Full text of Economic Policy Review (Federal Reserve Bank of New York) : Autumn 1981, Vol. 6, No. 3

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Federal
Reserve Bankof
NewYbrk
Quarterly Review




A u tu m n 1981
1

15

23
26
28

V o lu m e

6

No. 3

In te rn a tio n a l D iv e rs ific a tio n by
U n ite d S tate s P ension F unds
E xce ss R eserves and R eserve T a rg e tin g
C u rre n t d e v e lo p m e n ts
T he b u sin e ss s itu a tio n
N ew Y o rk e x p e rie n c e s re n e w e d s tre n g th
in p e rs o n a l in c o m e
T he fin a n c ia l m a rke ts

32

E v o lu tio n and G ro w th o f th e
U n ite d S tate s F o re ig n E x c h a n g e M a rk e t

45

T re a s u ry and F ed era l R eserve F o re ig n
E x c h a n g e O p e ra tio n s

The Q uarterly Review is published by
the Research and Statistics Function
o f the Federal Reserve Bank of New
York. Among the members of the staff
who contributed to this issue are
EDNA E. EHRLICH (on international
diversification by United States
pension funds, page 1); DAVID
C. BEEK (on excess reserves and
reserve targeting, page 15); RONA
B. STEIN and MARK A. WILLIS (chart
analysis of New York State’s renewed
strength in personal income,
pages 26-27); PATRICIA A. REVEY
(on the evolution and growth of the
United States foreign exchange
market, page 32).
A semiannual report of Treasury and
Federal Reserve foreign exchange
operations for the period February
through July 1981 begins on page 45.




International Diversification
by United States Pension Funds

The investment portfolios of United States pension
funds, which have been the largest single source of
funds for this country’s capital markets, are currently
undergoing profound changes. One of these is the
diversification into foreign securities in order to reduce
the risk of variability of return as well as to raise the
level of return. While the absolute amount going abroad
is still rather small, the percentage is gradually increas­
ing. Considering the extremely rapid rate at which the
pension funds are growing, this diversification could
be regarded as capable of having important domestic
and international implications.
Many tens of billions of dollars are being invested
by the pension funds each year. The greater part is
from private pension plans, primarily those sponsored
by corporations. Private pension fund assets totaled
$450 billion at the end of 1980, having grown by more
than 100 percent in just five years (table). A sharp
improvement in the market value of equities contributed
to an unusually large rise last year. But even in the
absence of this development there would have been a
very substantial increase. An explosion of investable
resources will most probably continue throughout the
decade. This will happen even after allowing for infla­
tion. A study prepared for the Department of Labor
In preparing this study the author had the benefit of many interviews
with pension plan executives and officials of various types of inter­
mediating financial institutions. They generally requested anonymity
with regard to information provided concerning amounts, approaches,
techniques, and views, but the author wishes to express her appre­
ciation to all of them. She is also grateful for assistance received
from staff members of the Department of Labor and the Securities
and Exchange Commission.




two years ago estimated that, measured in constant
(1975) dollars, the assets of private pension funds
will have more than doubled between 1975 and 1985
and will have increased by another 90 percent by 1995.1
Close to 40 percent of the private pension fund as­
sets at the end of 1980 was managed by the insurance
companies. The remainder, over 60 percent, was han­
dled by banks and adviser/managers. It is estimated
that, of the total $450 billion, roughly $9-10 billion was
invested in foreign assets. More than half of these
foreign assets represented pension fund monies in­
vested by the insurance companies, mainly in debt in­
struments and largely in Canadian assets, although the
holdings included fixed-income securities, mostly dollar
denominated, of a number of non-Canadian govern­
ments. The foreign investments by the other managers
were much more diversified. Geographically, they en­
compassed assets in about twenty countries, predom­
inantly in Europe and Japan, and smaller amounts in
countries elsewhere. Less than one third comprised
fixed-income securities (including international agency
and other securities denominated in United States dol­
lars, as well as foreign currency securities); more than
two thirds consisted of equities.

1 ICF Incorporated, A Private Pension Forecasting M o d e l (October
1979). The forecast for 1985, in constant 1975 dollars, is approxi­
mately $475 billion and for 1995, almost $900 billion. The forecasts
are based on a number of. assumptions, including labor force demo­
graphics, economic growth rates, and price developments. As is
always the possibility with long-range forecasts, some of the
assumptions might turn out to be quite a bit off the mark, as the authors
themselves caution.

FRBNY Quarterly Review/Autumn 1981

1

While state and local government retirem ent funds
total less than half as much as private pension funds,
they also constitute a huge pool of investment monies.
At the end of 1980 they totaled slightly over $200
billion, having not quite doubled since 1975 (table).
These funds operate for the most part under rather
rigid investment constraints, but m odifications are be­
ing slowly introduced. Two states already have started
diversifying into foreign assets, and others may even­
tually follow. Still, it w ill be many years before state
and local funds could conceivably account for a sig­
nificant volume of foreign investments.
Although there can be little question that, short of
some cataclysm ic event, private pension funds w ill
be increasing their foreign investments during the rest
of the eighties, one can only hypothesize about the
pace of the outflows. A good ball-park guess might be
that the share of foreign assets in total private pension
fund portfolios w ill rise during the decade at an annual
average of about V2 percentage point from the approx­
imately 2 percent they were at the end of 1980. The
dollar outflows implied by this assumption would be
substantial, but they would not be so large as to have
harmful effects on either dom estic financial markets or
the value of the dollar in foreign exchange markets.
This article examines in further detail (1) the m otiva­
tions of pension plan sponsors for diversifying into
foreign assets, (2 ) the considerations that in past
years restrained the outflow, (3) the activities of finan­
cial interm ediaries that have sought a role in carrying
out the pension funds’ international transactions,
(4) the manner and quantity in which funds are being

placed abroad, and (5) the possible im plications for
the United States balance of payments and financial
markets.

Motivations for international diversification
Two goals are sought by pension plan officials who
decide to broaden their portfolios to include foreign
assets. The first is a reduction of the risk associated
with variability of investment return. The second is an
improvement in the level of return. In the private
sector, failure to improve return necessitates larger
corporate contributions to meet actuarial funding re­
quirem ents; in the public sector, failure to improve re­
turn implies that, as pension commitments rise, larger
tax appropriations are required.
Not surprisingly, the pioneers in foreign asset diver­
sification were prim arily pension funds sponsored by
large corporations whose officials were already fa­
m iliar to some degree with foreign economies. How­
ever, many sponsors of sm aller private funds are now
also involved in such diversification. Most recently,
some officials responsible fo r public employee pension
funds have begun to shed their diffidence concerning
foreign asset diversification. The states of Alaska and
Vermont have been leaders in passing the required
laws and purchasing foreign assets, and there may be
other states considering enabling legislation. However,
the great m ajority of states still have laws that prohibit
public pension funds from making foreign investments
other than in Canada. Public pension funds governed
by New York State law are prohibited from investing
even in Canadian corporate equities, although they

Assets of Private and Public Pension Funds
In billions of dollars; year-end values*

Year

Private noninsured
pension funds

Private insured
pension fundsf

1974
1975
1976
1977
1978
1979
1980

...................................115.5
...................................146.8
...................................171.9
...................................178.5
...................................198.6
...................................222.4
...................................286.1

60.8
72.2
89.0
101.5
119.1
139.2
164.6

* Figures reflect equities at market value and other assets at book value,

t Includes noninsured "separate account” pension funds at the life insurance companies.
$ Includes pension funds and deferred profit-sharing funds of corporations, unions, multiemployer
groups, and nonprofit organizations.
Source: United States Securities and Exchange Commission.

2

FRBNY Quarterly Review/Autumn 1981




Total
private^
176.3
219.0
260.9
280.0
317.7
361.6
450.7

State and local
government
retirement
funds
88.0
104.8
120.6
132.6
153.0
170.1
202.7

may invest in foreign debt that is denominated in
United States dollars— i.e., in Eurodollar debt rated A
or better or in what are called Yankee bonds (bonds
issued in the United States by foreign entities). None­
theless, there is a growing tendency to loosen the
very rigid restraints that still limit most public pension
fund investment activities.
A number of institutional changes in pension fund
practices over the past decade that have dramatically
increased pension costs have added to the incentives
to seek new avenues for improving investment returns.
These changes include (1) heavier weighting of later,
higher earning years in calculating pension benefits,
and (2) steps to adjust both workers’ and retirees’ in­
comes to compensate for increases in the cost of
living. Pension fund officers have consequently come
to regard pension plan liabilities increasingly as a
purchasing power liability rather than as a fixed-dollar
liability and thereby have been additionally stimulated
to look for higher returns than those from the more
traditional investments.
Enactment in September 1974 of national legislation
popularly referred to as ERISA (Employee Retirement
Income Security Act), which governs virtually all pri­
vately sponsored employee benefit plans, added to the
interest in diversification. Previously, pension fund and
other fiduciaries had been required by individual state
laws to handle funds as “ a prudent man” would. In
addition, a number of states provided detailed guide­
lines regarding permissible and prohibited invest­
ments, although these were not applicable when a
trust agreement governing the creation and adminis­
tration of an employee benefit trust gave the trustee
full investment discretion. ERISA replaced the states’
comparatively simple and sometimes restrictive rules
with a directive that added considerable complexity
to the prudent man rule. Pension fund fiduciaries must
now make investment decisions “ with the care, skill,
prudence and diligence . . . that a prudent man . . .
familiar with such matters would use” . Moreover, their
prescribed duties include “ diversifying the investments
within portfolios so as to minimize the risk of large
losses” . Consequently, the national rule is not only
more demanding than most of the earlier state laws
but in effect insists on diversification. It has thus
opened the door to investments in certain types of
assets that pension fund officers had previously re­
garded as impermissible.
Already in the sixties, the spreading knowledge of
modern portfolio theory principles had led to wide
diversification of portfolios among domestic firms and
industries to reduce the risk of variability of return.
Increasing numbers of fiduciaries are now becoming
convinced that diversification beyond United States




markets would further reduce this risk. United States
securities markets no longer dominate the world
scene to the extent that they did: capitalization in
equities markets outside the United States comprise
approximately one half of the world total, and foreign
bonds more than one half the outstanding total. More­
over, many foreign industrial firms have a very respect­
able capitalization. In addition, foreign business and
interest rate cycles have generally not coincided with
those in the United States. Although the world has
grown more interdependent over time, this has been
an erratic development and the correlations between
the United States equities markets on the one side,
and foreign markets on the other, remain considerably
lower than the correlations of most United States in­
dustry groups with the total United States market.
For this reason, sufficiently broad diversification across
national boundaries is likely, over a period of time,
to dampen the variability of total return. Many pen­
sion fund officials have therefore concluded that there
are numerous prudent investment possibilities abroad
and that these permit investments to be made that can
be expected to help achieve the ERISA-mandated goal
of minimization of risk.
Many pension fund executives also think interna­
tional portfolio diversification provides opportunities
for increasing the absolute rate of return for any given
degree of risk. A large number of the most rapidly
growing firms are situated outside the United States,
reflecting fast expanding overseas markets and abun­
dant overseas supplies of industrial raw materials
and of labor at various skill levels. Moreover, while
opinions differ, some managers believe many foreign
securities markets are less “ efficient” than United
States markets, resulting in more opportunities for
finding undervalued securities. There is, in addition, the
possibility of boosting returns by moving funds around
to take advantage of the different cyclical stages char­
acterizing business conditions, equities markets, fixedincome markets, and exchange rates in the various
countries. Interest was also spurred by negative at­
titudes toward domestic investment. The lag in United
States government and industry policies in adjusting
to the steep rise in energy prices, and the delay of
certain United States industries in responding to for­
eign innovations, enabled numerous enterprises abroad
to become very competitive and profitable while
United States firms lost markets and ran into financial
difficulties. Many pension fund executives have also
been displeased with the performance of managers
of domestic portfolio investments. Given such consid­
erations, a growing number of pension fund officials
have come to feel they might gain a higher return
by investing part of their funds abroad.

FRBNY Quarterly Review/Autumn 1981

3

These views have been bolstered by the favorable
conclusions of a number of statistical studies, based on
various hypothetical portfolios over different time
periods. These studies have shown there would have
been definite benefits from foreign investment, both in
the level of return and the reduction of variability. The
degree of benefit demonstrated varies from one study
to another, depending upon the particular time span
used by the author, the countries covered, and the
types of investments, but the positive conclusions per­
sist through all of them. Moreover, the development of
sizable dollar exchange rate fluctuations after the end
of the Bretton Woods par value system had little effect
on the results. Whether measured in local currency
terms or converted into dollar terms, over any sub­
stantial time interval the advantages of higher levels of
overseas returns and of generally low correlations be­
tween economic fluctuations in the various foreign
countries outweighed any risk from currency fluctua­
tions.2
Deterrents to international diversification
Despite the many lures of international portfolio diver­
sification, the majority of pension plan sponsors, par­
ticularly those responsible for plans of moderate and
lesser size, had remained leery of foreign investments
for general as well as concrete reasons until recently.
The general deterrents
Primary among the deterring general factors had
been most sponsors’ unfamiliarity with foreign markets.
This implied complete dependence on outside advisers
and managers. Such a situation could intensify spon­
sors’ feelings of insecurity regarding the appropriate­
ness of foreign investment and could even prompt a
concern that they might be failing to meet ERISA pru­
dential requirements. A second impediment had been
the fear that foreign investments might be regarded
by important sectors of the community, whether workers
in the firms or others, as “ un-American” . Investment in
a country that had been a wartime enemy can occa­
sionally bring forth particularly strong complaints, as
can investments in countries where the governments
in power are considered antagonistic to, for example,
racial equality or civil rights. Thirdly, there are rela­
tively few persons in positions of responsibility who
want to be first in a new area. If someone makes an
unusual investment decision, and this turns out poorly
or even is simply somewhat less remunerative than
other investments that fall within a well-trodden path,

s A bibliography of some of the more recent studies is available upon
request.

4

FRBNY Quarterly Review/Autumn 1981




the person responsible cannot take refuge in having
done “ the same as the others” .
These considerations have lost force during the
past half decade as international trade has increased,
corporations have gone transnational, and publicity
has developed regarding the growing number of pen­
sion plan sponsors and other institutional investors
that are undertaking international diversification. Un­
doubtedly, there is also the consideration that foreign
diversification has by and large proved attractive.
Moreover, an increasing number of pension fund ad­
visers and managers have been developing services
and expertise to help investors choose and manage
foreign financial assets and have engaged in intensive
advertising of these services.
The informational problems
There are other, concrete deterrents to international
investment, but in recent years these have also dimin­
ished in importance. One of the principal complaints
had been that there was insufficient information about
the condition of individual foreign firms. There is no
equivalent on the European continent or in other for­
eign countries of the United States Securities and
Exchange Commission (SEC), with its requirements for
full and adequate disclosure of a firm’s business par­
ticulars, except for British Company Law, which has
similar disclosure rules. However, the swelling activity
during recent years in international bank credits and
bond issues, in international mergers and acquisitions,
and in foreign portfolio investments has led to a gradual
increase in the amount of business information avail­
able. Companies in Germany and Japan have been
among the leaders, with growing numbers seeking to
promote foreign interest in their securities by offering
detailed briefings to securities analysts and others,
even to the extent of holding meetings in this country.
Differences in accounting methods gave rise to an
allied problem. For example, unlike United States ac­
counting procedures, financial statements in most
European countries traditionally conceal the full value
of a firm’s reserves, thus making it impossible to de­
velop a complete picture of a firm’s profit or loss
situation. Another accounting problem has been the
scarcity of consolidated accounts, which include a
firm’s subsidiaries and other affiliates. An increasing
number of foreign companies, however, are now re­
porting on a consolidated basis. Moreover, some
American analysts, rather than attempting to compare
foreign balance sheets or profit and loss statements
with those of American firms, now try instead to dis­
cover the factors on which major foreign market par­
ticipants focus. They believe that emulation will enable
them to make more successful investment recommen­

dations. At the same time, steps have been taken by
groups abroad to produce information that would be
more comparable and comprehensive. Federations of
financial analysts have been set up within the past
two or three years in France, Germany, and the United
Kingdom with the explicit intention of trying to develop
reporting standards that would be similar for all Euro­
pean business firms. How quickly this goal will be
achieved remains to be seen.
The liquidity issue
Many pension fund sponsors have been concerned
that foreign securities markets were not sufficiently
liquid. Compared with the United States market, some
markets do indeed have only a few stocks that are
very actively traded. In Europe and Japan together,
there may be only about one hundred issues that are
extremely liquid. However, there are many stocks in
which the trading is about on a par with trading in the
United States in “ special situation” stocks. On an
overall basis, a number of markets are at least as
liquid as the United States market, and in some coun­
tries, including markets as different in size as Japan
and Hong Kong, the annual turnover rates, measured
as a percentage of capitalization, are even higher.
Intermediaries who take a positive view toward the
liquidity of foreign markets sometimes stress that, in
the absence of broad and deep markets, it is intimate
knowledge of the participants in the markets that is
most important. Transactions can be successful if one
knows who the stockholders are and works through
appropriate channels.
The question of costs
Higher transaction costs have disturbed some spon­
sors. It has been estimated that turnover costs for a
“ round trip” in the market— i.e., a purchase and a sale
— would generally amount to about 8 percent in Eu­
rope and 6 percent in Japan, including the brokerage
fees or commissions, the spreads quoted by market
makers, and the government “ stamp taxes” or “trans­
action fees” . These figures contrast sharply with the
1 or 2 percent prevalent in the United States. Manage­
ment fees and custodial fees are also higher abroad.
Some United States managers comment that, because
of the various higher costs, they have to be particularly
careful in revamping a foreign portfolio. Others ob­
serve, however, that on a net return basis the higher
foreign costs are not very significant, inasmuch as the
yields from foreign market investments may be many
percentage points greater than those from comparablerisk United States investments.
Some of the larger intermediaries deny that trans­
action costs are necessarily higher overseas. Unlike




the current situation in the United States, most foreign
markets are still on fixed-rate schedules and one can­
not negotiate commissions on a trade-by-trade basis,
but discounts can be obtained in certain countries. In
Japan, for instance, where rates are fixed by the
Ministry of Finance, a bank or other financial institution
can receive up to a 20 percent discount from the fee
normally charged by a securities broker. Similarly in
Germany— where, as in other countries on the Conti­
nent, the brokers are usually banks— discounts of up
to 25 percent can be obtained by banks, insurance
companies, or other large institutions. In Australia, one
can get a discount whenever there are big blocks of
shares around.
Foreign withholding taxes on interest and dividend
payments are, however, a cost that presents a partic­
ularly thorny question to pension fund officers. Since
pension fund investments are not subject to income
taxes in the United States, pension plan sponsors
often do not regard it appropriate to pay withholding
taxes abroad. Although not every market that is pop­
ular with United States investors imposes withholding
taxes— Hong Kong and Singapore are such excep­
tions— bilateral tax treaties between the United States
and many countries in Europe, as well as with Aus­
tralia, Canada, and Japan, for example, do contain
provisions for withholding taxes. The percentages
vary from country to country, but are generally less
for interest payments than for dividends.3
Exchange rate and capital transfer problems
The risk of unfavorable exchange rate developments
is another reason some pension plan executives have
been wary of international diversification. It would ap­
pear, however, that most of those who have overcome
their hesitation feel they do not have to worry about
short-term currency fluctuations since current liabili­
ties constitute only a minor part of their total pension
fund liabilities. Hence, they would never be obliged to
liquidate the (relatively small) foreign portion of their
3 Under the tax treaties, withholding taxes on dividends are usually
15 percent. In some countries, the gross tax initially withheld is higher
than 15 percent, and the United States investor has to reclaim the
excess. In a few countries (including Austria and Canada), the net
tax is less than 15 percent. As for interest income, the United States
model tax treaty calls for no withholding tax, but some countries are
unwilling to go along with this. Germany, the United Kingdom, and the
Netherlands do, but Belgium and Canada, for example, have a
withholding tax of 15 percent, France and Japan 10 percent, and
Switzerland 5 percent. There is usually no withholding tax on capital
gains. A new model tax treaty has been drafted by the United States
Treasury Department, but it will probably not affect tax rates for
institutional investors. Some countries, it should be noted, provide the
possibility of exemption from withholding taxes for certain categories
of investors.

FRBNY Quarterly Review/Autumn 1981

5

pension fund assets on short notice, when currency
movements might make such a step undesirable. Re­
garding the medium and long term, some pension
fund managers believe it is possible to forecast the
direction in which a currency will move largely on the
basis of fundamental economic considerations such as
likely inflationary developments, the probable rate of
real growth, and expectations regarding the foreign
trade or current account balance. Others take the
“ neutral” position of making no currency assumptions
since they believe (1) it is impossible to predict what
the currency developments are likely to be, and (2)
other factors are more important in the choice of
foreign investments. In some cases, foreign currencydenominated investments are being hedged.
Another type of conversion risk is the erection of
government barriers to the withdrawal at will by for­
eign investors of earnings or liquidation proceeds.
Many of the nonindustrial countries already have regu­
lations that impose certain explicit limits on with­
drawal. Others provide for ad hoc administrative de­
cisions by some government agency. Of 140 member
countries of the International Monetary Fund (IMF)
covered in a 1980 Fund report, only thirty-three had
no restrictions of any kind on capital payments.4 Of
these, sixteen were either industrial or oil-exporting
countries.
Although a country might not have restrictions on
capital payments, it might have, or choose to im­
pose, restraints on foreign capital inflows. A number
of countries that hold strong attractions for foreign
investors limit such investments through either legal
or regulatory barriers. During the past year, however,
there has been some small evidence, with actions by
Mexico as one example, of a possible tendency to
ease these restraints, partly in the belief that eco­
nomic progress could be furthered more rapidly if
foreign private capital were allowed to make more of
a contribution.
The intermediaries for pension fund diversification
As pension plan sponsors began to display a growing
interest in foreign portfolio investments, partly in
response to suggestions by a few outside advisers,
financial intermediaries of various kinds strove to
position themselves to compete in this new field.
These included the traditional managers of pension
funds, namely, commercial banks and insurance com­
panies, as well as the other types of investment man­
agers that had acquired a significant share of the
4 International Monetary Fund, A nnual R eport on E xchange A rrange­
m ents a n d Exchange Restrictions (1980). For two additional countries,
the IMF was unable to determine the situation.

Digitized for
6 FRASER
FRBNY Quarterly Review/Autumn 1981


pension fund business beginning in the 1960s. Others
sought to gain entry by showing that, unlike most
United States pension fund advisers and managers
who had had little experience with foreign markets and
therefore were unable to produce relevant track
records, they, on the contrary, had the requisite
knowledge and experience. Still others found a niche
for themselves by establishing services that were
ancillary to the international investment management
function itself.
The banks
Bank trust departments are still the principal managers
of pension plan funds— and now also of a large portion
of the internationally invested assets. Even the larger
banks that have become active in foreign asset man­
agement had initially to intensify their knowledge in
certain relevant areas, while others had to work from
a much lower base to acquire expertise on foreign
economies and companies, foreign securities markets
and currency markets, and the relevant networks of
foreign intermediaries. A few put securities analysts
and investment managers on the scene in existing
foreign branches. Others have gathered information
on foreign firms and monitored economic developments
in part through extensive visits abroad. Over time,
some of the banks have established new foreign affili­
ates of various kinds, with one purpose being to handle
the foreign investing or, as a minimum, the associated
foreign research activity for the banks’ United States
clients. Where these foreign offices are managing the
investments, they deal with foreign brokers. These are
usually London or other European brokers if the man­
ager is operating out of London or some other Euro­
pean city, and Japanese brokers if the manager is
operating out of Tokyo or Hong Kong in connection
with Asian and Australian investments. A number of
banks are also providing global master custodianship
services (box).
The banks have been using commingled funds es­
pecially established for foreign investments as the
principal vehicle for investing those portions of clients’
pension funds that have been designated for invest­
ment abroad, although a few banks also manage for­
eign assets for pension funds through separate ac­
counts. In addition, some relatively small amounts are
invested in foreign securities for pension fund clients
who have not explicitly allocated a portion for foreign
investment. This occurs when some other type of com­
mingled fund to which some of a client’s assets have
been allocated (whether it be a diversified common
trust fund, for example, or a growth fund or some
other specialized fund) includes securities of foreign
firms that fit within the framework of that particular

Custodial Services for Pension Funds’ Foreign Investments
U n d e r ER IS A ’s rule s c o n ce rn in g fid u c ia ry re sp o n si­
b ility , th e s o -c a lle d in d ic ia (evidence) of o w n e rsh ip of
fo re ig n assets h e ld fo r e m p lo ye e b e n efit plans m ust be
m ain ta in e d in lo c a tio n s s u b je c t to the ju ris d ic tio n of
U nited States d is tric t co u rts, e xce p t as m ig h t be o th e r­
w ise a u th o rize d by th e S e cre ta ry of L a b o r by re g u la ­
tio n . P rio r to 1977 th e re w e re m any q u e stio n s c o n ce rn ­
ing th e e ffe c t of th is rule on h o ld in g in d ic ia abro a d .
In th a t year, how ever, th e D ep a rtm e n t of Labor, w h ich
is the a g e ncy w ith p rim a ry ju ris d ic tio n o ve r em p lo ye e
b e n e fit plan fid u c ia ry re s p o n s ib ility , issued a re g u la tio n
s p e c ify in g th a t in d ic ia co u ld be held a b ro a d if the
rela te d assets w e re u n d e r th e m anagem ent and c o n tro l
o f a U nited States bank, in su ra n ce com pany, o r in ve st­
m ent a d v is e r/m a n a g e r re g iste re d w ith th e S e cu ritie s
and Exchange C om m ission, p ro vid in g th e se m et c e rta in
g iven c rite ria . O therw ise, the in d ic ia co u ld be held
a b ro a d o nly if in the p h ysica l possession o f a United
States b ank o r an S E C -re g iste re d b ro ke r o r de a ler, or
if in the c u s to d y of an e n tity desig na te d by the SEC
as a “ s a tis fa c to ry c o n tro l lo c a tio n ” .
M any U nited States banks w ere not h appy w ith the
1977 ru lin g sin ce o n ly b ro ke rs and de a lers, b u t n o t
banks, m ay a p p ea r b e fore the SEC. Thus, fo r fo re ig n
lo c a tio n s w h e re a bank d id not have a b ra n ch th a t co u ld
render c u s to d ia l service s, th e bank had to have a
b ro k e r o r d e a le r in te rce d e w ith th e SEC fo r a p p ro va l of
a fo re ig n c u s to d ia l agent, o r else had to u tiliz e the se r­
vice s of a b ra n ch of a c o m p e tito r U nited S tates bank.
In response to app ea ls from banks and the A m e rica n
B ankers A s s o c ia tio n , the req u ire m e n ts w ere eased
e ffe c tiv e M arch 30 of th is ye a r to p e rm it U nited S tates
banks to keep the in d ic ia in th e cu sto d y of a fo re ig n
bank o r o th e r s p e c ifie d types o f fo re ig n e n titie s as
long as th e c u s to d ia n is su p e rvise d o r reg u la te d by a
go ve rn m e nt a g ency o r re g u la to ry a u th o rity in the host
co u n try.
Several U nited S tates banks are now also p ro vid in g

fund. At the end of 1980, international commingled
funds amounted to 2 percent of all employee benefit
commingled funds set up by banks and approxim ately
1/2 percent of the aggregate employee benefit funds
managed by them as either trustee or investment
managing agent .5
5 Federal Financial Institution Examinations Council, Trust Assets of
Banks and Trust Companies— 1980. These data are compiled by the
Board of Governors of the Federal Reserve System, the Federal
Deposit Insurance Corporation, and the Office of the Comptroller of
the Currency.




s o -ca lle d g lo b a l m aste r cu s to d ia n s h ip se rvice s th a t
fu rth e r fa c ilita te the h a n d lin g o f fo re ig n investm ents
fo r any g iven pension plan sp o n sor. T hese s e rvice s are
p ro vid e d re g a rd le ss of w h o the m anagers are. Chase
M anhattan B ank is the m a jo r g lo b a l m aste r cu sto d ia n
fo r United S tates-based sp o n sors, having sta rte d th is
a c tiv ity in the e a rly se ve n tie s b e fo re e n a ctm e n t of
ERISA. It has re lie d upon its fo re ig n b ra n ch e s as su b ­
c u sto d ia n s in m ost o f th e co u n trie s w h e re it has
b ra n ch e s and has used fo re ig n banks in th e sam e
c a p a c ity in o th e r co u n trie s. C itib a n k also has p ro vid e d
such se rvice s fo r a n u m b e r of years. In th e past fe w
years th e re have been several a d d itio n a l U nited S tates
e n tra n ts into th e fie ld . Som e o f th e se a c tu a lly rely
h e a vily upon a n o th e r large d o m e stic o r fo re ig n bank
and its n e tw o rk of b ra n ch e s o r co rre s p o n d e n ts fo r th e
c u s to d ia l se rvice s req u ire d in th e m any lo ca tio n s w here
la rg e c o rp o ra te plan sp o n so rs m ay have fo re ig n in ­
vestm ents. A p a rtic u la rly in te re stin g rece n t e n tra n t is
the M itsu b ish i Bank o f C a lifo rn ia . M any of the c lie n ts
fo r its g lo b a l m aste r c u s to d ia n s h ip s e rvice s are re­
g io n a l banks th a t are m aster truste e s fo r pension plans
w ith rath e r sm all a m o u n ts invested overseas. T o p ro ­
vid e its g lo b a l c u s to d ia n s h ip service s, the M itsu b ish i
Bank m akes use of the w o rld w id e fa c ilitie s of the
M itsu b ish i Bank of Japan and the la tte r’s va rio u s fin a n ­
cia l affiliates.
The g lo b a l m aste r cu sto d ia n s h ip se rvice s o ffered are
m ore co m p re h e n sive at som e banks than at others,
b u t am ong th o se g e n e ra lly a va ilab le are safe kee p in g
o f the in d ic ia , c o lle c tio n of d ivid e n d s and in te re st,
c u rre n c y tra n sla tio n , and ce n tra lize d re p o rtin g o f all
investm ents and incom e. Thus, no m a tte r in how m any
c o u n trie s the fu n d s of a pension plan are invested, and
no m a tte r how m any m anagers are ha n dlin g p o rtio n s
o f th a t p la n ’s fu n ds, o v e ra ll re s p o n s ib ility fo r th e c u s­
to d ia l, b o o kkee p in g , and a cco u n tin g o p e ra tio n s can be
p la ce d in the hands o f a sin g le overseer.

