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Spring 1983

Volume 8 No. 1

F o re ig n P e nsio n F und In v e s tm e n ts
in th e U n ite d S ta te s
S o c ia l S e c u rity in G e rm a n y and
th e U n ite d K in g d o m
C h a rts on N ew Y o rk S ta te and Loca l
G o v e rn m e n t S p e n d in g
U.S. In te rn a tio n a l T ra d e in
S e rv ic e s
M o n e ta ry P o lic y and O p en M a rk e t
O p e ra tio n s in 1982
T re a s u ry and F ed era l R ese rve F ore ig n
E x c h a n g e O p e ra tio n s

The Quarterly Review is published by
the Research and Statistics Function
of the Federal Reserve Bank of New
York. Among the members of the staff
who contributed to this issue are
EDNA E. EHRLICH (on foreign pension
fund investments in the United States,
page 1); CHRISTINE CUMMING (on
social security in Germany and the
United Kingdom, page 13); LOIS
BANKS (charts on New York state
and loca l government spending,
page 26); ROBERT A. FELDMAN and
ALLEN J. PROCTOR (on U.S. inter­
national trade in services, page 30).
A report on monetary p olicy and open
m arket operations in 1982 begins on
page 37.
A semiannual report of Treasury and
Federal Reserve foreign exchange
operations fo r the period August 1982
through January 1983 starts on
page 55.




Foreign Pension Fund
Investments in the
United States
Foreign pension funds are investing sizable amounts
in the U.S. securities and real estate markets. These
pension funds, which supplement government social
security systems, are growing, as are those in the United
States, at a rapid rate. The annual flows into the funds
constitute a large part of national savings, and their
deployment accounts for an increasingly significant
share of total new investments in the capital markets
of the respective countries. At the same time, how­
ever, international diversification has become an im­
portant feature of pension fund management, with U.S.
assets generally accounting for a major portion of the
foreign investments.
This article focuses on U.S. investments by the pen­
sion funds of four foreign countries— the United King­
dom, the Netherlands, Canada, and Japan— which
together comprise all but a small portion of total
foreign pension fund holdings in the United States.
The first three are countries whose fund managers be­
gan to invest abroad many years ago.1 In Japan, inter­
national diversification got under way more recently,
and U.S. holdings are still quite small. However, Japa-

nese funds are in an early state of development, and
their portfolios will be expanding particularly rapidly.
U.S. assets also make up significant portions of the
pension funds of some countries not covered in this
article but, due to the comparatively small size of
the labor force in those countries, the totals invested
here are not substantial. Some larger countries do not
have funding requirements; consequently, accumulated
reserves are relatively insignificant.2
The flow into the United States from the foreign
funds has risen significantly in recent years, reflect­
ing both the swelling of the funds and the increase
in the share allocated to foreign investment. Of all the
world’s capital markets, those in the United States
have stood up over the long run as the most attractive.
During the past few years, growing uneasiness about
various political and economic developments in home
countries and elsewhere has strengthened the interest
in U.S. assets. At the same time, however, a trend has
been developing toward broader geographical diver­
sification by pension funds in countries where foreign
holdings have heretofore consisted overwhelmingly of
dollar assets.

The author is greatly obligated for information used in this article to a
host of individuals, too numerous to mention, from various foreign
entities, including government agencies, central banks, corporate
pension funds, financial intermediaries, and national organizations of
pension fund managers.

2 In Italy, less than 20 percent of the working population is covered
by private plans. Although reportedly a majority of the firms that
do have plans choose to fund them, thereby deriving tax benefits,
Italian foreign exchange regulations inhibit foreign investments.
In Germany, almost all business enterprises with pension plans carry
their plan liabilities on their corporate balance sheets instead
of setting aside separate reserves. The only firms whose pension plans
are funded are affiliates of companies headquartered in other
countries. In France, private pension plans are mandatory but
operate on what is, in effect, a pay-as-you-go system, with current
workers paying for current retirees.

i This is in sharp contrast to developments in the United States, where
international diversification began only in the late seventies. The move­
ment into foreign assets by U.S. pension funds, and its implications,
were examined in detail by the author in “ International Diversification
by United States Pension Funds”, this Quarterly Review (Autumn 1981).




FRBNY Quarterly Review/Spring 1983

1

Table 1

Funded Pension Plans— 1981
In billions

Country

Accumulated reserves as of end-1981
Trusteed
Insured
funds
funds

Growth of reserves in 1981
Trusteed
Insured
funds
funds

Canada*
15

Canadian d o lla r s .............................
U.S. d o lla r e q u iv a le n t........................ , , , .

10

1
1

51

121/z

8 1/2

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

6,500

3,200

1,100

U.S. do lla r e q u iv a le n t........................ ........

29Vz

14 Vs

5

700
3

Netherlands^
Dutch g u ild e r s .....................................

92

32§

10

3 1/z

U.S. d o lla r e q u iv a le n t........................ .........

37

13§

4

Vh

7

3 1/2

United Kingdom
33

Pounds sterling ...................................
U.S. d o lla r e q u iv a le n t........................

122

63

13% -

6 1/2

Some reserve figures are market value, others book value. Reserve growth figures fo r 1981 are m ainly book value.
M ost of the figures on insured funds are estim ates. U.S. d o lla r conversions are at end-1981 rates.
* Reserves for Canadian Government Annuities, a holdover from an earlier pension era, com prise an additional Can.$500 m illion.
t Data as of March 31, 1982, the end of the fiscal year.
t Excludes the General Public Service Pension Fund, the country’s largest fund (assets at the end of 1981 totaled FI 83 b illio n ),
since the only foreign assets it is allowed to acquire are foreign governm ent bonds listed on the Amsterdam stock exchange.
§ The insurance com panies are used almost solely for guaranteed contracts, prim arily by the sm aller pension funds. The volum e of
foreign investments was insignificant.
Sources: United Kingdom: Central Statistics Office, Financial S tatistics; the Netherlands: De Nederlandsche Bank, Annual Report;
Canada: S tatistics Canada, Trusteed Pension Plans Financial S tatistics and Financial Institutions Financial S tatistics; and
Japan: The Bank of Japan, Econom ic Statistics Monthly. Also, unpublished inform ation.

Despite the scarcity of hard data, inform ation gath­
ered fo r this article suggests that the amount of fo r­
eign pension money that has been coming here dur­
ing the last three years may have grown from perhaps
$ 21/2 billion a year to approxim ately $4 billion. This
range constitutes roughly the same order of magni­
tude as the estimated outflow of U.S. pension money
into investments abroad. It seems likely that a near
balance w ill continue to be the situation fo r at least
the next five years. One can therefore conclude that
the increasing internationalization of pension fund
portfolios is occurring w ithout significant effects on
the value of the dollar in the exchange markets. In
addition, the overseas investors are adding to the
depth and the liquidity of U.S. securities and real es­
tate markets. Moreover, both the foreign and the U.S.
pension funds are able to develop portfolios that
their sponsors and managers regard as better than

2

FRBNY Quarterly Review/Spring 1983




could be achieved if they were restricted to purely
dom estic investments.3
Pension fund reserves and government regulations
The actual volume of investments in U.S. assets de­
pends upon a large number of variables. The poten­
tial volume, however, depends basically on (1) the
size of the accum ulated pension fund reserves and of
the ongoing additions to these reserves, and (2) gov­
ernment regulations concerning p ortfolio investments.
Volume of reserves
The size and rate of growth of pension funds reflect,
among other factors, the number of people covered
and the liberality and m aturity of the plans. They also
3 For details on the motivations for U.S. fun ds’ diversification, see
article cited in footnote 1.

reflect government funding regulations— i.e., the extent
to which actuarially determined reserves must be ac­
cumulated. Figures showing the amount of reserves
accumulated by the end of 1981 in funded pension
plans in the four countries discussed, and the 1981
growth of reserves, appear in Table 1. Because invest­
ment regulations and policies differ between insurance
companies and other types of intermediaries, the table
divides the data into two components, insured and
trusteed. “Insured” funds are those handled by in­
surance companies, often on a guaranteed income
basis. “Trusteed” funds are those managed either
internally, i.e., by the firm sponsoring the pension plan,
or outside by noninsurance company intermediaries,
including banks, trust companies, brokerage houses,
and investment counselors.
The mass of reserves accumulated by United King­
dom pension funds was by far the largest, as was the
annual reserve growth. To some extent, the rate of
growth in recent years has reflected new tax incen­
tives introduced in the 1970s, which stimulated an in­
crease in funding.4 The smallest accumulation was in
Japan, where funded plans covered about the same
number of active workers as in the United Kingdom
but accounted for a much smaller percentage of the
labor force. Additional plans are being established at
a rather substantial pace, partly because of recently
heightened favorable tax treatment.5 Partly as a result
of this increase in plans, the liabilities and reserves
of the pension funds are climbing steeply. Also con­
tributing to the swelling of the funds are improvements
in benefits and a rise in employee and retiree ages
because of a sharp increase in the Japanese life span.
In all four countries, the large wage increases that
accompanied the high inflation rates of the past de­
cade contributed importantly to sharp upward pres­
sures on required reserves. However, in some coun­
tries actuarial assumptions were, or are being, modified
to allow for anticipation of higher portfolio returns,
thereby reducing for some funds indicated increases in
employer-employee contributions. Moreover, due to the
difficult financial situation in which many firms have
found themselves because of the worldwide recession,
some employers’ contributions have been temporarily
cut back. The contributions are expected to be restored
to their previous levels, however, as soon as financial
conditions permit.

Investment regulations
Government regulations concerning pension fund in­
vestments vary widely. They are very liberal in both
the United Kingdom and the Netherlands.6 In Canada,
however, the government regulates investments both
by type and quantity. And in Japan, where flexible Min­
istry of Finance guidelines substitute for regulations,
the guidelines are more restrictive of investments
handled by trust banks than those by insurance com­
panies.7 Everywhere, including countries not covered
here, local government employee plans are usually more
conservative in their investments than are other funded
plans, sometimes because of regulation, sometimes be­
cause of custom. This has resulted— at least until very
recently— in their making comparatively small, and even
no, foreign investments.
The basic national regulatory attitudes carry over
into the foreign investment sphere. The pension funds
of British private and nationalized industries are allowed
to invest abroad freely. The only restraints, as with
domestic investments, are those imposed by fund trust­
ees. The local authority pension funds still have some
constraints, but these are currently under review. Also,
the investments of pension funds managed by insur­
ance companies as part of their long-term funds are
subject to the general restriction that 80 percent of an
insurance company’s assets must correspond to the
particular currencies in which its liabilities are ex­
pressed. In the N etherlands, foreign investments are
similarly free of formal government restrictions. The
Chamber of Insurers, which supervises the private
plans but makes no general rules, may offer comments
regarding a plan’s investment policies. Reportedly, how­
ever, it seldom does this before an investment proves to
have been ill-advised.
In Canada and Japan the situation is very different.
Canadian tax regulations effectively limit foreign in­
vestments to 10 percent of the book value of total
assets. Any entity exempt from income taxes becomes
subject to a monthly penalty on foreign investments
in excess of the prescribed 10 percent. This ceiling
becomes especially restrictive when a manager wants
to realize a capital gain and to reinvest, since the
transaction immediately increases book value. Within
the overall 10 percent ceiling there is a further restric­
tion of 7 percent on foreign real estate. In Japan,

4 See the article beginning on page 13 of this Review for a discussion
of the relevant British government steps to shift the burden of
pension provision from the public sector to the private sector.

