The May 1971 International Monetary Crisis: Implications and Lessons

CFA Institute

The May 1971 International Monetary Crisis: Implications and LessonsAuthor(s): Geoffrey BellSource: Financial Analysts Journal, Vol. 27, No. 4 (Jul. - Aug., 1971), pp. 19-20+88-90+98Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4470820 .

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The

May 1971

Intoplncatlons and lessons

Monear mpioton ndlssn y G* B

by GEOFFREY BELL_

THE international exchange markets under- went yet another period of turmoil in May, 1971 in what seems to be an unending suc-

cession of crises. A number of currencies came under pressure and decisions were taken to allow the Deutschmark and Dutch guilder to float freely in the market with the Belgian franc floating on capital account and with the Swiss franc and Austrian schilling being revalued. At the time of the upheaval in the markets, most attention was focused on the United States balance of payments deficit as the supposed root cause of the crisis. Alternatively, commentators viewed the develop- ing German balance of payments surplus as a major contributing factor to the upheaval. Thus, this latest crisis tended to be viewed initially at least as resulting from a failure of the international adjustment mechanism to function properly (or a

persistence of the payments imbalance between the United States and Western Europe).

Yet, while the persistence of the United States balance of payments deficit was undoubtedly a contributing factor, the basic cause of the upheaval was the major interest rate differential between the United States and Western Europe that de- veloped over the past year. More particularly, the May, 1971 international financial crisis had its origin in the fact that German internal interest rates have been higher than those prevailing in the Eurodollar market, naturally resulting in large- scale shifts of funds into Germany. Only if this point is understood can the correct lessons for the future be drawn. Even so, the decisions of a number of governments to change their exchange rates, either by floating or by revaluation, have widespread implications for the way the international financial system will work in the future. The May, 1971 crisis clearly has implications both for the future conduct of monetary policy and for the

GEOFFREY BELL is currently Manager, U. S. Banking, of J. Schroder, Wagg & Co. Ltd. He has lectured on monetary economics at the London School of Eco- nomics and acted as an assistant advisor to Her Majesty's Treasury. Before joining Schroder's in April 1969, he was economic advisor to the British Embassy in Washington.

FINANCIAL ANALYSTS JOURNAL / JULY-AUGUST 1971 19



development of the international exchange rate system.

BACKGROUND OF THE CRISIS

The United States' payments deficit was very large in the first quarter of 1971, amounting to $5 billion on the Official Settlements basis (this reflects the accumulation of dollars in the hands of overseas official institutions and the reduction of U. S. reserve assets). United States' liabilities to foreign official institutions rose by over $4 billion with most of the reserve accumulation being in Germany, the United Kingdom and Japan. Al- though the figures are not yet available, it is clear that the payments deficit (again on the Official Settlements basis) was enormous in the second quarter, with the dollar holdings of the major European countries and Japan rising by an estimated $7 billion in the six-week period prior to mid-May.

Virtually until the end of April, these capital flows were induced by the disparity of interest rate levels between the United States and Western Europe. Interest rates began falling in the United States during 1970 as the economy slowed down and the Federal Reserve adopted a more expan- sionary monetary policy. But interest rates, especially in Germany and the United Kingdom, remained high as the authorities in those countries faced escalating wage costs and price increases. And, just as water tends to find its own level, so short-term capital moves in search of higher yields. Moreover, at the present time, funds shift from one money market center to the next considerably more rapidly and in larger amounts than ever in the past because of the existence of the Eurodollar market. Even in the absence of the Eurodollar market, there can be little doubt that a substantial differential between interest rates in countries would induce funds to shift, but the Eurodollar market makes the process almost instantaneous.

