Over the past few years, there has been considerable discussion of the relative merits of various types of controls over international capital movements. Controls that have been the subject of the most analysis and empirical investigation are the dual exchange market and the U. S. Interest Equalization Tax. Yet the U. K. investment currency market, which has operated in various forms for the past 30 years and which stems from the embargo on the export of capital by residents, has been largely neglected.2
In the basic dual exchange market, all capital transactions undertaken by residents and nonresidents take place at the capital exchange rate, and all current transactions take place at the official exchange rate. The United Kingdom’s arrangement is a variant of this system in that only certain capital account transactions attributable to U. K. residents are channeled through the investment currency market, while capital and current account transactions undertaken by nonresidents are conducted at the official exchange rate. The U. K. system thus represents an asymmetric version of the dual exchange market in the sense that participation in the financial exchange market is confined to residents. The stock of assets allocated to this market exceeds £7 billion and the premium over the official exchange rate has fluctuated between zero and 88 per cent. The control has survived several devaluations, the move from a fixed parity to a floating pound, and periods in which removal would probably have had little effect on the balance of payments. With the recovery in prospect for the U. K. balance of payments and with Britain’s commitment to dismantle exchange controls between itself and the European Economic Community (EEC), the present moment is opportune to study the system.
The analysis of the United Kingdom’s investment currency market that follows would be generally applicable to other countries operating a financial exchange market for the use of residents only.3 It would not, however, be applicable without modification to countries operating financial exchange markets in which only nonresidents participate.4 The paper seeks, in particular, to show the effects of the control on the balance of payments and on domestic interest rate policy, to identify the main influences on the size of the premium, to analyze the premium’s implications for U. K. investors, and to assess some of the major changes that have been introduced in the regulation and functioning of the system.
The discussion proceeds as follows: Section I summarizes the basic controls on overseas portfolio investment, identifies the main influences on the size of the premium, and shows the premium’s effects on the risk/return advantages of international diversification by U. K. investors. It goes on to show the significance of the regulation that permits residents to finance overseas portfolio investments by foreign borrowing and the effect of certain direct and property investment flows that have been allocated to this market.
Section II reviews the arguments that have been used in the economic literature to justify capital controls on long-term investment. It then gauges the effectiveness of the U. K. system in fulfilling some of the objectives that controls are designed to meet. In particular, there is an attempt to show whether or not the system confers a measure of independence on U. K. interest rate policy. Then, by working through the effects of abolition of the control, an order of magnitude is given to the outflow that the control is forestalling.
Section III is devoted to an analysis of several variants of the investment currency market that have been in use at various times. It examines the segregation of foreign capital markets and capital flows for exchange control purposes and the multiple premiums to which this gives rise, the parallel operation of an investment currency market for nonresidents, and the possible methods of phasing out controls between the United Kingdom and other member countries of the EEC.
Barattieri, Vittorio, and Giorgio Ragazzi, “An Analysis of the Two-Tier Foreign Exchange Market,” Banca Nazionale del Lavoro, Quarterly Review (December 1971), pp. 354–72.
Day, William H.L., “Dual Exchange Markets Versus Exclusive Forward Exchange Rate Support,” Staff Papers, Vol. 23 (July 1976), pp. 349–74.
Fleming, J. Marcus (1971), “Dual Exchange Rates for Current and Capital Transactions: A Theoretical Examination,” Ch. 12 in his book, Essays in International Economics (Harvard University Press, 1971), pp. 296–325.
Fleming, J. Marcus (1974), “Dual Exchange Markets and Other Remedies for Disruptive Capital Flows,” Staff Papers, Vol. 21 (March 1974), pp. 1–27.
Grubel, Herbert G., “Internationally Diversified Portfolios: Welfare Gains and Capital Flows,” American Economic Review, Vol. 58 (December 1968), pp. 1299–1314.
“An Inventory of U. K. External Assets and Liabilities: End-1976,” Bank of England, Quarterly Bulletin, Vol. 17 (June 1977), p. 198.
