WITH THE RELAXATION of exchange controls and the rapid rise in the volume of international trade over the last few years, there has developed both a very large supply of money, which is shifted from one international monetary center to another in search of higher interest rates, and a large volume of demand for money, which shifts in search of lower interest rates. Together, these shifts can subject a country whose interest rates become relatively low to rapid and large losses of gold and foreign exchange reserves. Even though the country’s longer-run position is not unsound, such losses may provoke speculative flights of “hot money,” which could place the exchange rate in jeopardy.
Failure to anticipate these results of a relaxation of exchange controls in an environment of stable exchanges is explained, in part, by a belief that the international shifts of short-term lendings and borrowings actually carried out would be limited to a small fraction of the amounts that lenders and borrowers desired to make. The cause of this limitation was found in a restricted availability of forward foreign exchange; and forward exchange is a necessary ingredient in a major part of the short-term lendings or borrowings that respond to differences in interest rates.
This paper will describe how the opportunity for large movements of short-term funds can be provided by the normal responses of exporters and importers to movements in the forward exchange rate. It will also note some implications of the situation for three alternative means of dealing with the capital movements: official operation in the forward market, widening the legal range of variation of the exchange rate (widening the spread between the “gold points”), and enlarging the narrower range within the gold points over which the exchange rate actually is permitted to move.
Mr. White, economist in the Finance Division, received his undergraduate and graduate training at Harvard University. He has contributed articles to a number of economic journals.
For a thorough discussion of many aspects of the forward exchange market not covered here, see S. C. Tsiang, “The Theory of Forward Exchange and Effects of Government Intervention on the Forward Exchange Market,” Staff Papers, Vol. VII (1959-60), pp. 75-106.
Definitions of terms used in this discussion:
Forward exchange: A contract to buy (sell) foreign exchange at some stated future date, the exchange rate used being agreed to at the time the contract is made. (Contracts are commonly made for periods of up to six months in advance of the exchange transaction.)
Forward cover: An exchange contract used to offset the exchange rate risk incurred in the holding of assets denominated in a foreign currency or in an obligation to make (receive) a payment in foreign currency.
Spot exchange rate: The rate of exchange between currencies—the exchange rate in which transactions that are to be immediately carried out are arranged.
Forward premium on the pound: The percentage excess of the price of the pound for future delivery over the spot exchange price of the pound in terms of some other currency. (When the forward pound is at a discount, the pound’s price in the forward market is cheaper than its price in the spot market.)
To aid understanding, the discussion of the forward exchange mechanism is being expressed in this paper in terms of sterling/dollar transactions. However, it is not implied that any of the situations described is especially characteristic of those two currencies.
“The potential benefit to the dollar, however, cannot be measured simply by the relative change in interest rates. Since very few short-term funds these days cross national boundaries without being covered against the risk of an alteration in the exchange rate before they are repatriated, the cost of such forward cover must also be taken into account. Indeed, when there are no pressing fears of depreciation, the forward rate will normally adjust itself to the differential in money rates between the two centres, thus eliminating the incentive to transfer funds. … [this] calls into question whether the mere adjustment of interest differentials can be relied upon to exert any significant effect on the flow of short-term funds unless it is flanked by an active policy of influencing forward exchange rates as well. In short, even if European money rates do not rise at all, the rise in U.S. rates may have no real impact on the flow of funds to Europe unless the authorities intervene in the forward market—as they did successfully in 1961.” From “America Tackles Its Deficit,” The Banker, Vol. CXIII (August 1963), p. 525.
Paul Einzig has said that some of the traders dealing in items with wide profit margins can afford to take the risk of going uncovered, especially since it keeps alive the chance of an exchange profit. But he apparently is not reporting anything like the systematic, strong reaction of traders to changes in the cost of forward cover which is implied by the reasoning offered above. Whereas Einzig says that traders in staple commodities operate on profit margins that are too narrow to permit the running of such risks (A Dynamic Theory of Forward Exchange, London, 1961, p. 65), the reasoning above implies that higher profits will be earned—on the average, at least—by using less exchange rate insurance, the more its cost rises toward the amount of the maximum exchange risk. Even if ownership capital would otherwise be inadequate, these extra profits should provide the intelligent commodity trader with a self-insurance fund adequate for survival of any plausible succession of exchange losses of, say, 1 per cent.
Somewhat stronger belief that traders are sensitive to the cost of forward cover is indicated by the testimony which the Governor of the Netherlands central bank gave to the Radcliffe Committee in late 1958 (Committee on the Working of the Monetary System, Minutes of Evidence, London, 1960, p. 816). However, no similar view could be found anywhere else in the Committee’s evidence, memoranda, or report.
Under these conditions the scope for arbitrage could be further enlarged by arbitragers’ forgoing forward cover. Those who are as willing as the traders to trust the exchange parities would see no advantage in selling the pound forward at a price little above its lower limit of $2.78. (See John Maynard Keynes, Treatise on Money, II, London, 1930, pp. 323–26.)
This and the speculative factor have been offered as explanations of the coexistence after mid-1960 of large arbitrage transfers and a yield on U.K. Treasury bills (net of the cost of cover) that remained 1 percentage point higher than the yield on U.S. bills (John H. Auten, “Foreign Exchange Rates and Interest-Rate Differentials,” The Journal of Finance, Vol. XVIII, March 1963, pp. 17-18). But because that explanation must assume substantial speculative purchases of forward sterling when the price falls only 0.6 cent below $2.80, and when a deepening U.S. recession could have promised a weaker spot pound, the trader reactions proposed in the present study seem to be a better explanation.