The Morgan Guaranty Trust Company pioneered in
establishing an international commingled fund for
ERISA accounts. It informed all ERISA clients in 1974
that, unless the client opted otherwise, a modest pro­
portion of their pension fund reserves would be in­
vested in foreign equities, to be built up at about 1
percent a year to around 5 percent by 1978.6 Subse6 Only a few clients rejected Morgan’s plan, and this “ strong” approach
is known to have been followed by three more banks. Other banks
propose foreign commingled fund investing to their clients on an
"invitation” basis.

FRBNY Quarterly Review/Autumn 1981

7

quently, the maximum allocation was raised to 10
percent, and Morgan now has one equity fund and
two bond funds holding most of the assets purchased
with ERISA reserves designated for foreign invest­
ments— about 6-7 percent of the total discretionary
employee benefit funds under its management. Citi­
bank, which set up its first international fund for
ERISA clients in 1978, does all the foreign investing
of allocated reserves through commingled funds. Cur­
rently, its international equity and bond funds total
close to 3 percent of its aggregate discretionary em­
ployee benefit funds, and it is recommending to most
clients that they increase their international allocation
to 10 percent over the next few years.
Since the mid-1970s a number of other banks have
also established international commingled funds. The
smallest is the Girard Bank, which has only about
$800 million of total employee benefit funds under
management but nonetheless introduced an interna­
tional pooled fund this May. In contrast, some banks
that are among the largest holders of ERISA funds
hesitated for quite some time before deciding to offer
international investment services to such clients. Now
they are ready to join the competition. Bankers Trust
has reorganized a commingled fund that had been
relatively dormant for fifteen years and is currently
talking to clients about the desirability of foreign di­
versification. Chase Manhattan Bank has two interna­
tional commingled funds starting operations, and plans
to ask all of its ERISA accounts to put in 2-3 percent
of their reserves. And the Bank of America has just
established a commingled fund with three divisions,
for investments in equities, fixed-income securities,
and/or international cash. This apparently is the first
international fund with a separate cash division; it
will enable a pension plan sponsor to make a specific
allocation for investment in highy liquid foreign assets.
At all but the very largest banks, the complexities
and costs of handling foreign investments generally
rule out separate accounts as opposed to commingled
funds. At any institution where an account is handled
separately, the client is not only charged a higher fee
but is generally required to undertake a minimum for­
eign investment of several million dollars. The main
reason for this latter rule is that prudent minimization
of risk is regarded as necessitating diversification into
securities in at least five different countries.
The life insurance companies
Life insurance companies rank second to banks in the
volume of pension funds managed. At the end of 1980,
pension fund assets accounted for 35 percent of the
companies’ total assets. These pension funds are
handled either as part of each insurance company’s

FRBNY Quarterly Review/Autumn 1981


“ general account” , where the funds are mingled with
life insurance and health insurance funds, or individ­
ually as “ separate accounts” . Most states impose
severe restrictions on general account investments,
including rigorous restraints on foreign investments.
New York State, for example, limits portfolio invest­
ments outside the United States to stipulated percent­
ages of an insurance company’s assets, namely, 10
percent for Canadian securities and 1 percent for all
other foreign securities.7 The rules of New York State
are important even for insurance companies based in
other states since they , must be in “ substantial com­
pliance” with New York regulations if they wish to do
any insurance business in this state. About half the
states are even more restrictive than New York. Neigh­
boring New Jersey, however, is among the less restric­
tive states. That state imposes no limit on investments
in Canada, deemed not to be a foreign country for
investment purposes, and permits investments in other
foreign securities of up to 2 percent of assets, although
investments in any one foreign country are not to
exceed 1 percent. Ten states have no statutes at all
regarding foreign investments.8
In many states the life insurance companies have
some extra leeway for general account foreign invest­
ments by way of a catch-all investment clause, referred
to in the industry as the “ basket” clause, which per­
mits a small percentage of total assets to be held in
almost any way an insurance company sees fit. In New
York State this “ basket” amounts to 4 percent; in New
Jersey it is 5 percent. Most companies prefer to utilize
this leeway for domestic investments, but a few may be
making use of part of it to add to foreign investments
beyond the limits otherwise permitted.
“ Separate accounts” were introduced in the early
1960s, when strong competition for pension fund busi­
ness began to emerge from new sources, and sponsors
were manifesting discontent with the returns from
their traditional investments with the life insurance
companies. The separate accounts have no restrictions
regarding foreign or any other types of investments,
although ERISA “ prudent man” responsibilities hold
for the management of these accounts as for other
accounts.
7 The life insurance company’s assets that are used as the base for
determining the indicated amounts are actually the company’s
"admitted assets", a term denoting assets that are in good standing.
The above-mentioned permitted foreign investments are in addition to
investments in any foreign country where the company is authorized
to do business. The latter investments are not to exceed one and
one-half times the company’s reserves and other obligations in that
country, or the amount it is required by law to invest in the country,
whichever is greater.
8 The author is indebted to the American Council of Life Insurance for
information on the various state laws.

One insurance company— The Prudential Insurance
Company of America, the largest United States life
insurance company— moved more quickly than others
in diversifying into foreign assets. As early as 1976
it established a commingled fund for pension and
profit-sharing funds called PRIVEST, whose assets
were to consist primarily of private (i.e. direct) place­
ments, traditionally an important part of life insurance
investments. One of the initial guidelines specified that
up to 10 percent of the portfolio could be allocated to
Canadian investments and up to 5 percent to other
foreign investments. This year, in another move, Pru­
dential embarked on two pilot programs of $50 million
in foreign bonds and $25 million in foreign equities to ’
test and develop its acquisition, trading, and other
operations in the foreign securities markets. The com­
pany expects that by the beginning of 1982 it will be
able to offer a pooled fund for foreign bonds and one
for foreign equities to any pension plan sponsor wish­
ing to diversify internationally. It also anticipates es­
tablishing an internal unit to handle foreign currencydenominated investments for its general account; such
investments would, however, be constrained in size
by state regulations regarding foreign investments.
Aetna Life Insurance Company has chosen a differ­
ent path. In June it combined with Warburg Investment
Management International, an SEC-registered British
firm that already was managing a sizable volume of
ERISA funds, to form a jointly owned United States
subsidiary, Aetna Warburg Investment Management In­
ternational. Aetna is responsible for the marketing
operations and Warburg, operating out of London, for
the investment and administrative activities. In this
undertaking, clients’ funds are being handled in sep­
arate accounts.
Other life insurance companies are already think­
ing of following suit via one channel or another that
would enable them to provide foreign investment
facilities to employee benefit funds. One is actively
studying the alternative routes for entering the foreign
portfolio investment area, with the expectation that a
decision will be made within the coming year. Another
is contemplating the introduction of foreign investment
services when it considers exchange rate conditions
more opportune. In at least one state where the regu­
lations regarding foreign investments are even more
restrictive than in New York, steps are being taken to
try to get these changed, which would open the way
for insurance companies to offer pension funds for­
eign investment opportunities.
Some insurance companies have been especially
interested in foreign investment in Mexico. In 1979 the
life insurance industry attempted to gain passage by
the New York State Legislature of a bill allowing




the companies to invest up to 10 percent of their
general account funds in Mexican securities— as
can be done with Canadian securities. When this effort
failed, the approach was shifted to obtaining two
statutory changes: (1) an increase in the general ceil­
ing on foreign asset investments from the present
1 percent to 2 percent; and (2) permission for an addi­
tional 1 percent of total assets to be placed in Mexi­
can investments. These, changes came very close to
passage in 1980, and their sponsors are fairly hopeful
of actual passage this time around.
Investment advisers and other intermediaries
The third group of portfolio managers, those called
investment advisers by the SEC, play a particularly
important role in handling pension fund assets for
the larger United States corporations. They are also
avid contenders for the new foreign investment busi­
ness. There were only a very few such managers two
years ago, but a total of about forty today.9 Current
competitors include foreign as well as United States
firms and also United States subsidiaries set up by
foreign firms or jointly by United States and foreign
firms. The recent development in this country of
mergers resulting in large financial conglomerates that
encompass a wide range of financial operations may
make for an increasingly varied picture.
Those managers of ERISA-subject pension funds
that are not United States banks or insurance com­
panies must be registered with the SEC. While a num­
ber of foreign-based managers are registered, many
do not wish to make known all the information that
SEC registration requires. They avoid this by setting
up special subsidiaries, usually in the United States, to
deal with ERISA clients. Apparently the majority of
these subsidiaries are, at most, contact points with
United States clients. The actual foreign investment
activity and relevant research is generally undertaken
from an office located in a foreign market center.
In general, firms of foreign origin are able to display
a longtime knowledge of, and experience in, foreign
securities markets that puts them, in the opinion of
some pension plan executives, a big step ahead of
domestic managers, even those that have opened up
foreign offices. A number of the foreign firms have been
active for many decades rather than for just a few
years although in most cases their foreign investment
operations until rather recently did not include Asian
and other areas outside Europe that are now attract­
ing considerable attention from international investors.
United States managers, on the other hand, are often
considered to have an advantage because of their fre9 For a listing, see Pensions a n d Investm ent Age, “ International Profile”
(April 27, 1981).

FRBNY Quarterly Review/Autumn 1981

9

quently greater familiarity with sophisticated invest­
ment tools, including modern portfolio theory and
advanced statistical techniques. Moreover, for many
sponsors, the ability of a management firm to show it
has a well-structured decision-making process is of
greater importance than the nationality or location of
the firm.
Some domestic firms seek to acquire the familiarity
with foreign markets and foreign securities necessary
for managing foreign investments by placing staff
abroad. Others rely upon the availability of increasing
amounts of published information from around the
world and facilities for instant global communica­
tion. Neither tactic, however, provides the track record
sponsors often want to see. Hence, another approach
has been to team up with an experienced foreign
money manager to form a United States subsidiary.
There are now a number of such joint ventures. What­
ever the setup, where there are both foreign and do­
mestic offices, the United States-based representatives
generally act primarily as contact persons while the
overseas personnel are the ones most directly involved
in the substantive issues of portfolio diversification. As
is the case with the foreign firms, overseas offices deal
with foreign brokers. Although a few United States
brokerage firms have established new offices abroad
during the past two years, the business of these
branches is more in the retail end and with foreign
institutions that wish to invest in the United States rather
than with United States institutional investors who are
putting money into foreign assets.
A handful of firms have found a very special niche
for themselves in providing advice to pension plan
sponsors regarding international portfolio managers
and other matters relevant to foreign diversification.
Most expanded into the international field after ex­
perience of a similar kind in the domestic area. Inter­
sec Research Corporation, however, was established
in 1975 as a new firm; the first United States counselor
in the international area, it also advises portfolio man­
agers. Among the services generally rendered by these
counselors are: assessment of a pension plan’s ob­
jectives and needs and the appropriateness of foreign
investment for that plan, analysis of the foreign invest­
ment “ style” or “ philosophy” of managers, monitoring
the performance of managers, and recommendations
regarding retention or discharge of existing managers
and/or the choice of new managers.
The foreign investment services offered by the in­
dependent managers have paralleled those by banks
and insurance companies with regard to handling pen­
sion funds as separate accounts or combined with
other accounts, although the latter are actually mutual
funds. However, in a recent development that is con­

10

FRBNY Quarterly Review/Autumn 1981




tributing to the ongoing blurring of lines between tradi­
tional types of financial institutions, several indepen­
dent managers, as well as consultants and brokerage
firms, have established or taken over state or national
chartered trust banks. These will enable the firms to
set up commingled funds and provide custodial ser­
vices in exactly the same way banks can.
The increase in international diversification
The number of companies that have put some portion
of their pension funds into foreign assets has grown
dramatically during the past few years. A recent sur­
vey of almost eleven hundred of the largest American
corporations found that, of those companies inter­
viewed that ranked among the Fortune top 100 indus­
trials, the number holding foreign assets had increased
from 17 percent in 1977 to 34 percent in 1980; among
Fortune’s second 100, the number had grown from
7 percent to 29 percent. Interest had intensified most
among firms responsible for funds with assets of over
$250 million, but smaller pension funds had also be­
come much more involved. Fully 11 percent of all the
firms surveyed had some portion of their pension fund
reserves in foreign assets at the end of 1980, and an­
other 18 percent said they were planning to start in­
vesting internationally during 1981 or 1982.10 Thus by
the end of next year almost one third of the surveyed
firms may have become international diversifiers.
The “ style" of investment
Many of the pension plans that are prepared to place
a fairly sizable amount abroad apportion the funds
among more than one manager, sometimes including
different types of intermediaries as well as both United
States-based and foreign-based managers. If a spon­
sor has only one manager, which would be generally
the situation for smaller investors, this would be a
“ global” or “ international” manager, responsible for
investments in many countries all over the globe,
either through a commingled fund or otherwise. If
there is more than one manager, there might be a
global manager, and/or a “ regional” manager (or
managers) responsible for investments in only a part
(or parts) of the world. Sometimes a sponsor may
choose “ specialist” managers limited to a specific
type of investment such as equities or bonds, or char­
acterized by a specific way of approaching the mar­
kets such as market “ timing” . Finally, some of the
managers are given permission to invest part of their
international allocation, when they consider it desiri# Greenwich Research Associates, Large C orporate Pensions 1981
R eport to P articipants. The approximately 1,100 companies surveyed
ranked among the 1,600 biggest firms in the country.

able, in dollar-denominated assets either in the United
States or in the Eurodollar market. In other cases, how­
ever, the sponsor’s guidelines allow dollar-denominated
assets to be held only for liquidity purposes.
The sponsor also has a choice of several types of
commingled funds. Some are index (passively man­
aged) funds; others are actively managed funds. The
index funds are regarded as a way to obtain widely
diversified foreign assets for a relatively low manage­
ment fee. They also have been utilized as a yardstick
against which to measure the performance of a plan’s
other portfolio managers. However, the index funds
are much less popular than the other international
commingled funds. Among the actively managed com­
mingled funds are a few that are limited as to type of
enterprise and number of countries in which they in­
vest, often blue-chip companies in the most advanced
industrialized countries. These are sometimes charac­
terized within knowledgeable circles as “ closet index
funds” . Other commingled funds may emphasize
growth companies or some particular type (or types)
of industry or, at a given time, may even have a
majority of assets in only one favored country. Still
others, in contrast, choose broad diversification, either
by type of firm or industrial sector or national econ­
omy, with investments in some cases being made in
as many as twelve or more countries. While a few banks
and other management firms offer just one international
securities fund, a number offer several different funds
that vary as to type of security or currency. This provides
a sponsor with greater flexibility in allocation choices
as well as greater ease of guideline modifications.
Once a decision has been made to diversify inter­
nationally, a pension plan sponsor may rely on new
cash flows as a source of funds for such investments.
At some banks, however, when a client has agreed
to allocate a given portion of its reserves to an in­
ternational fund, the bank simply liquidates a corre­
sponding amount of the client’s domestic holdings.
Many sponsors have built up foreign investments
only when economic and financial conditions seem to
favor such moves, but others have kept up their
planned outflows regardless of the changing interna­
tional constellation of interest, exchange, and inflation
rates and of capital market conditions. For them, the
basic, long-term considerations that led to their origi­
nal decision to commit part of their funds abroad re­
main the determining investment motivation. Relative­
ly few pension plans that have invested abroad
have engaged in any net reversal of such investments.
This positive attitude seems likely to continue. Of the
Fortune top 100 industrial firms already investing
abroad in 1980, over 75 percent have said they expect
to increase such investments during 1981-82, and




roughly 60 percent of those that rank among the next
300 firms have expressed the same intention.11
The amounts invested
Currently, relatively few firms have more than 5 per­
cent of their pension fund reserves invested in foreign
securities, but the number is rising, and some are
shooting for 10 or even 20 percent in the not too dis­
tant future.12 Moreover, as many as one in four of the
respondents to a 1980 survey said that they expected
to hold between 2 percent and 5 percent at the end of
that year in contrast to the one in ten that were hold­
ing such amounts twelve months earlier.13
One can do no better than make an educated guess
regarding the total amount of foreign securities al­
ready acquired for employee benefit fund portfolios.
The Department of Labor, which obtains an annual
financial report from all ERISA-covered employee
benefit plans, does not require that foreign investments
be reported separately from domestic investments.
Thus, only by going through thousands of reports, and
identifying all the securities listed, could the foreign
investments be sorted out, but this is not being done.
Furthermore, reports on purchases and sales of for­
eign securities filed on United States Treasury forms
and used for United States balance-of-payments sta­
tistics do not indicate which of these are transactions
for pension fund accounts and often do not include
transactions for such accounts that are executed by
managers from overseas offices or even by United
States-based managers who transmit their transaction
orders directly to foreign brokers. A few pension fund
consultants try to keep tabs on the amounts invested,
but none of these estimates are complete.
Banks managed $229 billion of employee benefit
funds at the end of 1980.14 Approximately $1.5 billion
of this total was in the international commingled funds.
The banks held additional foreign assets for the em­
ployee benefit funds either because of international
diversification for separate accounts or because of
foreign securities the banks purchased for commingled
funds that were not international funds.15 However,

11 Greenwich Research Associates, op. cit.
12 The two state retirement funds that hold foreign assets have 5 percent
as their current allocations, and at least one would not hesitate to
go as high as 10 percent.
13 Institutional Investor (April 1980).
14 Federal Financial Institutions Examination Council, op. c it
w Foreign securities purchases for “ domestic" commingled accounts
often are securities for which American Depositary Receipts are
available, and therefore might frequently represent purchases from
United States residents rather than new outflows.

FRBNY Quarterly Review/Autumn 1981

11

these latter types of holdings apparently did not
exceed $1 billion, or $2 billion at most. This would
Imply that roughly 1-1 Vz percent of the employee ben­
efit assets with banks was invested abroad, including
investments in Canada and in United States dollardenominated foreign issues. This compared with an
estimated Vz percent a year earlier, when employee
benefit funds managed by banks totaled $205 billion.
Life insurance companies, which had assets totaling
$479 billion at the end of 1980, were responsible for
the management of $165 billion of private pension plan
funds: $33 billion in separate accounts and $132 billion
in the general accounts. Among the insurance com­
panies’ total assets, approximately $20 billion (4 per­
cent) consisted of foreign securities. Debt securities,
which always bulk large in life insurance company
portfolios, accounted for $19 billion of the $20 billion.
Most of this comprised Canadian paper (government,
government agency, and corporate) and some small
amount of international agency bonds, but there were
also bonds of the governments of Mexico, Japan,
France, Sweden, Israel, and some other countries, as
well as debt of non-Canadian corporations.’4 Foreignissued stock probably amounted to no more than $1 bil­
lion. Almost all the foreign investments were for the
life insurance companies’ general accounts, and only
a very small part for the separate accounts. Since
roughly 30 percent of the total general accounts con­
sisted of pension fund monies, pension funds might be
regarded as the source of approximately $6 billion of
the foreign asset investments (compared with about
$5 billion the previous year), even though the pension
funds did not have the responsibility for stipulating
how their funds were to be invested.
While intermediaries outside the insurance and
banking communities have significant amounts of pen­
sion fund reserves under management, again only
estimates are available concerning the foreign securi­
ties investments they managed at the end of 1980. One
compilation suggests the total was almost $1 billion, up
approximately $200 million from 1979.17
In summary, the foregoing estimates suggest that at
the end of 1980 roughly $9-10 billion, approximately
2 percent, of private pension fund assets was held in
foreign securities through all management intermedi­
aries, including the portion of insurance company
general account foreign investments allocable to pen­
sion funds. The additional foreign assets managed
internally by private corporations at that time apparent­
ly totaled less than $100 million. However, some large
14 American Council of Life Insurance, 1981 Life Insurance Fact Book.
17 Information from Intersec Research Corporation.

12 FRASER
FRBNY Quarterly Review/Autumn 1981
Digitized for


sponsors who now have their own staffs managing do­
mestically invested pension funds anticipate they will
be able to undertake internal management of at least
part of their foreign investments in another five years
or so, after the staff has gained more knowledge about
foreign markets and foreign securities.
As pension funds continue to increase throughout
the 1980s, a net outflow would have to occur each
year just to maintain an unchanged foreign investment
percentage— unless the market value of the existing
foreign holdings took a sudden jump. Any growth of
the portion allocated to foreign assets would expand
the flow further, although it is likely that the annual
increase in total allocations will slacken after a number
of years. Part of the rise that must be expected during
the eighties will undoubtedly reflect the very recent
change in attitude of a number of big banks and life
insurance companies that have decided to compete
in providing new foreign asset investment opportuni­
ties for ERISA clients. The same is true concerning
the entrance of independent managers, brokers, and
consultants into the business of trust banking. With an
increasingly active and diversified group of intermedi­
aries available as foreign asset managers and custodi­
ans, it seems likely that additional pension plan spon­
sors will be attracted to international diversification.
Assuming that foreign diversification grows over the
rest of the decade at a rate that raises the share of
foreign assets in total private pension fund portfolios
by an annual average of about Vz percentage point, by
1990 foreign assets would comprise roughly 7 percent
of total private pension funds, with many large funds
reaching well beyond 10 percent. On the basis of the
forecasts of pension fund reserves made by ICF,
7 percent in foreign asset holdings in 1990 would
amount to approximately $120 billion (in current, i.e.,
inflated, dollars).18 This would imply that during each
of the next few years the outflow would remain below
$10 billion and would rise above that level only some
time in the middle of the decade. The amounts would
be larger if a significant number of state and local
pension plans were to start investing abroad.
Implications for United States markets
What might be the implications for the United States
balance of payments and financial markets as pension
funds increasingly diversify into foreign assets? The
foregoing estimates suggest that during the first half
of the decade net outflows might expand from the ap­
proximately $2% billion of last year to something short
11 The ICF “ cyclelong" model on which this figure is based assumed the
consumer price index would show a rise of 7 percent in 1986 and
6.5 percent in 1990. The ICF estimate of total private pension plan
assets in 1990 came to approximately $1.7 trillion (ICF, op. c it.).

of $10 billion by the mid-1980s.” These are not par­
ticularly large sums when compared with other types
of capital outflows. For example, during the last five
years, United States banks increased th eir dollar claims
on foreigners (excluding claims on their own foreign
branches) by an annual average of almost $18 billion.
And new direct foreign investments by United States
residents amounted to an annual average of over $4
billion. Inclusion of reinvested earnings would increase
this figure to $16 billion. 20
A growing international orientation by United
States pension funds w ill presumably affect to some
extent the location of th eir short-term liquid reserves,
the volume of which can fluctuate considerably. For
example, since 1978, “ cash and deposits” of private
noninsured pension funds have accounted fo r 4 per­
cent of total assets after having constituted only 2
percent for many years, and at the end of 1980 such
liquid assets amounted to $9.3 b illio n .21 This un­
doubtedly reflected the diversion of funds from long­
term investments in 1978, due to the drop in bond and
stock m arket prices and the surge in short-term in­
terest rates. Thereafter, liquid reserves were kept at
high levels presumably because of uncertainty about
the outlook for capital market developments and the
continuing attraction of short-term rates. In the future,
at sim ilar junctures, when short-term rates abroad are
also attractive, pension fund managers may pay in­
creased attention to the alternative foreign liquid
investment possibilities (as perhaps indicated by the
establishm ent of an international cash division in the
Bank of A m erica’s new international commingled fund).
A persistent trend toward greater international diver­
sification of short-term investments would introduce
the possibility that the management of such invest­
ments would contribute to exchange market volatility.
However, these flows would be just one stream in a
multitude of many fluctuating sources of supply and
demand in the huge short-term financial markets.
At the same time that United States investors have
begun to look abroad, the incentive to diversify and
the breadth and depth of United States capital markets
have led additional numbers of foreign investors to
look to the United States. Indeed, throughout the past
19 It is to be noted that, even when foreign fixed-income investments are
United States dollar denominated, as the bulk of the insurance
company investments have been, the borrowers generally convert
the funds into foreign currencies, resulting in flows through the
exchange markets.
20 Board of Governors of the Federal Reserve System, Federal Reserve
Bulletin, and the United States Department of Commerce, Survey
of Current Business.
United States Securities and Exchange Commission, SEC Monthly
Statistical Review ( May 1981).




Net Foreign Securities Purchases by
Private Investors
Billions of dollars
12
11

Net purchases of
.United States securitiesby foreign private investors

10
9

8
7
6
5
4
3
2
1

0
-1

1970

71

72

73

74

75

76

77

78

79

80

* No data available on components of net purchases
by United States private investors.
Source: United States Department of Commerce,
Bureau of Economic Analysis, Survey of
Current Business, June 1981.

decade, except fo r a bulge in outflows during the years
1974 through 1977 resulting from the elim ination of the
interest equalization tax and the reemergence of the
Yankee bond market, foreign private inflows into the
United States securities markets were considerably
greater than outflows into foreign securities markets
by a ll private United States investors— pension funds,
foundations and other institutions, businesses, and indi­
viduals (chart ).22 Thus, any diversion to foreign markets
of pension fund resources that m ight otherwise have
been invested in dom estic capital markets has in most
years been much more than offset in amount by inflows
from private foreign residents. In addition, there have
been considerable investments in United States private
securities by foreign official agencies.
22 Some penison fund outflows are not recorded in these figures, par­
ticularly, as noted above, when managers are operating out of overseas
offices and/or foreign brokers are being used.

FRBNY Quarterly Review/Autumn 1981

13

The clear-cut existence of a two-way flow of funds
in an increasingly interdependent world, but one
where the United States continues to exert an extraor­
dinarily strong pull on foreign investors— not only into
the securities market but also into real estate and
direct investments— makes it appear improbable that
the rise in investments abroad by United States pen­
sion funds (and other institutional investors) will lead
to a secular downward pressure on the United States
dollar. The current Administration’s general attitude
concerning the need to encourage investment, and
its budget and tax policies, may reinforce foreign­
ers’ interest in investing in this country. Moreover,
the longer term foreign investment strategies that
United States pension plan sponsors have by and
large followed, and the relatively low weight most of
them give to short-run exchange market conditions,
means that the management of these funds is not

14 FRASER
FRBNY Quarterly Review/Autumn 1981
Digitized for


likely to be a significant source of instability in ex­
change markets. Indeed, the presence of more inter­
national capital flows that are governed by a longer
view could actually be a source of stability.
Thus, the growing international diversification of
United States pension fund portfolios seems, from the
vantage point of 1981, to be a development that is
capable of providing benefits for both pension plan
sponsors and pension fund beneficiaries— if the spon­
sors are sufficiently knowledgeable to make the proper
choices concerning guidelines and managers. More­
over, the expanding diversification appears unlikely to
have any noticeably adverse effects on the exchange
rate for the dollar or any perceptibly negative effects
on United States financial markets. The outflows will
not be particularly large, compared with other capital
outflows, and investments in this country’s markets by
foreigners will probably continue to be much greater.