Role of U. S. Banks

Going back one stage, the problem of shifts of funds began with the cutback of U. S. bank borrowings of Eurodollars from their branches in Europe. Between June, 1970 and May, 1971, bank borrowings of Eurodollars fell by over $10 billion to a level below $2 billion. This extremely rapid fail in Eurodollar holdings took place despite efforts by--the Federal Reserve on November 30,

1970 ". . . to strengthen the inducement for Amer- ican banks to retain their Eurodollar liabilities and thus moderate the pace of repayments of Euro- dollar borrowings". The Federal Reserve raised from 10 to 20 per cent the reserves required from member banks against such borrowings in excess of an amount allowed to the banks as a reserve- free base. These efforts proved to be just as in- effective as the efforts made by the Federal Reserve to stop the same banks from building up their borrowings of Eurodollars in 1969. Just as the build-up of borrowings (as banks tried to circum- vent the Federal Reserve's tight money policies) caused serious disruptions in Europe by forcing up Eurodollar interest rates to what were by historical standards astronomic levels, the repayment of those Eurodollars was bound to lead to further dis.ruptions. Put most simply, someone else had to absorb those dollars and, given the scale of the repayment, that someone else had to be European central banks.

European Borrowing of Eurodollars

As U. S. banks reduced their borrowings, Euro- dollar interest rates were bound to fall, making borrowing in that market considerably cheaper than in most domestic markets in Europe. During the period between June, 1970 and March, 1971, when the bulk of the U. S. repayments took place, three-month deposit rates in the Eurodollar market fell from 9 to 51/2 per cent, with call rates falling from 8.6 to 4.6 per cent. On the other hand, internal interest rates in European countries either remained unchanged or fell only slightly. It became increasingly attractive for companies to use the Eurodollar market, rather than their more tradi- tional domestic sources, as means of raising funds. Eurodollar borrowings by United Kingdom companies increased by almost $500 million in the three months ending January, 1971 before the Bank of England realized that the domestic pro- gram of credit restraint was being breached. The Bank of England effectively arrested this inflow by insisting that companies borrow for a minimum of five years in that market.

But German companies were not encumbered by such restrictions and, with a differential of about two per cent for prime borrowers between domestic rates and rates in the Eurodollar market in recent

CONTINUED ON PAGE 88

20 FINANCIAL ANALYSTS JOURNAL / JULY-AUGUST 1971



The International Monetary Crisis CONTINUED FROM PAGE 20

months, borrowings soared. Over the nine months to March, 1971, short-term Eurodollar borrowings by German companies amounted to about $6 billion. As these companies switched dollars into Germany, the dollar reserves of the Bundesbank increased and, as the Bundesbank purchased these dollars for D-marks, the domestic money supply rose, thereby helping to frustrate attempts by the authorities to restrict spending. Although this ap- plied particularly to Germany, the same process was duplicated in other European countries. For example, in spite of the restrictions imposed by the Bank of England on the ability of companies in the United Kingdom to borrow Eurodollars, investors continued to switch funds between the Eurodollar market and the London money market on a very substantial scale, increasing the internal rate of growth of the money supply.

Recycling by Central Banks

Nevertheless, it is revealing (and ironic) that the European central banks, even in the early months of 1971 were still compounding the problem great- ly by their own actions. As they took in dollars, the central bankers put them on deposit with the Bank for International Settlements which, in turn, put them straight back into the Eurodollar market. Some central banks even put the funds back in the market directly. And so around and around went these Eurodollars in a bizarre sort of paper chase. The whole cycle was perpetuated as the gap between domestic interest rates in Germany, the United Kingdom and other European countries remained unaltered against the interest rates prevailing in the Eurodollar market. Moreover as the dollars were deposited and redeposited, the reserves of the central banks (and especially the Bundesbank) were artificially inflated, which then gave rise to speculative movements of funds in expectation of possible revaluations as governments took action to stem this tide. In other words, a problem of fund inflows resulting from interest rate differentials became a problem for central banks of trying to resist speculative movements of funds. It is very difficult to estimate the scale of this double-counting of dollar reserves following the central bank merry-go-round but some calcu-

lations put the amount of "dollars" created in this way at up to $13 billion or equivalent to 20 per cent of the entire Eurodollar market.