«The British government has established an interdepartmental
working group to look into all laws and conventions affecting pension
funds. Their report, due this year, could lead to some changes.

5 Tax revisions in the 1960s encouraged firms to start funded plans.
Previously, retirement plans were mostly unfunded and provided only
lump sum severance payments. In 1981, complete tax exemption
was provided for all funding contributions.

7 The trust banks and insurance companies are the only two kinds of
intermediaries allowed to manage Japanese pension funds. The single,
important exception is the Daiwa Bank, a commercial bank that in this
context is treated by the government as a trust bank.




FRBNY Quarterly Review/Spring 1983

3

M inistry of Finance guidelines perm it pension funds to
be invested in foreign-currency-denom inated financial
assets only up to 10 percent of total portfolios. The in­
surance companies are permitted to make additional
pension fund investments in foreign real estate, but only
w ithin the 20 percent lim it prescribed fo r aggregate real
estate investments. Moreover, informal agreements with
the M inistry of Finance at times restrict the amounts
of foreign investing that banks and insurance compa­
nies may do currently.

C hart 2

Estim ated U.S. Assets in Foreign
Pension Fund Portfolios
End-1981
B illio ns o f U.S. d o lla rs *
12----------------------------------------------------------------------------

10

Fin ancial assets
-

Real esta te asse ts

8—

Investments in U.S. and other foreign assets

6—

The aggregate numbers
The m ajor foreign financial assets in the pension fund
portfolios of the four countries are estimated, on the
basis of com paratively firm data, to have amounted at
the end of 1981 to the equivalent of about $20 b il­
lion (Chart 1). This figure reflects conversion of foreign

4—

B ritish

Dutch

* C onverted into U.S. do lla rs from foreign c u rre n c y figu res
at end-1981 rates.
^R eal esta te holdings may be no more than $1 00-2 00 m illion.
^R eal estate holdings may be only about $ 5 0 million.

Chart 1

Source:
A uthor’s estimates, based on data in
Chart 1 and unpublished inform ation.

Foreign Financial Assets in Foreign
Pension
Fund Portfolios
E nd-1981
B illions o f U.S. d o lla rs *

16-----------------------------------------------------------------------------14 —I

------------------------------------------------------

12 -

----------------------------------------------------------------------------

10_

------------------------------------------

8-

----------------------------------------------------------------------------

6 -

-------------------------------------------------------

4-

------------------------------------------

2 -

— 1------------------- 1—

B ritish t
jk

Dutch t

I

-------

Canadian §

Japanese "

Converted into U.S. do lla rs from foreign currency
figures at end-1981 rates.

^F o re ig n assets of tru steed funds and of relevant
p o rtion of life insurance com pany long-term funds.
^F o reign asse ts o f tru s te e d funds only.
Foreign assets
at life insurance com panies w ere negligible.
^F o reign assets of tru steed funds and of relevant
po rtio n o f life insurance com pany s e g rega ted funds.
"F oreig n assets of tru s te e d funds and of relevant
portion o f life insurance com pany assets.
S ources:

currency values into U.S. dollars at end-1981 exchange
rates. The assets comprised practically all of the foreign
financial investments but not any foreign real estate
holdings (which the author believes may have totaled
at least $4 billion).
Total U.S. assets held by the funds of the four
countries amounted, by very rough estimate, to about
$13-14 billion (Chart 2). U.S. financial assets accounted
for about $11 billion,8 or slightly over half of all foreign
financial investments. U.S. real estate investments are
estimated to have been about $21/2 billion, with United
Kingdom holdings constituting approximately 60 per­
cent of this aggregate.
A substantial portion of the United Kingdom pension
funds’ foreign assets was acquired in the two years
after exchange controls were lifted in O ctober 1979.
These controls had greatly curtailed foreign invest­
ments because of the very high premium that had to
be paid fo r dollars. The removal of controls released
a large pent-up demand, and purchases of foreign
assets, especially corporate equities, jumped. In 1981,
close to 25 percent of the trusteed funds’ net addi­
tions to their securities portfolios consisted of foreign

See Table 1.


4 FRBNY Quarterly Review/Spring 1983


8 Includes a small amount of Eurodollar bonds.

securities, and at the insurance companies the share
rose to almost 20 percent (Chart 3). By the end of
that year, approxim ately 10 percent of the accumulated
financial assets were foreign assets. Probably about
half of these were U.S. assets.
Foreign investments by the Dutch pension funds
picked up strongly in 1979, with bonds being favored
over equities. By 1980 and 1981 about 5 percent of the
annual additions to their financial investments were
foreign investments and, at the end of 1981, foreign
assets represented 6 percent of total financial assets
(Table 2). The w riter estimates that U.S. holdings ac­
counted fo r somewhat less than one third of these
investments.
For both the British and especially the Dutch funds,
investments in foreign real estate were also significant.
U.S. real estate investments, shown in Chart 2, may
well have represented at least 75 percent of the foreign
real estate held by the United Kingdom funds but prob­
ably no more than 40 percent of that held by the Dutch
funds.
Pension funds in Canada, as already noted, are ex­
pected by the authorities to hold their foreign invest­
ments to a maximum of 10 percent of portfolio. In Japan,
a sim ilar 10 percent restriction applies to foreigncurrency-denominated assets, but insurance compa­
nies can put additional money into foreign real
estate. Virtually all of the Canadian investments are in
corporate shares, and more than half of these were
acquired during the three years 1979-81 (Table 2).
Although only 4 percent of the end-1981 trusteed pen­
sion fund portfolios (including local government funds)
consisted of foreign assets, many pension plans of the
larger business firms and Federal Crown corporations
were at, o r very close to, the maximum 10 percent.9 In
Japan, even though only one year had elapsed since
the banks were allowed to put pension fund money
abroad, by the end of 1981 they already had an esti­
mated 2 percent invested overseas. The insurance
companies, which had been investing abroad fo r sev­
eral years, are believed to have had about 3 percent
of th eir aggregate portfolios in foreign holdings. U.S.
assets clearly accounted fo r all but a very small fra c­
tion of the Canadian foreign holdings, and apparently
they represented approxim ately 60 percent of the Japa­
nese foreign holdings.
The U.S. attractions
Although the concentration in U.S. assets began to de­
cline during the seventies in some of the countries,

the flows into the United States have continued to rise
along with the growth of the pension funds. The sheer
size of the U.S. securities markets, their high degree
of liquidity, the variety of econom ic sectors repre­
sented, and the vast array of securities issues from
business firm s and government entities have all con­
tributed to this drawing power.
Investments in U.S. real estate are also growing. The
Dutch and British funds had started to acquire real
estate in Europe during the 1960s in response to in­
flationary pressures on pension plan costs and to de­
clines in equities prices. By the mid-1970s their in­
vestments had extended into the United States. The
Canadian and Japanese pension funds, in contrast,
began to invest even in dom estic real estate only
very recently. Again m arket size has been among the
U.S. attractions for investors. One reason is that small
real estate staffs can develop broad holdings w hile
concentrating lim ited energies on a single country.

C hart 3

British Pension Funds’ Annual Net
Additions to Foreign Financial Holdings
Billions of
pounds sterlin g

Share of total
portfolio grow th

1.8

T ru s te e d fu n d s *

1.6
1.4

1.2

1.0
0.8

0.6
0.4

0.2

0
1977

1978

1979

1980

1981

* Foreign financial investm ents by tru steed pension
funds of private and nationalized firm s and public
au thoritie s.
* Estimated at 55 p e rce n t of the foreign financial
investm ents by insurance com pany long-term funds.
* Not available.

9 Among the largest Federal Crown corporations are such companies as
the Canadian National Railway, Air Canada, and the Canadian
Broadcasting Corporation.




S ource:
United Kingdom B usiness S ta tis tic s O ffice,
Business M onitor MQ5.

FRBNY Quarterly Review/Spring 1983

5

The U.S. markets are also more liquid than most other
real estate markets.
In more recent years, the apparent hardening of
political and m ilitary positions between the Soviet
Union and the United States, the unstable political
situation in several European countries, and the na­
tionalization of im portant industries in some countries
have made the U.S. financial and real estate markets
appear particularly attractive. Fund managers place a

high value on the relatively safe geographical location
of the United States, its free m arket orientation, its
reliable legal system, and its trem endous natural, in­
dustrial, technological, and m anpower resources.
Despite these perceptions, the emergence in the
postwar years of Japan and then of a number of other
countries as successful industrial producers inevita­
bly caused attention to be more broadly focused.
These investments have been aided by the rapid de­

Table 2

Dutch Private Pension Funds: Foreign Net Acquisitions
In m illions of guilders

Bonds

Year

Private
loans

Shares

Total as share
of year’s aggregate
net acquisitions

Total

1977

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

-7 0

292

— 214

8

*

1978

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

44

196

-2 2 6

14

*

1979

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

320

30

6

344

4

1980

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

299

82

219

600

5

1981

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

306

90

136

532

5

-

Total as share
of all assets

Addendum: Accumulated foreign holdings
End-1981

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

U.S. d o lla r equivalent ( m illio n s ) ------. . . .

1,721

1,471

697

596

1,935
784

6

5,127
2,077

6

Canadian Trusteed Pension Funds: Foreign Net Acquisitions
In m illions of Canadian dollars

Year

Bonds

Shares

Total

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

1

19

20

*

0

134

134

2

1979

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

3

516

519

7

1980

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

7

517

524

6

1981

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

17

535

552

6

1977
1978

Total as share
of all assets

Addendum: Accumulated foreign holdings
.........................................................

38

2,616

2,654

4

U.S. d o lla r equivalent (m illio n s ) ...............