Edna E. Ehrlich

Excess Reserves and
Reserve Targeting
In 1980 banks held on average about $275 million more
reserves than required by law. Although this is a rela­
tively small amount when measured against $42 billion
of required reserves and $1,500 billion of total bank
assets, the significance of excess reserves for mone­
tary policy and money market conditions far outweighs
their relative magnitude. Excess reserves arise out of
the process, on the one hand, of some 15,000 banks
trying to meet their weekly reserve requirements and,
on the other hand, of the Federal Reserve attempting
to hit its nonborrowed reserve targets. As a propor­
tion of required reserves, excess reserves are remark­
ably small, especially in light of the large number of
institutions simultaneously adjusting their reserve po­
sitions, the huge volume of funds shifting around the
banking system, and the considerable uncertainty
over float and other special factors affecting reserve
availability. However, since only a limited amount of
excess reserves can be carried forward, small
surpluses or shortages of reserves can have dispro­
portionate effects on the Federal funds and other
short-term interest rates. Moreover, the erratic and
unpredictable fluctuations in excess reserves can
complicate the task of setting and achieving weekly
reserve objectives. At times, the week-to-week changes
in excess reserves are sizable. During the last week
in March 1981, for example, banks held $462 million
of excess reserves, whereas in the previous week
they had realized a small deficiency.
The purpose of this article is to discuss the major
factors affecting the weekly movements of excess re­
serves. It examines the roles of carry-over privileges,
“ as-of” reserve adjustments, and seasonal factors in
causing these week-to-week fluctuations, and it analyz­




es the implications these variations have for the dayto-day management of monetary policy and the mar­
ket’s interpretation of Federal Reserve action. From a
longer term perspective, it examines how banks’ hold­
ings of excess reserves have been influenced by the
general rise in interest rates, the expansion of the
Federal funds market, and the implementation of
regulatory and policy changes by the Federal Re­
serve over the past fifteen years.
Excess reserves and interest rates
Excess reserves have much more important implica­
tions for money market conditions under the reserve
strategy that the Federal Reserve adopted on Octo­
ber 6, 1979 than they did prior to that period. Under
the new procedures, the Federal Reserve concentrates
on supplying reserves, rather than on setting the Fed­
eral funds rate, to achieve its monetary goals. Conse­
quently, factors— such as excess reserves— that in
the past had the potential for influencing short-term
interest rates, but were offset by the Domestic Open
Market Trading Desk, could well cause large rate
movements under the new approach to policy imple­
mentation and could lead to more variability in the
public’s demand for money.
At times the banking system may end up with a large
amount of unwanted excess reserves, and banks hold­
ing these large excesses will try to sell them in the
Federal funds market. Since reserves earn no interest,
banks may be willing to accept very low interest rates
to unload unusable excesses. Thus, relatively small
surpluses can cause short-term rates to fall sharply.
At other times, a relative shortage of excess re­
serves may develop. For example, excess reserves

FRBNY Quarterly Review/Autumn 1981

15

may end up at small banks, some of which do not
make an effort to sell them. Although the banking sys­
tem as a whole may be in good balance, some banks
may not be able to buy enough funds in the Federal
funds market to meet reserve requirements, even
though they bid up the rate. Eventually they may have
to turn to the discount window, but in the process they
may push up the Federal funds rate significantly.
Consequently, under current operating procedures,
relatively small changes in reserve positions can pro­
duce sharp changes in money market conditions and
may contribute to the variability of the money stock.
Excess reserves and reserve targeting
Although the Desk has no direct control over excess
reserves, the volume of excess reserves expected for
the week plays a significant role in determining the
Desk’s weekly open market operations. Under the
current operating procedures, the Board of Governors
staff and the manager of the Desk construct weekly
reserve paths that are consistent with the money
growth objectives established by the Federal Open
Market Committee (FOMC). In constructing and revis­
ing the weekly reserve paths, the Board staff calcu­
lates required reserves that are consistent with the
money growth objectives and adds on an estimate
of excess reserves to obtain the total reserve path.
The staff then derives a nonborrowed reserve objec­
tive by subtracting a borrowing level indicated by the
FOMC. The amount of borrowing is often relatively
close to the volume prevailing before the FOMC meet­
ing, but the FOMC on occasion may also increase or
reduce the level to step up or ease adjustment pres­
sures on the banks.1
At times the excess reserve estimate may prove
incorrect, in which case the need for discount window
borrowing will be different than expected. For example,
if the demand for excess reserves is underestimated,
the nonborrowed reserves supplied by the Desk will
generate a greater than expected need for borrowing
at the discount window. This higher than expected
borrowing may be reflected in a higher Federal funds
rate. Conversely, an overestimate of the demand for
excess reserves may produce a fall in the Federal
funds rate. Although these rate movements are trans­
itory and technical in nature, they may be misinter­
preted by market participants to indicate a greater
or less willingness on the part of the Federal Reserve
to supply reserves*
In addition to constructing the weekly reserve paths,
1 For further details on this procedure, see "Monetary Policy and
Open Market Operations in 1980” , this Q uarterly R eview (Summer
1981), pages 61-67.

16FRASER
FRBNY Quarterly Review/Autumn 1981
Digitized for


the Desk uses daily projections of the major market
factors affecting the supply of reserves— such as
float, Treasury balances, and currency in circulation.
These are factors over which the Desk has no direct
control. At times, these factors may differ significantly
from the projected levels, in which case the supply of
nonborrowed reserves available to the banking sys­
tem would be temporarily different from the expected
levels. If this occurs on a Wednesday, it may cause
excess reserves or borrowing to be substantially dif­
ferent from assumed levels. At other times, borrowing
from the discount window may be higher than the level
assumed in constructing the path. As a result, excess
reserves would be higher than estimated and money
market conditions would normally be easier than ex­
pected.
Excess reserves in perspective
Before getting into a detailed discussion of weekly
fluctuations in excess reserves, it is useful to put the
current behavior of excess reserves into historical per­
spective. A variety of market, technological, and reg­
ulatory developments over the past twenty years
helped banks lower their need for excess reserves.
Even though the size of the banking system expanded
dramatically during the last two decades, excess re­
serves declined significantly both in absolute terms
and as a percentage of required reserves (Chart 1).
In the early 1960s, excess reserves held by member
banks were as high as $600 million, equivalent to over
3 percent of their reserve requirements, but then they
declined to a $350-400 million level in the mid-1960s
and fell sharply again in the late 1960s. Thereafter,
excess reserves fluctuated mostly around the $200
million level, even as the banking system continued
to expand rapidly.
A variety of technological and structural changes
over the last two decades helped the banking system
reduce its need for excess reserves. Major advances
were made in the data-processing and telecommunica­
tions systems, which made it easier for banks to track
their reserve positions and transfer funds to other in­
stitutions. These developments also allowed many
smaller banks to participate actively in the Federal
funds market, either directly or indirectly through cor­
respondents. Moreover, with the acceleration of in­
flation and the accompanying rise in interest rates,
the opportunity cost of holding idle balances increased
rapidly, encouraging banks to implement better re­
serve management techniques.
Regulatory changes in the late 1960s also helped
reduce the need for excess reserves. In September
1968 the Federal Reserve allowed banks greater flexi­
bility in calculating and fulfilling their reserve require-

Chart 1

While the banking system grew substantially
during the last twenty years . . .
Billions of dollars

. . . excess reserves declined sharply in the
1960s and then leveled out in the 1970s,
both in dollar terms . . .
Millions of dollars
Excess reserves

ments by switching from contemporaneous to lagged
reserve accounting and by liberalizing the reserve
carry-over privilege. A fter 1968, banks were required
to base their calculations of required reserves on their
reservable liabilities held two weeks earlier. Vault cash
was also lagged two weeks; that is, reserve require­
ments in the current maintenance period could be
satisfied by vault cash held two weeks earlier. At the
same time, banks were allowed to carry forward one
week a part or all of th eir current period’s reserve
surplus or deficit. However, the portion carried for­
ward could not exceed 2 percent of their required
reserves, and banks could not run deficits two weeks
in a row w ithout incurring a penalty .2 Also, any surplus
not used in the subsequent week was lost.
These changes made it easier fo r banks to manage
th eir reserve positions and to reduce their excess re­
serves. From the view point of a bank’s money desk
manager, the new rules provided clear advantages.
Liberalization of the carry-over privilege allowed banks
to make good use of excesses in the previous week.
Moreover, with lagged reserve accounting, banks knew
well in advance what th eir reserve requirements would
be. The lagging of vault cash also eliminated lastminute changes in maintained reserves as a result of
unexpected inflows or outflows of cash. While other
factors were also at work to reduce excess reserves,
the September 1968 regulatory changes accounted for
a major portion of the decline, according to our sta­
tistical analysis .3 Unfortunately, it was not possible to
isolate the impact of the change in accounting rules
from the effect of the liberalization of the carry-over
privilege, since both occurred simultaneously.

Recent movements in excess reserves

. . . and as a percentage of
required reserves.
Percent

Source: Board of Governors of the Federal
Reserve System.




After fluctuating mostly around the $200 m illion
level in the 1970s, it appeared that excess reserves
might settle more or less permanently at this level.
But excess reserves then increased by about $33 mil2 Before September 1968, member banks could make up reserve
deficiencies in the following period of up to 2 percent of required
reserves, but there was no carry-over privilege for surplus reserves.
Also, before 1968, the reserve maintenance period was synchronous
with the computation period. But in effect there was a one-day lag,
because daily reserves were measured at the close of business
while daily deposits were measured at the opening of business.
There was, in effect, a one-day lagged accounting of vault cash as
well. The maintenance period also varied by size of bank— one week
for reserve city banks and two weeks for country banks.
3 Regression analysis was used to estimate the impact of the 1968
regulatory changes. According to the results, excess reserves fell
about $120 million after September 1968. Other explanatory variables
used in the equation included dummy variables representing the
October 1979 change in operating procedures, the November 1980
implementation of the Monetary Control Act, and a time trend reflecting
technological and market developments. Monthly data for the 1959-80
period were employed.

FRBNY Quarterly Review/Autumn 1981

17

lion, according to our estimates, after the Federal
Reserve switched operating procedures in October
1979 (box). Under the new strategy, banks could no
longer count on the Federal Reserve to supply re­
serves necessary to maintain a given funds rate, and
this in turn appears to have prompted some banks at
least to be more cautious in the way they manage
their reserve positions by holding more excess re­
serves on average.
Excess reserves also increased dramatically follow­
ing the implementation of the Monetary Control Act
in November 1980. Immediately after implementation,
excess reserves averaged $600 million, substantially
above the $250 million level prevailing in early 1980.
But in subsequent months excess reserves returned
to more normal levels. Since the number of institutions
required to maintain reserves was greatly expanded
by the new law, it appears that the large jump in ex­
cess reserves reported in late 1980 and early 1981
might have resulted from unfamiliarity with the new
reporting requirements, especially among the smaller
institutions.4
Weekly fluctuations of excess reserves
While the average level of excess reserves declined
substantially over the last twenty years, the weekly
variability remained high. In 1980, for example, the
average level of excess reserves for all banks was
only $275 million, but the average week-to-week vari­
ation was more than $260 million. A large portion of
these weekly variations is attributable to certain tech­
nical factors, particularly seasonal patterns, carry­
over privileges, and as-of adjustments. In addition,
other short-term demand and supply factors may also
contribute at times to the variability of weekly ex­
cess reserve numbers.
“ Seasonal” factors
Excess reserves do not exhibit sustained swings in
levels for several weeks or months at a time. Rather,
the “ seasonal” pattern (or, perhaps more accurately,
the calendar pattern) generally consists of one-week
increases in excess reserves, reflecting mostly quar­
terly statement dates, month-end dates, social security
payment dates, and bank holidays. These one-week
spurts are relevant only when analyzing weekly fig­
ures, as they are normally washed out in the monthly
data. Total and required reserves, on the other hand,
do exhibit more sustained swings, reflecting patterns
in deposits and other reservable liabilities.

* Statistical analysis on a disaggregated basis indicates that most of
this large increase occurred at banks outside New York City.

FRBNY Quarterly Review/Autumn 1981
Digitized for18
FRASER


Statistical analysis of weekly data during the past
several years indicates that, as a rule of thumb, banks
step up their excess reserve balances by about $85
million, on average, during weeks containing the last
day of the month and an extra $90 million during
weeks containing the end of the quarter. In addition,
banks hold approximately $42 million more excess
reserves during weeks that social security benefit
checks are mailed and $133 million more during
weeks containing a nationwide bank holiday (box).
The impact of individual dates is varied, however.
The increases associated with the end of the second
and fourth quarters are usually larger than those for
the first and third quarters, for example. This is
partly because the Fourth of July and the ChristmasNew Year holidays frequently fall during the same
weeks as the ends of the second and fourth quarters,
respectively.
The main reasons for these calendar increases in
excess reserves appear to be the larger volume and
greater variability of funds flowing into and out of the
banking system during these weeks than at other
times. This would be especially true during weeks
when social security checks are mailed to benefici­
aries and at the month end and quarter end, when
there are frequently large flows into and out of busi­
ness checking accounts. Banks also reportedly find
it more difficult to predict inflows and outflows of
funds during weeks containing a holiday. Banks vary
somewhat in their reaction to these calendar factors.
For example, unlike the other banks, the New York
banks show no statistically significant increase in
average holdings of excess reserves at the quarter end.
However, like the other banks, the large New York
banks show a similar jump in excess reserves during
weeks containing a holiday or social security pay­
ment date.
Reserve carry-over
While calendar factors induce banks to hold more
excess reserves during certain weeks of the year,
reserve carry-overs encourage banks to adjust their
surplus reserves with a view toward their previous
and succeeding weeks’ reserve positions. The carry­
over provision gives banks some leeway in meeting
their reserve requirements by allowing the banks to
carry forward their reserve surpluses or deficiencies
up to a maximum of 2 percent of their required re­
serves.
An examination of recent data indicates that banks
make wide and frequent use of the carry-over privi­
lege. In 1980, banks carried forward, on average,
about $230 million of gross excesses from the previ­
ous week and $130 million of gross deficiencies. In

Factors Affecting Weekly Variations of Excess Reserves: A Statistical Analysis
Moreover, immediately following the November 1980
implementation of the Monetary Control Act, banks
sharply increased their holdings of excess reserves,
but in subsequent weeks they gradually trimmed back
on their excess balances as they became more familiar
with the new requirements. Demand factors such as
interest rates and activity levels appeared to have little
predictive value on a week-to-week basis.
The regression results were as follows:

Regression analysis was used to estimate the impact
of certain technical factors on week-to-week fluctua­
tions of excess reserves. Reserve carry-overs, quarterly
statement dates, month-end dates, social security pay­
ment dates, and bank holidays accounted for a large
portion of the weekly changes. In addition, the October
1979 change in Federal Reserve operating procedures
toward placing more emphasis on the supply of bank
reserves caused excess reserves to increase somewhat.
Excess reserves

=

206.9 — 0.55 carry-over
(22.8) (-8 .0 )
- f 41.6 social security
(2.9)

4- 33.1 October 1979
(2.6)

- f 89.7 quarter end
(4.4)

- f 84.8 month end
(5.4)

+ 132.6 holiday
(10.0)

-f- 223.2 November 1980
(6.6)

Sam ple p eriod:

July 1, 1970 to July 1, 1981 (weekly).

Sum m ary statistics:

DW = 1.97;

R2= 0.44;

SEE = 116.3;

— 11.4 post-November 1980
(-6 .7 )

Figures in parentheses are t-values.

Variables:

Excess rese rve s...........................

Excess reserves in millions of dollars.

Carry-over

Net reserve carry-over in millions of dollars.

...................................

Quarter end .................................

Dummy variable with 1’s for weeks containing the last day of the quarter and 0’s elsewhere.

Month end ...................................

Dummy variable with 1’s for weeks containing the last day of the month and 0's elsewhere.

Social s e c u rity .............................

Dummy variable with 1's for weeks containing the social security benefit payment dates
(generally the third day of the month) and 0's elsewhere.

Holiday .........................................

Dummy variable with 1's for weeks containing bank holidays and 0’s elsewhere.

October 1979 ...............................

Dummy variable to represent Federal Reserve procedural change from targeting the Federal
funds rate to targeting bank reserves, with 1’s for weeks after October 6, 1979 and 0’s elsewhere.

November 1980 ...........................

Dummy variable to represent implementation of the Monetary Control Act, with 1’s for weeks
ended after November 12, 1980 and 0's elsewhere.

Post-November 1980 ...................

Trend variable for the November 20-July 1 subperiod, to represent banks’ gradual adjustment
to the new requirements of the Monetary Control Act.

1980, net carry-over frequently approached the $200
m illion level. Large banks, in particular, made exten­
sive use of the carry-over privilege to manage their
reserve positions over several weeks rather than in
a single week.
The carry-over privilege contributes to the variability
of excess reserves by encouraging banks to “ over­
adjust” their current reserve positions in order to take
full advantage of reserves carried over from the pre­
vious period. As can be seen in Chart 2, both reserve
carry-over and excess reserves exhibit strong sawtooth
patterns, that is, they move in fairly regular up-down
patterns around their average levels. The sawtooth
patterns of excess and carry-over reserves are directly




related to each other. A large excess in the current
week normally results in a large positive carry-over
and a small surplus (or even a deficit occasionally)
in the follow ing period. This, in turn, induces the op­
posite reaction in the succeeding week. Moreover,
since banks lose the advantage of any carry-over not
utilized in the succeeding period, they are likely to
overadjust their current positions to ensure against
any such loss, accentuating the o scillations .5 Our re5 For example, if a bank’s surplus carry-over into the current week is
$5 million, it is likely to aim for a deficit in the current period of at
least $5 million, so as not to lose any benefit of the carry-over. Any
uncovered deficiency in the current period would, in turn, be carried
over to the succeeding week.

FRBNY Quarterly Review/Autumn 1981

19

gression results in the box indicate that, for the bank­
ing system as a whole, excess reserves move in the
opposite direction from carry-over by a m ultiple of
0.55. In other words, if reserves carried over into the
current period increased by $100 m illion, excess re­
serves w ould norm ally be $55 m illion low er than
otherwise, and vice versa.
In most weeks, excess reserves fluctuate between
zero and $400 m illion but, on occasion, the variations
are substantially larger. The size of the oscillations
depends partly on whether the m ajor banks collec­
tively are in deficit or in surplus. If they are all in

Chart 2

Banks are a llo w e d to ca rry fo rw a rd
one w ee k rese rve e xce sse s o r d e fic its
up to 2 p e rc e n t o f th e ir re q u ire d reserves.
S in ce th e y lose th e advantage o f any
c a rry -o v e r n ot u tiliz e d in the su c c e e d in g
p e rio d , th e y are like ly to "o v e ra d ju s t”
th e ir w ee kly rese rve p o s itio n s to assure
a g a in st such loss.
As a result,
w e e k ly e xcess reserves e x h ib it a stron g
sa w too th p a tte rn . . .
Millions of dollars
1000

Excess reserves
8 0 0 ---------------------------6 0 0 ---------------------------400

0
-2 0 0

~4° °

J

F M A M J

J
1980

A S O N D J F M A M J
1981

. . . w hich is re fle c te d in a sim ila r
p a tte rn fo r reserve ca rry-o ve r.

1980
Source: Board of Governors of the Federal
Reserve System.

Digitized for
20FRASER
FRBNY Quarterly Review/Autumn 1981


1981

sim ilar positions, the oscillations can be as large as
$800 m illion from a peak to a trough. If, on the other
hand, m ajor banks are on opposite sides of the fence,
the fluctuations fo r the banking system as a whole
can be much smaller.
The oscillations may be initiated by a number of d if­
ferent factors. They may begin with a sharp unexpected
jum p in bank borrowing, which increases total re­
serves in relation to required reserves. At the time
they borrow, banks often do not perceive that reserves
w ill be plentiful for the week on average. At other
times, banks may position themselves to take advan­
tage of reserve carry-over or expected rate move­
ments by holding larger than average excesses in
the current week. On other occasions, operational
difficulties or large last-minute inflows may cause
banks to wind up with more reserves than desired.
The carry-over privilege, while causing excess re­
serves to oscillate, does not significantly affect the
implementation of monetary policy. Since the amount
carried over into the current period is known at the
beginning of the week, it can be offset by the Desk.
(There may be some uncertainty, however, as to how
much of the carry-over w ill actually be utilized by
the banks.) Moreover, reserve carry-over serves a
useful purpose by acting as a moderating influence
on the money market. W ithout carry-over, a shock to
reserves would have to be absorbed in the current
week, either by banks holding larger than desired
excesses or by banks borrowing more than expected
from the discount window. As a consequence, it is
likely that w ithout carry-over the Federal funds rate
(and bank borrowing from the discount window) would
fluctuate more from week to week than they do
currently.
“ As-of” adjustments
At times, errors or disruptions occur in the process of
transferring funds or securities to or from the Federal
Reserve. Frequently, they w ill result from transposi­
tional mistakes or breakdowns in the telecom m unica­
tions or data-processing systems. They include entries
posted to the wrong reserve accounts, delays in post­
ing entries, and erroneous instructions by depository
institutions. To rectify these errors, bookkeeping cor­
rections called as-of adjustments are made to the
affected banks’ reserve positions at the various Fed­
eral Reserve Banks. If the error is discovered in the
week in which it occurs, the current w eek’s reserve
position can generally be corrected. However, if the
error is discovered in a subsequent period, a problem
arises as to w hether to make the adjustment to the
current or a previous week’s reserve position.
There are three types of as-of adjustments: ASOAs,

ASOBs, and ASOCs. ASOAs are corrections made to
banks’ reserve positions in the current or subsequent
week, while ASOBs are adjustments made to banks’
positions in the previous week, and ASOCs are cor­
rections made to banks’ reserve positions in statement
periods prior to the previous week. For example, sup­
pose that July 16-22 is the current reserve mainte­
nance week; then, ASOAs would be made to the
July 16-22 or July 23-29 week, ASOBs to the July
9-15 week, and ASOCs to the July 2-8 and other prior
weeks.
The as-of adjustments are applied to previous,
current, or subsequent weeks according to guidelines
laid down by the Reserve Banks. According to the New
York Federal Reserve Bank’s rules, for example,6
positive as-of adjustments issued during the current
period but involving the two prior reserve periods are
normally applied first to reduce penalty deficiencies
(that is, deficiencies that exceed the allowable 2 per­
cent carry-over limit and are subject to a penalty
rate) in the two prior weeks (as ASOBs and ASOCs);
any unused portions of the reserve adjustments are
then applied to the current or subsequent period (as
ASOAs). Similarly, negative as-of adjustments involving
the two prior periods generally are first applied as
ASOBs and ASOCs to reduce unusable surpluses
(that is, excesses that exceed the maximum 2 per­
cent carry-over limit) in the two previous periods, and
the remaining portions are applied as ASOAs to the
current or subsequent period. As-of adjustments is­
sued in and involving the current period are applied
as ASOAs in either the current or following period.7
As a consequence, banks seldom lose and frequently
gain from as-of adjustments. ASOBs and ASOCs will
almost always improve but will seldom worsen a
bank’s past reserve position, while ASOAs can usually
be offset by buying or selling funds in the Federal
funds market. Because banks acquire unusable ex­
cesses more often than they incur penalty deficiencies,
excess reserve data are almost always revised down­
ward. In 1980, excess reserves were revised downward
as a result of as-of adjustments by an average weekly
amount of nearly $60 million, equivalent to about 20
percent of total excess reserves. In many weeks the
•Although the requirements vary somewhat among the District Banks to
reflect different needs and conditions, the New York Federal Reserve
Bank's guidelines summarized here are fairly similar to those of the
other Reserve Banks. A more detailed description of this Bank’s guide­
lines is available from the Federal Reserve Bank of New York.
1 Under the New York Federal Reserve Bank’s guidelines, ASOAs are
routinely applied to the current period if they are received by
the Accounting Department by Tuesday; otherwise, they are applied
to the follow ing reserve period unless requested otherwise by the
depository institution.




revisions resulting from as-of adjustments were sub­
stantially larger than these averages; frequently, they
were $100 million and sometimes they were over $400
million.8
For the most part, this flexible policy regarding the
application of as-of adjustments is equitable, for with­
out such latitude a bank might be unfairly penalized
if it were required to apply the full as-of adjustment
to the week in which it occurred, especially if the
bank had offset the mistake by maintaining more or
less reserves than it would have otherwise. On the
other hand, this policy reduces the effective costs of
maintaining too little or too much reserves for many
banks. The reason is that there is a fairly good chance
for these banks to benefit from an as-of adjustment
which will either reduce a past deficiency that was
subject to a penalty rate or allow use of a past sur­
plus that was ineligible for carry-over.
Economic and other factors
Economic as well as technical factors will affect
banks’ management of excess reserves. On the de­
mand side, the level af interest rates determines the
opportunity cost of holding unnecessary balances. As
rates rise, banks will be induced to conserve on idle
funds, although such adjustment may take place over
a period of time rather than immediately. Banks may
also increase their holdings of excess reserves during
times of uncertainty and instability in the money
markets. Moreover, since banks can carry forward a
portion of their reserve excess or deficit, they are
likely to adjust their current holdings of excess re­
serves in line with their view of future interest rate
• As-of adjustments arising from accounting or administrative
errors or delays in processing transactions by Federal Reserve
offices are based on the principle that banks should neither gain
nor lose as a result of such errors. In practice, however, it is
easier to demonstrate when a bank has lost than when it has
benefited from an error or delay affecting a prior period. Conse­
quently, in such circumstances, the Federal Reserve Banks usually
give banks the benefit of the doubt by applying as-of adjustments
in the manner described.
The Federal Reserve Banks also consider requests from banks
for reserve adjustments for errors made by the banks themselves.
These errors may be similar to those made by the Federal Reserve;
for example, a bank may transfer funds to the wrong bank.
However, before acting on such a request, the Federal Reserve
Bank will first satisfy itself that the institutions involved are not
attempting to manage their reserve positions after the fact and it
will normally apply both sides of the adjustment simultaneously
(a credit for the one institution and a debit for the other). The
Federal Reserve Banks make these adjustments out of a sense of
equity and as a service to the institutions since the Reserve Banks,
as banks of account, are usually in the best position to correct
the reserve impact of such errors. A Federal Reserve Bank may
decline requests where corrections are equally feasible on the
part of the banks, and it may also discourage repeated requests in
the interest of encouraging an institution to correct shortcomings
in its own internal procedures.

FRBNY Quarterly Review/Autumn 1981

21

movements. If they expect rates to go down, they will
likely run deficits in the current period and make up
the deficiencies at a later time when rates are expected
to be lower.
At times, banks may miscalculate aggregate reserve
availability and money market conditions and position
themselves incorrectly for the settlement day by bor­
rowing more than needed early in the week; then, if
the Desk provides reserves in accordance with its
nonborrowed reserve objective, too many reserves
will result. Part of the adjustment will then normally
occur in lower borrowings later in the week and the
remainder in larger holdings of excess reserves.’ Typi­
cally, such an “ oversupply” of reserves shows up late
on Wednesday with a substantial easing of the Federal
funds rate. Analysis of weekly data over the last sev­
eral years indicates that a 1 percentage point drop in
the late Wednesday Federal funds rate below the
weekly effective rate is associated with a $15 million
increase in the week’s excess reserves over the pre­
vailing average level.
Finally, operational difficulties may prevent banks
at times from achieving the minimal level of excess
reserves desired. Common problems include break­
downs of data-processing and communications sys­
tems or unexpected inflows and late payments by cor­
respondent banks on settlement day.
Policy implications
This analysis raises some issues regarding current
practices, procedures, and regulations affecting excess
reserves. The use of as-of adjustments is especially
relevant, for, although as-of adjustments are relatively
small compared with total reserves, they are sizable
when compared with excess reserves. Critics argue
9 At times, though, the Desk will take into account this ‘‘overborrowing”
and permit nonborrowed reserves to fall short of the path.

22FRASER
FRBNY Quarterly Review/Autumn 1981
Digitized for


that the Federal Reserve Banks’ policies or applying
reserve adjustments to previous weeks only to the ex­
tent that they reduce past penalties or unusable sur­
pluses substantially reduce the risks and costs to
banks for not tightly managing their reserve posi­
tions and weaken the Desk’s control over reserves
by allowing banks to adjust their reserve positions
after the fact. The Federal Reserve could close this gap
in the Desk’s control by requiring that all as-of ad­
justments be applied to the current or future period
regardless of when they occurred. However, such a
policy change would raise questions of equity, espe­
cially if the banks are penalized for errors for which
they are not responsible.
Summary
Banks substantially reduced their holdings of excess
reserves between the early 1960s and late 1970s but
then increased them on two major occasions during
the last two years. Structural and technological inno­
vations in the money market, regulatory and proce­
dural changes by the Federal Reserve, and a general
rise in interest rates contributed to these long-run
changes. While the average level of excess reserves is
fairly low, the current holdings of excess reserves fluc­
tuate sharply on a week-to-week basis. To a large ex­
tent, these weekly variations can be explained by such
factors as carry-over privileges, as-of adjustments,
and calendar patterns. But a part of these weekly fluc­
tuations is erratic and unpredictable and complicates
the task of setting and achieving weekly reserve ob­
jectives. In the face of the weekly variations in ex­
cess reserves, reserve carry-over acts as a moderating
influence on money market conditions; however, rela­
tively small changes in excess reserves can none­
theless produce comparatively large movements in
short-term rates, especially on Wednesdays, and may
contribute to the variability of the money stock.