Of course, at another level, the May, 1971 crisis was generated by. a general market feeling that, sooner or later, the value of the D-mark and a number of other European currencies would have to move up in value against the dollar as the United States balance of payments deficit could not be permitted to continue indefinitely. But, and this point must be emphasized, the timing of the May crisis was determined by the flows of funds between the Eurodollar and domestic European markets. The crisis did not initially arise over concern about possible exchange rate adjustments; that came later. The same argument may be made another way. The underlying U. S. payments deficit is estimated to be running at about $3 billion a year, so the reduction of U. S. bank borrowings of Eurodollars in the period of nine months ending May, 1971 was more than three times as great as the annual underlying deficit. In these circumstances, it is difficult to sustain the argument that it was the underlying deficit, rather than the shift of short-term funds from the United States to Europe, that lay behind this crisis.

IMPLICATIONS FOR THE FUTURE

Co-ordination of Monetary Policies

The first clear and overwhelming lesson to be drawn from this latest international monetary crisis is that, in a world of fixed exchange rates and free convertibility, countries cannot pursue independent monetary policies. Just as water will find its own level, funds will move if interest rates are out of line between one money market center and another. And there is little that even Canute-minded central bankers can do to arrest the forces of the market. The Eurodollar market has facilitated movements of funds searching for higher yields, either on the basis of simple interest rate arbitrage or on expectations of capital gains resulting from exchange rate adjustments. Thus banks operating in the Eurodollar market, by being willing to shift large amounts of funds at a moment's notice on their own behalf or at the request of depositor companies, have effectively integrated the world's money markets. This means that governments must either try to seprarate their internal markets from the external money market by one means or




another, or accept the fact that domestic interest rates have to be kept in line with those prevailing in the Eurodollar market.

Put another way, with fixed exchange rates and in the absence of exchange controls, European countries do not have independent contro,l over the rate of growth of their money supply. If, as was recently the case in Germany, domestic interest rates are higher than Eurodollar rates, then funds will flow into the country, leading to an expansion of the domestic money supply. Other things being equal, the flow will continue until the two sets of interest rates are equalized. More generally, the flows of funds across the exchanges will be. such as to bring rates of growth of domestic money sup- plies broadly into line with the rate of growth of the world's money supply - and essentially that means the growth of the money supply in the United States.

In concrete terms, the monetary authorities of Western Europe have to focus their attention on the level of interest rates in their domestic markets rather than the rate of growth of the money supply. That is, the money supply becomes determined by the wishes of the public and, as a result, monetary policy cannot be used for purposes of domestic demand management except on the occasions when internal and external monetary requirements are in harmony.

This obviously leads to the general requirement that interest rate policies of the major industrial nations should be co-ordinated more closely than in the past. But this implies a co-incidence of the economic cycle between the United States and Western Europe. And it is not only unrealistic but basically absurd, given the relatively small scale of international transactions, to expect monetary policy in the United States to be determined solely or even in large part with Europe in mind if (as in 1970) the two continents are at different stages of the economic cycle. In other words, the United States cannot be expected to give up monetary policy as a weapon of domestic demand management. However, this does not mean that the United States can disclaim all responsibility for the external impact of its economic policy. Moreover, it does not imp,ly that nothing can be done to avoid the, potential disruptions caused by differing monetary requirements in Europe and the United States..

In this context, the first requirement is for the

Federal Reserve, either directly or through the Bank for International Settlements, to include the Eurodollar market within its open market operations. During May and June, 1971, the U. S. Treasury and Export-Import Bank sold $3.5 billion of debt obligations in the Eurodollar market for purchase by the branches of U. S. banks. By these actions, the Administration mops up dollars and hence pushes up Eurodollar interest rates more into line with those prevailing in the domestic money markets of Europe. The logical extension of this policy is for the Federal Reserve to sell or buy debt instruments in the market as a regular practice in order to keep Eurodollar interest rates more closely in harmony with European domestic interest rates. Given the size of the likely Treasury deficit in the 1972 fiscal year (for example), there is enough ammunition for the Federal Reserve to push interest rates in the market virtually to any level desired. Admittedly, the Treasury would be paying more to raise funds than in the domestic U. S. market, but this is a small price to pay if the end result is to avoid the recurrence of the recent problems. Again, there is always a danger of further outflows of funds from the United States if a differential is maintained between Eurodollar and U. S. domestic interest rates. But the combina- tion of the Federal Reserve and Office of Foreign Direct Investments' balance of payments programs and a decision by the Treasury to offer attractive interest rates on debt held by overseas official institutions should ensure that the problem will not be that serious. At the same time, higher interest rates on such debt will eliminate any temptation to