32

2,206

2,238

4

End-1981

Table does not include m inor amounts of other types of foreign financial assets or any foreign real estate.
* Less than Va percent.
Sources: De Nederlandsche Bank, Annual Report, and S tatistics Canada, Trusteed Pension Plans Financial Statistics.

6

Total as share
of year’s aggregate
net acq uisitions

FRBNY Quarterly Review/Spring 1983




velopment of capital markets outside the United States,
which has reduced the share of U.S. equities in the
world market from almost 70 percent a decade ago
to only a little over half of the world total today. The
world role of the U.S. bond market has similarly de­
clined relative to national bond markets in other coun­
tries and, especially, relative to the Eurobond market.
Thus, there are two basically opposed develop­
ments affecting the foreign investment decisions of
the foreign pension fund managers. The net effect
has been an increase of investments in third-country
assets but at the same time investments in U.S. assets
continue to expand. Moreover, the interest in real es­
tate as a long-term investment is supporting the flow
into the United States. In sum, although the dominance
of U.S. assets in the foreign sectors of pension fund
portfolios has declined, U.S. assets still constitute by
far the largest foreign component.
Investments in U.S. securities
During the 1960s and well into the 1970s the United
States was the leading foreign location for United
Kingdom pension fund financial investments, which
were almost entirely equities. The U.S. investments
accounted for perhaps as much as 80 percent of the
total. However, during the seventies, funds began to
be placed increasingly in Japan and in small amounts
in areas formerly part of the British Empire. Invest­
ments were also made in continental Europe. A slug­
gish U.S. stock market contributed to a slow growth
of U.S. holdings. By 1981, U.S. assets probably were
down to approximately half of the total. Nonetheless,
they had increased in absolute volume. Moreover, dur­
ing 1982 a swing from Japanese investments back to
U.S. investments got underway.
An important foreign investment vehicle for all but
the larger pension funds has been the British taxexempt unit trusts (similar to closed-end mutual funds
in the United States) set up by merchant banks, clear­
ing banks, and large stockbrokers. The merchant
banks have the biggest share of the business, while
the trusts run by the stockbrokers have as their clients
primarily small pension funds. Small funds also acquire
foreign assets through insurance companies, which
make foreign investments for their general funds—
although some insurance companies also use the unit
trusts. There are a number of international unit trusts
that can invest anywhere, but more recently some
have been established to invest in specific geographic
areas. Apparently a considerable part of the non-U.S.
investments is being channeled through these specific
area trusts, including investments by large pension
funds that do not have in-house expertise for certain
countries.




Although foreign financial assets constituted about
6 percent of Dutch pension funds at the end of 1981,10
holdings of U.S. financial assets probably comprised
less than half. Fixed-income assets accounted for ap­
proximately 60 percent of total foreign financial invest­
ments, but U.S. assets were perhaps only a third of
these. Private loans constituted close to half of the
interest-yielding assets and were almost entirely in other
countries. Of the equities, however, apparently more
than half were U.S. securities, and the percentage
clearly increased during 1982.”
Until recently, almost all of the foreign investments
of the Canadian pension funds were in the United
States. At the end of 1981, corporate shares comprised
close to 99 percent of their total foreign investments;
all but an insignificant portion consisted of shares in
U.S. companies. The United States is so comfortably
close and the choice of equity issues so vast com­
pared with Canada’s primarily resource-based activi­
ties, relatively few funds have invested in other mar­
kets. Some funds are even being sent below the border
in the form of venture capital. The funds have not in­
vested in U.S. bonds because Canadian yields have
been much higher. A few of the larger funds have
been making direct loans to U.S. firms; these are on a
floating-rate basis, against mortgage security, and with
final maturities that go out to twenty-five years. None­
theless, the great majority of pension funds among
both trusteed accounts and insurance company segre­
gated accounts that have foreign assets hold U.S.
corporate shares as their sole foreign investment.12
The Canadians’ almost exclusive concentration on
the United States is changing, however. In the last year
or so, some fair-sized amounts have been placed else­
where, principally in Japan and Europe. Some large
funds are investing directly, using investment advisers
in London or the Far East. In addition, Canadian in­
vestment counselors have set up mutual funds for
offshore investment, and Canadian trust companies
have established pooled funds for the same purpose.
There are already a few funds designed solely for in­
vesting in non-U.S. equities.
The Japanese pension funds hold the bulk of their
foreign investments in dollar-denominated securities.
10 This excludes pension funds with insurance companies, which until
recently had invested only a minute amount abroad.
11 Some of the largest foreign investments are by the several Dutchbased multinational companies. Their foreign holdings reflect to a
minor extent anticipated foreign liabilities to provide pensions for
staff members who expect to retire overseas. Often dollar assets ate
held even when pension liabilities are expected to be in other foreign
currencies, especially currencies of countries that do not have
important securities markets.
12 In many cases, however, the holdings are limited to shares of a U.S.
parent company.

FRBNY Quarterly Review/Spring 1983

7

Equities comprised only 3 1/2 percent of their for­
eign holdings at the end of 1981; almost all, both at
the trust banks and the insurance companies, were
shares of U.S. corporations. The fixed-income securi­
ties were more widely distributed. At most banks and
insurance companies the majority of such holdings
were dollar denominated, including large amounts of
Eurodollar bonds as well as bonds issued by foreigners
in the U.S. market, the so-called Yankee bonds. At a few
banks, Canadian dollar bonds were dominant or almost
equal in importance to U.S. dollar securities.
By 1982, as the Japanese funds continued a rapid
buildup of foreign investments, diversification became
increasingly evident. Some portfolios had securities
that were denominated in about eight additional cur­
rencies. These included sterling, several Continental
currencies, Australian dollars, and some East Asian
currencies.
Investments in U.S. real estate
The U.S. real estate investments of foreign pension
funds have been primarily in commercial buildings.
Office buildings are particularly popular. One reason
is that it is easier for foreigners to determine the value
of such buildings than of other real estate since cus­
tomary office needs of U.S. and foreign users are more
similar than are the ways in which other types of
buildings are used. Moreover, office rentals are
the most easily indexed to take account of future
inflation. There has also been a good deal of invest­
ment in shopping centers, although the recession
dampened the attraction of such properties (and also
of warehouses) sooner than that of office buildings.
Oil and gas properties have been of interest to some
funds, but the recent weakness in the oil sector pre­
sumably affected such investing. Finally, a few funds
have invested in apartment buildings, although in com­
paratively small amounts, and some hold parcels of
as yet undeveloped land.
Pension funds in the U nited Kingdom are very heavily
into real estate. Many of the large funds have as much as
one quarter of their assets invested in real estate, and
investments by other funds generally range between
15 and 20 percent. This contrasts with about 3 percent
for U.S. pension funds. The principal impetus to di­
versification into foreign real estate came from the
skyrocketing of prices of British properties during the
seventies as a result of inflation and a flood of com­
peting institutional investors. By the early eighties,
first-year returns on London prime properties (which
are in very limited supply because of government
planning controls that severely restrict the demoli­
tion of old buildings) reportedly were only one half
those of unleveraged U.S. properties. Another moti­

8

FRBNY Quarterly Review/Spring 1983




vation for investing abroad was that many large funds
whose property holdings were heavily concentrated
in London felt that prudent management required them
to diversify.
For many of the big funds, foreign real estate now
constitutes 2 or 3 percent of aggregate portfolio, and
for a few funds more than double that share. The bulk
of this investment has been in the United States. About
thirty to fifty smaller pension funds and a few of the
larger funds make their U.S. real estate investments
through specially tax-exempt Property Unit Trusts
(PUTs), almost all open ended. Several PUTs have
been established specifically for investing in the United
States. Some of these are joint British-American under­
takings.
The half dozen or so large pension funds that have
been the major real estate investors were active in buy­
ing, developing, and leasing properties in the United
Kingdom for many years, and a few are doing the same
in the United States. Most, however, are pursuing a
low-risk policy for the present of buying only existing
properties. Some funds have made joint investments
with American institutional buyers, either because the
price of the property is higher than the amount the
pension fund wishes to put into any single investment
(the upper limit usually is $50-80 million) or because
the pension fund believes the American participants
would have a better understanding of local conditions
and property values. When there has been property
development, the American partner has usually taken
the development risk, with the British pension fund
committed to buying the property after it is com­
pleted and partially rented.
The strong interest of Dutch pension funds in real
estate is very obvious; it is not unknown for a large fund
to have close to 40 percent of total portfolio in this form,
while the more typical portfolio holds between 10 and
20 percent. Foreign real estate constitutes a major
component of the funds’ holdings, in part because
there is very limited opportunity for increased invest­
ment in commercial buildings in the Netherlands. By
the end of the seventies, U.S. investments had come to
the fore. During the past two years there was a slow­
down in such purchases but, as 1982 was drawing to
a close, interest had begun to pick up again in antici­
pation of a U.S. economic recovery.
The Dutch have been, and remain, very much at­
tracted to shopping centers. However, they buy build­
ings only after they have been erected. When new
property development has been undertaken, it has
always been on a joint-venture basis, with an American
partner putting up the buildings. The small pension
funds, which do not have the staff to go directly into
foreign real estate, have been able to channel funds

through three large Dutch real estate investment trusts.
Unlike British PUTs, none of these were established
solely for tax-exempt institutional investors. The pen­
sion funds nonetheless use the trusts for a real estate
play, since the income the pension funds receive is ex­
empt from Dutch taxes.
Canadian pension funds have been permitted to
invest in foreign real estate only since 1977. They can
do so up to 7 percent of the total 10 percent foreign
investment allowed. However, until recently only the
larger pension funds held significant amounts of even
domestic real estate. For pension funds in the aggre­
gate, real estate comprised less than 2 percent of total
portfolio assets, although for some large ones the
ratio went as high as 10 percent. Now a few funds are
starting to invest abroad, that is, in the United States.
The Canadian funds are not allowed to own either
domestic or foreign real estate directly except for lim­
ited amounts. Several alternative routes have been
chosen. One is through investment in shares or deben­
tures of tax-exempt corporations set up under a special
provision of the Tax Act that was designed to enable
pension funds to make real estate investments. Other
routes have included joint venturing with Canadian
real estate development firms, investment through U.S.
real estate pools set up by Canadian investment coun­
seling firms, and investment through U.S. subsidiaries
established by the pension funds themselves.13
As already noted, the only Japanese pension fund
reserves that can be invested in foreign real estate
are those managed by the insurance companies. As of
mid-1982, their foreign real estate holdings totaled
less than 1 percent of all assets (compared with 6 per­
cent invested in domestic real estate), but almost all was
in the United States. Only a few companies have so far
purchased foreign properties, but they are planning to
add to their holdings, some on a continuing basis. More­
over, purchases by other companies are in the offing.
Half of the investments have been in existing buildings;
in other cases, new properties are being developed. All
of the investments so far have included an American
partner. There are no official limits on the size of foreign
real estate transactions, but the Finance Ministry has
to be notified prior to every such deal. When the yen
has been under strong pressure because of heavy out­
flows, administrative guidance has occasionally been
used to influence the amount of capital being trans­
ferred abroad.
Many foreign pension funds were, and still are,

w A new U.S.-Canadian tax treaty that is expected to be approved by
the U.S. Senate this year will’ provide Canadian pension funds with
exemption from the 15 percent withholding tax on dividends and
interest that other Canadian investors must pay.