Jones-Lee, Michael W., “Some Portfolio Adjustment Theorems for the Case of Non-Negativity Constraints on Security Holdings,” Journal of Finance, Vol. 26 (June 1971), pp. 763–75.
Lanyi, Anthony, “Separate Exchange Markets for Capital and Current Transactions,” Staff Papers, Vol. 22 (November 1975), pp. 714–49.
Levy, Haim, and Marshall Sarnat, “International Diversification of Investment Portfolios,” American Economic Review, Vol. 60 (September 1970), pp. 668–75.
Royama, Shoichi, and Koichi Hamada, “Substitution and Complementarity in the Choice of Risky Assets,” in Risk Aversion and Portfolio Choice, ed. by Donald D. Hester and James Tobin (New York, 1967), pp. 27–40.
Snider, Delbert A., “The Case for Capital Controls to Relieve the U. S. Balance of Payments,” American Economic Review, Vol. 54 (June 1964), pp. 346–58.
Mr. Woolley, economist in the Exchange and Trade Relations Department, received his doctorate from the University of York, England, where he was also a member of the faculty. He has been a member of the U. K. Stock Exchange and a Specialist Adviser to the House of Lords. His contributions to academic and financial journals have been mainly in the field of international finance.
The research on which this paper is based was begun while the author was at the University of York, and was then financed by the Esmée Fairbairn Charitable Trust. In addition to colleagues at the Fund, the author is grateful to Heather Hunter for her assistance in preparing this paper.
To the best of the author’s knowledge, the only previous studies have been Woolley (1974 and 1976), a description of the mechanics of the market published by the Bank of England in 1976 (See “The Investment Currency Market,” Bank of England, Quarterly Bulletin, Vol. 16 (September 1976), pp. 314-22.), and an extended reference in Cairncross (1973).
France operated a security currency market for residents’ transactions in various foreign securities between 1969 and 1971, and in Norway and Sweden, foreign securities are transferable between residents at a premium, although the foreign exchange itself is not negotiable.
South Africa has a securities rand market for nonresidents. Until recently, the Netherlands had an “O-guilder” market for nonresidents investing in Dutch bonds.
This is qualified by any changes that may occur in stocks of liquid investment currency held by dealers or investors.
In 1977, the Bank of England estimated the value of U. K. portfolio investment abroad at approximately £8,150 million at the end of 1976. But it stated that this was no more than a broad indication and that this figure overstated the size of the pool by including securities that were financed by foreign currency borrowing and, therefore, were not premium-worthy. The figure of £7 billion used here was obtained after a deduction of £1,150 million was made that represents the estimated value of the securities financed by overseas borrowing. These figures are drawn from “An Inventory of U. K. External Assets and Liabilities: End-1976,” Bank of England, Quarterly Bulletin, Vol. 17 (June 1977), p. 198.
This was the replacement value, since it included the full premium, whereas if investors allowed for the 25 per cent surrender, a realizable value of £9,360 million was indicated.
If there is a turnover of the pool of proportion a per period, then at the end of period t, the pool will have a value St, of
St = Soe-αxt
where S0 is the value of the pool at t=0. We therefore have the premium at time t equal to
where Σ denotes the aggregate desired holdings of foreign securities in residents’ portfolios.
It is assumed in this paper that investors observe the axioms for portfolio selection first proposed by Markowitz (1959), and that investors’ preferences may therefore be described by an ordinal preference function.
U = U(R, σ)
U = an ordinal preference index
R = expected portfolio rate of return
r = variance of portfolio rate of return
where P0 is the buying price, P1 is the selling price, and d is the dividend payable in the holding period.
where C0 is the official exchange rate between sterling and the relevant currency at the time of purchase, C1 is the exchange rate at the end of the period, and the dividend is converted at C1.
where π0 and π1 are the premiums at the time of purchase and sale, respectively, and x is the surrender proportion. The dividend is again assumed to be converted at the official exchange rate at the end of the period, since it is not eligible for the premium.