David C. Beek

The
business
situation
Current
developments
Chart 1

Measures of wage and compensation
changes are giving mixed signals.
Increases in adjusted hourly earnings in
the private nonfarm economy appear to
be moderating . . .
Percent

1976

1977

1978

1979

1980

1981

. . . while increases in average hourly
compensation show no sign of slowing.
Percent
Compen!sation per man-hour in the p ivate non farm
business sector
“ (Percent age chang e from two quarters previous
at an an nual rate)

k yf v . /
\

LI I I S ^ T r l I I I i i i
1976

1977

1978

1979

V
mi
1980

Source: United States Department of Labor,
Bureau of Labor Statistics.




fr~

I1981I I I

Economic activity leveled off during the summer
months, follow ing the mild downturn in the spring. In­
dustrial production in August was essentially un­
changed from what it had been last spring and, indeed,
was still running slightly below the peak attained in
March 1979. Auto sales, after languishing for most of
the summer, strengthened in August and early Septem­
ber largely in response to the various m erchandising
incentives. At the same time, domestic auto produc­
tion tapered off, with further cutbacks scheduled fo r
later in the year. In the face of the high interest rates,
construction activity continued to drop. Modest gains
elsewhere in the economy, however, counterbalanced
the weakness in construction, and the unemployment
rate has held fairly steady.
The one bright spot in the economic situation has
been the slowdown in inflation thus far in 1981. During
the first eight months of the year, the consumer price
index rose at an annual rate of 9.4 percent, in contrast
to a 12.4 percent increase in 1980. The slowdown in
price increases at the producers’ level was even
greater. The producers’ price index for nonfood finished
goods rose at an annual rate of 9.6 percent over the
first eight months of the year as compared with a
13.4 percent increase in 1980. Looking ahead to the
longer term, the extent to which the price slowdown is
maintained w ill depend critica lly on what happens to
wages and productivity.
The various measures of wages and compensation
have been giving off mixed signals (Chart 1). Many of
the series do tend to be fairly erratic, which makes it
d ifficult to interpret them over short time periods.
Over the six months ended in August, average hourly
earnings in the private nonfarm economy rose at an
annual rate of 7.8 percent, compared with a 10.3 per­
cent rate of increase in the previous six-month period.

FRBNY Quarterly Review/Autumn 1981

23

Chart 2

Union wage increases appear to be
leveling off . . .
Percent
12

- - - - - - (- - - - - - -- --- —r- - - - - - - - - - - Employment cost index
W ages and salaries

Union

11 (Chant;je from a yea r earlier,

i

not s«jasonally adju sted)
10

9
—

8

6

I I

1977

/

Nonur ion

/

7

■x.

/

■
. I II
1978

M

i. . . i .. i
1979

l

..

1980

I M l
1981

. . . with the slowdown concentrated
in manufacturing.
13 ----------

Empio yment cost i ndex

12

(Chancje from a ye£ir earlier,
'n o t sejasonally adju sted)

(union
--------^^TTanufacturing —

11

/

10

/

9
8

-____

7
6

I

1977

I I I
1978

^

Union
nonmanufacturing

I I I

I I I

1979

1980

I I IJ
1981

Source: United States Department of Labor,
Bureau of Labor Statistics.

(The earlier jum p in wages reflected in part the 8.1 per­
cent increase in the minimum wage effective in Janu­
ary.) This m oderation follow s nearly two years of
accelerating wage advances. A sharp rise in hourly
wages occurred in August, but this could be a result
of some bunching of pay raises that was not corrected
by the seasonal adjustment process.
In contrast, no clear-cut sign of m oderation has yet
appeared in average hourly compensation (which in­
cludes wages, salaries, and fringe benefits). Hourly
com pensation in the nonfarm business sector rose at
an annual rate of 10.6 percent over the first half of
1981, compared with a 9.5 percent rate of increase in
the previous two quarters. The first-quarter 1981 com ­
pensation increase was inflated in part by the Janu­

24

FRBNY Quarterly Review/Autumn 1981




ary 1 increase in social security taxes paid by employ­
ers. Nevertheless, since growth of com pensation in the
second quarter of 1981 was at an annual rate of 9.6
percent, there is little sign of any marked slowing.
Union wage increases appear to be leveling off
(Chart 2). In the second quarter of 1981, wages of all
unionized workers covered in the employment cost
index rose at an annual rate of 10.1 percent from
twelve months previous, down slightly from the in­
crease in 1980. This flattening-out of union wage in­
creases follow s a two-year acceleration that reached
a plateau toward the end of 1980. Industry detail shows
that the m oderation is concentrated in the manufac­
turing sector. Wages of unionized w orkers there rose
in the second quarter of 1981 at an annual rate of 9.6
percent from year-earlier levels, the smallest increase
since the fourth quarter of 1979.
Data on effective wage adjustments in m ajor collec­
tive bargaining agreements also point to some slowing
of union wage advances. For the union sector as a
whole, total effective wage adjustments (which re­
flect first-year increases negotiated in the quarter, as
well as increases under earlier contracts and cost-ofliving increases under current and prior contracts)
were at an annual rate of 11.7 percent in the second
quarter, down from the 13.9 percent rate of the second
quarter of 1980. Wage and benefit increases in newly
negotiated contracts ran a bit higher during the first
half of 1981 than they had over the same period last
year. However, the larger wage and benefit increases
negotiated so far this year partly reflected the fact
that com paratively few of these agreements contained
cost-of-living adjustments (COLAs ).1 Wage increases
have tended to be higher for settlements w ithout
COLAs. In any case, 1981 is a light bargaining year,
so that these larger settlem ents w ill have only a mod­
est im pact on the overall trend in union wages.
Recent collective bargaining activity has been influ­
enced by severe econom ic difficulties in a number of
industries. Since the end of 1979, an unusual surge of
plant closings and wage concessions under existing
contracts have affected a total of nearly 300,000 w ork­
ers (over a third of whom were auto workers). Revi­
sions of collective bargaining agreements before ex­
piration because of adverse business conditions had
been relatively rare. The wage concessions that have
occurred since 1979 have taken many form s and have
affected both union and nonunion workers. For exam­
ple, under the m uch-publicized Chrysler agreement,
the current COLA and future COLAs, as well as a

1 Only 21 percent of the workers under these settlements were covered
by COLAs, whereas 57 percent of all workers under major collective
bargaining agreements are covered by COLAs.

scheduled wage increase, were to be foregone for the
duration of the contract. The Firestone Company,
which had announced the closing of seven plants, ob­
tained a 14 percent wage cut for certain workers as
well as COLA concessions by both union and nonunion
employees.
By and large, the impact of these concessions on
total effective adjustments has been small. Neverthe­
less, the proliferation of such concessions may influ­
ence the tone of future negotiations. Similarly, it is not
possible to measure the extent to which the climate
for collective bargaining has changed in the aftermath
of the recent air-traffic controllers’ strike. But this, too,
has the potential for affecting future settlements.
The Federal Government is bringing strong pressure
for wage moderation for its own employees. President
Reagan recommended that Federal white-collar work­
ers receive a 4.8 percent pay increase in October.2
If the Congress concurs, this would be the smallest
2 The President’s recommended increase for white-collar workers
earning less than $50,112 a year is less than one third of the
15.1 percent increase that would be called for under the provisions
of the Pay Comparability Act of 1970. The President's recommenda­
tion automatically takes effect in October unless overridden by the
Congress. President Reagan also recommended that Federal
executives, whose pay has been frozen since 1979, receive a
4.8 percent annual increase. Included in this group are middle- and
senior-level executives. However, on September 30, the Congress
rejected any immediate increase in pay for these positions. Military
personnel, in contrast, will receive the full 15.1 percent increase.




average increase for Federal white-collar workers
since their 1973 raise. The Congress had already
passed a statute limiting the wage increases for
Federal blue-collar workers for fiscal 1982 to 4.8 per-,
cent as well. Reducing wage increases for Federal
workers may also induce a slowing in the private
sector by moderating the wage increases necessary
to attract workers to comparable private-sector jobs.
Additional downward pressure on wages, it has been
suggested, could come from the recently enacted per­
sonal income tax cuts, the first of which took effect on
October 1. Because the tax cuts increase take-home
pay, workers may feel under less pressure to push
for wage increases just to maintain their purchasing
power. Moreover, the tax cuts strengthen work in­
centives. Some people will be encouraged to enter the
labor force, whereas their take-home earnings under
the previous tax system would not have been large
enough to make it worth their while to work. Others
who do have jobs will find it advantageous to work
longer hours or even to take a second job. The result­
ing increase in workers and work effort will also lessen
overall pressure for wage increases. At the same time,
however, much of the tax cuts will be used by house­
holds to buy additional goods and services. Within a
short period of time, the initial wage moderation asso­
ciated with the tax cut could be offset in part by the
influence of these demand pressures. Thus, it is un­
clear what the net effect of the tax cut on wages would
eventually be.

FRBNY Quarterly Review/Autumn 1981

25

NEW YORK EXPERIENCES RENEWED STRENGTH
IN PERSONAL INCOME
Until recently, growth of total personal incom e of New York State residents
had been lagging the nation and the mideast re g io n *
In 1980, however, it
advanced at about the same pace.
Total Personal Income
Average annual growth
1969-79

1979-80

New York State

Mideast region

United States

6

10

J______L

12

4

Percent

6
Percent

8

10

In fact, adjusting for population change, personal incom e per capita in New York State
increased more rapidly in this latest period.
Per Capita Personal Income
Average annual growth
1969-79

1979-80

New York State

Mideast region

United States

*The mideast region includes Delaware, District of Columbia, Maryland, New Jersey, New York, and Pennsylvania.

26

FRBNY Quarterly Review/Autumn 1981




12

This difference is even more pronounced in real terms because of the relatively
modest rate of inflation in New York State.+
Real Per Capita Personal Income
Average annual growth
1969-79

1979-80

New York S tate

United States

Percent

In fact, by the end of the seventies, real per capita growth in the New York City
metropolitan area exceeded that in other localities of the south and west as well as
those which, like New York, had problems in the early to midseventies.
Real Per Capita Personal Income in Selected Metropolitan Areas
Average annual growth
1969-78

1978-79+
New York
Atlanta
Boston
Chicago
Houston
Los Angeles

-2

0

Percent

1
Percent

t In the absence of a consumer price index for New York State, an average of the indexes for the
New York-Northeastern New Jersey and Buffalo metropolitan areas was used.
+ Local area data are available only through 1979.
Source: United States Department of Commerce, Bureau of Economic Analysis,
Regional Economic Information System.




Prepared by Rona B. Stein and Mark A. Willis

FRBNY Quarterly Review/Autumn 1981

27

The
financial
markets
Current
developments
Most short-term rates began to decline
during September . . .
Percent
Federal
funds

Three-month
certificates of deposit
iThirty-day dealer
commercial paper

Discount rate

. . . but long-term rates reached
record levels.
Percent
1 8 ----------

Ten-year
securities

Twenty-year
government securities

Sources: Federal Reserve Bank of New York and Board
of Governors of the Federal Reserve System.

28

FRBNY Quarterly Review/Autumn 1981




Short-term interest rates began to decline during the
summer. The overnight Federal funds rate fell from
an average level of 19 percent in July to I 6 V2 percent
in the second week of September. Most other short­
term rates, however, fell by only 100 basis points or so
during this interval. The ensuing reductions of com ­
mercial banks’ prime lending rates, which began in
mid-September, brought the prevailing prime rate down
to 191/2 percent by September 21. On the same day,
the Federal Reserve reduced the surcharge imposed
on loans to those large banks who are frequent bor­
rowers from 4 percent to 3 percent. In the long-term
markets, in contrast, yields continued to rise during
August and September, and record-high yields were
established in many sectors. Although bond yields be­
gan to fall in mid-September, the markets remained
fairly unsettled. Investors were concerned with the
sizable Treasury borrowing schedule for the next few
months, as well as the deficits contained in the fiscal
program planned fo r the next three years (chart).
Certain aspects of the fiscal program have had a par­
ticu la rly adverse im pact on the markets fo r tax-exem pt
securities. Forthcoming reductions of the highest mar­
ginal tax rates on personal income, and the introduc­
tion of the tax-exem pt all savers’ certificates, may have
reduced the household sector’s w illingness to hold
these securities at yields consistent with historical
relationships between the returns on taxable and taxexempt issues. The effects on state and local govern­
ment budgets of scheduled reductions of Federal
spending also may be a factor behind these m arkets’
recent performance, as investors assess more care­
fully the fiscal strength of government borrowers.
Quite apart from the effects of fiscal policy changes,
market participants report that two im portant groups

of traditional investors in tax-exempt securities— com­
mercial banks and property and casualty insurers—
have been backing out of the market in recent months.
Both groups of institutions face reduced needs for
tax-exempt income. And, like other investors, these
institutions have been concentrating their purchases
of tax-exempt securities in the shorter maturities. As
a result of all these factors, yields on municipal securi­
ties— especially long-term issues— were bid up rapidly
throughout the summer.
Mergers and acquisitions
In July, reports of developments in the financial sector
were dominated by accounts of the financing arrange­
ments for corporate mergers and acquisitions. Much
of the attention focused on firms in the energy and
chemical industries. In one six-week period, bank credit
lines totaling more than $40 billion were arranged to
support (or defend against) prospective business com­
binations involving firms in these industries.
By themselves, these credit lines will not have a
substantial impact on United States bank credit
growth. American banks and their overseas branches
are responsible for only $20-25 billion of these lend­
ing commitments, with foreign banks holding the re­
mainder. But this estimate of the total lending com­
mitment of United States banks overstates the volume
of lending that is likely to be undertaken. In several
cases, a single prospective acquisition attracted the
interest of several possible buyers, each of which
arranged a credit line. With this double counting re­
moved, the maximum volume of lending by American
banks as a result of these commitments is on the
order of $10 billion.1 In comparison, the sum of loans
and investments at United States commercial banks
in July was nearly $1,300 billion. Of this total, business
loans amounted to almost $350 billion.
Although public attention has been focused on a
few large transactions, the overall pace of merger
activity seems to have picked up in 1981. In the first
six months of the year, both the number and dollar
volume of mergers and acquisitions exceeded their
totals for the comparable period in 1980. Several
factors are at work here. The most pervasive may be
an apparent relaxation of Federal antitrust policy.
While the new Administration has continued to pursue
cases against firms that exercise monopoly powers in
fields that clearly would benefit from increased com­
petition, it has tended not to impede business com­
1 There is a further complication. The effect of these loans on bank
credit statistics depends on how the transactions are recorded.
Loans booked at domestic offices of United States banks are
included in the bank credit aggregate, but loans booked at overseas
branches are not.




binations— even those involving large firms— that
would not create monopoly power.
In the new regulatory environment, large firms in
several key industries have engaged in merger activ­
ity. In the financial services industry, this year’s most
notable mergers have been combinations of nonbank
institutions designed to prepare for competition with
commercial banks in retail or wholesale markets. And,
in the energy field, the belief on the part of some
firms that increases in the real prices of oil, coal, and
natural gas will continue has spurred their interest in
acquiring firms that own such resources. (It is clear,
however, that the price expectations of the buying
firms are higher than those of the market as a whole.
Indeed, the market prices of energy stocks may re­
flect expectations of declining real energy prices.)
The relatively low levels of stock prices, adjusted
for inflation, may be another factor behind the in­
crease in merger activity. Once a firm decides to
expand its operations, stock market conditions are an
important consideration in its choice between acquir­
ing other firms and investing in physical assets. For
some time now, the relationship between the market
value of a firm’s equity and debt and the replacement
cost of its physical capital at current production costs
(that is, the replacement cost of capital) has been
recognized as an important determinant of business
investment spending. When market value is below
replacement cost, it makes sense for firms to expand
through mergers and acquisitions rather than by in­
vestment in physical assets. On the other hand, when
market value exceeds replacement costs, it makes
sense for firms to expand through the direct purchase
of physical assets.
Somewhat surprisingly, previous periods of extraor­
dinary merger activity have not been marked by weak
stock market performances. There have been three
such intervals in the last century— in the 1890s, dur­
ing the last half of the 1920s, and again in the 1960s.
Stock prices rose steadily during each of these
periods, as did the pace of overall economic activity.
But this historical evidence should not be interpreted
as proof of the irrelevance of comparisons between
market values and replacement costs. Trends in ag­
gregate measures of stock prices can mask underly­
ing movements in the relative market value of different
firms or industries. Some of the historical evidence
suggests that the relationship between market value
and replacement cost has had an important effect in
determining the means of expansion within particular
industries.2
2 See Burton G. Malkiel, George M. von Furstenberg, and Harry S.
Watson, “ Expectations, Tobin’s q and Industry Investment” , Journal
o f Finance (May 1979).

FRBNY Quarterly Review/Autumn 1981

29

Implications for the banking system
This summer’s merger activity in the chemical and en­
ergy industries reflected a greater than usual reliance
on borrowed funds. Investment bankers and others
involved in these transactions assert that this is due
to the fact that shareholders have a strong preference
for being paid immediately and in cash (as opposed
to the exchange of shares or payment in debt securi­
ties). These assertions cannot easily be verified. If
true, however, they would explain the need for acquir­
ing firms to assemble large sums of cash quickly.
A continuation of large-scale bank lending in con­
nection with merger activity would raise important
questions for monetary policy. One such question is
whether loans extended under these commitments
would contribute to the growth of the money and
credit aggregates. If they did, there would arise the
question of how monetary policy should respond to
the growth of those aggregates or to the changing
patterns of credit flows that also might result. At first
glance, it would appear that the appropriate policy
response depends primarily on the effects of these
activities on the financial system, particularly in the
commercial banking sector. It is not possible to state
a general conclusion, however, because there is a
considerable range of feasible outcomes.
It is likely, though not inevitable, that there would
be at least temporary increases in the broad monetary
aggregates— M-3, L, and perhaps M-2. Since the bor­
rowing firms manage their liquid assets very carefully,
it is unlikely that they would hold the funds drawn
from credit lines in demand accounts (and thus in­
crease the level of M-1B).3 But their temporary invest­
ments in repurchase agreements (RPs), certificates of
deposit (CDs), or Eurodollars would increase the lev­
els of the broader aggregates.
Once the shares of an acquired firm have been pur­
chased, the former owners of the firm would have to
allocate their receipts between reinvestment in equi­
ties, buying other financial or physical assets, and
consumption spending. Since acquiring firms would
have paid more than the market value of outstanding
shares, the merger transaction would increase the
wealth of the former shareholders. Their profits from
the transaction would allow them to increase their
consumption spending, bid up asset prices, or both.4

3 Transitory increases in M-1B might occur, however, as buying
firms move funds into demand deposits when checks to the former
shareholders of the acquired firm are presented for payment.
* To the extent that shares were held by pension funds or other
institutions, so that individuals did not perceive an increase in
spendable wealth, aggregate consumption spending probably would
not be affected very much, if at all.

30

FRBNY Quarterly Review/Autumn 1981




Initially, bank credit demand would be increased
as a result of the merger financing. But subse­
quent decisions of corporate officials reacting to
financial developments would determine whether the
increase in the demand for bank credit would be
temporary or permanent. Most of the large syndicated
credits have been structured as revolving lines of
credit for the first three or four years of the agreement
and will be converted to term loans for the last four
to six years. Under these arrangements, corporate
borrowers can repay any borrowed funds (and ter­
minate the lending agreements) without penalty at any
point during the first three or four years. These credit
lines relieve corporate borrowers of any immediate
concern about the availability of funds for merger
activity. But the relative prices of alternative sources
of borrowed funds will determine the extent of con­
tinued reliance on bank credit. If corporate financial
officials perceive the long-run costs of bond issuance
or other forms of borrowing to be less than the cost
of bank borrowing, they will pay down their bank loans
with the proceeds of these borrowings.
In describing the range of possible effects of largescale merger lending on the monetary and credit
aggregates, it is easiest to examine two extreme cases.
At the outset of any massive merger-financing episode,
it is much more likely that banks would finance loans
by buying liabilities (such as CDs, Eurodollars, or
Federal funds) than by selling assets (loans or securi­
ties). If, at prevailing rates, former shareholders of
the acquired firm chose to invest their stock-sale
proceeds in such bank liabilities, the recycling of
funds would be complete and the expansion in the
broader aggregates and bank credit would not quickly
be reversed.
But the rise in demands for money and credit
caused by bank-financed merger loans could evaporate
even before the original merger loans were paid off.
If the former owners of the acquired firm preferred to
hold claims other than bank liabilities— Treasury se­
curities, for example— CD rates would have to rise
in relation to those on Treasury issues, as the banking
system tried to issue more certificates to a public
which had no greater desire to hold them. Under
these circumstances, with the relative returns on
Treasury securities falling, the banks might choose to
reduce their reliance on CDs, instead selling Treasury
securities to continue the funding of their expanded
loan portfolios. The merger financing would have had
only transitory effects on the demands for the broader
aggregates and bank credit. But the bank credit aggre­
gate would include a higher proportion of loans and a
correspondingly smaller proportion of securities.
It is likely, then, that bank lending for merger activi­

ties would cause at least a transitory rise in the de­
mands for the broader aggregates and bank credit. If
acquiring firms found no preferable funding sources,
and if banks did not sell off securities, the increase in
bank credit demands would persist.5 It is also possible
that the rise in the demands for the broader aggre­
gates would be lasting.
Policy implications
It is important to realize that potential increases in the
demands for money and credit that have been dis­
cussed here are merely reflections of portfolio rear­
rangements. A variety of factors— the relationship of
market value to replacement cost, antitrust policy, and
others— may continue to encourage corporate merger
activity. In executing these transactions, corporate
officials again might decide to increase, at least tem­
porarily, their reliance on bank borrowing. In the first
instance, this increase in borrowing would not increase
the aggregate demand for goods and services and
would not add to inflationary pressures.
Any stimulus to economic activity that occurred sub­
sequently, however, would be the result of investors’
spending the proceeds of their stock sales4 and would
be virtually indistinguishable from other forces affect­
ing spending in the economy. In turn, increased levels
of spending would tend to raise the demand for M-1B.
But, with an unchanged target for this aggregate, in­
terest rate pressures would tend to counter the stimu­
lus to spending. Hence, it would be consistent with
unchanged policy goals for the Federal Reserve to
pursue unchanged targets for the narrower aggregate.
An adjustment of this target would be in order, how­
ever, if spending pressures from whatever sources
led to inflation that ran persistently above goals.
The broader aggregates (M-2, M-3, and L) might be
somewhat higher than they would have been without
the flurry of merger lending. Banks would be able to
support larger loan portfolios with the liabilities in­
cluded in these aggregates, without having to bid up
the rates on these claims as much as they would
otherwise. As a result, the rates at which credit could
be made available for other purposes would be little
affected.
In the period immediately following the merger
transactions, two distinct factors might impose up­
ward pressure on interest rates. To the extent that
expansionary pressures increased in the economy as
a whole, any associated increase in borrowing de­

5 Again, however, the net impact of accounting decisions by banks with
foreign branches could distort the statistical results. See footnote 1.
6 Such spending might be encouraged by the increased liquidity of
the former shareholders’ portfolios. See footnote 4.




mands would tend to raise rates. Moreover, the cost
of bank loans might be particularly affected in the
short run, since the funding of larger portfolios might
strain banks’ ability to raise funds at prevailing rates.
The rise in interest rates would tend to counter the
general increase in spending; it would not reduce the
volume of funds available for lending to individuals
or small businesses.
If the Federal Reserve were not willing to accept
more rapid growth of bank credit and the broader
aggregates, some other credit demands might be
crowded out by merger financing, in the sense that
the entire economy would be subjected to higher
interest rates and some prospective borrowers would
be forced to delay or cancel their plans. This restraint
would exist even in the absence of a stimulus to
spending from the wealth effects discussed above.
In this case, concerns about the effects of merger
lending on the borrowing opportunities of households
and small businesses would have substance. These
problems would arise, however, not from the merger
financing itself, but from an unwillingness to tolerate
deviations from the growth targets for the money and
credit aggregates.
A summary
The current rise in corporate merger activity reflects
a desire on the part of the managers and shareholders
of corporations to reallocate the ownership of cor­
porate assets. Although it has attracted much atten­
tion, the recent spate of lending activity involving the
chemical and energy industries seems small in rela­
tion to the size of total loan holdings of the banking
system. These financings, however, raised the question
of how monetary policy should respond to a continu­
ation of large-scale merger lending.
The financial transactions associated with a con­
tinuation of such lending should cause only small and
transitory increases in the demands for M-1B. Their
impact on the demands for the broader monetary
aggregates and bank credit, however, could be more
significant. To the extent that the pickup in the growth
of the broader monetary aggregates and bank credit
reflected the portfolio adjustments arising from the
merger financing rather than intentions to spend, it
would not represent additional inflationary pressures.
Accordingly, largely accepting the resulting run-up in
the broader aggregates would not seem inappropriate.
Merger activity raises public policy questions con­
cerning the organization of American business. For the
financial markets, however, the issue of immediate
concern is not whether such activity is healthy or
unhealthy, but what monetary policy would be appro­
priate to the pursuit of unchanged economic goals.
FRBNY Quarterly Review/Autumn 1981

31

Evolution and Growth
of the United States
Foreign Exchange Market
The foreign exchange market in the United States has
undergone substantial changes over the past several
years. The number of institutions and individuals oper­
ating in the market whether for commercial or financial
reasons has increased sharply. Trading volumes have
expanded dramatically, with turnover amounting to $23
billion a day as measured by the Federal Reserve
Bank of New York’s March 1980 market survey, nearly
a fivefold increase from the $5 billion recorded in
April 1977. New York, by far the largest of United
States trading centers, has been transformed from a
regional market to a major link between Europe and
the Far East that now rivals London as the leading
center for global foreign exchange dealings.
This shift in the importance of the United States
foreign exchange market is closely associated with
the growing internationalization of the United States
economy. The share of United States exports and
imports in gross national product (GNP) has risen,
foreign banks have established a presence in the
United States just as this country’s banks have moved
overseas, and the ebb and flow of capital is much
freer and more rapid among major financial centers
here and abroad.
A second key factor precipitating broader and more
active involvement in the United States foreign ex­
change market has been the dramatic sharpening of
exchange rate fluctuations. While the causes of ex­
change rate volatility are complex and controversial,
most observers can agree that far-reaching distur­
bances to the world economy are involved. The in­
crease in the world price of oil, the accumulation and

32

FRBNY Quarterly Review/Autumn 1981




recycling of Organization of Petroleum Exporting
Countries (OPEC) surpluses, wide swings in inflation
and output, and shifts in monetary and fiscal policies
among industrial countries have all contributed to the
gyration in exchange rates. But, regardless of the ul­
timate cause, it is clear that exchange rate volatility
has created the potential for large exchange gains
and losses, inducing changes in financial behavior.
Top bank management has focused more closely on
the importance of currency exposures, a growing
number of banks have positioned their trading oper­
ations as profit centers, and income from foreign ex­
change trading has become an important source of
commercial bank earnings. For business firms, the
management of money and foreign exchange has be­
come an integral part of financial operations and
planning. Efforts to reduce currency risk to assets and
future cash flows and, to a lesser extent, to minimize
the impact of currency fluctuations on reported in­
comes have led to more sophisticated corporate risk
management techniques, often involving a more active
presence in the exchange market. Other institutions
and individuals have also become increasingly sophis­
ticated about the role of foreign exchange in financial
management, as evidenced by the growth of
multicurrency-denominated portfolios and the develop­
ment of a large market for trading foreign exchange
futures.
A third development important to the growth of the
United States foreign exchange market involves
changes in trading practices and conventions. Direct
dealing between United States banks, international bro­

kering, and quoting rates in European terms are recent
innovations which have improved the functioning of
this country’s market and helped integrate it with the
broader global foreign exchange market. This article,
based on discussions with market practitioners in New
York and drawing on data from the March 1980 survey
of the United States market by the New York Federal
Reserve Bank, reviews in greater detail the develop­
ments that have contributed to the evolution and
growth of the United States foreign exchange market.
The first section examines changes in commercial
bank behavior, the second looks at the activities of
nonbank participants, and the third and final section
describes innovations in foreign exchange dealing
relationships.
Changes in commercial bank behavior
Interbank trading has soared in recent years beyond
what is strictly attributable to hedging the increased
volume of customer business. Under the assumption
that banks normally require between four and six
transactions to cover each customer order, fully one
half of the $385 billion increase in foreign exchange
turnover between 1977 and 1980 is accounted for by
“ pure” interbank positioning. The growth of inter­
bank business is most evident in the spot market
where, according to the March 1980 survey, inter­
bank trades exceeded customer deals by a factor of
twenty, compared with a multiple of ten in the April
1977 sample. This pickup in active professional trad­
ing has occurred principally in response to three de­
velopments in the foreign exchange market during
the 1970s.
• United States banks have responded to a shift
in the locus of foreign exchange demand to the
United States market both by expanding their
foreign exchange trading operations and by
changing the nature of this activity from part of
customer services to an important profit center,
thereby bringing banks into the market more than
previously as principals trading for their own
accounts.
• The entry of a large number of foreign banks to
New York has sharpened competitive conditions,
reinforcing the change already under way toward
more active position-taking.
• Exchange rates have displayed larger and more
unpredictable fluctuations than before, and this
heightened uncertainty has contributed to rapid
intraday trading at the expense of longer term
positioning.