NOTICE OF 100th CONSECUTIVE QUARTERLY DIVIDEND

The Board of Directors today declared a regular quarterly dividend of 44 cents per share on the common stock, payable on August 16, 1971 to shareholders of record at the close of business July 20, 1971.

KARL SHAVER, Secretary June 3, 1971

GAS rg5

FINANCIAL ANALYSTS JOURNAL / JULY-AUGUST 1971 89



European central banks to recycle dollars back into the Eurodollar market.

Regulation Q

A second requirement is for the Federal Reserve to prevent any future heavy build-up of U. S. bank borrowings of Eurodollars if and when monetary conditions tighten in the United States. This may be the appropriate occasion to hammer another nail into the coffin of Regulation 0. There can be little doubt that the effect of the Federal Reserve's reliance on Regulation Q as an integral part of monetary policy in 1969 and 1970 was to ensure that virtually the entire excess demand for funds by banks fell on the Eurodollar market. Banks could not compete for domestic deposits but could gain funds by borrowing Eurodollars; hence the build-up of Eurodollar borrowings and consequent repayment. On the other hand, in the absence of the Regulation Q ceilings, the excess demand for funds would have been spread across the entire U. S. market as well as the Eurodollar market and so the build-up of borrowings would have been considerably smaller. The lesson is quite plain; avoid another bout of Eurodollar borrowing by U. S. banks for purely domestic reasons. (Inci- dentally, this line of reasoning leads to some in- teresting questions as to the future of U. S. bank branches in Europe opened primarily as a means of channelling funds back to their head offices.)

Curbs on the Eurodollar Market There has been much talk about the need for

imposing curbs on the Eurodollar market in the wake of the crisis. Controls may be broadly cate- gorized into two parts: those aimed at restricting the convertibility of Eurodollars and currencies generally and those placed on banks operating directly in the market such as reserve requirements. Just as the British authorities have effectively pro- hibited the use of the Eurodollar market for U.K. companies by insisting on borrowings with a minimum maturity of five years, the same type of re- striction could well be imposed in Germany. The aim of such measures would be to separate the domestic money markets from the international market by restricting the ability of borrowing companies to arbitrage between the two. The major difficulty would be that of making the measures work since, if the differential interest rate between the domestic and international market is large

enough, ways will be found to shift funds. In addition, on more general grounds, controls are undesirable. They limit competition, raise costs, lead to misallocations of resources and hence pro- mote inefficiencies.

The other form of restrictions has the aim of limiting the ability of the banks themselves operating in the Eurodollar market to move funds-i.e., instead of curbs on borrowing, the curbs are placed on lending. But to achieve this end effectively, all countries would have to agree to act in precisely the same manner and this would not be easy to arrange. To the extent that reserve requirements differed from one money market center to the next, then the base of banking operations would move to the center where the controls were least onerous. Nevertheless, there is a strong case for some sort of controls on the banks such as would limit the ability of banks to blow up their balance sheets. Perhaps the imposition of reserve requirements would help by introducing an upward ceiling on the bank credit multiplier. Currently, the credit multiplier is very large if not infinite. Similarly, a uniform capital/deposit ratio for banks operating in the market would restrict the size of the bank balance sheets and hence the scale of movement of funds. But the essential requirement is to remove the root cause of the problem rather than just the symptom. If interest rate le-vels and balance of payments positions are kept more closely in harmony, then the Eurodollar market would hardly be a problem. Alternatively, countries could adopt exchange rate practices which would give them an extra degree of freedom in the pursuit of economic policy.