This discussion has implicitly assumed that the foreign currency in which the securities are denominated has a unitary exchange rate and free convertibility. For certain countries of interest to U. K. residents (e.g., South Africa, Belgium), there are dual exchange markets and other capital controls that must be taken into account in calculating the return. In order to formulate the expected return, the investor must therefore make estimates not only of P1, C1, π1, and d, together with any possible changes in U. K. exchange controls (such as might, for example, affect *•), but must also try to anticipate any relevant changes or developments in regulations or two-tier markets abroad.
The returns are based on the U.K. Financial Times—Actuaries 500-share index and the U.S. Standard and Poor’s 425-share industrial index. U. S. investment is taken as the proxy for overseas investment because of its heavy weighting in the pool. Equity returns, rather than bond returns, have been used, since the premium penalizes fixed-interest investment and ensures that few foreign bonds are purchased with investment currency.
In portfolio theory terms, the effect can be assessed in terms of the change in the variance of the returns on the foreign securities and the covariances between the returns on the various foreign securities and between the returns on foreign and domestic securities.
The capital return on securities purchased with investment currency is:
This is the same as the overall return except that it omits the dividend element, which is considered separately below. The capital return, assuming that the borrowing and the investment are in the same currency and that a back-to-back loan is employed, is
If P1 − P0 < 0, x = 0, whereas if P1 − P0 > 0, x = 0.25.
Where the investment takes place in a different currency from the borrowing, the capital return is
where C0 and C1 are the official exchange rates between the currency in which the securities are denominated and sterling at the time of purchase and sale, respectively; F0 and F1 are the official exchange rates between the currency in which the borrowing is denominated and sterling at the time of purchase and sale, respectively. The conclusions regarding changes in the premium are the same as when the currencies are matched, but, in this case, a change in either of the two official exchange rates can alter the sign of the overall return.
The income return on currency-financed investment is
where Y is the annual dividend yield on the securities. The income return, assuming a back-to-back loan, is
where ra is the servicing cost of the overseas loan and rUK is the return on the deposit in the United Kingdom. Of the variables in this expression, C1, π1, and Y are expected future values; ra and rUK are known or expected, depending upon the length of the loan and the corresponding deposit.
The return on direct investment collapses to
Where P0 denotes the initial foreign currency outlay, d denotes the accrued profits, and P1 denotes any proceeds from the liquidation or sale of the investment.
The usual argument in favor of lighter controls on direct investment outflows is that the investing companies retain control over the investment, trading, financing, and profit distribution policies of their overseas subsidiaries and branches, and these policies can still be influenced by the authorities of the capital-exporting countries in a way that is impossible when minority shareholdings are purchased in overseas firms. In addition, it is felt, rightly or wrongly, that the return on direct investment is both quicker and higher, and thus more useful for the balances of payments, than that on portfolio investment.
Such deterrents may be of a fiscal, legal, or political nature.
The reverse of the surrender policy might be an arrangement requiring investors to acquire only part of the foreign currency for purchases of securities at the premium rate and enabling them to acquire the balance at the official exchange rate while permitting the whole of the proceeds of sales of securities to be transmitted through the premium currency market. Such a policy would, at first sight, appear appropriate if the overall balance of payments position improved sufficiently to countenance a small net outflow in place of the small net inflow yielded by the present policy. The scheme would, however, be unworkable, since it would be profitable for investors to purchase foreign currency securities and immediately resell them so as to gain the premium on that part that had not borne the premium when purchased. This process would be repeated until, in a short time, the premium disappeared and the outflow through the official market would be the same as if the exchange restrictions had been lifted entirely.
Lanyi (1975) has provided examples of linkages between the financial and official markets in the symmetric two-tier system.
See Richard Caves, “The Welfare Economics of Controls on Capital Movements,” in Swoboda (1976), pp. 31-46.
See “The U.K. Exchange Control: A Short History,” Bank of England, Quarterly Bulletin, Vol. 7 (September 1967), pp. 245-60.