Profit-center foreign exchange trading
An active foreign exchange market has been slower
to develop in the United States than other major in­
dustrial countries. Traditionally, the role of the foreign
sector in the United States economy has been com­
paratively small, United States trade has been dollar
denominated, and United States multinationals trans­
acted most of their foreign exchange business abroad.
Lacking a sufficient base for establishing full and ac­
tive foreign exchange trading departments and con­
cerned about the liquidity of the market, most United
States banks restricted noncommercial volumes to
matching off customer transactions in the interbank
market by amount and by value date. Over the past
several years, however, a growing number of United
States banks have become willing to position heavily
in foreign exchange on the basis of expected changes
in exchange rates and in interest rate differentials,
although such positions are increasingly held for only
limited time intervals. Banks have found it desirable
to take on exposures and to maintain an active pres­
ence in the market in order to offer a more competi­
tive service to a growing customer base and to take
advantage of the profit opportunities perceived in
fluctuating exchange rates.
The major impetus behind this change in approach
is the growing international orientation of United
States economic relationships. This country’s trade
and inward and outward direct investment have ex­
panded sharply. International financial management
is also evolving rapidly. Corporations and individuals,
seeking protection from a volatile inflationary environ­
ment and responding to the incentives in fluctuating
exchange rates, now include the world’s major cur­
rencies in their portfolio decisions. Banks themselves
are taking a global view of their assets and liabili­
ties. Indeed, the location of economic activity no
longer indicates where associated financial transac­
tions will be executed or in what currency they will
be denominated.
Furthermore, the tendency for United States cor­
porations to centralize money and foreign exchange
management at headquarters and the development of
currency futures in Chicago have led more participants
to turn specifically to the United States market for
their foreign exchange requirements, as did also
European restrictions on bank exchange transactions
imposed following the 1974 failure of Bankhaus Herstatt. The United States authorities, by contrast, re­
sisted the imposition of official controls in response
to the Herstatt crisis and the difficulties experienced
by Franklin National Bank.
This resistance to official controls was itself a strong
inducement for many participants to transact foreign

FRBNY Quarterly Review/Autumn 1981

33

Overview of the United States Foreign Exchange Market*
The United States foreign exchange m arket con­
sists of a network of com m ercial banks— located
principally in New York and, to a lesser extent, in
other major cities— which buy and sell bank de­
posits (“ exchange” ) in another currency, and of
several organized exchanges, which trade foreign
exchange futures contracts. Except for the cur­
rency futures market, there is no central m arket­
place where participants meet to trade. Instead
trading is over the counter, with dealers com­
m unicating directly by telephone and telex or in­
d irectly through foreign exchange brokers who
serve as agents, bringing together buyers and
sellers fo r a fee.
While most banking institutions are prepared to
offer their customers a service in foreign ex­
change, there are only about 80-100 banks that
actively trade foreign exchange for their own ac­
count. Of these, relatively few act as market mak­
ers by standing ready to quote fresh prices and
execute business up to recognized amounts. At
the same time, foreign exchange brokers in the
United States number less than a dozen. Thus,
the heart of the market is comparatively small.
The overwhelming bulk of all transactions oc­
curs in the interbank market, where banks seek
to hedge or manage their exchange risk and to
anticipate exchange and interest rate movements.
Their operations give the market liquidity and
make possible the smooth transaction of cus­
tom er business. The custom er or retail market,
which accounts directly for as little as 10 percent
but indirectly for perhaps as much as 50-60 per­
cent of all exchange deals, consists of m ulti­
national corporations, nondealing banks, other
nonbank financial institutions, and individuals.
Roughly two thirds of all foreign exchange
transactions are conducted spot, that is, at cur­
rent exchange rates for value two business days
after the dealing date. Another 30 percent of all
* For a full review of the market, see Roger M. Kubarych,
Foreign Exchange Markets in the United States (Federal
Reserve Bank of New York, 1978).

34

FRBNY Quarterly Review/Autumn 1981




transactions are swaps involving the sim ulta­
neous purchase and sale of a specified amount
of foreign currency for two different m aturities.
Swaps are most comm only used to fund ex­
change positions, to take a view on interest rate
differentials between two currencies, and in bor­
rowing and lending operations. Only 6 percent of
total exchange transactions are outright forw ards
involving a single purchase or sale of foreign
currency fo r a value date more than two days
in the future.
Foreign exchange trading in the United States
is highly com petitive. No one bank or single
group of banks commands a dom inant share of
turnover in such m ajor currencies as the German
mark, Japanese yen, Canadian dollar, or pound
sterling. However, in other currencies such as the
Belgian franc and Italian lira where the strength
of comm ercial, financial, and speculative demand
does not support an active market, trading is rela­
tively more concentrated among a few banks.
In the United States, foreign exchange trading

Table 1

Turnover Statistics
In billions of dollars
April 1977
44 banks

March 1980
41 banks

March 1980
90 banks

106.3

325.8

491.3

Interbank .................
of which: brokers . . .
Customer .................

58.7
54.0
23.1
4.7

216.0
206.1
104.3
10.1

315.4
300.4
162.5
15.1

Outright forwards . .

5.6

22.4

29.4

Spot ..........................

of which: Inter­
national Monetary
Swaps

......................

.

4.5

6.3

42.1

87.2

146.5

* Not available.
Federal Reserve Bank of New York: Foreign Exchange Turn­
over Surveys (April 1977 and March 1980).

Overview of the United States Foreign Exchange Market* (continued)
is not regulated, though bank examiners review
exchange transactions as a normal part of rou­
tine bank supervision. Commercial banks operate
under self-im posed internal controls that cover
most aspects of their involvement in the market.
Issues related to foreign exchange trading, oper­
ations, and technical practices are discussed on
the institutional level in the forum of the Foreign
Exchange Committee, established in 1978 under

the sponsorship of the New York Federal Re­
serve Bank. The Foreign Exchange Committee
consists of representatives from east coast, re­
gional and foreign banks, brokerage firms, and
as observers members of the FOREX Association
of North Am erica. The FOREX brings together as
individuals a large number of traders and brok­
ers from 220 banking and 19 brokerage offices
around the country.

Table 2

Turnover and Market Share of Active Trading Banks by Currency
March 1980
Turnover
(billions of
United States dollars)

Share of 4
most active banks
(percent)

Share of 8
most active banks
(percent)

Share of 20
most active banks
(percent)

German m a rk ...................................

155.8

28.0

45.6

73.9

Pound sterling .................................

111.5

24.3

43.9

74.9

Canadian d o lla r ...............................

60.0

30.3

50.8

82.8

Swiss franc .....................................

' 49.7

38.0

62.5

89.0

Japanese y e n ...................................

50.0

32.4

51.8

82.2

French franc ...................................

33.6

51.8

73.8

95.0

Netherlands guilder .......................

9.3

48.4

72.9

97.4

Belgian f r a n c ...................................

5.1

50.0

77.4

98.6

Italian l i r a ..........................................

4.2

69.2

85.5

97.7

O th e r..................................................

10.7

60.4

78.4

96.0

Total ..................................................

490.1

24.9

39.0

67.3

Currency

Data based on the Federal Reserve Bank of New York’s Foreign Exchange Turnover Survey (March 1980).




FRBNY Quarterly Review/Autumn 1981

35

exchange business in the United States, fo r it under­
scored a strong philosophical commitment to free and
open financial markets. Rather than regulate foreign
exchange trading banks, supervisory authorities de­
fined general guidelines for prudent business prac­
tice in foreign exchange and placed responsibility for
com pliance on individual banks.1 Accordingly, top
bank executives established e xplicit policies to con­
trol exchange risk, mismatch risk, credit risk, and
other risks inherent in foreign exchange operations.
These internal controls put United States banks in a
far better position to manage their foreign currency
exposures, provided the basis for holding exchange
trading departments e xplicitly accountable for their
contribution toward earnings, and gave management
the confidence to expand the volume of trading activity.
Foreign bank com petition
Increasingly, the w orld ’s major banks have moved to
establish branches or affiliates in New York and other
financially prom inent American cities. In 1979 there
were 234 foreign-owned banking offices from 48
countries in New York, compared with 139 in 1976.
Foreign banks have found numerous attractions in the
United States in addition to servicing the business in­
terests of their customers: direct access, to the United
States loan m arket and a huge dollar funding pool; cost
and inform ational advantages in operating locally
rather than through correspondents; locational bene­
fits in servicing Latin American and Canadian clients,
among others. While foreign exchange has not been
a m ajor motivation for establishing offices in the
United States, most foreign banks have consciously
used their trading departments to help cover business
costs and as a marketing tool in developing relations
with United States multinational corporations. Table 3
illustrates that foreign banks enjoy a sizable share
of market turnover in their home currencies, ranging
from 14 percent of trading in the Canadian dollar
through 27 percent in the Japanese yen and up to
46 percent of trading in the French franc.
Foreign banks have had certain natural advantages in
handling foreign exchange business. Foreign exchange
trading reached an earlier and fuller development in
Europe, owing to the relatively large role of foreign
trade in European economies. The use of foreign ex­
change to carry out open m arket operations by central
banks in countries lacking broad and deep domestic
1 See "Uniform Guidelines on Internal Controls for Foreign Exchange
Activities in Commercial Banks", reprinted in The Foreign Exchange
Committee Annual Report 1980, for an outline of minimum internal
controls for foreign exchange activities in commercial banks rec­
ommended by Federal bank regulatory agencies and released by the
Federal Financial Institutions Examinations Council.

36

FRBNY Quarterly Review/Autumn 1981




Table 3

Foreign Currency Trading by Foreign
Banks in the United States
In percent
Country
of origin
Germany .....................
United Kingdom .........
Canada .......................
Japan ...........................
Switzerland .................
France .........................

Number
of banks

Market share of
domestic currency

8
4
5
8
3
6

24.2
16.5
14.4
27.1
20.1
46.0

Data from Federal Reserve Bank of New York, Foreign
Exchange Turnover Survey (March 1980).

money markets also spurred foreign exchange trading.
Over time, Continental banks evolved a com paratively
aggressive style of trading, based on the continuous
purchase and sale of currencies to earn a m iddlem an’s
spread and to capitalize on very short-term fluctua­
tions in rates. This type of transactions dealing—
which developed during the Bretton Woods regime of
exchange rates as a complement to longer term posi­
tioning— encouraged traders to sharpen th eir skills
in assessing the impact of new inform ation, in evalu­
ating how other traders would react, and in giving
customers the best quotes. Foreign banks have thus
added to the competitiveness of the United States for­
eign exchange market. This challenge occurred in a
period when Am erican banks were finding that, with
greater corporate sophistication about the workings of
foreign exchange, they could no longer enjoy com­
fortable spreads on their custom er business but had
instead to pursue additional earnings by correctly
positioning themselves in the market.
Exchange rate volatility
With the unusual variation in exchange rates since
1973, market practitioners report and a number of
formal studies indicate that predicting exchange rate
changes has become extrem ely difficult. Forecasts of
future spot rates based on forward rates are quite
imprecise, leaving investors vulnerable to substantial
losses. Sim ilarly, analytic models, w hile providing ba­
sic insights into the determ inants of exchange rate
changes, are typically poor predictors of actual ex­
change rate movements. Moreover, comparisons of
exchange rate forecasts with actual exchange rate
movements show that the prediction error character­
istically becomes larger with a lengthening in the

moderating the growth of money and credit in the
United States economy. Indeed, all currencies except
the Swiss franc show a significant increase in daily,
weekly, and monthly variability after O ctober 1979,
compared either w ith the entire preceding period of
generalized floating or with the period imm ediately
follow ing the November 1, 1978 dollar defense pack­
age when the United States authorities undertook to
intervene more forcefully to m aintain orderly markets
for the dollar.2
This higher risk environment has prompted market
professionals to shrink back even further from opera­
tions based on longer run exchange rate expectations.

forecast horizon. Not surprisingly, banks establishing
profit goals w ithin what for them constitute accept­
able levels of risk have generally found it prudent to
pursue profits over rather short time horizons.
To isolate the risk characteristics of exchange rate
fluctuations, Table 4 presents the average standard
deviation of daily, weekly, and monthly percentage
changes in the dollar spot rate vis-a-vis several major
currencies. The standard deviation is taken as a good
measure of risk on the grounds that unpredictability
is associated with, if not im plied by, variability. The
numbers clearly indicate that higher levels of risk are
associated with longer term exchange rate changes.
They also confirm that position-taking in the interbank
exchange m arket has become even riskier in recent
years particularly follow ing the October 1979 change
in monetary policy by the Federal Reserve, w hich
placed greater emphasis on the supply of bank re­
serves and less emphasis on the Federal funds rate in

* For an extensive discussion of the link between the Federal Reserve’s
monetary control procedures and spot and forward exchange rate
volatility, see “ The New Federal Reserve Operating Procedure: An
External Perspective", New Monetary Control Procedures (Federal
Reserve Staff study, Vol. II, Board of Governors of the Federal Reserve
System, February 1981).

Table 4

Spot Exchange Rate Variability
Standard deviation of percentage changes*

Currency

March 1973
through
October 1979

November 1978
through
October 1979

October 1979
through
August 1981

Daily changes:
German m a r k .................................................................. ........................................ 0.573
Swiss franc .................................................................... ........................................ 0.738
Japanese yen ................................................................ .........................................0.488
Canadian d o lla r ..................................... ........................ .........................................0.195
Sterling ..................................................................................................................... 0.462

0.427
0.596
0.590
0.211
0.512

0.706
0.790
0.736
0.250
0.647

0.977
1.471
1.316
0.511
1.263

1.556
1.777
1.640
0.578
1.465

2.197
2.886
2.150
1.309
2.830

3.514
3.791
3.789
1.231
3.388

Weekly changes:
German m a r k .................................................................. ........................................ 1.290
Swiss franc ............................................................................................................ 1.630
Japanese yen ................................................................ ........................................ 1.128
Canadian d o lla r .............................................................. ........................................ 0.469
Sterling ..................................................................................................................... 1.069
Monthly changes:
German m a r k .................................................................. .........................................3.046
Swiss franc .................................................................... .........................................3.430
Japanese yen ................................................................ .........................................2.609
Canadian d o lla r .............................................................. .........................................1.158
Sterling ......................................................................................................................2.450

* The standard deviations of weekly and monthly changes represent means of standard deviations of five series of five-day percentage
changes and twenty-one series of twenty-one-day percentage changes. Thus, for example, weekly percentage changes were measured
Monday to Monday, Tuesday to Tuesday, and so on to obtain five nonoverlapping series. Similarly twenty-one nonoverlapping series of
monthly intervals were constructed, approximating percentage changes from the first day of a given month to the first day of the next
month, successively for all subsequent business days.
Source: Data from Board of Governors of the Federal Reserve System.




FRBNY Quarterly Review/Autumn 1981

37

The time between the taking on and the unwinding of
positions has become very short, amounting to min­
utes and hours rather than days and weeks as traders
have sought to catch and profit from intraday turns
in the rate. The reluctance to carry exposures for
even so short a period as overnight is underscored by
data collected by the United States Treasury showing
a decline since 1977-78 in end-of-day positions for
the most active trading banks.
The emphasis on rapid “ in and out” transactions has
also led to an explosive rise in spot turnover at the
expense of swap trading. As documented by the
March 1980 survey, the share of total turnover ac­
counted for by swaps declined to 30 percent from
40 percent in April 1977. With more positioning done
intraday and thereby squared off rapidly, banks have
cut back on the financing requirements that would
otherwise be satisfied through swap transactions. Also,
expanded activity in the spot market has stretched
thin the pool of talent available to conduct technically
sophisticated trading to profit from expected changes
in differentials between dollar and foreign currency
interest rates.
While rapid intraday spot trading minimizes ex­
change risks relative to longer term positioning, this
approach to trading is not without major drawbacks.
Insofar as each transaction entails the obligation to
make payment, the explosive rise in daily settlements
associated with heavy intraday trading has heightened
the possibility of payment errors and of outright losses
due to the failure of counterparties to deliver. This
adds to normal business and credit risks. Soaring
transactions volumes have also entailed such heavy
operating costs that many banks have witnessed a
declining rate of profitability. Furthermore, the very
unwillingness of banks to hold positions for any length
of time (which may be thought of as a reduction of
their inventories) can itself accentuate erratic or one­
way rate movements. Excesses of supply or demand
rather than being cushioned through interbank inven­
tory adjustments are more quickly reflected in rate
movements. Under such circumstances, the growing
number of participants who operate on the basis of
technical models have at times exerted a noticeable
influence on exchange rate changes.
These problems have led major banks to begin
reviewing their operations with a view toward im­
proving returns on a risk- and cost-adjusted basis. One
possibility under consideration is the assumption of
longer term positions to improve profit potential. De­
pending on the attitudes of management and the per­
ceived adequacy of capital, some banks may decide
that the improvement in prospective returns and the
reduction of operating costs are adequate compensa­

38

FRBNY Quarterly Review/Autumn 1981




tion for the higher level of risk associated with some­
what longer term exposures. Another option under
review is to shift greater resources into swap position­
ing in order to profit from anticipated changes in
interest differentials. Banks engaging in swap opera­
tions need not expand their balance sheets since swap
transactions involve forward assets and liabilities held
on a contingent basis. While swap operations entail
potential losses arising from gaps between the timing
of payments and receipts, they do not give rise to open
exchange risk since the same amount of currencies
are simultaneously bought and sold.
Accordingly, foreign exchange trading banks may
find incentives to relax the strategy of positioning very
heavily intraday on the basis of exchange rate expecta­
tions in favor of more swap market operations based
on interest rate considerations. Expanded swap activity
may also arise with the establishment of International
Bank Facilities (IBF) later this year. Through such
facilities, banks operating in the United States will be
able for the first time to take deposits or extend credit
in foreign currencies when transacting business with
foreign residents. This may encourage the use of swaps
as an alternative to the domestic money markets in
generating dollar or foreign currency funding, par­
ticularly by United States banks first entering the Euro­
markets through the IBF or by others shifting some of
their Eurocurrency business to the United States from
markets abroad.
Expanding nonbank participation in the United States
foreign exchange market
With institutions and individuals turning more fre­
quently and in greater numbers to the United States
foreign exchange market, nonbank purchases and sales
of foreign exchange quadrupled from an estimated $10
billion a month in early 1977 to $42 billion in the
March 1980 survey. Customer demands grew much
faster than would otherwise be indicated by the expan­
sion in United States trade at 75 percent and the
pickup in United States firms’ overseas assets and
liabilities at 60 percent over the same three-year
period. Indeed, a large portion of the surge in foreign
exchange activity reflects new and sophisticated adap­
tations to a volatile financial environment, as evidenced
in more active corporate hedging practices, the de­
velopment of multicurrency-denominated portfolios,
and the growth of foreign currency futures trading.
Corporate hedging
In recent years, United States corporations have placed
greater emphasis on the economic effects of exchange
rate fluctuations, have increasingly centralized their
treasury functions, and have deepened their under­

standing of foreign exchange market operations. While
these developments originated in the volatile exchange
rate environment of the early 1970s, they accelerated
rapidly in response to the Financial Accounting Stand­
ards Board Rule No. 8 (FASB-8). By requiring that ex­
change gains and losses be recognized immediately as
part of quarterly income, rather than being smoothed
out or deferred through the use of reserve accounts,
FASB-8 made reported quarterly earnings vulnerable
to the impact of large exchange rate swings.
An early corporate reaction to FASB-8 was to hedge
balance-sheet exposures in order to minimize the
effect of foreign exchange translation on earnings per
share. Over time, however, financial analysts and
shareholders have learned to discount the impact of
accounting-induced gains and losses on corporate
income. And corporate treasurers themselves have
found that decisions taken to hedge balance-sheet
exposures sometimes prove uneconomic, compromis­
ing longer term goals of protecting the value of the
firm. Consequently, companies have tended to move
away from translation exposure as the most relevant
measure of what should be hedged toward a broad
economic definition of exposure, taking into account
current and anticipated cash flows.
As exchange rate considerations have gained in
importance, United States firms have lodged greater
foreign exchange expertise and decision making at
headquarters. The centralization of foreign exchange
management, most often at the level of the parent, has
been accompanied by a shift in the actual implemen­
tation of transactions to New York and to other major
cities from foreign entities overseas. But the adoption
of a centralized approach has also fostered the growth
of the United States foreign exchange market in less
direct ways. Because large corporations frequently
deal in a number of alternative markets simultaneously,
their willingness to transact business in New York has
provided United States banks with incentives to offer
highly competitive rates on currencies. Moreover, cor­
porate demands for market analysis and counsel have
encouraged the growth of bank foreign exchange ad­
visory services and trained personnel, enhancing the
stature of New York as a financial center.
These changes in corporate structure and behavior
have also led to the adoption of more sophisticated
exposure management strategies. In practice, fewer
corporations than in the past operate at the extremes
of never or of always hedging their exchange risks.3
3 Hedging is used here in the broadest sense to include all techniques
that change, neutralize, or offset a company’s exchange risk, rather
than in the narrow sense of the purchase or sale of foreign
exchange to protect balance-sheet positions from currency fluctuations.




Because major differences among currency risks and
returns are not canceled out over the relevant corpo­
rate time horizon of several months, a strategy of ignor­
ing currency exposures can be disastrous. On the other
hand, the costs of being fully covered can also be
unnecessarily high, easily outweighing the expected
losses of not covering and frequently exacting a price
in terms of basic economic objectives. Also, avoiding
all exchange losses by definition precludes the op­
portunity for foreign exchange gains. Accordingly, a
growing number of corporate managers now seek to
establish a desirable level of exposure subject to ac­
ceptable risks and costs. This has had a number of
consequences.
(1) More firms have chosen to manage their foreign
exchange positions actively and to diversify their ex­
posures across currencies. As a result, many trans­
actions previously regarded as risky are now part of
sound financial practice. Also, exposure management
tools once thought to be rarefied have gained broader
acceptance among corporate treasurers. These include
financial pooling and the reinvoicing of trade among
subsidiaries to satisfy all but the net funding and
foreign exchange requirements of local units, some­
times through the vehicle of multicurrency manage­
ment centers established in offshore low tax areas.
(2) Even while remaining essentially risk adverse
and continuing to attach more importance to avoiding
exchange losses than to benefiting from exchange rate
gains, corporate managers are now more willing to
respond to actual and expected changes in exchange
rate returns. Leading and lagging, shifts in borrowing,
variations in inventories, and other mechanisms to
change the mix of assets and liabilities are more com­
monly used to move into currencies with actual and
anticipated rising yields and to move away from cur­
rencies with actual and anticipated falling yields.
(3) Companies report a growing willingness to shift
in and out of hedges. Reversing a hedge or a covering
mechanism may be essential to minimize actual or
opportunity losses if exchange rates move in directions
opposite to forecast or if rates reach levels more
quickly than initially anticipated. With rate movements
becoming more volatile, the risks of actual losses have
increased, while the opportunity costs of not buying or
selling foreign currencies at the most favorable prices
(which are never known with certainty) have also
mounted. Not surprisingly, therefore, a growing num­
ber of corporate treasurers have turned to a more
active approach to exposure management, with the

FRBNY Quarterly Review/Autumn 1981

39

result that foreign exchange transaction volumes have
increased dramatically.4
Multicurrency portfolios
Amid heightened exchange rate volatility, the desira­
bility of holding multicurrency portfolios has become
increasingly obvious. Diversified portfolios are insu­
lated from the effects of exchange risk to the extent
that the distribution of currencies on the asset side
is matched to actual or expected liabilities. Alter­
natively, if some currency exposure is accepted, then
diversification can lead to lower portfolio risk for a
given level of expected return, essentially because
there is reason to expect fluctuations in the return of
any one currency to be partially offset by opposite
fluctuations in the return of another currency. Ac­
cordingly, the risk of a given portfolio is expected to
be smaller than the weighted average of the risks of
the several currency assets in that portfolio. These
diversification incentives have played an important
role in the growing volume of foreign exchange
traded in the United States and elsewhere around the
globe.
Tables 5 and 6 show the performance of five major
currencies vis-d-vis the United States dollar in two
recent periods, the first from April 1977 through the
third quarter of 1979 and the second from October
1979 through March 1981. Judging from these calcu­
lations, it is obvious that holding different currencies
on an uncovered basis may involve a high degree
of risk since returns can change substantially over
time with variations in interest rates and exchange
rates. History provides little grounds for confidence
in the expectation that differences in nominal interest
yields will be compensated for by spot exchange rate
changes. As the tables show, there are substantial
differences across currencies in the annual average
returns that were earned during each of the two
periods.
The tables also present several multicurrency port­
folios, constructed from the vantagepoint of a United
States-based investor interested in dollar-denominated
returns. The first two portfolios show the results of a
passive investment strategy, with major currencies
represented in proportion to their share in the total
market capitalization of stocks and bonds in selected

* Active hedging practices may have led corporate treasurers to use the
forward market more intensively. Forward contracts may be closed
out at any time prior to maturity and may therefore be easier to reverse
than some alternative combination of spot and money market transac­
tions. In the March 1980 survey, nonfinancial institutions transacted
about 61 percent of their exchange business through outright forwards
and swaps and the remainder in the spot market. Unfortunately, the
data do not permit a comparison with the 1977 survey.

40

FRBNY Quarterly Review/Autumn 1981




major industrial countries at the end of 1979. By
choosing portfolios that represent the “ market” , the
passive investment approach seeks to diversify away
all risk except that associated with the market as a
whole. This approach is advantageous for small in­
vestment trusts, pension funds, and other institutions
that may wish to diversify internationally but lack
sufficient research services and analysts to pursue
an active investment program. By contrast, the last
two portfolios contain various foreign currencies in
equal amounts. Their performance indicates the sen­
sitivity of overall portfolio returns to the mix of chosen
assets under changing financial conditions. Portfolios
that turned out to yield the highest return after Octo­
ber 1979 are those that did not include the mark as one
of the selected currencies, while in the earlier period
excluding the mark would have significantly lowered
portfolio returns.
Two aspects of diversification are worth bearing in
mind. Foreign investors, as well as domestic residents
with funds initially allocated entirely to domestic cur­
rency assets, appear ready to respond not only to
developments between the United States and foreign
markets but to developments among nondollar cur­
rency centers as well. The growing number of curren­
cies that have become attractive candidates for diver­
sified portfolios has been a major boost to the
expansion of foreign exchange market activity.
Second, with considerable attention focusing on
official reserve diversification, the importance of
private-sector shifts of funds is frequently underrated.
Indeed, there is little question that private portfolios
around the world are losing their exclusively domestic
character as businesses, investment trusts, and individ­
uals diversify the currency denomination of their
money, bond, and equity portfolios. Divergent returns
among various domestic monies and among the
world’s major stock and bond markets have made it
possible to improve portfolio earnings without an in­
crease in risk and to protect financial assets in an
unsatisfactory investment climate from the loss of real
purchasing power. Moreover, private asset managers
are generally quick to adjust the currency composition
of their portfolios to changes in the relative risks and
expected returns that they perceive, while there is rea­
son to believe that official portfolio shifts may be less
abrupt and may involve a longer term transition to a
desired mix of currencies. Therefore the availability
and movement of internationally switchable funds,
which have played an important part in the growth of
the foreign exchange markets, should be seen even
more as the response of private market participants
than of official institutions to high exchange risk and to
an otherwise volatile financial environment.

Tables

Average Return and Risk of Selected Currencies
April 1977 through September 1979*
Average
annualized
exchange rate
change

Currency
United States d o lla r .............................
German mark ....................................... ........

11.18

Sterling

.................................................. ........

Portfolio If

-

............................................ ........

7.37

7.37

1.73

4.07

15.25

23.84

14.91

19.98

4.92

13.69

35.49

10.15

7.75

17.90

25.57

4.22

8.61

4.40

15.03

3.50

6.72

10.21

8.60
20.26

8.77

Canadian dollar ...................................

Standard
deviation
of total
return

8.27

French franc .........................................
Japanese yen ....................................... ........

Interest rate
return

Total average
annualized
return

Portfolio l i t ............................................ ........

7.95

5.92

13.86

Portfolio 111§ .......................................... ........

6.51

6.72

13.23

15.36

7.39

12.72

14.61

Interest rate
return

Total average
annualized
return

Standard
deviation
of total
return

Portfolio IV||

. . ....................... ..

........

5.34

Table 6

Average Return and Risk of Selected Currencies
October 1979 through March 1981*
Average
annualized
exchange rate
change

Currency

12.08

United States d o lla r .......................................
German mark ..................................................

-1 2 .1 8

9.12

-

French franc ....................................................

-1 2 .8 0

11.71

-

Japanese yen ..................................................

1.29

9.66

12.08

2.48

3.06

34.01

1.09

32.94

10.95

44.67

............................................................

-

0.19

13.65

13.46

30.75

Canadian dollar .............................................

-

1.42

13.02

11.60

11.21

Portfolio If

Sterling

......................................................

-

1.46

11.51

10.16

12.14

Portfolio l i t ......................................................