strongly drawn to the sun-belt states. Others, believing
that a number of such locations have been overbuilt,
prefer other parts of the country. Many invest only in the
downtown areas of big cities, while others see oppor­
tunities in “second-tier” properties in more modest-size
communities, although often requiring higher returns
from such investments.
Tax considerations have influenced some foreign
pension funds in the choice of U.S. locations as well as
of the institutional arrangements. For example, Cali­
fornia real estate has been shunned by some because
of the state’s unitary income tax, which is based on a
company’s consolidated operations regardless of loca­
tion. In part, their reaction reflects the belief this tax
would result in a lower return than could be obtained
from a similar investment in most other states. And to
avoid U.S. Federal taxes, pension funds have some­
times been invested through specially established
Netherlands Antilles subsidiaries. The dividends and
interest paid out by these subsidiaries are exempt,
under a U.S.-Netherlands Antilles tax treaty, from U.S.
withholding taxes which otherwise can be imposed
on the distributions from the profits of foreign cor­
porations’ U.S. branches. However, beginning two
years hence, because of the 1980 Foreign Investment
in Real Property Tax Act, these subsidiaries will no
longer have the present additional exemption from
taxes on capital gains from the sale of real property.
This will reduce, although not eliminate, the advantage
of investing through Netherlands Antilles subsidiaries.

Future developments
Pension fund growth
Pension fund reserves in the four countries are almost
certainly going to continue to expand strongly through­
out the mid-1980s and probably beyond, as net cash
flows from contributions and from earnings on growing
masses of investments rise. Increased pension fund
reserves will be required to cover an expanding num­
ber of employees and improved benefits. The changes
in benefits will vary, but among the goals sought in
one country or another there will be higher retirement
income, more generous disability and beneficiary
treatment, more protection against inflation, and earlier
vesting. The number of retired employees will of
course be rising, and for some mature pension plans
the payout to retirees will impose a considerable brake
on net cash flow. However, this can have only a mar­
ginal effect on the growth of total fund assets during
this decade.
The worldwide recession of the past two years has
undoubtedly affected the rate of aggregate pension
fund growth. Companies have gone out of business

FRBNY Quarterly Review/Spring 1983

9

and unemployment has increased. In addition, a stepup in early retirements, initiated by some firms as one
way of dealing with a surplus of employees, has had
an adverse impact on the cash flows of some pension
funds. Nonetheless, the number of active workers cov­
ered by pension plans in any one country may not
have declined to any significant extent, where it has
at all. Moreover, strongly rising yields on existing port­
folios have partly made up for any slack in fund con­
tributions. And economic recovery, unless it turns out
to be very stunted, can be expected to lead over the
years to further growth of plan membership.
In a country like Japan, where pension plans are
still very young and limited in number, the increases
in cash flow from widening coverage and better bene­
fits should be especially large for many years. It is
anticipated that pension fund totals there could easily
increase by 20-25 percent a year. In Canada, annual
additions to reserves of 15-20 percent are foreseen
for the next several years.14 In the Netherlands, annual
net cash flows during the next five years at a rate of
at least 10 percent of portfolio seem probable. In the
United Kingdom, the rate of annual accumulations
may be just about 10 percent. Overall then, by 1987
the Canadian funds may have at least doubled from
their 1981 levels, while the Japanese funds, because
of their exceptional rate of growth, may well have
expanded to more than 2.Vz times their 1981 levels. The
United Kingdom and the Dutch funds may each grow by
approximately 75 percent.
The implications of such rapid growth for foreign
investments seem clear. In none of the four countries
does the domestic economy provide investment oppor­
tunities for the swelling masses of pension funds that
are at a level of risk and sufficiently numerous, diver­
sified, and profitable to satisfy the funds’ prudential
and earnings requirements.15

M A slowdown might develop in the second half of the decade. The
Canadian and the Quebec social security retirement systems will be
going into deficit by the end of this year, and mandatory contributions
are expected to be doubled or more by the late 1980s. Many employers
who operate voluntary pension plans reportedly might then find it
financially necessary to reduce benifits, or even to terminate plans.
15 Two years ago the Governor of the Bank of England made a comment
in another context that is of interest here: “The equity capital of the
larger British companies, accounting for perhaps three quarters of the
output of our private-sector industry and commerce, is increasingly
owned by the main institutional investors, above all the life assurance
companies and pension funds. Indeed the cash inflow of these institu­
tions and the relative shortage of equity available for purchases in the
market may be an important element in the comparative strength of the
equity market despite the poor profitability of much of British
industry.” (Reflections on the Role of the Institutions in Financing
Industry, First 1981 Stockton Lecture, London Business School,
January 2 2 ,198 1.) The second sentence points to one reason why
British pension funds have felt a need to invest a substantial portion
of their reserves abroad.


10 FRBNY Quarterly Review/Spring 1983


Investments in the United States
Although the British pension funds will grow more slowly
than those in at least two of the other countries, the im­
portance of the British funds as investors in U.S. assets
remains great because of their volume and their in­
clination to enlarge the foreign portion of their port­
folios. Those funds that may have reached their de­
sired foreign investment limits would still be putting
abroad sizable portions of their annual accruals. More
modest-size funds, which have smaller shares invested
abroad, may well continue to increase the place of
foreign assets in their portfolios by investing through
unit trusts, which are very actively marketing their
services. Insurance companies, more than half of whose
business comes from pension funds, have also begun
to step up their foreign investments. In addition, there
has been an easing of investment restrictions on local
authority pension funds that is making it possible for
them to place more of their reserves abroad. Given
the current pace of foreign investing and the attitudes
of investors, it would not be at all surprising if the
foreign assets of British pension funds were to in­
crease from the almost 15 percent of portfolio they
had reached by the end of 1982 to 15-20 percent of the
expanded aggregate reserves within another five years.
A good deal more than half of the increase is likely
to be in U.S. assets. Since U.S. equities accounted
for only about 50 percent of their total equities hold­
ings in 1981, any substantial decline would imply a
significantly unbalanced portfolio, measured by the
share of U.S. equities in world equity capital. For this
to happen, either the U.S. economy would have had
to deteriorate very seriously, or currency develop­
ments would have had to improve greatly the pros­
pective returns from investments elsewhere. The out­
look for continued investment in foreign real estate,
which in effect means U.S. real estate, is also good.
The discrepancy between foreign real estate holdings
of 2-3 percent of portfolio for some large funds and
8-9 percent for others suggests there is considerable
room for expansion of even large funds’ investments.
The smaller funds, which so far have invested only
a tiny percentage in foreign real estate, are likely to
build up to a somewhat more significant level, pri­
marily through the specialized PUTs.
The Dutch will certainly also continue to place a
substantial portion of their accumulated reserves
abroad. Some funds have considerably more than 20
percent invested abroad, while the foreign share for all
funds is only 6 percent. This implies that most funds are
below even this level. The share of foreign assets in
each year’s net investments has been creeping up­
ward, pointing to an inclination to allocate a larger
portion of reserves to such assets. Insurance com­

panies apparently have also started to invest abroad.
Recent developments suggest that perhaps half of
the new foreign investments out of Dutch pension
fund reserves will be in the United States. Most of
this will be in equities, but real estate investments,
which slowed down for two years, will again be im­
portant. The managers of some of the large pension
funds that had stopped making such investments were
in late 1982 again perceiving good real estate values
as a result of the recession. Moreover, Dutch real
estate trusts that invest in the United States have
been intensively soliciting other Dutch pension funds
also to invest here.
Pension funds in both Canada and Japan, despite
the 10 percent ceilings, will be placing substantial
amounts abroad over the coming several years. In the
first place, total foreign investments are currently far
below the ceilings. Secondly, fund reserves in each of
the two countries are expected to climb rapidly,
roughly doubling by 1987 in the case of Canada and
even sooner for Japan.
In Canada, there is an increasing tendency to make
use of the full 10 percent. The largest pension funds
have been pressing against the ceiling for some time.
Indeed, some have even chosen to invest as much as
15 percent and to pay the tax penalty. In addition, man­
agers of other funds, who have in the aggregate used
less than half of the allowable percentage, have recently
become more outward looking. Although U.S. securities
investments are unlikely to be as overwhelmingly
dominant among foreign investments as heretofore, net
U.S. securities acquisitions should continue to be
strongly positive, with only temporary slowdowns when
conditions in currency or equity markets appear to
favor substantial increases in investments elsewhere.
It seems likely, moreover, that U.S. real estate invest­
ments will expand. The importance of domestic real
estate investments in Canadian pension fund port­
folios is apparently on the verge of a significant in­
crease. Foreign real estate investments will certainly
grow along with the domestic investments, as they
have in the past, and these will undoubtedly continue
to be virtually ail U.S. investments. Although some
managers still feel the indirect route required to put
money into foreign real estate is too troublesome, it
is likely that, if investments already made show attrac­
tive returns, more investors will follow.
In Japan, pension fund managers had been seeking
permission to invest abroad for some time prior to the
recent Ministry of Finance approval. That approval
was finally granted for several reasons, including such
widely varying reasons as concern that reserves were
growing too rapidly to enable a sufficient volume of
good investment opportunities to be found at home and




the always present possibility of a disastrous earth­
quake in Japan. Now the managers are eager to utilize
the new opening to foreign capital markets as rapidly as
they prudently can. During the last year alone, the trust
banks increased the foreign investments in pension fund
portfolios from 2 percent to over 3 percent, on average,
and the insurance companies from 3 percent to almost
5 percent. As they increase these investments, they
are going more heavily into equities, and interestbearing instruments are declining from their early share
of over 90 percent. This may not mean much change in
the weight given U.S. securities. Dollar-denominated
issues apparently constituted between one half and two
thirds of the foreign bond holdings. Equity investments
would be in roughly the same currency proportion as
bond holdings have been, if the former are geographi­
cally allocated in line with the approximately two-thirds
share that dollar equities currently constitute of the
world’s non-Japanese equities. Thus, a major part of the
ongoing foreign investments would be channeled to the
United States. Foreign real estate investments will also
continue to grow as a share of insurance company
portfolios. As with investors from other countries, the
United States has been the preferred location for pur­
chases already made and will almost surely remain so.
It would be unrealistic to try to quantify in detail the
likely flows into U.S. assets sketched in the preceding
paragraphs. Nonetheless, one can be bold and, on
the basis of the many assumptions stated, venture some
extremely rough guesses regarding the totals that might
be entering the country during the six-year period
through 1987.
For the U nited Kingdom pension funds, the antic­
ipated rate of growth, and the likely allocation in the
foreign investment share between U.S. assets and other
assets, suggest that the flow into the United States
could reach $18 billion.16
For the Dutch trusteed funds, which are only about
one fifth the size to start with, investments might amount
to about $4 billion. A comparatively small additional
amount could come from the pension funds handled
by the Dutch insurance companies.
The Canadian funds, because of the 10 percent lim­
itation on foreign investments and the geographic
diversification away from their now overwhelmingly
U.S. holdings, might invest approximately $6 billion.
The Japanese funds, also limited to only 10 percent
of portfolio plus some real estate investments, will be
growing more rapidly than the Canadian funds and
will continue to place a major share in the United
States. Over the six-year period, Japanese invest­
ments could aggregate about $7 billion.
M This and the following figures are in current dollars.

