In april 1972, the European Communities (EC) introduced a system of narrower margins of fluctuation for their cross exchange rates known as the “snake.” The maximum possible fluctuation between member currency spot exchange rates was halved from ±4½ per cent to ±2¼ per cent. Wth further reductions and the eventual elimination of margins of fluctuation envisaged, the snake was seen as a stepping stone toward monetary union in the EC. However, actual developments have fallen short of original aspirations. Despite the protection of exchange controls, the snake has been beset on a number of occasions by waves of speculation. Large-scale short-term capital movements forced the withdrawal of the United Kingdom in June 1972, Italy in February 1973, and France in January 1974 and March 1976. The movements of short-term capital have been seen by member governments as being occasionally disruptive in the sense that they have not always been seen as being warranted by underlying economic conditions.
No intervention arrangements for maintaining internally fixed exchange rates can be expected to survive permanently divergent rates of monetary expansion in member countries. However, the achievement of monetary union would be facilitated by intervention arrangements that successfully combat disruptive capital flows without the need for controls on intra-EC capital movements. This paper examines a reform of the snake that would fulfill this requirement. After describing the current mechanism of the snake, the paper describes and compares an alternative arrangement—a “forward snake.” Under this alternative intervention mechanism, official support would be switched from the spot to the forward market; spot exchange rates would be free; and partner currencies purchased (sold) through forward support operations would, on maturity, be sold (purchased) in the free spot market.1
Pegged forward exchange rates will be shown to be advantageous in a number of ways:
(1) Unlike spot market speculation, forward market speculation involves no movement of funds; exchange controls to restrain speculation in the officially supported exchange markets would not, therefore, interfere with the free flow of capital within the EC.
(2) During the period before maturity of official forward contracts, both strong and weak countries would be encouraged to bring interest rates into line with those in other member countries in order to avoid losses associated with exchange transactions; that is, a harmonization of monetary policies would be encouraged.
(3) The interests of traders are, in general, better served by stability of forward rather than of spot exchange rates.
Free spot exchange rates will be shown to add additional advantages:
(1) The freedom for the authorities to undertake discretionary purchases and sales of partner currencies in the spot markets would remove the need for financing and settlements between member countries.
(2) Reserves and money stocks would be unaffected by the whims of transactors in short-term capital.
(3) Speculation would be discouraged by greater risk associated with the stochastic element in the profitability equation of speculators—the expected spot rate.
The structure of this paper is as follows. Section I describes the current operation of the snake; Section II describes the operation of a forward snake. Section III compares the current snake and the forward snake according to their impact on harmonization of monetary policy, speculation and the prospects for removal of margins of exchange rate fluctuation, the need for exchange controls that impede the free flow of capital within the EC, and the well-being of traders. The conclusion presents a possible scenario for monetary union within the EC following a transition from the current snake to the forward snake.
Mr. Day, an economist in the Central European Division of the European Department when this paper was prepared, is currently in the Financial Studies Division of the Research Department. He is an external graduate of the University of London and received his doctorate from the University of Birmingham. Before joining the Fund staff, he taught at the University of Manchester.
Outside the context of the snake, a theoretical foundation for the policy proposal is provided in William H. L. Day, “The Advantages of Exclusive Forward Exchange Rate Support,” Staff Papers, Vol. 23 (March 1976), pp. 137–63; “Dual Exchange Markets Versus Exclusive Forward Exchange Rate Support,” Staff Papers, Vol. 23 (July 1976), pp. 349–74; “Domestic Interest Rates Under a Pegged Forward Exchange Rate” (unpublished, International Monetary Fund, June 10, 1975); and “Destabilizing Capital Flows: An Exchange Market Policy Proposal” (doctoral thesis, University of Birmingham, September 1973).
On October 18, 1976 [after this paper was written], the deutsche mark was revalued by 2 per cent against the Netherlands guilder.
It is not strictly correct to state that “… a Community level for the dollar is an essential prerequisite of any system of coordinated intervention in dollars” (“The European System of Narrower Exchange Rate Margins,” Deutsche Bundesbank, Monthly Report, Vol. 28 (January 1976), p. 23). Maintaining a joint float against the dollar requires only that the combined sum of member official spot dollar purchases equals zero. The limits of the snake could be maintained while floating against the dollar by the authorities of the weak currency selling dollars and purchasing its weak domestic currency, and the authorities of the strong currency buying an equal amount of dollars with its strong domestic currency. Concertation would be required concerning the magnitude of intervention, but there would be no settlements problem. See Joanne Salop, “Dollar Intervention Within the Snake” (unpublished, International Monetary Fund, August 13, 1976).