-

3.36

10.79

7.54

29.35

Portfolio lll§

....................................................

-

5.06

11.43

6.47

25.41

Portfolio IV||

....................................................

-

3.28

12.01

8.82

24.71

* Exchange rate changes are based on the monthly average of daily exchange rate changes. Interest rate returns are based on the
monthly average of selected short-term rates in national markets for all currencies except the dollar. Interest returns on the dollar
reflect the monthly average of daily yields on three-month United States Treasury bills. Source: International Monetary Fund,
International Financial Statistics, and Morgan Guaranty, World Financial Markets.
f Portfolio I consists of 56 percent of dollars, 18 percent of yen, 10 percent of marks, 8 percent of sterling, 5 percent of Canadian
dollars, and 3 percent of French francs.
$ Portfolio II consists of 41 percent of yen, 22 percent of marks, 18 percent of sterling, 11 percent of Canadian dollars, and 8 percent
of French francs.
§ Portfolio III consists of 20 percent each of German marks, French francs, Japanese yen, pound sterling, and Canadian dollars.
II Portfolio IV consists of 25 percent each of French francs, Japanese yen, pound sterling, and Canadian dollars.




FRBNY Quarterly Review/Autumn 1981

41

Foreign currency futures
Foreign currency futures have become a popular alter­
native to traditional financial instruments for individual
investors seeking to maintain or improve upon the real
value of their assets. Foreign currency futures offer the
prospect of large exchange gains, while the possibil­
ity of setting foreign exchange losses against ordinary
income may also motivate some investors seeking to
protect their aftertax income from higher, inflationinduced tax rates. Individual investors may constitute
a larger class of transactor on the futures market than
other participants, such as small corporations or com­
modities trading firms. Because commercial banks are
reluctant to deal with parties not having recognized
commercial or financial transactions, individuals have
few other opportunities to speculate in foreign ex­
change. Even individuals with access to the interbank
exchange market may find that the costs of transacting
business are sometimes quite high. By contrast, there
is considerable scope for leveraging positions with
modest capital outlays on the futures exchanges, such
as the International Monetary Market of the Chicago
Mercantile Exchange (IMM) where most currency fu­
tures are traded.
IMM orders, which customarily enter the interbank
market through the arbitrage activities of a special
class of IMM clearing member, represent a fast grow­
ing and important source of foreign exchange activity
in the United States. Such activity accounted directly
in the March 1980 survey for 15 percent of commer­
cial banks’ total customer business (spot, swap, and
forward) and fully 35 percent of banks’ customer busi­
ness done in the forward market. But these numbers
understate the impact of the IMM on the interbank
market in at least two respects. Direct arbitrage by
commercial banks, which initiate IMM trades through
floor brokers and then lay off these positions in the
interbank market, has increased as banks have begun
using their trading expertise actively to exploit the
profit potential between the IMM futures and the inter­
bank forward market. Moreover, banks writing forward
contracts with IMM arbitragers typically cover their
currency risk through offsetting purchases or sales in
the spot market and their maturity risk through a series
of swaps. Like regular customer orders, IMM orders
thus set in motion multiple transactions in the inter­
bank market.
Innovation in foreign exchange dealing relationships
Market mechanisms in the United States, developed
when exchange rates were fixed and the need for
foreign exchange services in the United States was
far smaller, came naturally under increasing strains
with the rapid expansion in foreign exchange demands

42

FRBNY Quarterly Review/Autumn 1981




and far-reaching disturbances to the global economy.
Over time, the need to respond quickly to rapidly
moving events put a premium on mechanisms which
were swift and efficient and challenged the adequacy
of traditional dealing relationships. In 1978, after sev­
eral years of debate, banks and brokers in the United
States introduced three major changes in market prac­
tice.
• Foreign exchange trading banks, rather than
doing business among themselves almost exclu­
sively through the intermediation of United States
foreign exchange brokers, began dealing directly
with each other at home and using international
brokers not domiciled in the United States when
dealing abroad.
• Foreign exchange brokers located in the United
States began to broker internationally, accepting
bids and offers from banks located abroad.
• Exchange rate quotations for currencies other
than the pound sterling shifted from United States
terms, that is, dollars and cents per unit of for­
eign currency, to European terms, that is, foreign
currency units per United States dollar.
These changes facilitated the expansion of foreign
exchange trading by eliminating conventions that had
come to discourage full participation in the market and
by integrating the United States market more closely
with markets overseas.
Previously, banks in the United States would deal
either directly with banks abroad or through the local
brokerage system. There was little direct bank-to-bank
trading in the United States market. Under this system,
traders were not always assured of getting up-to-date
market information and the freshest bids and offers.
This disadvantage was particularly acute for banks
lacking widespread name recognition or a sizable cus­
tomer and correspondent base and consequently not in
a good position to establish direct dealing relationships
with the broader and more active European market.
The high cost of telex and telephone communications
linking New York to Europe also deterred many banks
from direct dealing abroad. Direct dealing with foreign
banks was therefore limited to banks with broad foreign
exchange trading relationships and with management
support for a reasonably large trading operation.
Before 1978, therefore, United States brokers fre­
quently found it difficult to locate willing buyers and
sellers since a relatively small number of banks trading
direct overseas accounted for the bulk of foreign ex­
change turnover. Direct dealing accounted for about

70 percent of spot turnover in the United States in the
April 1977 foreign exchange survey, after adjusting for
double counting of transactions between United States
banks (Table 7). By the same token, a number of banks
— not sure of being able to do business in the brokers
market but equipped to handle foreign exchange trans­
actions for their customers— looked instead to larger
correspondent banks to execute their orders.
While the rigidities implied by conventional dealing
relationships had their greatest impact on the local
brokers market, even banks dealing direct abroad were
affected. When, for example, business was heavily con­
centrated in the foreign brokers market, information
on bids and offers could be acquired only with certain
delays. The extra search time involved in getting busi­
ness done and the dangers of being stuck with posi­
tions that could not be unwound quickly or on accept­
able terms became serious issues as the m arket grew
in com plexity and as exchange rate movements picked
up momentum.
Direct dealing between United States names has
helped overcome many of these problems. Direct deal­
ing banks can expect each other to provide fresh rate
quotations for m arketable amounts in a sp irit of reci­
procity. To be sure, differences in bank size and ex­
pertise in various currencies w ill influence the cost of
reciprocity and also the readiness of individual banks
to deal direct. However, banks accepting these mutual
obligations find that they can execute transactions at
almost any time during the business day and have
greater fle xib ility in handling large or odd-dated cus­
tomer orders not readily suited to the brokers market.
These capabilities have added depth to the market and
have enlarged transactions volumes through more
regular participants.
For their part, now that United States brokers have
comm unications links to Europe, they are able to col­
lect bids and offers provided by a large number of
European, M iddle Eastern, and Far Eastern banks and
to pass these on to traders in New York and in other
United States cities either by phone calls or in many
cases over speakerphones. The ability to deal through
the brokers on a com petitive basis by receiving fresh
and tim ely prices has provided additional impetus fo r
regional and com paratively small United States banks
to set up foreign exchange trading departments and
fo r established trading rooms to expand their oper­
ations. With more and more banks w illing to deal
through the brokers, the market has gained liquidity,
i.e., participants can get more business done w ithout
affecting the prevailing price. Also, brokers can and
frequently do provide the best international bid and
offer. The advantage to the banks is that the broker’s
commission may at times be sm aller than the cost of




Table 7

United States Foreign Exchange Turnover by
Type of Dealing
As a percentage of spot turnover in the interbank market*
Direct dealing
April March
1977
1980

Type of
dealing

Brokered dealing
April
March
1977
1980

Between United States
•

t

14

73

34

t

32

73

48

27

52

27

20

Between banks in the
United States and banks

* Based on gross spot currency transactions of ninety and
forty-four banking institutions, respectively, in March 1980 and
April 1977, after adjusting for double counting of transactions
between banks located in the United States.
f Negligible.

the spread when dealing direct. Because commission
arrangements now include the granting of discounts
with increasing business volumes, there are also bene­
fits to dealing through the brokers in size. Further,
the savings in staff, equipment, and time that other­
wise would be required to stay in contact with the
growing number of banks that trade foreign exchange
provide still another inducement to trading through
the brokers. For all these reasons, use of the brokers
has increased dram atically, in large part at the ex­
pense of direct dealing overseas. In the March 1980
survey, transactions through brokers accounted for
more than 50 percent of the sample’s spot foreign
exchange business, compared with about 30 percent
in 1977 (Table 7).
With the shift to European terms, United States
dealers began using the same pricing convention as
that employed elsewhere, in effect adopting the te r­
m inology of other markets for the sake of greater
efficiency. The decision was not made lightly since
the question of how dealers quote prices involves the
language of the m arketplace and is therefore a matter
of identity and tradition as well as of technical con­
venience. But, whatever the initial concerns, the use
of European terms has made it easier to trade with
other markets by removing a source of potential con­
fusion in com m unications and by cutting down on the
time needed to execute individual transactions.
In sum, direct dea!ing between United States names,
international brokering, and the switch to European
terms as a common standard for quoting rates have

FRBNY Quarterly Review/Autumn 1981

43

improved the functioning of the United States foreign
exchange market. With information disseminated rap­
idly and completely and with traders readily able to
buy and sell at current and uniformly quoted prices,
the market is both more efficient and more liquid
than before.
Concluding remarks
The upsurge of foreign exchange trading in the United
States has occurred essentially in response to the in­
creasing volatility of exchange rates and to the inter­
nationalization of the United States exchange market
and its fuller integration with the global foreign ex­
change market. So long as the international economy
continues to experience high and variable inflation,
major current account imbalances, divergent mone­
tary and fiscal policies, and other factors recognized
as contributing fundamentally to exchange rate insta­
bility, the challenge of heightened exchange rate vola­
tility is likely to persist.
Meanwhile, barriers to the movement of trade and
capital notwithstanding, national economies are be­
coming more interdependent, broadening further the
scope for sophisticated foreign exchange management
by a variety of institutions and individuals. Active
hedging policies and the development of multicurrencydenominated asset (and liability) portfolios are still on
a relatively limited scale. Yet the incentives to move
further in this direction are strong, in an environment
of variable inflation and exchange rate volatility, and
the opportunities to do so are growing, with the
development of new financial instruments and the
opening-up of national financial markets around the
world. The sheer size of the United States money and
capital markets, unparalleled innovations within and
among those markets, and the growing sensitivity of

FRBNY Quarterly Review/Autumn 1981
Digitized 44
for FRASER


investors and borrowers to expected exchange rate
changes as an important component of the yield or
cost of financial assets all suggest that the scope for
additional private-sector participation in the United
States foreign exchange market is substantial.
But also, working in the opposite direction, are some
factors suggesting a somewhat more moderate pace
of growth in the years ahead. There are limits to the
expansion of intraday spot trading by market profes­
sionals in terms of transaction costs, payment errors,
and settlement risk. And, in the absence of a welldeveloped foreign currency deposit market in the
United States or in neighboring offshore markets,
there are also natural limits to the expansion of swap
trading. These considerations make it doubtful that
interbank positioning will continue in the future to
play as paramount a role in boosting trading volumes
as in the past. At the same time, most foreign banks
with an interest in locating in the United States have
already done so, while the centralization of exchange
risk management at United States corporate head­
quarters is by now already well-developed. In many
countries abroad, restrictions on foreign exchange
trading have also begun to ease. Moreover, interna­
tional brokering and direct dealing among United
States names, while facilitating the expansion of
foreign exchange business and making it possible
for the United States market to become more fully
integrated with markets overseas, are by their nature
structural changes whose impact on volume growth
can be expected to dwindle over time. Therefore,
while there are good reasons to expect continued
growth of the United States foreign exchange market,
the likelihood is that the future expansion of the
market will be less than the very rapid pace of recent
years.

Patricia A. Revey

February-July 1981 Semiannual Report
(This report was issued to the Congress, and
to the press on Thursday, September 3, 1981.)

Treasury and Federal Reserve
Foreign Exchange Operations
The United States dollar advanced strongly against
all currencies during the period under review in re­
sponse to a variety of economic and political factors
in the United States and abroad. In the United States,
the current account remained in surplus. The domestic
economy showed considerable resilience. The demand
for money and credit continued strong, and United
States interest rates remained high. Also, price indexes
published during the period pointed to a significant
decline in the inflation rate. Moreover, the already fa­
vorable market sentiment toward the Reagan adminis­
tration was strengthened by its apparent resolve and
effectiveness in translating from plan to action its
major fiscal program designed to deal with inflation
while revitalizing the United States economy.
The performance of major industrial countries
abroad was less favorable. The current accounts of
several countries, notably Germany, were in substan­
tial deficit. Inflation was accelerating in most countries
other than Japan. Economic activity abroad was gen­
erally sluggish. In many countries, the weakness of
domestic demand was seen in the markets as con­
straining the authorities from raising interest rates
sufficiently to attract capital inflows for financing cur­
rent account deficits at prevailing exchange rates or

A report by Sam Y. Cross. Mr. Cross is Senior Vice President in
charge of the Foreign Group of the Federal Reserve Bank of New
York and Manager of Foreign Operations for the System Open
Market Account.




to curb inflation. Market participants focused on the
policy challenges facing many governments abroad
and were concerned that policies would not be
adopted to deal with these problems effectively. More­
over, political developments in Eastern Europe and in
the Middle East added to uncertainties for the outlook,
especially for Europe, and left traders and investors
with the view that the United States was a relatively
attractive outlet for investment.
In this environment, the market perceived little
downside risk for the dollar in the exchange markets.
Consequently, the dollar fluctuated higher over most
of the period under review. Early in February, the sell­
ing pressures against other currencies focused mostly
on the German mark, which not only declined against
the dollar but also was weak within the joint float
arrangement of the European Monetary System
(EMS). After midmonth, the Bundesbank took strong
action to defend the mark, and before long increases
in short-term interest rates in Germany were followed
by rising interest rates in many other financial mar­
kets on the Continent. At the same time, interest rates
in the United States eased somewhat. As market par­
ticipants moved to cover short currency positions, the
mark rebounded and other currencies also strength­
ened by mid-March.
From April to mid-May, there was renewed up­
ward pressure on short-term United States interest
rates and the dollar resumed its advance. By mid­
spring this tendency was reinforced, as the markets
attempted to assess the implications of renewed

FRBNY Quarterly Review/Autumn 1981

45

unrest in Poland, the change of government in France,
and political developments in several other European
countries. Moreover, United States statistics for the
first quarter highlighted the unexpected strength of
the domestic economy. As market participants began
to adjust their expectations concerning the near-term
outlook for the economy and for interest rates, the
dollar advanced strongly.
Coming into the summer, market participants took
an increasingly bearish view of the outlook for Europe.
A debate over monetary and exchange rate policies
had emerged in the press, intensifying with the ap­
proach of the July 19-20 Ottawa summit. Market par­
ticipants focused on complaints by foreign govern­
ments that the high level of United States interest
rates was complicating their efforts to encourage
economic recovery and to avoid further depreciations
of their currencies. At the same time, evidence sug­
gested that the United States economy had lost
its upward momentum. Inflation figures continued to
show improvement, while the growth of the narrow
monetary aggregates had moderated. Expectations
developed that United States interest rates might ease
from their near-record highs. In these circumstances,
the dollar remained in demand but fluctuated more
irregularly than before.
After mid-July the demand for credit in the United
States was stubbornly strong in the face of high inter­
est rates and the broader monetary aggregates con­
tinued to be buoyant. The market was impressed by
Chairman Volcker’s reaffirmation of the Federal Re­
serve’s commitment to restrain monetary expansion. In
addition, the market was becoming concerned about
the impact of the United States government’s nearterm financing requirements on United States financial
markets. In this environment, interest rates remained
high, disappointing expectations of near-term de­
clines. Moreover, as the Administration’s economic
proposals gained Congressional approval, market par­
ticipants compared the breadth of support for the new
policy directions in the United States with the con­
tinuing debates on a full range of policies in many
countries abroad. As a result, market sentiment toward
the dollar became bullish. The dollar closed the period,
advancing strongly across the board. The extent to
which the exchange rates for individual currencies
moved against the dollar depended in large part on
economic and political factors in their respective
countries. But, overall, the dollar ended the period up
221/4 percent against sterling, up I 6V2 percent against
the Japanese yen, and up 161/4 percent against the
German mark.
In their operations in the exchange market, the
United States authorities intervened to settle a vola­

FRBNY Quarterly Review/Autumn 1981
Digitized 46
for FRASER


tile market on nine trading days in February, when the
dollar was rising sharply. The equivalent of $610.0
million net of marks was purchased in the market and
an additional $168.4 million of marks was bought from
correspondents. The proceeds of these market and
correspondent purchases were split evenly between
the Federal Reserve and the Treasury and were added
to their respective balances.
On March 30, when trading in the exchange markets
faltered amidst the uncertainties following the assas­
sination attempt on President Reagan, the Trading
Desk intervened to reassure the markets. A total of
$74.4 million equivalent in marks was sold from bal­
ances, again split evenly between the Federal Reserve
and the Treasury. On the following day, exchange
markets quickly returned to more orderly conditions.
The Treasury indicated in April that, after study
and consultation with officials of the Federal Reserve,
the United States had adopted a minimal interven­
tion approach to intervene only when necessary to
counter conditions of disorder in the exchange mar­
ket. On May 4, Treasury Under Secretary Sprinkel set
forth the rationale for this approach in testimony
before the Joint Economic Committee of the Congress.
The United States did not intervene on its own
account through the remainder of the period under
review. The Trading Desk continued to cooperate with
other central banks by intervening as their agent from
time to time in the New York market. Over the sixmonth period, such operations were conducted in
German marks, French francs, Japanese yen, and the
Canadian dollar. In their own markets, central banks
of other countries continued to intervene, operating
heavily at times, mostly to limit the decline of their
currencies against the dollar.
In April, the Swedish Riksbank repaid, prior to
maturity, the $200 million drawn in January under the
swap arrangement with the Federal Reserve, following
a heavy reflow of funds into the Swedish krona. In
May a $200 million increase in the arrangement that
had been agreed upon for one year lapsed and the
swap line reverted to the earlier $300 million amount.
On July 27 the United States Treasury paid off the
first maturing tranche equivalent to $744.5 million of
its Swiss franc-denominated securities. These securi­
ties were issued with the cooperation of the Swiss
authorities in connection with the dollar-support pro­
gram of November 1978. After this redemption the
Treasury had outstanding $5,692.1 million equivalent
of foreign currency notes, public series, of which
$5,233.6 million is denominated in German marks and
$458.5 million is denominated in Swiss francs. These
securities mature between September 1, 1981 and
July 26,1983.

Table 1

Federal Reserve Reciprocal Currency Arrangements
In millions of dollars

Institution

Amount of facility
January 1, 1981

Austrian National B a n k .................................................................................
National Bank of Belgium ...........................................................................
Bank of Canada ............................................................................................
National Bank of D e nm ark...........................................................................
Bank of England .........................................................................................
Bank of F ra n c e ...............................................................................................
German Federal Bank .................................................................................
Bank of Ita ly ....................................................................................................

Decrease effective
May 23, 1981

250
1,000
2,000
250
3,000
2,000
6,000
3,000
5,000
700
500
250
500
4,000

Bank of M e x ic o ..............................................................................................
Netherlands Bank .........................................................................................
Bank of N o rw a y..............................................................................................
Bank of Sw eden.............................................................................................
Swiss National B a n k .....................................................................................
Bank for International Settlements:
Swiss francs-dollars .................................................................................
Other authorized European currencies-dollars......................................

600
1,250

T o ta l..................................................................................................................

30,300

Chart 1

Chart 2

The Dollar Against Selected
Foreign Currencies

Selected Interest Rates

Percent

Percentage change of weekly averages of bid rates
for dollars from the average rate for the week of
June 30-July 6, 1980. Figures calculated from
New York noon quotations.




Amount of facility
July 31, 1981
250
1,000
2,000
250
3,000
2,000
6,000
3,000
5,000
700
500
250
300
4,000

200

600
1,250
30,100

200

Three-month maturities
Percent

1980

1981

Weekly averages of daily rates.

FRBNY Quarterly Review/Autumn 1981

47

In the seven months through July 1981, the Federal
Reserve had gains of $4.9 m illion on its exchange
market operations, while the Exchange Stabilization
Fund lost $4.5 million. The Treasury’s general account
lost $82.7 m illion, reflecting losses of $144.3 million as
a result of annual renewals at current m arket rates of
the agreement to warehouse with the Federal Reserve
Swiss franc proceeds of Treasury securities and gains
of $61.6 m illion on the reacquisition of Swiss francs in
connection with the redemption at maturity of Swiss
franc-denominated securities. As of July 31, valuation
losses on outstanding balances were $571.1 m illion for
the Federal Reserve and $1,807.2 m illion for the Ex­
change Stabilization Fund. The Treasury’s general
account had valuation gains of $1,313.5 m illion related
to outstanding issues of securities denominated in
foreign currencies.

German mark
Early in 1981 Germany’s current account deficit
showed no signs of contracting despite continued
stagnation of the dom estic economy. Though import
demand had weakened and export orders had picked
up from earlier depressed levels, these initial improve­
ments were more than offset by the adverse impact
on Germany’s terms of trade of the sharp deprecia­
tion of the mark. At the same time, growing tourism,
interest, and dividend payments led to a further deteri­
oration in services. The authorities had hoped to cor­
rect the current account deficit gradually by a shift
of resources toward investment and exports and, in
the interim, to finance the deficit by a combination
of private and official capital inflows. But the pro­
tracted nature of the deficit exerted a negative im­
pact on sentiment toward the mark, and private capital
flowed heavily out of Germany instead. Meanwhile,
domestic demand remained exceptionally weak. Cen­
tral bank money was growing in the upper half of the
4-7 percent annual growth range, and short-term
domestic interest rates at 9 percent were the subject
of domestic debate— criticized for being too high to
permit a recovery of domestic economic activity but
too low to defend the mark from downward pressures
in the exchange market.
By February the outflow of funds from Germany
accelerated sharply. Market participants were deeply
concerned about the lack of resolution w ithin Ger­
many over the appropriate role for monetary policy in
dealing with the weakness of the external sector and
about security issues raised by persistent tensions in
Poland. At the same time, there was growing confi­
dence in the policies and leadership of the new United
States adm inistration under President Reagan, which
had already established a clear direction for the United

48

FRBNY Quarterly Review/Autumn 1981




Chart 3

Germany
Movements in exchange rate and official
foreign currency reserves
Marks per dollar
1.60
Exchange rate

Billions of dollars

0
Foreign currency
rpciprup.cs*
Scale------ ►

1.80
2.00
2.20

2.40
2.60
2.80
3.00

-

■
■

|
■

n
■I
i i M ii
J

A

S O
1980

N

D

J

■
1111M u
F M A M J
1981

J

-

A

2.0

3.0

Exchange rates shown in this and the following charts
are weekly averages of noon bid rates for dollars in
New York. Foreign currency reserves shown in this
and the following charts are drawn from IMF data
published in International Financial Statistics.
* Foreign exchange reserves for Germany and other
members of the European Monetary System, including
the United Kingdom, incorporate adjustments for
gold and foreign exchange swaps against European
currency units (ECUs) done with the European
Monetary Fund.

States in econom ic and m ilitary matters. With interest
rates in Germany relatively low compared with those in
the United States and some other industrial countries,
funds flowed heavily out of marks, principally into dol­
lar assets but also into sterling and higher yield­
ing currencies of the EMS. By midmonth the mark
had plummeted to DM 2.25 against the dollar for a
decline of 51/2 percent from end-January levels and
some 20 percent from the previous September. W ithin
the EMS the mark was trading at or near the floor
of the jo in t float vis-a-vis the French franc. The
Bundesbank intervened in dollars and, together with
the Bank of France, also in French francs to preserve
the limits of the EMS. Largely reflecting these opera­
tions, Germany’s foreign exchange reserves declined
to $42.7 billion at end-February, down $1.7 billion from
the level outstanding on January 31. Meanwhile, dur­
ing February the United States authorities intervened
to settle trading conditions which were frequently
one way. The authorities bought $610.0 m illion equiv­
alent of marks net in the market and $168.4 m illion

equivalent from correspondents which were added to
balances of the Federal Reserve and the United States
Treasury.
The sharp and prolonged decline of the mark posed
serious problems for the German authorities. The
depreciating mark boosted domestic currency prices
of oil and other dollar-invoiced imports relative to
export prices, thus magnifying the current account
deficit. The rising cost of imports fed directly into
domestic producer and consumer prices ahead of
important spring wage negotiations and thereby
threatened to provoke new domestic cost pressures.
The mark’s decline also complicated efforts to finance
the external deficit and generated some uneasiness on
the part of official mark holders. On February 19 the
Bundesbank temporarily closed the Lombard window,
suspended the traditional fixed-rate facility, and an­
nounced that Lombard credits would henceforth be
made available at its discretion and at rates deter­
mined on a day-to-day basis. Bundesbank President
Poehl stated that the immediate aim of these measures
was to tighten German monetary policy in order to
safeguard the stability of the mark. Thereafter, German
short-term interest rates shot up and call money tem­
porarily reached 20-30 percent before settling back to
trade around 12-13 percent.
Exchange market participants reacted positively to
the tightening of German monetary policy. As interest
differentials adverse to the mark either narrowed
sharply or disappeared completely, previously adverse
commercial leads and lags were unwound and non­
residents repaid earlier mark-denominated borrowings.
This reflow of short-term funds into marks, principally
out of French and Belgian francs, strengthened the
mark dramatically within the EMS, and the mark
traded after mid-February at the top of the joint float
arrangement. The Bundesbank was therefore able to
begin purchasing EMS currencies in the market to
repay debt to the FECOM (European Fund for Mone­
tary Cooperation), incurred earlier while the mark was
at the botto|n of the EMS. Meanwhile, with United
States interest rates also coming off near record highs,
the mark rebounded against the dollar to trade around
DM 2.09-2.12 through early April. For their part the
United States authorities limited their intervention to
one occasion, on March 30, following the assassina­
tion attempt on President Reagan, when they sold $74.4
million equivalent of marks out of balances.
During the spring the Bundesbank maintained its
essentially restrictive monetary policy stance. Officials
stated that there was no basic conflict between in­
ternal and external policy considerations. Short-term
stimulus to the economy, whatever the temporary
benefits to growth, would be counterproductive since




it would increase domestic consumption and inflation
at the expense of longer term needs such as capital
formation, efficient economic decision making, and
productivity gains. The authorities therefore kept a
tight rein on liquidity mainly through open market
operations and foreign currency swaps. These opera­
tions convinced exchange market participants that the
Bundesbank would not allow interest rates to ease.
But the occasionally highly charged domestic debate
over monetary policy also suggested that the authori­
ties would not be in a position to increase short-term
interest rates in the face of continued recession and
substantial unemployment.
Meanwhile, in the United States, demands for money
and credit pressed against a restrained supply of bank
reserves and exerted upward pressure on short-term
United States interest rates from April through midJune. The rise in United States interest rates was not
matched by increases in German money market rates,
so that interest differentials adverse to the mark
widened from 2 percent in March to 6 percent by
early June. In the credit markets, however, yields on
German bonds increased by more than yields in the
United States. These pressures on the German bond
market spilled over into the exchanges, as for­
eigners liquidated some of their mark-denominated
assets to limit capital losses. In these circumstances,
the mark was again under downward pressure and
had dropped to DM 2.25 before May 10, when Fran­
cois Mitterrand was elected President of France. Then
a wave of French franc selling pulled the mark and
other EMS currencies even lower in the exchanges.
To maintain the intervention limits of the joint float,
the Bundesbank along with the Bank of France sold
large amounts of marks against French francs through
end-May before tough French exchange controls
helped bring the market into better balance. The
Bundesbank also sold large amounts of dollars in the
market to absorb part of the mark liquidity created by
the EMS intervention and to moderate the steep fall
of the mark against the dollar, which declined further
to nearly DM 2.33 by the month end. Part of these
dollar sales occurred through the agency of the Trad­
ing Desk at the Federal Reserve Bank of New York
operating on behalf of the Bundesbank. However, the
Desk did not intervene in the exchanges on behalf of
the Federal Reserve or the United States Treasury.
In mid-June, selling pressures on the mark abated.
By this time, United States economic activity had
turned sluggish, inflation figures had improved, and
growth of the monetary aggregates moderated. In
these circumstances, United States interest rates
had begun to soften and were widely expected to
register sustained declines, thereby narrowing interest

FRBNY Quarterly Review/Autumn 1981

49

differentials adverse to the mark. But the market had
become increasingly pessimistic over the outlook for
Europe. M ajor political and security issues were of
concern, as underlined by persistent tensions in
Poland and by new questions about the fram ework of
Western European relations raised by changes in sev­
eral governments. With respect to Germany, there
were open disputes in Germ any’s governing coalition
over a broad range of issues. Germany’s trade figures
had not yet shown much evidence of improved com ­
petitiveness resulting from the substantial real depre­
ciation of the mark. Consumer price inflation was also
accelerating, and there was little prospect fo r a nearterm reduction of price pressures, given the rise in
labor compensation negotiated in the spring.
With these various concerns depressing sentiment
toward the mark, the German currency weakened
still further against the dollar in late June and July,
when United States interest rates firmed up rather
than declining as expected. Continued bearish senti­
ment toward the mark also hampered progress in
financing the current account. For several months,

long-term private capital had remained in deficit,
although the pace of net outflows had slowed. By
June the previous inflow of short-term capital was
being reversed. Partly for this reason the Bundesbank
announced that German interest rates w ould remain
high and that the growth of central bank money would
be held in the lower half of the annual target range.
At the same time, the federal government continued
to borrow heavily abroad in order to finance the siz­
able current account deficit, amounting to DM 29
billion at an annual rate in the first six months of the
year. Between January and June the public authorities
raised about DM 14 billion in foreign credits, with a
large share coming directly from Saudi Arabia.
During July, as the exchange market focused on
fiscal policy developments in Germany relative to
those in the United States, the mark came more
heavily on offer. In Germany, increasing government
expenditures threatened to raise the public-sector
deficit in 1981 to 4.5 percent of gross national product
(GNP) from under 3 percent of GNP only two years
earlier. Although containing the upward trend in

Table 2

Drawings and Repayments by Foreign Central Banks and the Bank for International Settlements
under Reciprocal Currency Arrangements
In millions of dollars; drawings ( + ) or repayments ( — )
Outstanding
January 1, 1981

1981
I

1981
II

1981
July

Outstanding
July 31, 1981

-0-

+200.0

-2 0 0 .0

-0-

-0-

Amount of
commitments
January 1, 1981

1981
I

1981
II

Germany .................................................................................

