network. A netting computer provides each bank with its own preliminary debit or credit netting balance and makes available to each bank the nature (debit/credit) of the balance of every other clearing bank (also entered into a Reuters page by the BIS). The netting center also transmits these final netting balances to the BIS. The BIS maintains a daily clearing account for each clearing bank, which is credited or debited with the final netting balances of each bank. If at 3:15 p.m. some banks’ net positions still exceed 1 million ECU, a further half-hour is allowed for an interbank market among the reduced set of participants—so-called special transfers. After this period, to deal with the remaining “small change” transactions required to bring the clearing accounts to a zero balance, the BIS, acting as an agent, arranges loans from the net credit banks to the net debit banks. To do this the BIS maintains an ECU “sight account” for each clearing bank with a balance that cannot exceed 1 million ECU. These accounts pay zero interest and no overdrafts are permitted. The BIS can, at its discretion, transfer up to 1 million ECU in any one day from the account of one bank to the account of the other banks and log the transfer as an interbank loan between the two banks at the BIS overnight interest rate. Effectively, this is a housekeeping operation to eliminate frictional ECU clearing balances. If a clearing bank is unable to obtain sufficient ECU credit to settle its clearing balance, then the rules (never yet invoked) prescribe that the day’s clearing will be unwound and all payments orders given and received by the nonperforming bank will be canceled. The remaining payment orders are automatically value-date adjusted to the next day.
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. At the writing of this paper, these facilities had not yet been used.
Since the total net debit position of the clearing banks is always equal to their total net credit position on payments it has been argued that any overnight interest rate will clear the interbank market (Jean (1990)) and that, therefore, the interest rate must be set externally. It is always true, however, that net debits equal net credits on a day’s payments. In the ECU system, they also equal net interbank lending because of the lack of other media to settle. Nevertheless, in the absence of a market manipulation, the market should clear through the emergence of credit risk premia charged to individual debit banks.
That the banks must occasionally clear this position through “special transfers,” however, indicates that either there are some additional rate payments or that a set of unwritten rules exists for allocating risks among the creditor banks that are reluctant to lend to the debit banks.
The exogenous interest rate setting rule also satisfies the requirement that the interest rate of some nominal instrument, such as required reserves, be set exogenously for the unit of account to have determinant real value. Note that any exogenous rate setting rule would do to make the value determinate, regardless of the theoretical rationale for choosing it.
For example, in the simplest case, if the expectations hypothesis of the term structure is valid, i(t)ECU is the arithmetic average of future expected bank ECU tomorrow/next rates through time t. More generally, the expectations hypothesis yield would be adjusted by liquidity premia and discounts.
The equilibrating features of this rule for the setting of the overnight interest rate applies only to the flow disequilibrium in the exchange market during the day. It is likely that there will be occasions when the banking sector has a positive net asset position in ECU while there exists an excess supply of ECU in the exchange market.
Indeed, the rule for setting the interest rate for overnight loans engendered in the clearing operation emerged from the notion that the Basket and the ECU were the same. If the two units were the same, there was a need to give a markup to the core banks in the exchange market when they were buying in ECU, relending the ECU overnight to the net debit banks, and funding the acquisition with Baskets; hence, the interest rate rule prescribed that they charge the offer rate on overnight lending in the Basket currencies.
In other words, when ECU bank assets exceed ECU bank liabilities, then the marginal funding cost for ECU assets is the Basket interest rate.
Lund (1991) explicitly recognizes that expectations about a future pegging of the ECU rate influence the pricing of the ECU today. But he relies on the demand/supply argument to explain immediate fluctuations in the ECU/Basket exchange rate.
Recall that the normal bid-offer spread is about five basis points.
Bank for International Settlements, International Banking and Financial Market Developments (Basle: Bank for International Settlements, February 1993), p. 5.
We emphasize that the combination of the interest parity condition with the exogenous setting of the ECU interest rate are sufficient conditions for making the exchange rate determinate. McCallum (1992), in commenting on an earlier version of this paper, argues that the interest setting mechanism used by the BIS is a lagged endogenous variable because it depends on flows in the exchange market two days prior to a day’s clearing. Using a model in which the overnight rate is a lagged endogenous variable (although not identical to the BIS’s rate mechanism) McCallum shows that a determinate exchange rate solution can emerge.