FRBNY Quarterly Review/Spring 1983

11

Conclusions
The indicated figures suggest that flows into the United
States from these pension funds during the six years
ending 1987 could aggregate roughly $35 billion. There
will also be some comparatively minor flows from other
countries. On an annual basis, total flows from abroad
might increase from about $4-6 billion in the first years
to $6-9 billion in the later years. Most would go into
equities, some into interest-yielding investments, and
some into real estate. While actual developments
might well prove to be significantly different from these
guesstimates, the figures nonetheless provide some
conjectural amounts against which to pit the outflows
into foreign assets from U.S. pension funds.
In an earlier Review article, it was suggested that
outward flows would gradually increase over the cur­
rent decade from the approximately $2% billion esti­
mated for 1980 but would remain below $10 billion into
the middle of the decade.17 Information on outflows since
then indicates that thus far this prediction has been
borne out. The estimates of flows into the United States
17 Article cited in footnote 1.


12 FRBNY Quarterly Review/Spring 1983


developed above therefore point to the probability
of a fair degree of balance between capital inflows
from foreign pension funds and capital outflows from
U.S. pension funds. The impact on U.S. markets should
consequently be close to a wash in dollar terms, but
the inflows should also have the beneficial effects of
adding depth and liquidity to capital and real estate
markets because of the larger number of participants
and the different considerations that often motivate
foreign investors. Moreover, the foreign and domestic
pension funds should each be securing a portfolio that,
according to their managers’ respective perceptions,
is a better portfolio, that is, one that will provide higher
yields and/or be subject to less risk in terms of volatility.
Finally, the present analysis indicates that during the
foreseeable future the international capital transactions
by these particular institutional investors will remain
small relative to total U.S. international capital flows.
The findings also suggest that the transactions will
tend to produce, over reasonable intervals of time,
roughly equal supply and demand for the dollar. They
should, therefore, not have any long-term destabilizing
effect on the dollar exchange rate.

Edna E. Ehrlich

Social Security in Germany
and the United Kingdom

The United States is not alone in its difficulties with
social security finances. The problems faced by the
U.S. system— disproportionately high benefits relative
to contributions, as well as unfavorable demographic
developments and the impact of simultaneously high
rates of inflation and unemployment— plague the so­
cial security systems of all industrial countries.
The European experience with social security is
instructive for the United States because many solu­
tions proposed for this country have received a trial
abroad. The social security financial crisis now faced
by the United States began in Europe during the
1970s. All four major countries (Germany, France, Italy,
and the United Kingdom) made fundamental reforms
or substantial adjustments to their social security pro­
grams.
Efforts to limit the growth of social security in Ger­
many and the United Kingdom— the focus of this arti­
cle— are of particular interest to the United States. In
Germany, the authorities viewed the financial problem
as essentially short term. Therefore, they employed
short-term measures such as interfund transfers and
temporary limits on the increase in benefits. In con­
trast, the authorities in the United Kingdom viewed
their problem as one of long-term inadequacy in the
existing system. They undertook a comprehensive re­
form to shift a large part of the burden of old-age

The author would like to express her appreciation to Lynn Ellingson,
Lillian Liu, and Daniel Wartonick of the Social Security Administra­
tion’s Comparative Studies Staff for helpful assistance and advice.
They bear no responsibility for the contents or the views of this article.




pension provisions from the public to the private
sector.
Both countries still face questions about the sol­
vency of their systems. The German pension funds are
threatened in the near term; they may deplete their
liquid reserves by early 1984. In the United Kingdom,
the security of social security finances as the reform
is phased in over the longer term remains unclear.
This article provides historical perspective on the
difficulties of the social security systems in Germany
and the United Kingdom, describes what was done,
and suggests what kind of lessons can be drawn.

Social security abroad
Social security systems vary widely among industrial
countries in organization, coverage, benefits and their
adjustment, as well as funding.1 Social security systems
in Europe are generally more comprehensive than in
the United States. Social security there includes ex­
tensive health and disability insurance, unemployment
compensation, and family allowances in addition to
the old-age pension program, the predominant element
in the U.S. social security system. Most impor­
tant is the far larger public-sector role in providing
health care and health insurance in major European
countries. European unemployment and disability ben­
efits also tend to be more generous.

1 This section draws heavily on the excellent Social Security Programs
Throughout the World, a biannual publication of the U.S. Department
of Health and Human Services, Social Security Administration, Office
of Policy, Office of Research and Statistics, Research Report No. 58.

FRBNY Quarterly Review/Spring 1983

13

security expenditures is used, spending is also higher
as a share of GNP in Germany. In all three countries,
social security spending currently accounts fo r around
a third of overall government expenditures.

Table 1

Old-Age Pension Insurance Systems
Date of first law indicated in parentheses
Earnings related

Dual system

Belgium (1924)

Canada (1927)

Germany (1889)

Sweden (1913)

Italy (1919)

United Kingdom (1908)

Japan (1941)
Switzerland (1946)
United States (1935)
Source: See footnote 1 in text.

There are two main models for old-age pension in­
surance (Table 1). A social insurance system, where
contributions and benefits are based largely, if not
entirely, on earnings, is found in the United States and
Germany. The second model, a dual system which
provides a basic benefit to all contributors regardless
of earnings and an earnings-related benefit, is found
in the United Kingdom. A few countries have old-age
pension insurance systems fitting into neither cate­
gory. France, fo r example, combines a social insurance
system with a mandatory private pension program. In
addition to the main systems, there are frequently
special funds fo r certain occupational groups: miners
in Germany, fo r example, or farmers in France.
C om parability of social security finances across
countries is also com plicated by accounting differ­
ences. In Germany, pension, unemployment, and health
insurance form separate and identifiable funds, much
as they do in the United States. In the United King­
dom, however, a single social security contribution
covers all programs and all programs are part of the
central government budget.
The size of social security contributions and spend­
ing varies across countries. As Table 2 shows, total
social security contributions in Germany are much
higher relative to GNP than in the United States or
the United Kingdom.2 When a broad definition of social

2 C om parisons of governm ent spending across countries are
som etimes diffic u lt because the organization of governm ent differs
across countries. The most useful com parison, therefore, is
of spending at all levels of governm ent, that is, the total spending
of Federal (c e n tra l), state (regional), and local governm ents plus
the social insurance funds. Social security spending includes
social assistance (w elfare benefits and housing allowances, for
exam ple), w hich accounts for about a third of the figure for
the United States and the United Kingdom and only a fifth of the
fig u re for Germany. Germany still has relatively higher spending if
social assistance is elim inated.

14 FRBNY Quarterly Review/Spring 1983



Funding
Sources of funding vary considerably across coun­
tries but differ from the U.S. system in two im­
portant ways. First, tax rates fo r total social security
programs are generally much higher abroad and so­
cial security contributions from employers are often
larger than those from employees. C ontribution rates
for old-age, survivors’, and disa bility insurance— rates
roughly comparable to the U.S. social security tax—
are also generally higher abroad (Table 3).
Higher social security contribution rates reflect the
higher level of social security expenditures relative to
GNP in many countries, including Germany. A sm aller
tax base, however, not greater expenditures, accounts
fo r higher contribution rates in the United Kingdom.
The ceiling on covered wages in the United Kingdom
is low relative to average income when compared
with the United States, and contributions are optional
for those with incomes below a floor.
When the focus is narrowed to old-age and survivors’
pensions alone, the relationship between contributors
and beneficiaries also explains higher contribution
rates. Data on the ratio of all workers of all ages to
nonworkers over 65 (the dependent elderly) suggest
that the United States faces a more favorable balance
between workers and “ dependents” than Europe
(Table 4). The difference in the ratios is expected to
narrow in the 1980s, as the U.S. ratio continues to
decline, while those of Germany and the United King­
dom should rise somewhat. The relatively favorable
U.S. situation reflects the higher U.S. birth rate and
the impact of immigration.
Second, in every European country except France,
the social security system relies on some funding
from the general revenues of the central government.
In Germany, general revenues in principle fund only
that part of social security which consists of payments
to noncontributors. In practice, the Germans have
found it d ifficult to hold the subsidy w ithin that bound.
In the United Kingdom, the governm ent’s grant from
general revenues in 1982 amounted to 13 percent of
social security expenditures, a share recently lowered
from 18 percent.
European social security systems, like the U.S. sys­
tem, operate on a pay-as-you-go basis. In the postwar
period, virtually every industrial country has operated
its social security system on a pay-as-you-go rather
than on a funded basis, especially since high rates
of inflation dissipated whatever reserves there were in

Table 2

Social Security Contributions and Expenditures*
In percent
Country

1965

1970

1975

1980

1982

G e r m a n y ...............................................................................

26.4

29.0

32.8

36.1

United K in g d o m ..................................................................

14.2

12.8

16.1

15.4

16.3

United S ta te s ......................................................................

16.1

19.5

23.6

24.3

26.4

G e rm a n y ...............................................................................

9.3

10.9

13.4

15.5

16.2

United K in g d o m ..................................................................

4.7

5.2

6.5

6.2

6.9

United S ta te s ......................................................................