5,233.6

-0-

-0-

-0-

5,233.6

S w itzerland.............................................................................

1,203.0

-0-

-0-

— 744.5

458.5

Total

6,436.6

-0-

-0-

-7 4 4 .5

5,692.1

Bank drawing on
Federal Reserve System
Bank of Sweden ..................................................................
Data are on a value-date basis.

Table 3

United States Treasury Securities, Foreign Currency Denominated
In millions of dollars equivalent; issues ( + ) or redemptions ( — )

Issues

1981
July ,

Amount of
commitments
July 31, 1981

Public series:

.......................................................................................

Data are on a value-date basis.
Because of rounding, figures may not add to totals.

50FRASER
FRBNY Quarterly Review/Autumn 1981
Digitized for


spending had become a priority, measures to reduce
expenditures in the 1982 budget were drafted in the
midst of heated public debate, raising some questions
whether the final budget proposal would be approved
by the Parliament. Meanwhile, the Reagan adm inistra­
tion gained Congressional support for m ajor expendi­
ture cuts and tax reductions, marking an im portant
shift in fiscal policy that was aimed at reducing infla­
tion and providing greater incentives to the private
sector. The exchange m arket assessed the new direc­
tion of United States fiscal policy favorably. There
were still concerns that defense outlays and tax cuts
might in combination swell rather than reduce the
budget deficit. But growing confidence that the Fed­
eral Reserve would keep the growth of bank reserves
and the monetary aggregates under firm control
helped alleviate inflationary fears and also reinforced
expectations that United States interest rates would
remain high. The m arket’s generally positive reaction
to the Reagan adm inistration’s economic program,
coupled with the attraction of high yields on dollar
placements, led to a surge of dollar bidding during
July. In these circum stances, the mark dropped
sharply lower in frequently heavy trading to DM 2.4770
by the month end for a net 161/2 percent decline over
the six months under review. Meanwhile, Germany’s
foreign exchange reserves increased $647 m illion from
February levels to stand at $43.4 billion on July 31,
1981. The rise in reserves mainly reflected sizable in­
tervention purchases of currencies within the EMS
after March, mostly French francs but also Belgian
francs, which offset intervention sales of dollars in the
final months of the period.

Swiss franc
Coming into 1981 the Swiss economy was continuing
to show greater momentum than those of most other
industrialized countries. At the same time, the pace of
consumer price increases had accelerated sharply in
response to resilient consumption demand and to the
progressive decline in the Swiss franc during much of
1980. The Swiss authorities were anxious to combat
these emerging inflationary pressures while mindful of
the risks of precipitating a downturn for Switzerland in
view of the sluggishness of the international economy.
As a result, the Swiss National Bank announced it
w ould leave its monetary base growth target for 1981
unchanged from that of 1980 at 4 percent.
At that time, interest rates in Switzerland were well
below those in all other major industrial countries, and
the differential vis-a-vis the United States had again
widened to 10 percentage points. In response, many
corporate entities, governments, and other official
agencies borrowed francs dom estically or in the Euro-




Chart 4

Switzerland
Movements in exchange rate and official
foreign currency reserves
Francs per dollar
1.50--------------------

Billions of dollars
---------------------- 4.0

___ Exchange rate_
-*------ Scale
2.301

J

A

S

O N
1980

D

J

F

M

A M
1981

J

J

A

‘ -4 .0

See exchange rate footnote on Chart 3.

Swiss franc market, where many borrowers had
options allowing them to switch loan currency de­
nominations on rollover dates. In addition, with devel­
opments in Eastern Europe seen in the market as
casting a cloud over all the Continent, the Swiss franc
had lost some of its traditional attraction as a refuge
for capital. As a result, inflows of funds were insuf­
ficient to offset the buildup of interest-sensitive capi­
tal outflows, and during January the Swiss franc con­
tinued to weaken both against the dollar and other
European currencies. By the beginning of the period,
the Swiss franc had declined about 16 percent from
its 1980 highs to a three-year low of SF 1.9270 against
the dollar and was trading at SF 0.90 against the Ger­
man mark. Swiss foreign exchange reserves stood at
$ 12.1 billion.
On February 3 the National Bank of Switzerland
raised its discount and Lombard rates Vz percentage
point to 31/2 percent and 41/2 percent, respectively, the
first change in these rates in nearly a year. The actions
were taken to support the franc in the exchanges and
to adjust official rates to tightening domestic money
market conditions. But interest rate differentials un­
favorable to the Swiss franc remained wide, and the
franc continued to decline against a generally
strengthening dollar. As the franc eased, the National
Bank sold dollars to support the rate but operated
in more modest amounts than many other central
banks.

FRBNY Quarterly Review/Autumn 1981

51

Following a change in the administration of Ger­
many’s Lombard facility, which precipitated a sharp
rise in German money market interest rates, the Swiss
National Bank announced a second round of interest
rate increases. On February 20 the discount and Lom­
bard rates were raised to 4 percent and 51/2 percent,
respectively, and the National Bank also conducted
foreign currency swap operations— its major tool for
monetary control— so as to tighten further money
market conditions. By mid-March, money market rates
had risen to about 9 percent, levels not seen since
the mid-1970s. Also, dollar interest rates eased some­
what and the adverse interest differentials narrowed
sharply, helping the franc strengthen in the exchanges
to a level of SF 1.8530 on March 18.
By this time it had become clear that the Swiss
economy, rather than weakening as expected, con­
tinued to expand in the first quarter of 1981, in sharp
contrast to the sluggishness in Germany and else­
where. Increases in employment, though slowing from
the strong 1980 pace, remained sufficient to enable
Switzerland to avoid the rising unemployment so trou­
blesome to many industrial nations. Domestic con­
sumption and construction activity had remained buoy­
ant even in the face of mortgage rates which soared
to levels not seen since 1975. These pressures had
contributed to an acceleration of the inflation rate to
about 6 percent which, though high by historical stan­
dards for Switzerland, was nevertheless still among the
lowest rates in the world. In the United States the
unexpected strength of the economy renewed mone­
tary growth and put considerable upward pressure on
dollar interest rates, which was sustained over the
remainder of the period. As the dollar again came into
demand, the franc fell in the exchanges.
With the economy robust, the Swiss authorities had
leeway to pursue policies intended to push the inflation
rate back down. Beginning in late April and continuing
through May, the Swiss National Bank fostered tighter
money market conditions by allowing liquidityproviding foreign currency swaps to run off. On
May 11, the National Bank again raised the discount
and Lombard rates, this time to 5 percent and 6V2
percent, respectively, and shortly thereafter announced
a willingness to see the monetary base fall below its
annual target range. In response, Swiss interest rates
moved even higher, including the politically sensitive
mortgage interest rate and other long-term interest
rates.
These developments coincided with the presidential
elections in France and, as all European currencies
initially dropped against the dollar, the Swiss franc
fell further to a low of SF 2.0790, down 12 percent from
its March highs. Thereafter, however, Switzerland came

FRBNY Quarterly Review/Autumn 1981
Digitized for52
FRASER


to be seen as a politically stable and economically
sound investment outlet and the Swiss franc began to
regain some of the status of a “ safe haven” currency.
In the context of this improving exchange market psy­
chology, speculative and investment flows turned in
favor of the franc. Funds also flowed in from Germany
to repay franc borrowings, which had become nearly
as expensive as mark credit. Through the end of June
the franc firmed slightly against the dollar and climbed
against the mark to SF 0.85, thus breaking out of the
narrow range around SF 0.90 which had held for about
two years.
Through July the franc declined against the dollar
in line with other currencies and against the mark,
mainly in response to growing market expectations of
an EMS realignment that was thought likely to benefit
the mark. By the end of the month the franc had de­
clined to SF 2.15 against the dollar and to SF 0.87
against the mark, down about 1 1 % percent against
the dollar and up 4 percent against the mark for the
six-month interval. For the period overall, Swiss foreign
currency reserves fluctuated modestly, largely in re­
sponse to foreign currency swap operations conducted
to influence growth of the Swiss monetary base. At
the close of the period, Swiss reserves stood at $9.9
billion, down $2.2 billion from the end of January.
On July 27 the United Stated Treasury redeemed the
first maturing tranche of its Swiss franc-denominated
securities in the amount of SF 1.2 billion issued in
July 1979, with the cooperation of Swiss authorities
in connection with the dollar-support program of No­
vember 1978. To neutralize the liquidity effects of the
note transactions, the Swiss National Bank allowed a
portion of maturing foreign currency swaps to run off,
thereby absorbing liquidity injected by the retirement
of the notes. As a result, the money markets remained
generally steady over the month end.
Japanese yen
Early in 1981 the yen continued to benefit in the
exchanges from the rapid adjustment of Japan’s econ­
omy to the second oil shock. Restrictive monetary
and fiscal policies had successfully curtailed domestic
demand, limited the buildup of inflationary expecta­
tions and, together with moderate wage settlements,
contained the impact of oil price increases on do­
mestic costs. At the same time, changes in production
processes under way since the mid-1970s had made
industry less dependent on imported raw materials,
particularly oil. These developments, together with the
impact of the 1979-80 depreciation of the yen, led to a
marked improvement in the current account, which
swung from deep deficit to virtual balance. They also
impressed international investors sufficiently to attract

Chart 5

Japan
Movements in exchange rate and official
foreign currency reserves
Yen per dollar
190-----------------

Billions of dollars
------------------------2.0

.Exchange rate.
------ Scale

200210220^ \ —

t

230Foreign currency
reserves____
Scale----- ►

240250L

J

A

S O N
1980

D

J

U

. . .

F

I

I

M A M J
1981

— -0.5
-

J

A

1.0

See exchange rate footnote on Chart 3.

massive inflows of funds, particularly from Organization
of Petroleum Exporting Countries (OPEC) investors
eager to increase the share of yen-denominated assets
in their portfolios. As a result, the yen rebounded in
the exchanges to ¥ 206.10 in New York on January 31,
up 21 percent against the dollar and 27 percent against
the German mark from its lows of April 1980. The gov­
ernment proceeded to liberalize substantially exchange
controls on international capital transactions. Also,
Japan’s foreign exchange reserves rose to $22.7 billion
by end-January.
Meanwhile, however, dom estic demand had stalled
and, with the improvement in Japan’s external posi­
tion, the authorities had begun to relax the tight stance
of policy after mid-1980. Yet, by early 1981, consump­
tion and residential construction continued to falter and
business fixed investment, previously the only domestic
source of strength, was also decelerating rapidly. The
growth of the monetary aggregates had slowed, and
yen money m arket rates softened. Inflationary pres­
sures had eased, partly reflecting the dampening im­
pact on import prices of the yen’s appreciation, so
that wholesale price inflation had dropped from a yearon-year rate of 24 percent in the spring of 1980 to
about 5 percent in early 1981. Meanwhile, in the ex­
change market the rising dollar had eroded the yen’s
earlier buoyancy, but the rate nonetheless remained
relatively stable around ¥ 208 through mid-March.
Against the currencies on the Continent, the yen held
up relatively well even w hile those currencies bene­
fited from a sharp rise in th eir interest rates. In these
circum stances, dom estic pressures on the authorities




intensified during February and March to adopt reflationary measures including a reduction of interest
rates.
On March 17 the government introduced a fiscal
package which accelerated budgeted public-w orks ex­
penditures and provided low-cost financing to promote
housing construction, to aid small companies, and to
boost exports of industrial plants. These measures
were generally thought to be modest so as not to
compromise m aterially the goals of reducing the
budget deficit in the fiscal year ending March 1982
and of easing the burden on the markets of financing
the central governm ent’s large requirement. At the
same time, the Bank of Japan lowered its discount rate
1 percentage point to 61/4 percent fo r the third cut in
less than a year, reduced banks’ reserve requirements,
and then followed up by substantially relaxing windowguidance ceilings on the growth of bank lending.
But the authorities were also concerned that the
large interest differentials adverse to the yen might
trigger volatile capital outflows. Japan’s interest rates
were the lowest among the m ajor industrial countries.
The liberalization of Japanese exchange controls also
provided greater opportunities for capital outflows.
Among other things, the Bank of Japan introduced
a new lending arrangement sim ilar to the special
Lombard fa cility in Germany, enabling the central bank
to charge more than the official discount rate on its
lending to commercial banks whenever necessary to
counter potentially excessive capital outflows or down­
ward pressures on the yen.
In the event, sentim ent toward the yen in the ex­
changes turned more cautious during the spring.
Though market participants were still confident in the
thrust of Japan’s econom ic policies and the overall
perform ance of the economy, there were reasons to
question whether the rapid improvement in the current
account would continue. The likelihood of trade re­
strictions against Japan’s automobile exports dimmed
prospects for future export earnings, as did selfimposed export restraints by Japanese manufacturers
in industries faced with growing protectionist sentiment
abroad. Spreading recession in m ajor overseas mar­
kets clouded export prospects even further. Conse­
quently, the trade surplus was thought unlikely to widen
sufficiently to cover rising interest payments on non­
resident yen deposits and tourism outflows which
were significantly boosting Japan’s traditional services
deficit.
In these circum stances, large interest differentials
adverse to yen-denominated assets began to show
through. Japanese resident institutions and individuals
— already in the process of adjusting to newly liberal­
ized foreign exchange controls— stepped up their ex­

FRBNY Quarterly Review/Autumn 1981

53

port of capital as interest differentials favoring the dollar
widened from about 7 percentage points in March to
over 11 percentage points in May and early June. In
particular, life insurance companies, pension funds,
and bank trusts took advantage of access to overseas
investments by establishing a presence in the United
States capital markets at yields more attractive than
those available in Japan. As a result, the yen declined
along with other major foreign currencies against the
dollar, dropping 73A percent from m id-March levels to
¥ 224 by early June.
These developments put pressure on Japan’s capi­
tal markets, com plicating the authorities’ efforts to
bolster domestic growth and to finance the large
government deficit at current yields. The authorities
were concerned that raising the national bond coupon,
a key indicator of overall long-term interest rates in
Japan, would lead to higher lending rates throughout
the economy. Reluctant therefore to increase new issue
rates as rates in the secondary market rose, the govern­
ment had difficulty arranging the June issue of ten-year
bonds and had to w ithdraw the July issue altogether.
In the exchange market, concern developed that these
strains in the capital market would spill over into the
currency markets, as foreign investors decelerated
their purchases of Japanese assets or even began
selling off some of their holdings. Moreover, the grow ­
ing perception that the authorities would find it diffi­
cult to support the yen by raising Japanese interest
rates contributed to a further decline in the yen to
¥ 228 by end-June.

Table 4

Net Profits (+ ) and Losses ( - ) on
United States Treasury and Federal Reserve
Current Foreign Exchange Operations
In millions of dollars

Period

Federal
Reserve

United States Treasury
Exchange
Stabilization
General
Fund account

First quarter 1981 ............

+

6.2

-

0.7

Second quarter 1 9 8 1 ___

-

1.4

-

3.8

July 1981 ...........................

+

0.1

Valuation profits and
losses on outstanding
assets and liabilities
as of July 31, 1981 ........

-571.1

-0-

54

-0+

61.6

Sterling
-1,8 0 7 .2 +1,313.5

.t '•........................Data are on a value-date basis.

FRBNY Quarterly Review/Autumn 1981




-1 4 4 .3

These pressures against the yen intensified con­
siderably during July, as the long-awaited decline in
United States interest rates failed to m aterialize. With
little prospect that large interest differentials adverse
to the yen would narrow and that the currency would
soon rebound against the dollar, a broad range of
participants accelerated their sales of yen in an effort
to lim it losses. At the same time, foreign corporations
stepped up short-term yen borrowings to meet financ­
ing needs in other currencies, while comm ercial leads
and lags also shifted against the yen. As the flow of
funds gathered force, the decline of the yen began to
outpace the fall of the European currencies against
the rapidly strengthening dollar.
To cushion the yen’s decline, the Bank of Japan
intervened in Tokyo substantially on occasion and
in New York through this Bank as agent. However,
Bank of Japan Governor Mayekawa explained that,
while intervening to smooth erratic rate movements,
the Bank of Japan did not consider it necessary to
adopt exceptional measures to stop the yen’s slide.
The authorities asserted in numerous public statements
that the yen had depreciated by more than was justi­
fied in terms of econom ic fundamentals and was there­
fore likely to move back up over time. Consumer price
inflation was abating rapidly and, given the moderate
outcome of the wage round negotiated in the spring,
could be expected to remain the lowest among the
m ajor industrial countries. Meanwhile, exports were
proving stronger than earlier anticipated, despite ne­
gotiated export restrictions and were contributing to a
modest surplus on the current account. The authorities
also noted that short-term bank flows were still posi­
tive, even while Japan’s long-term capital account had
moved into deficit. This result largely reflected the fact
that the covered cost of borrowing dollars was often
less than local yen financing, creating incentives for
both Japanese banks and nonbanks to borrow abroad.
But, in the exchange market, the yen continued drop­
ping sharply to close at ¥ 240.35 on July 31, down 16%
percent against the dollar over the six-m onth period
under review but unchanged against the German mark
on balance. Exchange market intervention by the
authorities contributed to a $278 m illion decline in
Japan’s foreign exchange reserves during July. None­
theless, at end-July Japan’s reserves stood at $23.9
billion, up $1.2 billion on balance, mostly reflecting
interest receipts on Japan’s reserve holdings.

By early 1981 the British economy had shown substan­
tial improvements in both price and current account
performance. Inflation had fallen back fo r several
months to single-digit rates from the 20 percent or

more level of a year earlier. The current account
moved into a surplus of $6.6 billion fo r 1980, making
the year-on-year improvement of $10 billion the largest
of any industrial country and in sharp contrast to the
general experience. These considerable achievements
reflected a continued expansion of North Sea oil ex­
ports and an improvement in the nonoil terms of trade.
They also reflected a sharp slashing of inventories
which was but one feature of the severe recession that
had gripped the economy for more than a year. Indeed,
with corporate profits squeezed by persistently high
interest rates, wages, energy prices, and a strong
pound, British companies had also been forced to re­
duce fixed investment and to lay off workers in order
to restore their liquid asset positions. Even so, the
growth of sterling M-3 remained well above its target
range, reflecting the continuing demand for bank
credit, the unexpectedly large public-sector borrow ­
ing, and the ending of the supplementary special
deposit scheme in June 1980. The Bank of England,
therefore, kept monetary policy restrictive, and British
interest rates had been slow to decline.
Britain’s improving external position and relatively
high interest rates had combined to push sterling up
to a six-year high against the dollar and to rise even
further against the Continental currencies. By endJanuary, however, the pound eased back to trade around




$2.3630 against the dollar and was at 104.4, according
to a new trade-weighted index adopted by the Bank
of England on February 2. Meanwhile, the British au­
thorities had taken advantage of the strength of ster­
ling to repay prior to m aturity a number of international
loans taken up in the mid-1970s. As a result, British
foreign exchange reserves were down from their 1980
highs but still stood at $18.7 billion.
By early February, the pace of capital outflows had
accelerated, as United States interest rates had be­
come unexpectedly firm and the dollar was strong
generally in the exchanges. Although nonresidents
continued to add to their sterling balances, there was
increasing evidence that British residents were taking
advantage of the elim ination of exchange controls to
diversify their investment portfolios into other curren­
cies. Moreover, the protracted recession in the United
Kingdom was weighing more heavily on market psy­
chology. The persistent strength of sterling had gen­
erated bitter com plaints from British industrialists over
narrowing profit margins and declining product mar­
ket shares. The rate of unemployment was rising more
quickly and headed toward 10 percent. Also, a govern­
ment decision to m odify its plans for closing uneco­
nomic coal mines, follow ing an outburst of strikes by
the nation’s coal miners, was interpreted in the press
as indicating the governm ent’s willingness to ease
stringent policies aimed at making the economy work
more efficiently. As a result, expectations developed
in the market that the United Kingdom authorities
might take advantage of the improvements both in
inflation and in the current account to soften the
restrictive policy stance and to provide some stimulus
to the domestic economy.
Therefore, as the m arket awaited the March 10 bud­
get, talk circulated that the authorities would cut the
minimum lending rate by perhaps as much as 3 to 4
percentage points and allow a downward adjustment
in the exchange rate as a means of stim ulating eco­
nomic activity. In this environment, the pound eased
back against the dollar in line with other European
currencies. But after mid-February, when interest rates
in a number of other European currencies were sharply
increased, commercial leads and lags moved heavily
against sterling and some OPEC members shifted
funds out of the pound. As a result, by early March
the pound broke stride with the currencies of the
Continent and fell against the dollar some 8 percent
to as low as $2.1750.
For their part the authorities remained concerned
over the possibility of a resurgence in monetary growth
and inflation and over the persistence of a large publicsector borrowing requirement. In his March 10 budget
speech, C hancellor Howe reiterated the governm ent’s

FRBNY Quarterly Review/Autumn 1981

55

determination to maintain a restrictive policy stance
until inflation came under control and called for in­
creases in indirect taxes to reduce the projected
public-sector borrowing requirement by £3 billion to
£10 1/2 billion. This tightening of fiscal policy was
coupled with a 2 percentage point reduction of the cen­
tral bank’s minimum lending rate to 12 percent per an­
num as well as with a lowering of the target for sterling
M-3 growth to a 6-10 percent annual range. The low­
ering of the minimum lending rate had already been
discounted in the money and exchange markets.
After the uncertainties about the budget had been
cleared away, sterling moved up along with other
European currencies as United States interest rates
eased back from earlier highs. Thus, the pound re­
covered to $2.2960 around mid-March on a reflow of
capital and a reversal of previously adverse commer­
cial leads and lags. Against the dollar, sterling was a
net 3 percent lower from end-January levels. Against
other European currencies, it was also lower by about
7 percent, so that in effective terms the pound was
trading about 100.2, a decline of 4 percent.
By April, British interest rates had settled around
levels similar to those in Germany. Anecdotal infor­
mation suggested that the economy was leveling off.
But actual economic and financial trends were unusu­
ally difficult to monitor. A civil servants’ strike had the
effect both of delaying tax payments to the Exchequer
and of impeding the collection of key trade and finan­
cial statistics. The Bank of England was proceeding
with its plans to change operating techniques for mone­
tary control so as to increase the role of market forces
in determining short-term interest rates. And, as each
step of the process was announced, the markets were
somewhat unsure of the near-term implications. The
pound eased along with other currencies against the
dollar throughout the spring. By late May, it was about
10 percent lower at around $2.07. In effective terms, it
was trading at 98.8.
During June the focus of market attention shifted
to sterling. For some time, the energy situation had
shielded the pound from a number of adverse factors.
These included Britain’s loss of competitiveness aris­
ing from earlier high rates of inflation and a strong ex­
change rate, a seriously deteriorating economy, and
a weakening of political support for the government’s
continuing restrictive policies. Thus, when an increas­
ing oversupply of oil internationally prompted a sig­
nificant cut in the price of North Sea crude, an impor­
tant element of favorable market psychology was shat­
tered and the vulnerability of sterling began to show
through.
The pound, therefore, came under heavy selling
pressure during June and July, dropping through the
FRBNY Quarterly Review/Autumn 1981
Digitized for 56
FRASER


psychologically important level of $2.00. Market par­
ticipants were doubtful that the government would
support the rate through a large increase in interest
rates in view of the continuing recession. Talk circu­
lated in the markets that exchange controls might be
reimposed, prompting even further selling of sterling.
Thereafter, sterling stabilized, as British interest
rates rose after the Bank of England began provid­
ing funds to the money market above rather than at
the minimum lending rate. Also, following the resolu­
tion of the civil servants’ strike, a pickup in tax col­
lections was expected to tighten liquidity even more.
The abatement of civil disturbances gave an addi­
tional lift, while Prime Minister Thatcher’s proposal
of a modest spending program to encourage privatesector hiring of young people was not viewed as a
significant departure from past restrictive policies and
thus tended to reassure the exchange markets. As a
result, sterling traded around $1.84 on July 31 for
an overall decline of 221/4 percent against the dollar
for the six-month period. In effective terms, the pound
declined 1 1 1/4 percent to 92.5 at the end of July.
Meanwhile, over the six-month period the §anJ< of
England maintained its policy of intervening lightly on
both sides of the market to smooth out sharp fluctua­
tions in the rate. Accordingly, during the period under
review, the United Kingdom external reserves were
affected mainly by the repayment and prepayment of
loans. Britain’s foreign exchange reserves declined
$5.1 billion over the six-month period to $13.6 bil­
lion on July 31.
French franc
By the beginning of the period under review, the French
economy had moved into a recession that was to prove
deeper and more protracted than many of the slow­
downs then taking place elsewhere on the Continent.
Industrial production was down 10 percent from the.
level of the previous year, and unemployment had
risen in line with the growth of the Jabor force tcf 7.3
percent. At the same time, the sharp increase in oil
prices of recent years and lagging productivity growth
had contributed to a weakening of France’s external
position and a worrisome deterioration in its price per­
formance. France's current account had swung back
into a deficit of $7 billion, and inflation had acceler­
ated above the two-digit level once more to a rate of
13 percent.
Faced with these setbacks to the five-year program
of economic stabilization, the French authorities re­
mained committed tb the priorities of curbing inflation
and maintaining the strength of the French franc.
Whatever stimulus that had been provided to the econ­
omy in 1980 and again in late February 1981 was

modest in size and was intended to contribute even­
tually to export competitiveness. Monetary policy re­
mained restrictive. The Bank of France had reduced its
growth target fo r M-2 for 1981 to 10 percent, and the
already tight limits on banks’ credit growth were low­
ered 1 percentage point on average. Interest rates in
France remained high relative to interest rates in
most other countries on the Continent. In addition, the
government continued to encourage large enterprises
in France to take advantage of capital markets abroad
to finance on a long-term basis large investment proj­
ects at home.
In the exchange markets, the current account deficit
continued to be more than offset by capital inflows,
reflecting the attraction of interest-sensitive funds from
abroad and efforts of domestic residents to meet local
financing needs in foreign currencies. In addition, the
m arket’s attitude toward the French franc was gen­
erally more positive than for other European curren­
cies. France’s current account deficit, though a source
of concern, was considerably sm aller than for Ger­
many, its principal trading partner. The government’s
fiscal deficit, though greater than the preceding year,
was only V /2 percent of overall GNP, so that financing
the deficit was not as much of a burden as in many
other countries. France’s traditionally good relations
with M iddle Eastern countries were generally thought
in the market to make it easier fo r France to attract
funds from investors seeking an alternative to the
dollar. These long-standing ties were also thought to
help protect the nation from short-run disruptions in
oil supplies, while France’s commitment to the devel­
opment of nuclear energy was seen as providing a
more secure energy source in the longer run. More­
over, with the approach of presidential elections later
in the spring, market participants believed that the
government would take extraordinary steps if neces­
sary to bolster the franc should it come under selling
pressure. Meanwhile, France’s foreign exchange re­
serves had swelled to an impressive $26.5 billion by
January 31.
In this positive psychological climate, the franc had
traded at or near the top of the EMS for almost two
years, even as it declined against the generally
rising dollar to FF 4.90 by end-January. Early in Feb­
ruary, the franc continued to decline more slowly
against the dollar than did the other EMS currencies,
falling some 41/2 percent to FF 5.1150 by midmonth.
Within the EMS, it remained at its upper intervention
lim it and the French, German, and Belgian central
banks intervened to keep the franc within its 21A
percent band. In late February, however, the French
franc fell below the German mark in the EMS follow ­
ing action by the Bundesbank to raise interest rates




Chart 7

France
Movements in exchange rate and official
foreign currency reserves
Francs per dollar
3.50

Billions of dollars

4.00

1.0

4.50

0

5.00

-

1.0

5.50

-

2.0

6.00

-

3.0

-

4.0

6.50
7.00

J___ I
J

A

S O N
1980

D

J

F M A M J
1981

J

A

See exchange rate footnote on Chart 3.

in Germany. With French interest rates increasing not
as rapidly as elsewhere, funds shifted out of francs
and commercial leads and lags swung from francs to
marks. Thus, by early March the franc had settled about
1/4 percent below the mark in the EMS. Against the
dollar, it fluctuated in line with other European cur­
rencies, recovering by the end of March to earlyFebruary levels. Nevertheless, France’s foreign ex­
change reserves continued to strengthen, rising $1.3
billion over February-March to $27.8 billion reflecting
in part intervention w ithin the EMS.
Within France, the performance of the economy was
becoming a matter of increasing public debate. Output
had stabilized, but there was little evidence of an upturn.
Unemployment was rising even more rapidly than be­
fore. Inflation remained high. And the current account
deficit showed no sign of narrowing. In the exchange
markets the franc continued to be bolstered by rela­
tively high nominal interest rates through mid-April.
Thereafter, as the electoral contest went through the
first round of a two-stage voting procedure and fore­
casters indicated that the outcome would be close,
some international investors began moving funds out
of the franc. But, with the Bank of France now inter­
vening to keep the franc from slipping w ithin the
EMS, the rate continued to hold steady against the
mark. In this manner, the franc declined 81/4 percent
against the dollar to FF 5.3950 by May 8, just prior
to the second round of voting.