Until the return of the French franc to the snake in July 1975, settlement was subject to the constraint that the ratio of gold, SDRs, and the IMF reserve position to foreign exchange equaled the ratio in the debtor’s reserves. However, gold was not actually used in settlement.
This assumes that claims and liabilities of the European Monetary Cooperation Fund are not included in the definition of the reserves. This is not true, for example, in the Federal Republic of Germany.
The advantages from supporting forward markets of alternative maturities are described in Day’s article in the March 1976 issue of Staff Papers (cited in footnote 1), pp. 155–58. Since arbitrageurs would roll over their positions at intervals equal to the maturity period of the supported forward rate, it would become increasingly costly both administratively and as far as exchange transactions losses were concerned to operate the system on forward rates of shorter maturity.
The policy proposal cannot be put into reverse by supporting spot exchange rates and selling any acquired currency in the forward market. This would involve forward intervention in the opposite direction to conventional forward intervention policy. It would tend to reduce (increase) the forward premium on the weak (strong) currency and induce destabilizing interest arbitrage capital flows. A comparison between conventional forward intervention policy under a supported spot rate and discretionary spot intervention under a supported forward rate is made in Day, ibid., pp. 158–61.
Pierre Prissert, A Critical Re-Examination of the Forward Exchange Theory, reprinted by Société Universitaire Européenne de Recherches Financières (1974), p. 16.
These base money changes would be, at most, a small percentage of the magnitude of intervention of the particular country. This is in contrast to the current arrangements where base money changes equal the combined magnitude of intervention by both countries.
Under the forward snake intervention arrangement described in this paper, the authorities of both the strong and weak currencies would incur losses simultaneously and would be induced, respectively, to loosen and to tighten monetary policy. An alternative arrangement to that described in this paper would be to maintain the limits of the forward snake by requiring intervention by the authorities of the weak currency only. Such an arrangement would be more deflationary, since there would be no inducement for looser monetary policy in the strong currency. To the extent that excessive monetary expansion in isolated member countries is likely to be more common than excessive monetary tightness in isolated countries, such an arrangement may be preferable economically. It is not proposed in this paper, however, because, first, it would represent a further departure from the current snake arrangements and, second, it would be farther from the spirit of Community policy and action than combined intervention would be.
The losses on maturing forward contracts made by the Bank of England following the 1967 devaluation of sterling are here a good example.
Obviously, a strong country would not like to see a devaluation of a weak currency in which it held a long position. This is precisely why there is an incentive for the strong country as well as the weak country to adjust through appropriate changes in demand management rather than through exchange rate changes. If the forward snake were seen as a system of adjustable par values rather than as a precursor of monetary union, agreement might be possible only if the limits of the snake were to be maintained by intervention by the weak countries only. It is the author’s view that it would be preferable to go all the way to a forward snake with combined intervention by both strong and weak countries for those countries that were determined to maintain the initial parities rather than to go halfway to a forward snake with intervention by weak countries only in which countries reserved the right to use the exchange rate as an instrument of policy.
Under both the current and forward snakes, the official open foreign currency position is shortened by trade deficits and speculation against the currency. If the same amount of speculation and the same trade deficits occurred under the current and forward snakes, the reduction in the official spot foreign currency holdings under the current snake would equal the official forward commitment to supply foreign currency under the forward snake. In the event of a given devaluation, the loss on forward commitments under the forward snake would equal the smaller reserve revaluation profit that would be incurred under the current snake.
In the absence of parity changes, losses on exchange transactions under the forward snake would have been matched by similar losses under the current snake. Under a pegged spot rate, excess demand for foreign currency in the forward market is transmitted to the supported spot market by banks covering their open positions, that is, by passive interest arbitrage. As a result, both the official reserves and the official domestic currency financial requirement decrease. Interest receipts on official foreign exchange holdings and interest payments on the national debt both decrease. An implicit official loss is incurred equal to the interest differential against the domestic currency multiplied by the excess demand in the forward market. This loss is approximately equal to the forward premium on the currency multiplied by the excess demand in the forward market, that is, approximately equal to the loss that would have been incurred if official support had been given exclusively to the forward rate with an unchanged interest differential and an unchanged magnitude of excess demand in the forward market.
See Day, “Domestic Interest Rates Under a Pegged Forward Exchange Rate” (cited in footnote 1).