4.4

5.9

7.2

7.7

8.4

G e rm a n y ...............................................................................

30.6

29.1

31.5

34.1

United K in g d o m ..................................................................

19.5

20.8

19.9

26.0

29.5

United S ta te s ......................................................................

19.2

24.0

32.0

33.2

33.9

G e rm a n y ...............................................................................

10.6

10.5

14.3

15.3

16.2

United K in g d o m ..................................................................

6.9

7.9

9.1

11.3

13.3

United S ta te s ......................................................................

5.4

7.8

11.4

11.1

12.0

Contributions as a share of general government receipts
36.9

Contributions as a share of G N P /G D P f

Expenditures as a share of general government expenditures
34.6

Expenditures as a share of G N P /G D P f

‘ Social security revenues and expenditures are broadly defined. See footnote 2 in text.
fG D P = g ro s s dom estic product; G N P = gro ss national product.
Sources: Office for Economic Cooperation and Development (OECD), N ational Accounts 1963-1980, and staff estim ates for 1982.

Chart 1

Index of Live Births
Index 1910=100

1 6 0 ---------------------------------------------------------

Sources:
Bureau of the Census, S tatistical Abstract of the United S tate s: Federal Statistical O ffice, S tatistical Yearbook of
the Federal Republic of Germany, and the United Kingdom C entral S tatistical Office, Annual A b stra ct of Statistics.




FRBNY Quarterly Review/Spring 1983

15

Table 3

Sources of Old-Age Insurance Funding
Contribution rate in percent*
Employee

Employer

Governm ent

C ontribution for:

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

7.00

8.86

Annual subsidies
(about 20 percent
in 1982)

Old age and
survivors

•(-Canada .....................................

1.80

1.80

Cost of universal
pension, any deficit,
some incom e-tested
benefits

Earnings-related
benefit

8.20

None

Old age and w idows

Annual subsidy
(about 14 percent)
plus contributions
of workers on
m aternity leave or
unemployment

Old age,
disability,
death

17.16

Lump-sum subsidy
plus cost of meanstested benefits

Old age,
disability,
death

5.30
4.55

20 percent
of benefits

Old age,
disability,
death

C ountry
Belgium

France

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

G e rm a n y .................... .................

9.00*

I t a ly ..............................................

§Japan:
Employee insurance:
M e n ..............................................
Women .................................

5.30

National insurance ..................

S w e d e n ........................................

__

331/3 percent of
benefits
21.15

30 percent of
universal
pension benefits

Old age,
disability,
death

4.70

20 percent o f o ldage, 50 percent of
disability, plus
some means-tested
benefits

Old age,
disability,
death

United Kingdom ...................... .

11.951!

13 percent of costs
plus full cost of
means-tested
allow ances

Old age,
d isability,
unemployment,
sickness, death

United S ta te s .............................

5.40

Cost of means-tested
b e nefits**

Switzerland

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

Old age,
survivors,
d is a b ility

*1981 con tributio n rates s till in effect o r more recent rate, where available. Except fo r Italy, Belgium , and Sweden, every country has a
c eiling on covered earnings.
fT h e rate is low because the system is young and has a large accum ulated surplus.
^Rises to 9.25 percent fo r em ployer and employee in Septem ber 1983.
§E arnings-related schem e can be contracted out (see United Kingdom discussion in text) if private benefits meet social security benefits.
The em ployee con tributio n then falls to 3.7 percent for men, 3.0 percent for women, and the em ployer con tributio n falls to zero.
IIThe em ployer contribution includes 1.5 percent national insurance surcharge. The surcharge is scheduled to fall to 1 percent in August 1983.
If the earnings-related portion is contracted out (see United Kingdom discussion in te x t), the em ployee rate drops to 6.9 percent on all
but the first £32.50 a week of covered earnings. For the em ployer, the rate falls to 7.9 percent on all but the first £32.50 a week.
“ Supplem ental social security.

16

FRBNY Quarterly Review/Spring 1983




the years follow ing W orld War II.3 An old-age insurance
program of some sort had been in effect in most coun­
tries before World War II. In practice, such programs
were never more than partially funded.4
The role of private pensions
Social security pension plans also vary across coun­
tries in the degree of integration w ith private pension
plans. In the United States and Germany, social se­
curity and private pension systems are not form ally
integrated. About 50 percent of workers in the United
States and about 60 percent in Germany are covered
by private pensions.
In the United Kingdom, private pensions are an al­
ternative to the earnings-related social security pen­
sion, w hich serves as a minimum standard. Around
45 percent of workers are covered by private pension
plans through the contracting-out option described
on page 24.
By contrast, private pensions are mandatory for
around 80 percent of w orkers in France. In a plan
that resembles the dual social security system de­
scribed above, the social security fund in France pro­
vides a flat-rate benefit and the private pension an
earnings-related benefit. Switzerland is considering a
sim ilar plan.
Private pension benefits are generally not indexed,
although German employers are required by a 1974
law to review pensions every three years and adjust
them fo r at least half the loss in purchasing power.
In France, some indexation occurs through the prac­
tice of rep artition .5
In all three countries, private pensions replace be­
tween 10 and 20 percent of average wages. Thus, they
are an im portant supplem ent to social security bene­
fits, pushing overall replacement rates toward 70
percent in Germany and France and toward 50 per­
cent in the United Kingdom. Replacement rates in the
United Kingdom and France are expected to rise fur-

3 Canada, Japan, and Sweden have accum ulated large surpluses
because the ir systems are fairly young, but even these countries do
not operate the ir systems on a funded basis.
4 In Germany, for example, reserves ranged from coverage of
ten years in 1917 to essentially no coverage in 1924.
5 Max Horlick, "P rivate Pension Plans in West Germany and France”
(Research Report No. 55, Social Security Adm inistration, Office of
Policy), O ctober 1980. Under repartition— a version of pay-as-yougo— pension fund revenues are redistributed to pensioners
according to the num ber of "pe nsion po in ts" accum ulated, points
being determ ined from earnings and length of service. Partial
indexation occurs as wages rise, provided no serious im balance
between pensioners and contributors develops.




Table 4

Ratio of Workers to Dependent Elderly, 1950-90
C ountry

1950

1960

1970

1980

1990

United S ta te s .............
Germany ....................

7.15
5.95

5.51
5.09

5.15
3.71

4.95
3.46

3.87

United K in g d o m .........

5.22

4.56

4.05

3.66

3.73

4.70

The dependent elderly are nonworkers over age 65.
Source: International Labor Organization (ILO ), Labour Force
Estimates and Projections, 1950-2000 (second edition).

ther as the private pension plans mature over the
next decade.6
A comparison of the European situation with the
United States.
In Europe, the picture of social security funding prob­
lems frequently offered has been analogous to the
standard portrayal of the U.S. situation. That portrayal
contends that:
• the present tem porary solvency problem was
caused by uncontrollable factors like the re­
cession,
• no problem exists in the medium term as
scheduled tax increases restore solvency, and
• a long-run solvency problem exists because of
unfavorable dem ographic factors.
The belief that social security faced only a short-run
crisis may account fo r the belated response in many
countries to persistent social security problems.7
The tim ing of the three stages of the funding prob­
lem in the standard portrayal differs significantly be­
tween Europe and the United States. The short-term
crisis which has beset Europe since the mid-1970s is
believed to be the result of the sharp slowdown in
econom ic growth after 1974-75 and unfavorable de­
velopments in the age structure of the population. Over
the period 1950-75, the population over 65 grew 2 to
3 percent in the m ajor European countries, while the
w orking population aged 15 to 65 years increased
only slightly.
Relief from the short-term crisis was anticipated to

6 Leif Haanes-Olsen, "E arnings-R eplacem ent Rate of Old-Age
Benefits, 1965-75, Selected C ountries", S ocial Security B ulletin
(January 1978).
7 A discussion of trends in social security over the 1970s in a
large number of countries is contained in llene R. Zeitzer, “ Social
Security Trends and Developments in Industrialized C ountries",
S ocial S ecurity B ulletin (M arch 1983).

FRBNY Quarterly Review/Spring 1983

17

come by the 1980s at the latest. A slowdown in the
growth of the elderly population to a rate matching
that of the w orking-age population was expected to
stabilize social security finances. War and depression
in the first half of the century had thinned the genera­
tions retiring after 1975. The postwar baby boom in
Europe— delayed relative to the United States by the
econom ic dislocation after World War II— would just
be entering the labor force (Chart 1).
This medium-term relief was expected to be followed
by a serious crisis in the next century. The eventual
retirem ent of the baby boom generation combined
with the low birth rate in recent years would lead to a
new and serious funding problem.
In reality, the short-term crisis has not passed in
many countries. The medium-term outlook is clouded,
even gloomy. In part, the continuing crisis results from
the return to recession after the second o il-price
shock. But it also reflects the failure to perceive the
problems of the mid-1970s as more than tem porary
imbalances.

Chart 2

Ratio of the Present Discount Value of
Benefits to Lifetime Contributions
Plus In tere st*
Present value ratio

2.0

1.2

The imbalance between benefits and contributions
In a recent article, Capra, Skaperdas, and Kubarych
(Autumn 1982 issue of this Review) questioned the
standard portrayal of the U.S. social security system ’s
financial troubles. In their view, the fundamental prob­
lem is that retirees can expect to receive benefits far
in excess of lifetim e contributions plus interest.
The critique of the standard portrayal applies to
Europe as well as the United States.8 A comparison
of the ratio of benefits to combined employeremployee contributions for representative pensioners
in the United States, Germany, and the United King­
dom illustrates some common elements as well as
some differences in U.S. and European social security
problems (Chart 2). The hypothetical individual in all
three countries is a single male with average income
throughout his working lifetim e.9
Current retirees in all three countries appear to be
treated relatively favorably. The present discounted
value of the benefits received by a retiree at the start
of 1983 is more than tw ice the value of his lifetim e
contributions with interest in the United States and
about 1.5 tim es his contributions in Germany and the
United Kingdom. Relatively higher contribution rates
and real interest rates in the past account in large part
fo r the lower benefit to contribution ratios in Europe.
The ratio fo r the United Kingdom is also relatively high
because current retirees made no contributions be­
fore the start of the current system (1948) and the
basic benefit increased sharply in 1975.
In the longer run, the ratios show a decline in every
country, although those of the European countries
stabilize at a level somewhat below that o f the United
States. The U.S. ratio declines rapidly and stabilizes
after 2030 at 0.90. Germany’s ratio falls more slowly
and remains around 0.85 after 2010. In the United
Kingdom, the ratio declines still more slowly, a result
of the gradual phasing-in of the 1975 reform, until it
falls below 0.90 around 2025.

t

1.0
°

1983

1990

2000
2010
Y ear of retirem ent

2020

2030

* E stim ate s c o m p u te d fo r a 6 5 -y e a r-o ld s in g le m ale
re tire e w ith average lifetim e earnings. The U.S.
e s tim a te s are an update o f th o s e p re s e n te d in C apra,
S k a p e rd a s , and K ubarych (A utum n 1982 is s u e o f this
R e v ie w ). The c a lc u la tio n s fo r G erm any and th e
U nited K ingdom are d e s c rib e d in a m em orandum w h ich
can be o b ta in e d fro m the author.
i'W h e n ra tio is 1.0-, th e p re s e n t value o f e x p e c te d b e n e fits
eq u a ls accu m ulate d e m p lo y e r-e m p lo y e e co n trib u tio n s
plus interest.