The International Adjustment Process

There can be little doubt that the May Crisis has re-opened the whole question of exchange rate flexibility. The action taken by the German and Dutch authorities to allow their exchange rates to float freely in the market is directly in conflict with the Articles of Agreement of the International Monetary Fund. Similarly, the resort by Canada to floating in June, 1970 was illegal as was the temporary float adopted by Germany in October, 1969. But, when the pressure in the exchange markets is intense, governments will take action that effectively relieves the pressure. The lesson

CONCLUDED ON PAGE 98




ment supported intermediary institutions, who then retain share positions until new bull markets make liquidation practical.

The investing world outside of Japan has become aware of certain competitive advantages possessed by Japan. The typical Japanese worker is work-directed. Even though his wages remain well below those in

the other four areas, his productivity and workmanship are high. This shrinking world of ours is exposing the product of almost every country to almost every other country. No amount of advertising alone could establish world acceptance of prod- ucts like Sony, Nikon, Noritake, Seiko, Toyota or Hitachi. What they offer is good basic design, reliable

construction and durability, at competitive prices.

Quite naturally non-Japanese investors want to back winners in the race for the world consumer's dollar.

Although a yen revaluation or import quota against Japan would have bearish implications, an investor is not wholly irrational if he confesses to a yen for a yen. *

The International Monetary Crisis CONTINUED FROM PAGE 90

to be drawn is that Articles of Agreement of the International Monetary Fund should be altered to conform with prevailing practices. The argument made to the effect that ex post legality (or so draw- ing the Articles that governments have virtually total freedom to modify exchange rate practice) is an empty exercise. However, a strong case can be made for having "rules of the game" even when those rules are extremely flexible as such rules offer some measure of control and element of sanction on governments. An international financial system that offers a degree of predictability is to be pre- ferred over a system of total unpredictability.

Thus the timing is right to revive the almost for- gotten IMF Study on Exchange Rate Flexibility put forward in September, 1970. The Report's recom- mendations including more frequent and smaller parity changes, wider exchange rate margins and trans-itional floating between one parity and the next, ought to be incorporated into the Articles of Agreement. Perhaps a new initiative by the United States would be more successful than in 1970. Any initiative this time would almost certainly have the wholehearted support of the IMF itself which increasingly is. found in the unhappy position of lagging behind developments in the international financial system.

Looking beyond the immediate future, the system would benefit immeasurably from wider exchange rate margins. Efforts to harmonize interest rates among nations help, but there are bound to be occasions when interest rates (as well a.s payments positions in general) get out of line. In these circumstances, the possibility that the exchange

rate could fluctuate up to three per cent above (or below) parity would reduce the magnitude of shifts of funds. Since the exchange rate would be expected to move back down to parity when interest rates came more closely into alignment, the incen- tive to shift funds would be tempered. Put another way, wider exchange margins permit interest rates to vary to some degree among money miarket centers. Such a system might also encourage countries to change parities more frequently. For example, if a particular exchange rate reached the new (three per cent) ceiling above the then current parity, governments might-be willing to adopt that ceiling as the new parity without inviting the usual public outcries. The world would simply become more accustomed to exchange rate variations. This, in turn, would help to adjust the payments imbalance between the United States and the rest of the world.

Finally, one can be certain that the events of May, 1971 rammed home a lesson to the Euro- pean Economic Community. The EEC was to launch the first steps toward establishing a common currency in June, 1971 by narrowing the exchange rate margins amo4g the member countries. The events of May blasted this idea out of the water even before the experiment had begun. But this could be beneficial to the community by introducing a measure of realism into the nego- tiations. A common currency is the end result of common economic and monetary policies, not the beginning. Once agreement has been reached on harmonizing rates of economic growth, balance of payments positions and interest rate levels, then the EEC will have achieved the essentials for a common currency unit. Their immediate efforts have to be directed toward these fundamental objectives, rather than toward objectives that are merely technical or cosmetic. +




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The May 1971 International Monetary Crisis: Implications and Lessons