Some of the relevant factors are the following: The slope of the other bilateral Dtrad curves may be raised above that of the U.K.-U.S. curve because of less well organized forward exchange markets; a 3 per cent permitted range of variation for the spot exchange rates between European currencies (more, where Switzerland is involved) in contrast to the 1½ per cent range for rates against the dollar (see discussion of widening the spread between the gold points below); and less confidence in the maintenance of the exchange parities of such countries.
The opportunity for covered transfer from the United States to the United Kingdom is further reduced where there are arbitrage funds in France that also will be attracted to the United Kingdom. If the associated sales of forward pounds in exchange for francs proved sufficient to account for a ⅓ per cent depreciation of the forward £/F rate, only ¼ per cent more would have been left for the use of the arbitragers who wanted to leave New York; and, as above, this would have to be divided between the two bilateral forward markets. Hence, the trilateral channel would provide cover for only a little over one fourth as much arbitrage as the 1 per cent depreciation of the forward £/$ rate would provide through the direct, bilateral channel.
A factor which may increase the scope for trilateral arbitrage is central bank purchases of home forward currency to limit the severity of its depreciation.
The cheapening of the forward price of pounds may cause some diversion from the spot to the forward market of speculation that would occur in any case; but this can be disregarded because it would merely substitute a rise in short-term official liabilities for a fall in official reserves. If the cheapening goes far enough to bring the pound close to its lower gold point, it will also cause the speculative purchases of forward pounds described earlier, and purchases of that kind should be taken into consideration.
It should be noted that the creation of extra forward contracts with traders merely formalizes a part of the authorities’ existing obligation to provide importers with foreign exchange in three months’ time; importers merely arrange now to purchase foreign exchange in three months’ time that they would otherwise have had to purchase in three months without prearrangement. From this consideration, the additional short-term liabilities can be considered as neutralizing a much smaller amount of foreign exchange assets.
Two new viewpoints on that question may be of interest. Einzig argues that prolonged official efforts to hold down the premium on forward foreign exchange when the home currency position is weak are undesirable because they could require the central bank to assume a volume of forward liabilities larger than its gold and exchange holdings. That excess would be of no concern (psychological factors aside) insofar as the buyers of forward exchange lacked surplus liquid assets and therefore would be unable to hold abroad the exchange acquired when the contract matured. (If they did hold liquid funds, they would presumably acquire spot exchange if forward exchange remained expensive.) However, he finds that foreign-owned domestic companies are an important special case; they would not buy spot exchange to protect themselves against a possible devaluation but would buy large amounts of forward exchange, provided that the premium paid was not too high. They could do so, even though illiquid, because the companies’ inventories and other assets could be liquidated if it became necessary to provide local currency to carry through the forward contract. (See Paul Einzig, “Some Recent Developments in Official Forward Exchange Operations,” The Economic Journal, Vol. LXXIII, June 1963, pp. 248-50, 252-53.)
But the only condition under which they would want to restrict their domestic operations to gain funds for financing the acquisition of foreign balances would be when the central bank was forced to stop holding down the premium on forward exchange at a moment when devaluation seemed likely. And for even that situation to be relevant, it must be assumed that the foreign-owned firms would not have become interested in holding spot foreign exchange at the expense of their regular business operations except for having been first drawn into it by the possibility of speculating cheaply in the forward market.
The case for prolonged official sales of forward exchange seems likely to survive this criticism.
Another criticism of prolonged official intervention in the forward market (Jerome L. Stein, “The Rationality of Official Intervention in the Forward Exchange Market,” The Quarterly Journal of Economics, Vol. LXXVII, May 1963, pp. 312-16) can be interpreted as merely a warning to the confused central bank that would want to attract short-term capital by selling the home currency forward, when the (annual rate of) forward discount on the home currency was already smaller than the excess interest yield obtainable on domestic Treasury bills; such sales would, of course, increase the discount on the home currency and thereby discourage the movement of short-term funds into the country. Bent Hansen objected to that form of prolonged official participation which would seek successive additions to the stock of arbitrage funds held in a low-interest-rate country which was experiencing persisting current-account deficits. Once the domestic arbitrage funds held abroad and the easily attractable foreign funds were attracted, the remaining supply would be inelastic, and further transfers could be secured only by very large additional official sales of forward exchange (Bent Hansen, “Interest and Foreign Exchange Policy,” Skandinaviska Banken Quarterly Review, Vol. 39, October 1958, p. 121). It is possible that the recent rapid growth of the stock of arbitrageable funds has greatly reduced the importance of this objection.
The zero point could move in either direction. It is actually the two curves underlying the Dtrad curve, Dm and Sx, which undergo the doubling of slopes. These curves can be conceived of as remaining imchanged at a point midway between the gold points, with the steepening of slopes taking the form of a rotation around each midpoint. If the two curves intersect at that level (Dtrad = zero at $2.80), the zero point on Dtrad does not shift. But if the intersection point, and c, are above $2.80 (as when imports are larger than exports), widening the spread will raise the intersection point and c; that means that the part of the Dtrad curve lying above $2.80 is shifted to the right. If the forward rate is above $2.80, the widening of the spread causes funds to move from New York to London; in the more likely case of a forward rate not much below $2.80, it would cause only a small movement to New York.