18

FRBNY Quarterly Review/Spring 1983




8 In an analysis sim ilar to Capra, Skaperdas, and Kubarych, evidence
that current retirees in Germany receive larger benefits than their
contributions is found in Klaus-Peter Koppelmann, Intertem poral
Incom e D istribution in the Statutory Pension Insurance of West
Germany, Studies in A p p lie d Econom ics and Statistics, volum e 8
(van den Hoeck & Ruprecht, Goettingen, 1979).
9 In the United Kingdom, the representative individual elects to remain
in the social security system. The British situation differs in another
im portant respect. Unlike the United States and Germany, social
security con tributio ns include unemployment, sickness, and dis­
ab ility insurance as well as old-age pension insurance. For an
individual who remains in the social security system, it seems
reasonable to com pare the benefits to contribution ratio to the longrun share of pension outlays in total National Insurance Fund
expenditures. In the 1971-81 period, this share was 70 percent. The
low er expected United Kingdom ratio is taken into account in Chart 2.

The imbalance between benefits and contributions
plays a major role in the short-term and the mediumterm financial difficulties of social security in all three
countries. This problem of imbalance is especially im­
portant and persistent in the United States. In the
longer run, however, the imbalance is eliminated as
the ratios fall below 1. By then, other factors, primarily
unfavorable demographic conditions, threaten the sol­
vency of all three old-age retirement systems.

Reasons for the difficulties abroad
To a large extent, the current imbalance between ben­
efits and contributions in Europe reflects the generous
policies of the late 1960s and early 1970s. The changes
in those years moved social security increasingly away
from a program in which benefits were related to con­
tributions to a program which extensively redistrib­
uted income. The introduction of minimum pensions
and the extension of benefits to those whose contribu­
tions were too low to qualify for regular pensions are
examples of such changes.
Benefits to contributors were also increased sharply
in the early 1970s, especially through early retirement
programs in Germany and through the adoption of a
generous inflation adjustment standard in the United
Kingdom. Contribution rates, while high, failed to rise
sufficiently to compensate.
Inflation’s effects on private savings, especially pri­
vate pensions, have also played a role. Since private
pensions are usually not indexed, they tend to lose
real purchasing power. Moreover, interest rates on
savings instruments abroad, while not limited by ceil­
ings like Regulation Q, have at times been low relative
to inflation. This problem has been more acute in the
United Kingdom, where inflation has been higher. The
erosion of the real value of pensions and other forms
of saving has no doubt increased the pressure on gov­
ernments to improve social security benefits.
To a lesser extent, the difficulties are the result of an
unanticipated increase in life expectancy, especially
an increase in the probability that large numbers of
workers will live long enough to retire. Around 1930,
life expectancy for men at age 20 was roughly 67
years in both Germany and the United Kingdom. It had
reached 70 years by 1950 and nearly 71.5 years by
1978, owing in part to a considerably reduced death
rate among those aged 45 to 60.10 Gains in life expec­
tancy for women have been even more substantial as
the risks of childbearing have declined.
Social security problems have been greatly aggra-

The comparable numbers for the United States are 64 in 1920,
66 in 1950, and 68 in 1978.




vated by weaker economic growth after 1973. Both
Germany and the United Kingdom experienced a
greater slowdown than the United States after the bout
of inflation and recession resulting from the first oil
shock in 1973. The problems that the slowdown pro­
duced in the two countries, however, have been differ­
ent. In Germany, slower growth was accompanied by
a lasting rise in the unemployment rate but relatively
low inflation. In the United Kingdom, the slowdown
produced a later, but swift, rise in unemployment, and
a continuation until 1982 of the relatively rapid infla­
tion experienced since the 1960s.
Germany
The source of the German social security problem lay
in the rapid expansion of benefits in the early 1970s.
The scope of the social insurance program was in­
creased, reaching housewives, the handicapped, and
other low contributors to the system. Germany intro­
duced a minimum pension for those over 65 whose
contributions were too low to qualify for a regular so­
cial security pension. In 1972, the German government
moved forward the adjustment of pensions for infla­
tion by six months.
The expansion of benefits did not immediately
drive the old-age pension fund into deficit. It did lead
to a rapid rise in real pension benefits per recipient
between 1968 and 1972 (Chart 3).
The benefit change having the largest effect, how­
ever, was early retirement with full benefits. In 1973,
the German government began to offer early retire­
ment to a broader class of workers, a possibility
formerly available only to workers in especially haz­
ardous occupations. Germany offered full retirement
benefits to men with thirty-five years of service from
age 63 on— two years before the statutory retirement
age. The offer of full retirement pensions at age 63 was
considerably more liberal than the newly introduced
early retirement option in the United States. U.S. work­
ers aged 62 and over could retire early, but with an
actuarially reduced pension.
Another measure to facilitate early retirement was
included in 1974 legislation tightening regulation of
private pensions. The new law permitted private pen­
sion plans to offer flexible retirement benefits from
age 63 on. Thus, it provided an additional inducement
to early retirement for the 60 percent of workers
covered by private pensions.
The German authorities apparently expected the
possibility of elective early retirement to have little
impact on the work effort of older workers. The pre­
diction proved to be incorrect. The number of pension
recipients continued to grow rapidly between 1974
and 1977 (Chart 3), even though the number of persons

FRBNY Quarterly Review/Spring 1983

19

Chart 3

Real Pension Benefits in Germany
Index 1965=100
280
260
240
220

200
180
160
140

120
100
80

1965

1967

1969

1971

1973

1975

1977

1979

1981

* Deflated by the consumer price index.
Sources:
Federal S tatistical O ffice, S ta tis tic a l Yearbook
of the Federal R epublic of Germany; Deutsche
Bundesbank, Monthly Report.

aged 65 declined. As Table 5 shows, labor force par­
ticipa tion rates among men aged 55 and over dropped
quickly in the 1970s.
The surplus in the pension funds fo r wage and sal­
ary earners disappeared in 1975, when the effects of
benefit changes and the 1974-75 recession began to
appear. Depressed revenues, the result of the elim ­
ination of nearly 2 m illion jobs in the recession, and
unabated growth of expenditures quickly dissipated
the reserves of the combined wage and salary funds
set by law at one year’s outlay.
Further strain on the system resulted from the rapid
rise in unemployment among older workers, a group
facing special difficulties in finding new employment
w ithout retraining or accepting large wage cuts. Be­
ginning in 1976, older workers could retire as early as
age 60, or up to five years early, provided they met
certain requirements on length of employment and
period of unemployment.11 Indeed, it is possible if

11 A more com plete discussion is contained in Martin B. Tracy,
"F le xib le Retirement Features A broad” , S ocial Security B ulletin
(M ay 1978), pages 18-36.

20

FRBNY Quarterly Review/Spring 1983




not sanctioned for w orkers to leave their employment
voluntarily at age 59, collect unemployment benefits
for a year, and thus qualify for full pension benefits
at age 60. In addition, more generous interpretations
of early retirem ent provisions for those with health
or disability problems contributed further to a rapid
decline in labor force participation by older workers.
Encouraging older w orkers to leave the labor force
was in part motivated by rising youth unemployment.
Unemployment among both older and younger w ork­
ers reflects a more general structural unemployment
problem. Because older unemployed workers are often
low skilled or possess obsolete skills, they may com­
pete directly with younger w orkers fo r unskilled jobs.
Early retirem ent has proven to be an expensive way
to solve the problem of structural unemployment. It not
only adds to the current pension burden but to the
future burden as well, as early retirem ent provisions
are likely to be d ifficult to remove.
The wage inflation of the early 1970s, aggravated
by the oil-price shock in 1973, haunted the German
social security system later through the long lags
built into the benefits adjustment scheme.12 The calcu­
lation of social security benefits involves two kinds
of adjustment. To determine the initial level of bene­
fits, past earnings are revalued to present-day levels.
Revaluation is necessary because incomes from past
years have low purchasing power today, even at
modest rates of inflation. Germany revalues an indi­
vidu al’s past earnings according to the growth of
average wages. Then, to maintain the purchasing
power of benefits in subsequent years, increases in
benefits are tied to the rate of growth of average
wages over a period of 2Vz to 3 1/2 years earlier, de­
pending on the particular fund.
The lagged relationship to wage increases was
intended to smooth out fluctuations in aggregate de­
mand, but in 1976 it had unforeseen negative conse­
quences. The rapid growth of wages in 1973 and 1974
(around 10 percent) spilled into the social security sys­
tem just as wages began to decelerate sharply in the
German economy. The system ’s reserves fell $2.5 b il­
lion or 15 percent in 1976 and continued to fall in 1977.
With reserves falling at such a rapid rate, the financial
problems could no longer be ignored.

12 The Germans disting uish between benefits adjustm ent ( D ynam isierung) and indexation {In d e x ie ru n g ). In Germany, increases in pension
benefits are linked to increases in wages, but each year’s increase
must be approved by parliam ent through passage of a Pension
A djustm ent Law (Rentenanpassungsgesetz). Indexation, w hich is
prohibited in Germany by the 1948 C urrency Law, im plies autom atic
increases as the price level rises. In the United States, fo r example,
social security benefits increase autom atically w ithout
C ongressional action.