FRBNY Quarterly Review/Autumn 1981

57

Mitterrand’s election came as a surprise to the ex­
change markets. With the Paris stock market plummet­
ing, massive amounts of funds began to be moved out
of the franc. These flows largely took the form of com­
mercial leads and lags but also represented withdrawals
of deposits and liquidations of investments. These sell­
ing pressures quickly pushed the franc from the middle
to the floor of the joint float and to FF 5.5875 against the
dollar late in May.
The authorities responded quickly to contain these
selling pressures. The Bank of France intervened heavi­
ly to keep the franc within its 2Vk percent band against
the mark. Effective May 14, the central bank raised
reserve requirements on sight deposits and eliminated
the special reserve requirement on nonresident depos­
its that had been imposed to curtail capital inflows
late in 1980. Also, it raised the discount rate on sevenday Treasury bills by 41/2 percentage points to 18 per­
cent, while day-to-day rates in the money market
jumped from 131/2 percent to 16 percent. At the same
time, leading economic advisers to the new president
reaffirmed France’s commitment to the EMS arrange­
ments.
Once in office the new government took further ac­
tion to stabilize the franc by tightening exchange con­
trols. With respect to trade financing, it reduced the
scope for leading and lagging commercial payments
and receipts to one calendar month (retroactive to
May 1). Regarding portfolio investment in foreign cur­
rencies, residents were required as of May 22 to pur­
chase the exchange from other residents, thereby
establishing a separate market for these transactions
and removing them as a source of pressure on the
exchange rate. For its part, the Bank of France hiked
its discount rate on seven-day Treasury bills another
4V2 percentage points to 22 percent and day-to-day
interest rates moved up as high as 20 percent.
In response to these stringent moves, the franc came
into demand as exporters scrambled to convert foreigncurrency receipts ahead of the month end. By endMay, therefore, the franc was off its lows against both
the mark and the dollar. Thereafter, the new exchange
control measures were expected to generate a con­
tinuing reversal of leads and lags well into the summer.
Also, the tightening of credit conditions and the sharp
rise in Euro-French franc interest rates to around
25 percent helped discourage nonresident outflows.
Thus, the franc soon settled in around the middle of
the EMS, a position it was generally to maintain through
end-July.
As a result, the franc traded comfortably within the
EMS during the June 21 Parliamentary elections that
provided a sufficient majority to the new government
to implement its economic program. By July, the au­

58 FRBNY Quarterly Review/Autumn 1981


thorities were proceeding with their program to re­
duce unemployment by expanding the economy and
increasing its productive potential, while also carry­
ing through a long-standing plan to nationalize key
sectors of the economy. In particular, they announced
plans to increase social benefit expenditures, raised
the minimum wage, and announced plans for new
education, housing, and industrial retraining programs.
Even with tax increases to generate more revenue,
the fiscal deficit was expected to double for 1981.
The government also moved forward with plans to
nationalize eleven industrial groups. Commercial bank
lending ceilings were raised and minimum reserve
requirements lowered to allow greater expansion of
bank lending.
With the exchange markets now more settled, the
Bank of France was also able to permit short-term
interest rates to decline gradually, so that by end-July
the central bank’s discount rate on seven-day Treasury
bills was down to 181/2 percent and day-to-day rates
had eased to 17% percent. Even so, the market re­
mained pessimistic over the outlook for the franc, since
France had adopted strongly stimulative policies while
other countries were still emphasizing restraint. With
the dollar rising across the board, the franc eased by
the month end to FF 5.8775, down 20 percent on bal­
ance for the six-month period. Even within the EMS
the market found reason to contrast the recent reflationary measures of the French government with the
budget-cutting efforts taking place in Germany, espe­
cially after the Ottawa summit. Even so, the franc held
its own around the middle of the joint band to close
the period trading at FF 2.3728 against the German
mark, down 31A percent on balance over the sixmonth period. Meanwhile, France’s foreign exchange
reserves, which had dropped $4.5 billion during MayJune, declined only another $558 million to $22.6 bil­
lion, to register a net decline of $3.8 billion over the
February-July period.
Italian lira
The Italian lira was under considerable downward
pressure coming into the period as the market re­
sponded to a swing in Italy’s current account back into
heavy deficit, the persistence of relatively high infla­
tion at home, and the lack of progress in containing
government expenditures and curbing the publicsector deficit. The $15 billion deterioration in Italy’s
current account over 1980 to a $10 billion deficit had
reflected in part an adverse turn in Italy’s terms of
trade resulting from the sharp increase in dollar
prices for energy and other imported products. It
reflected as well the weakening demand in Italy’s
principal export markets. In addition, the rapid pace

of inflation, at 20 percent by late 1980, had brought
into question the competitiveness of Italy’s export
sector, especially in those countries participating in
the fixed exchange rate arrangements of the EMS.
Moreover, the large and growing public-sector deficit
that amounted to 11 percent of gross domestic product
(GDP) further clouded the prospect for reducing in­
flationary pressures in the near term. That deficit
reflected a number of deep-seated problems includ­
ing the high level of wage settlements, the pervasive­
ness of a wage indexation system, and the lagging
productivity growth and weakening capital structure
of Italy’s large government-enterprise sector.
These problems had come into focus early in 1981
in the absence of progress in improving price or
trade perform ance at a time when industrial output
had rebounded from earlier depressed levels. The
government had proposed a medium-term program in­
tended to cut current spending, to stimulate invest­
ment, and to finance the increased investment spend­
ing abroad. But the pace of public spending had
quickened and monetary growth had accelerated. In
this environment, the lira had fallen against the dollar
to a record low in New York trading of LIT 1,004.50
by the end of January. Within the EMS, the lira had
required steady intervention support by the Bank of
Italy to hold its position. Even so, Italy’s foreign cur­
rency reserves stood at a relatively high $20.5 billion.
Meanwhile, the task of controlling inflation and
supporting the lira in the exchanges had fallen on the
Bank of Italy, which acted on January 31 to tighten
control over expansion of money and credit. Ceilings
on bank lending were extended to include loans under
LIT 130 m illion and foreign currency loans, both pre­
viously excluded from lim itation. The new ceilings
were made effective March 31, at which time loans
coming under the new controls were to be reduced to
end-December levels and then subject to a new and
lower set of growth limits fo r the remainder of the
year. Credit extensions above the limits were made
subject to a 50 percent deposit requirement in noninterest-bearing accounts at the central bank. As be­
fore, foreign currency loans to exporters were
excluded. These actions improved exchange market
sentiment toward the lira early in February. Though the
lira eased against the dollar, which was strengthening
at the time, it kept generally in line with other curren­
cies in the EMS.
During February, however, the most recent informa­
tion suggested a further widening of the trade and
current account deficits and intensification of domestic
inflationary pressures. As a result, the lira failed to
recover late in the month by as much as the currencies
of other Continental countries, which were being bid




up in response to sharp increases in short-term inter­
est rates in their dom estic markets. By mid-March the
lira had slipped nearly 4 percent against the German
mark and was thus requiring intervention support to
hold its position w ithin the EMS. As the March 31
deadline approached for cutting back on foreign cur­
rency loans under the new credit ceilings, importers
and other residents came into the m arket as buyers of
foreign currency. These transactions added to the
pressure against the lira, which fell through Italy’s
divergence threshold w ithin the EMS even as the Bank
of Italy stepped up its intervention support. These
operations contributed to a $4 billion decline in Italy’s
foreign currency reserves during February-March.
In response to these exchange m arket pressures,
a series of actions were taken to support the lira over
the weekend of March 21-22. They included a 6 per­
cent downward adjustment of the lira ’s central rate
within the EMS, which was reflected in the market by
a 21/2 percent depreciation against the dollar. Also, to
absorb liquidity the Bank of Italy hiked reserve re­
quirements from 15% percent to 20 percent above endFebruary levels on both resident and nonresident liradenominated bank deposits. It also raised the discount
rate by 21/2 percentage points to 19 percent, the first
change in this rate since September 29, 1980. In ad­
dition, the government announced its intention to pro­
pose measures to Parliament to offset the potential
effect on the government deficit of several budgetary
amendments passed by Parliament in preceding
weeks. The proposals focused on cuts in current

Chart 8

Italy
Movements in exchange rate and official
foreign currency reserves
Lira per dollar
800

Billions of dollars

900
1000
1100

1200
1300
1400

J

A

S O
1980

N

D

J

F M A M J
1981

J A

See exchange rate footnote on Chart 3.

FRBNY Quarterly Review/Autumn 1981

59

spending in line with those announced during the
winter which, when approved by Parliament, would
be sufficient to bring the projected 1981 government
deficit back to the LIT 37.5 trillion level originally
envisaged.
After these measures and as a result of its new EMS
parity, the lira moved from the bottom to near the top
among the EMS currencies. Also, the expansion of
money and credit began to slow in response to the
tightening of monetary policy. Skepticism remained,
however, over the fiscal situation. As a result, the lira
soon began to ease toward the middle of the EMS
and the Bank of Italy intervened on occasion to limit
any slippage.
During April and May, as United States interest rates
had again turned higher, short-term funds were drawn
increasingly from Italy. Thus, the lira became more
vulnerable to downward pressure. Moreover, at home
Italy’s inflation problem had again become a major
focus of public debate. Exchange market participants
took note that the Parliament had not yet acted on
either the short-term austerity measures proposed by
the government in March or the three-year program
under discussion for months. In addition, a major
political controversy diverted attention away from
economic matters. When it reached a crisis in late
May that brought down the Forlani government, any
chance of near-term action on policy initiatives evap­
orated. Moreover, by end-May, Italy’s foreign exchange
reserves had dropped a further $2 billion to $14.5
billion.
To address the immediate pressures in the exchange
and financial markets, the Forlani government— acting
in a caretaker capacity— imposed an austerity pro­
gram by decree that included increases in certain
public charges and cuts of 5 to 10 percent in some
categories of government spending. These actions
were intended to reduce the government deficit by
about 7Vz percent in 1981 if approved by Parliament
within sixty days. The government simultaneously im­
posed an import deposit scheme, also by decree,
which required that all purchasers of foreign exchange
place with the Bank of Italy a ninety-day, noninterestbearing deposit equal to 30 percent of the exchange
transaction. These deposits had the effect of increasing
the cost of payments in foreign currency as well
as cutting into credit available for domestic purposes.
After these actions, the lira traded more comfortably
within the EMS, enabling the Bank of Italy progres­
sively to scale back its intervention support of the
currency. Against the dollar, the lira continued to de­
cline but, in contrast to preceding months, no more
rapidly than other Continental currencies. During July
the formation of a new government under the Republi­

60 FRBNY Quarterly Review/Autumn 1981


can Giovanni Spadolini and the onset of seasonal
inflows from tourism gave additional support to the lira.
The Bank of Italy then became a sizable net buyer of
dollars for the first time during the period under re­
view. By the end of July, the lira was trading at
LIT 1,227.50, down on balance 221A percent against
the dollar and down 5 percent against the German
mark. Meanwhile, Italy’s foreign currency reserves
rose $2.0 billion after end-May to $16.5 billion at endJuly for a $4.0 billion decline over the six-month
period under review.
Other currencies within the European Monetary System
In early 1981 the countries whose currencies are
members of the EMS joint floating arrangement faced
similar problems. Most were dependent on capital in­
flows to finance current account deficits. Fiscal deficits
had grown and were exerting increasing strains on do­
mestic capital markets, and inflationary pressures
appeared to be accelerating even as the domestic econ­
omies were weakening. Although monetary policies
were generally restrictive, slowdowns in the domestic
economies and rising unemployment were seen in the
market as constraining the authorities from increasing
interest rates further to maintain the currencies’
attractiveness to international investors and port­
folio managers. Some countries had been able to
attract substantial amounts of private funds, and
others looked to government-arranged loans from
abroad as a means of achieving external balance and
stabilizing their currencies within the joint float. But,
in either case, the EMS currencies were vulnerable
to capital outflows attracted by relatively high inter­
est rates in other countries and to an increasingly
bullish sentiment toward the dollar. As a result, these
currencies were continuing to decline as the six-month
period under review opened.
Within the EMS, there were also considerable
strains and the 2!4 percent band for all but the Italian
lira was fully stretched. Requiring persistent support
at the bottom of the band was the Belgian franc, along
with the German mark. The Belgian franc was weighed
down by concern over a domestic economy that was
undergoing difficult structural adjustment, experiencing
rising unemployment, and suffering from a fiscal deficit
that had mounted to more than 10 percent of GNP.
The current account deficit also was large, and both
deficits were being financed to a large extent through
government-arranged loans denominated mostly in dol­
lars and other Eurocurrencies. Close behind the French
franc at the top of the band was the Dutch guilder. It
was helped by the relatively favorable current account
position of the Netherlands and interest rates that were
high enough to continue to attract nonresident invest­

ment in long-term guilder-denominated bonds. The
Danish krone and Irish pound fluctuated around the
middle of the band, and the Danish and Irish authori­
ties relied heavily on conversions of foreign borrow­
ings to keep their currencies trading comfortably within
the joint float.
This configuration of currencies changed abruptly
in mid-February, when the German authorities reacted
to intensifying selling pressure against their currency
by tightening monetary policy. German interest rates
rose considerably, especially rates on call money, and
the mark snapped up within the EMS, rising from the
bottom to the top of the joint float. As the mark
advanced within the EMS, the French franc and Dutch
guilder came under modest selling pressure against
the mark. But these pressures were soon contained,
and the currencies stayed in the upper half of the
European Community (EC) band after the Bank of
France and the Netherlands Bank, following quickly on
the Bundesbank’s measures, raised their own interest
rates by 1 to V/2 percentage points. The Danish krone
and the Irish pound eased into the lower half of the
joint float but were kept from falling further by modest
intervention.
This changing configuration of currencies within the
EMS left the Belgian franc all the more exposed at the
bottom of the joint float. Belgium’s fiscal and current
account deficits continued to deteriorate. The authori­
ties were reluctant to raise domestic interest rates
because the economy was still weak and labor un­
rest was already festering in some of the most de­
pressed industries. The coalition government was hav­
ing difficulty agreeing on a program of expenditure
cuts and other measures to reduce the fiscal deficit.
And the prolonged negotiations on economic policy
were casting doubt in the exchange markets about
the government’s ability to deal with the country’s
economic problems.
Against this background, the Belgian franc remained
pinned to its lower intervention point as the EMS group
of currencies gained against the dollar late in Febru­
ary. In March, following a downward adjustment of the
Italian lira which put it in the upper half of its new
band, the franc was exposed to even greater selling
pressure. Heavy support had to be provided for the
Belgian franc mainly by sales of German marks and
French francs. The Belgian National Bank increased
its official lending rates in stages over the month. By
March 26, its discount rate was up 1 percentage point
to 13 percent and its Lombard rate was up 3 percent­
age points to 15 percent. Also during the month, the
government announced parts of its program to cut the
fiscal deficit by BF 30 billion. However, the pressures
against the Belgian franc remained intense as con­




tinuing shifts in commercial leads and lags aggravated
the exchange market impact of the large current
account deficit. On March 30 the government re­
signed, and immediately thereafter the National Bank
hiked its discount and Lombard rates another 3 per­
centage points. It also imposed measures to ensure
that financial institutions would not restore their liquid­
ity by unloading government debt and would not add
to outflows of capital by extending credits to the private
sector. To restore confidence in the franc, a one-month
freeze on wholesale and retail prices was imposed
effective April 2. These new initiatives helped ease
the immediate pressures against the Belgian franc.
During April and early May, trading became more com­
fortable within the EMS, which nevertheless declined
progressively against a generally strengthening dollar.
The mark remained at the top of the band, providing
the Bundesbank an opportunity to improve its position
within FECOM by acquiring small amounts of other EMS
currencies in the market and by having its currency
used in intervention to support other EMS curren­
cies. The Belgian franc gradually came into better
balance, moving off the floor of the EMS in a favor­
able reaction to the recent tightening of monetary
policy. The Dutch guilder, by contrast, declined into
the middle of the band as the market reacted to the
failure of Dutch interest rates to keep pace with
those abroad and to uncertainties ahead of Parlia­
mentary elections. The Danish krone also eased
slightly within the joint float, while the Irish pound
stayed near the bottom of the band. Intervention by the
central banks of Belgium, the Netherlands, Denmark,
and Ireland was modest and conducted mostly in dol­
lars to stabilize the position of their currencies in the
EMS. As the French presidential elections moved
through the first round of balloting, by contrast, official
purchases of francs against both marks and dollars
became heavy as the Bank of France acted to steady
the franc in the middle of the joint float.
Later in May, the announcement of Mitterrand’s
victory in the French presidential elections brought
the French franc under immediate pressure in the EMS
and generated skepticism in the market over the
commitment of a new French government to the EMS
institutions. The French authorities soon acted to sup­
port their currency by tightening exchange controls
and by raising interest rates sufficiently to trigger some
reversal of leads and lags. In addition, to reassure the
markets, both President Mitterrand and Chancellor
Schmidt publicly reaffirmed their intention to cooperate
in upholding the EMS arrangements. Meanwhile, the
Dutch guilder, aided by fairly moderate but persistent
intervention by the Netherlands Bank, managed to
maintain its position in the upper half of the joint float.

FRPNY Quarterly Review/Autumn 1981

61

Also, the Danish krone and the Irish pound remained
stable within the EMS.
During June and July the Belgian franc came under
renewed selling pressure as the market reacted to a
progressive lowering of domestic interest rates and to
the new government’s lack of progress in reducing the
fiscal deficit. The central banks met this pressure with
forceful intervention, however, and by late July the
franc had stabilized within its EMS band. Never­
theless, the market remained concerned about the
prospects for EMS countries, individually and collec­
tively. With sentiment toward the dollar becoming
increasingly bullish during the summer, the EMS
currencies as a group weakened further. By the end
of July, the EMS currencies had declined against the
dollar by 161/4 percent to 221A percent on balance
over the six-month period.
Canadian dollar
The Canadian government sought to harness Canada’s
rich natural resources to generate higher economic
growth and to curb the deeply entrenched inflationary
pressures. Its plans for achieving these objectives
were embodied in proposals submitted late last year
to Parliament for the 1981 budget and for a national
energy program. According to the budget, the federal
deficit would be substantially reduced over several
years with cuts, among other things, in transfers to
the provinces in the context of the next federalprovincial review of financial arrangements in 1982.
The largest contribution to cuts in the fiscal deficit,
however, came from changes in taxation and subsidies
proposed in the energy program. According to the
proposed energy program, the federal government
would unilaterally establish a single price for crude
oil at levels, though higher than before, still well
below international levels. Unification of domestic and
imported crude oil prices would be achieved through
new levies and a gradual elimination of the direct
government subsidy on imported oil. Incentives for
exploration and development would be provided in
amounts varying largely with the degree of Canadian
ownership and control of the enterprises concerned.
A federal tax on oil and gas revenues, together with
the increased levies, would considerably increase
federal revenues.
In the exchanges, market participants questioned
whether adequate incentives would remain to main­
tain the momentum of exploration and development
and to continue to attract the sizable inflow of invest­
ment from abroad that had buoyed the currency over
previous years. In addition, the pricing and revenue
provisions, together with other elements of the budget,
raised complex issues about the relationship between

62

FRBNY Quarterly Review/Autumn 1981




the federal and provincial governments. Late in the
year, the Canadian dollar had come under selling
pressure in the exchange markets, dropping to its low­
est levels since the 1930s. The Bank of Canada had
responded forcefully to these selling pressures by in­
tervening heavily to cushion the Canadian dollar’s
decline and by raising short-term interest rates. As a
result, the market had come into better balance and
the spot rate had recovered somewhat. It was still
trading, however, not far above its recent lows at
Can.$1.1948 by the end of January. Meanwhile, Can­
ada’s foreign currency reserves stood at $1.4 billion,
and the government of Canada's outstanding borrow­
ings under its $3.0 billion credit line with foreign
banks amounted to $300 million. Its $2.5 billion credit
line with Canadian chartered banks remained fully
available. (The latter credit line was increased to
$3.5 billion in June 1981.)
By February a more positive attitude developed for
the Canadian dollar. Canada’s trade position had bene­
fited from earlier shifts in the terms of trade and an
improved competitive position. The trade surplus had
climbed to an annual rate of $10 billion in the last
quarter of 1980, swinging the current account into an
uncharacteristic surplus at a time when most indus­
trialized countries were in deep current account deficit.
Also, the Canadian economy was particularly buoyant
late in 1980, led by expanding exports. This pickup
in activity contrasted with the developing slowdown in
much of Europe and Japan.
The unexpected pickup in economic activity and
ensuing resurgence in M-1 provided the basis for the
monetary authorities to put upward pressure on short­
term interest rates. In addition, the persistently high
level of interest rates in the United States and the
potential for interest-sensitive outflows to put renewed
selling pressure on the Canadian dollar, and thereby
to exacerbate the inflationary situation, suggested the
desirability of allowing Canadian interest rates to
move gradually higher. Thus, Canadian interest rates
continued to increase in early March, even as United
States interest rates subsequently edged lower, so
that the usual pattern of interest rate differentials fa­
vorable to Canada was reestablished. Also, on Febru­
ary 13, the Bank of Canada, in announcing its mone­
tary growth targets for the new year, cut the 1981
range for M-1 expansion 1 percentage point to 4-8
percent.
In response to these various factors, the Canadian
dollar strengthened in the exchanges by about 1 1/2 per­
cent to around Can.$1.1783 by mid-March. The Bank
of Canada, continuing to intervene to moderate shortrun fluctuations in the currency, was a net purchaser
of dollars in the exchanges, as is reflected in the

Chart 9

Canada
Movements in exchange rate and official
foreign currency reserves
Billions of dollars
1.5

Canadian dollar per dollar
1.14
1.16

.

1.18
1.20

■

I

1.22

■

I

1.26

J

I I
A

I

N

I

1

V

1 1 1 1 II

II

S O
1980

0.5

0

•

Foreign currency
rese'rves
S cale------ ►

1.24

1.0

Exchange rate
------ Scale

D

J

11

F M A M J
1981

J

A

-1.5

See exchange rate footnote on Chart 3.

Chart 10

Interest Rates in the United States,
Canada, and the Eurodollar Market
Three-month maturities*

Certificates of deposit
of New York banks,
(secondary market)

A

— Canadian
finance paper

J

A

S

O
1980

N

D

J

F

I I I
M

A
M
1981

I J_ _ L
J

J

A

*Weekly averages of daily rates.

$378 m illion increase in foreign exchange reserves
during February-March.
During the second quarter, however, the outlook for
the Canadian dollar became more guarded. Negotia­
tions to resolve disagreements over pricing of oil and




gas were dragging on w ithout clear results. Pending
resolution of these issues, the principal energyproducing province of Alberta had started to cut
back oil production and these cutbacks were leading
to a previously unexpected increase in Canada’s oilim port bill as well as clouding prospects fo r the an­
ticipated increase in federal government revenues.
Also, in the context of a federal government proposal
to repatriate the Canadian constitution, a number of
issues relating to the relationship between the federal
and provincial governments were being reviewed by
the courts. Meanwhile, a first-quarter slackening of
export demand, particularly to the United States, had
cut into Canada’s trade surplus, and the current ac­
count appeared to be returning to deficit. Moreover,
dom estic inflation had accelerated, spurred partly by
increases in energy prices, and the consumer price
index was now rising at an annual rate in excess of
12 percent. Also, wage settlements had failed to mod­
erate, a number of industries were being hit by labor
strikes, and d ifficult wage negotiations were approach­
ing. Partly for dom estic reasons and partly in response
to a renewed rise in United States interest rates, the
Bank of Canada allowed Canadian rates to move up
further. Initially, however, Canadian interest rates did
not keep pace with those in the United States so that
by m id-April the previously favorable interest differen­
tials had eroded. Thus, the Canadian dollar eased
against the rapidly rising United States dollar through
the spring. But it continued to move higher against the
other currencies which were weakening more rapidly
against the United States currency.
Nevertheless, Canada had headed back toward its
traditional pattern of current account deficit financed
by capital inflows. Canadian entities had significantly
stepped up their borrowing activities in the United
States. With the Canadian dollar still close to its his­
to ric lows against the United States dollar and with the
monetary authorities having demonstrated determ ina­
tion to defend the rate, many borrowers took advantage
of the relatively firm United States currency to borrow
abroad and convert the proceeds to finance domestic
needs. At the same time, however, Canadian residents
sought to make direct and portfolio investments
abroad, both in the energy sector to take advantage
of more rapid price increases than permitted at home
and in other natural resource industries. Canadian
investors were also purchasing foreign-owned assets
in Canada. In this connection, a few foreign-owned
companies in Canada became targets of unsolicited
takeover bids, and w idely publicized fights for control
drew attention to the impact of the new pricing and
tax provisions favoring Canadian ownership in the
energy sector. As market participants considered the

FRBNY Quarterly Review/Autumn 1981

63

implications for capital flows and debt servicing require­
ments of shifting ownership of the natural resource in­
dustries to Canadian ownership, the Canadian dollar
became increasingly vulnerable in the exchanges.
Indeed, in July the Canadian dollar came under
extreme downward pressure in a selling wave that
was precipitated by a few large commercial orders.
Once the decline began, market participants focused
their attention on other factors that were also adverse
for the Canadian dollar. With the United States dollar
rising sharply against other currencies at the same
time, the Canadian dollar fell further. To steady the
market, the Bank of Canada bought Canadian dollars
heavily in the market. It financed its intervention, in
part, by drawing $700 million under its $3.0 billion
facility with foreign banks, leaving its $3.5 billion

64

FRBNY Quarterly Review/Autumn 1981




standby facility with the Canadian chartered banks
fully in place. Also, to support the exchange rate, the
Bank of Canada moved to push interest rates sharply
higher, and by the close of the period the rate on
three-month Treasury bills had climbed to slightly over
20 percent, the highest in years. On July 29 the Min­
istry of Finance announced that it had obtained agree­
ment from the major Canadian banks to curb loans to
finance takeovers of foreign companies. This action
helped bring the Canadian dollar market into better
balance after the period under review. But in the interim
the Canadian dollar dropped lower to Can.$1.2344,
registering a decline of 31A percent for the six months
between end-January and end-July. Also, at end-July,
Canadian reserves stood at $748 million, down $600
million on balance.

THE ARITHMETIC OF INTEREST RATES
The Federal Reserve Bank of New Y ork’s new, 32-page
booklet, “ The Arithm etic of Interest Rates” , seeks to
explain how to calculate interest rates. It begins with
the elements of simple interest and builds on these to
explain, in lay terms, the concept and mathematics of
compound interest. The booklet also attempts to un­
ravel some of the problems consumers m ight have in
calculating interest yields on Treasury securities, as
well as figuring monthly mortgage and consumer in­
stalment loan payments.
It is available free of charge from :
Public Inform ation Department
Federal Reserve Bank of New York
33 Liberty Street
New York, N.Y. 10045

Subscriptions to the Quarterly Review are free. M ultiple copies in reasonable
quantities are available to selected organizations for educational purposes. Single
and m ultiple copies for United States and fo r other Western Hemisphere sub­
scribers are sent via third- and fourth-class mail, respectively. All copies for
Eastern Hemisphere subscribers are airlifted to Amsterdam, from where they are
forwarded via surface mail. M ultiple-copy subscriptions are packaged in envelopes
containing no more than ten copies each.
Quarterly Review subscribers also receive the Bank’s Annual Report.




Library of Congress Catalog Card Number: 77-646559