The United Kingdom
Like the United States and Germany, the United King­
dom experienced an expansion of social security ben­
efits in the early 1970s. Many features of the expan­
sion in the United Kingdom resemble those in Ger­
many. For example, in the early 1970s, the United
Kingdom introduced a minimum pension for those over
80 who had w ork experience too short or income too
low to qualify fo r a social security pension.
Unlike Germany, however, the expansion did not re­
sult largely from a sense of considerable prosperity
and overoptim istic predictions of continued rapid
growth. The expansion in the United Kingdom had
its roots in the growing disparity between the w ell­
being of those retired and those still w orking.
The old-age pension system in the United Kingdom
had struggled for over two decades before the 1975
reform with inadequate pension provisions, little in­
flation protection, and a growing government share in
support for the aged. The system in effect from the
early 1960s until 1975 consisted of two tiers: a flatrate benefit provided by the government to all and an
earnings-related benefit intended for those not covered
by a private pension plan. These benefits provided one
of the lowest earnings-replacem ent rates in Europe.13
The problem became painful by the late 1960s. The
governm ent’s review of public pensions for inflation
adjustment every two years was too infrequent. Real
social security pension benefits per recipient stagnated
between 1965 and 1971 (Chart 4), despite average real
growth of 2.5 percent in the economy. Inflation had
depleted the purchasing power of savings and private
pensions, which were not indexed. With both public
and private pensions unable to provide adequate sup­
port fo r the elderly, some expansion of pension bene­
fits seemed inevitable, but the role of the public
sector was unclear.
Despite the com paratively low social security bene­
fits in the United Kingdom, the common view of Con­
servative and Labor governments alike was that the
public sector was being asked to bear too large a
share of the pension burden. The heavy reliance on
social security pensions and the slow spread of private
pension plans led to a search for social security re­
form. This view held even though the social security
system as a whole (excluding health) had usually
been in surplus.
While long-term reform plans were being drawn, ac­
celerating inflation spurred changes in the procedures

by which initial benefits were calculated and then
increased in subsequent years. In the United Kingdom,
social security benefits were not and still are not in­
dexed automatically. Instead, they are reviewed and,
if necessary, adjusted in a discretionary fashion as
part of the budget process. The United States adjusted
pensions for inflation in the same way until 1975. In
1973, the United Kingdom increased the frequency of
reviews from every two years to every year. Pensions
were to rise by the higher of the increase in the wage
index or the price index, a generous practice by inter­
national comparison that added an estimated 10 per­
cent to pensions between 1973 and 1976. Real bene­
fits per recipient rose rapidly over this period (Chart 4).
Methods to alleviate financial difficulties
The methods used to alleviate the financial difficulties
of social security once the crisis arrived w ill be fa­
m iliar to those follow ing the social security discussion
in the United States:
• In both countries, social security taxes have
been raised. The rise in Germany has been
modest, amounting to only Vz percentage
point. In the United Kingdom, the overall con­
tribution rate has risen more substantially.

Table 5

Labor Force Participation of the Elderly
In percent
Country

1960

1970

1975

1980*

60.1
84.7
37.0
19.1

60.5
80.8
42.2
16.0

56.8
74.7
40.7
13.1

55.9
72.1
41.5
12.5

52.1
82.0
27.8
14.1

52.0
82.2
29.9
11.7

45.4
71.8
27.3
6.9

44.7
67.8
28.5
4.6

t
t
t
13.1

63.8
91.2
39.1
11.0

61.6
88.3
37.6
8.2

64.0
88.4
41.4
7.7

United States:
Ages 55-64 ................

Ages 65 and o v e r . . .
Germany:
Ages 55-64 ................

Ages 65 and o v e r . . .

%

United Kingdom:
Ages 55-64 ................

Ages 65 and o v e r . . .

‘ Actual numbers for 1979 for the United States and OECD
estimates for the United Kingdom.
tN o t available.

13 Jonathan A ldrich, "T he Earnings of Replacement of Old-Age Benefits
in 12 Countries, 1969-80” , S ocial Security B ulletin (N ovem ber 1982),
page 5. Moreover, unlike Germany and the United States, social
security benefits are taxable in the United Kingdom.




Sources: OECD, D em ographic Trends 1950-1990 (1979);
recent data: ILO, Yearbook o f Labour Statistics.

FRBNY Quarterly Review/Spring 1983

21

Chart 4

Real Pension Benefits in the
United Kingdom
Index 1965=100
2 0 0 — --------------------------------------------------------------------------------------------------------------------------------

---- 1
---- 1
---- 1
----1---- 1
---- 1
---- 1
---- 1
---- 1
---- 1
---- 1
---- 1
---- 1
----1
---- 1
___ I
90'---- 1
1965
1967 1969 1971
1973 1975 1977
1979 1981

* Deflated by the consumer price index.
Sources:

United Kingdom Central Statistical Office,

Monthly Digest of S tatistics and National Income and
Expenditure.

• Both Germany and the United Kingdom have
also moved to lim it the inflation adjustment
of benefits. In Germany, this has taken the
form of temporary, but very effective, mea­
sures. In the United Kingdom, adjustm ent has
been permanently set by legislation to a lower
path.
• Finally, the United Kingdom has embarked on
an ambitious program to shift the burden of
pension provision from the public sector to the
private sector, with the government providing
protection against inflation.
Germany
Following the rapid rundown of reserves in 1976 and
1977, the government took a number of measures to
restore balance in the social security funds in 1977
and 1978. The measures taken reflected the w idely
held view that the funding problems of the mid- to late
1970s were temporary. Economic growth was expected
to return to its long-term trend, bringing a reduction
o f unemployment. Short-term dem ographic develop­
ments would turn in Germany’s favor by the late 1970s

FRBNY Quarterly Review/Spring 1983
Digitized for 22
FRASER


as the less numerous generations born in the 1920s
began to retire and the postwar baby boom came of
age. Therefore, the solutions were tem porary in na­
ture or easily reversible.
The most im portant action was to place ceilings on
the increase in pensions for 1979, 1980, and 1981 of
4.5 percent, 4.0 percent, and 4.0 percent, respectively,
well below the scheduled increases of around 6 per­
cent. Pensions rose over the three years less than the
cumulative rate of price increase. The cap on benefits
increases was, however, understood as strictly tem ­
porary, and a return to benefits adjustm ent on the
basis of wage growth occurred as planned in 1982.
In other measures in 1977 and 1978, the government
postponed the date of inflation adjustm ent by six
months, reversing the 1972 change. It transferred re­
sponsibility fo r some contributions from the pension
fund to the health fund. It also scheduled an increase
in the pension contribution of V2 percentage point
to 18.5 percent in 1981.
The combined effect of the measures taken in 1977
and 1978 and improved econom ic growth in 1979 and
early 1980 led to a return to surplus in 1980 and some
modest buildup in reserves in 1980 and 1981. The
Deutsche Bundesbank estimates that the measures
saved the social security fund close to DM 35 billion
in 1981.14 By 1981, the federal government could cut
its grant to the social security fund to reduce its own
budget deficit and could rescind the scheduled in­
crease in the contribution rate.
The capping of benefit increases was particularly
effective. Real pension benefits per recipient declined
between 1978 and 1981, stabilizing real total benefits
despite a rising retired population (Chart 3).
The improvement was only temporary, however.
The 1981-82 recession produced a dram atic rise in
unemployment. Social security revenues stagnated.
More fundam entally, the favorable dem ographic de­
velopments expected fo r the late 1970s were in part
offset by a sharp fall in the average age of retirem ent
for men.15 The Deutsche Bundesbank recently esti­
mated that in 1980, the average age of retirem ent for
men was just under 59 years of age, w hile the aver­
age fo r women was just above 60.16 Finally, as wages

14 Deutsche Bundesbank, "T he Finances of the Statutory Pension
Insurance Funds Between 1978 and 1981” , M onthly Report
(A pril 1982), page 15.
15 Curiously, Germany encourages deferm ent of retirem ent with a
bonus system more generous than that in the United States. A
w orker may receive an addition of 7.2 percent of his benefit
for each year worked after the age of 65 until the age of 70. The
bonus, w hich was legislated before 1974, appears to con flict
with the early retirem ent programs.
18 Deutsche Bundesbank, op. cit., page 16.

gradually decelerated, pension benefits increased
faster than payrolls under the lagged adjustment pro­
cess employed in Germany. The pension fund there­
fore tends toward deficit in periods of wage decelera­
tion.
With unemployment predicted to average between
9 and 10 percent in 1983, the near-term outlook for
the combined wage and salary pension funds has de­
teriorated. The German government again faces grim
predictions of depleted reserves, perhaps as early as
the spring of 1984. Some measures to tighten social
security have already been put in place. Pension re­
cipients will now have to pay part of their own health
insurance premiums, a reduction of about 1 percent of
pension, with increases in their share scheduled for
1984 and 1985. The date for upward adjustment of
benefits has been postponed by six months, for a sec­
ond time, until July 1983. These modest measures are
expected to save the funds around $1.5 billion.17 In addi­
tion, the social security contribution has been raised to
18.5 percent effective September 1983.
In his May 1983 state of the nation address, Chan­
cellor Kohl recommended measures to secure the
finances of the social security system in the short and
the long term. To relieve the short-term liquidity prob­
lems, he suggested broadening the wage base on
which pension contributions are paid to include bo­
nuses and sick pay, eliminating the lag in the inflation
adjustment of pensions and tightening some qualifica­
tions for early retirement.
For a long-term solution, he outlined three broad
principles:
• benefits must continue to be related to con­
tributions,
• inflation adjustment should be tied to aftertax
rather than pretax workers’ incomes, and
• the amount of funding from general revenues
should fluctuate less from year to year.
United Kingdom
The long-term structure of the old-age pension sys­
tem in the United Kingdom was established in the
ambitious 1975 reform. Because of the arrangements
to determine and adjust benefits, however, questions
about the ultimate size of the long-term social secu­
rity burden remain.
After the recession in 1975, the United Kingdom
made some changes in the social security system
analogous to those made in Germany. To cope with

German Institute for Economic Research, “ Expenditure Reductions
in the Statutory Pension Insurance”, Weekly Report 41182
(October 14 ,1 9 8 2 ).




the rising number of unemployed persons, a new law
permitted workers to retire one year early and to
receive higher benefits if the job was filled by an
unemployed person.
The United Kingdom also scaled back its adjust­
ment of pension benefits, often through changes in
the adjustment method. In 1976, the government
switched from adjusting pensions for past inflation to
adjusting them for projected price increases. This,
along with discretionary adjustments, reduced pen­
sions by as much as 10 percent by 1981. In 1980, the
government made a general commitment to adjust for
price inflation only rather than raising pensions by
the higher of wage or price increases. Price changes
were to be measured over a two-year period, which
would allow the government to adjust pensions to
expected inflation in the upcoming (fiscal) year but
would also permit the government to correct its fore­
cast errors in the next adjustment. In a move that
will incorporate the recent good inflation performance
into benefit increases, the 1983-84 government budget
announced a return to adjustment of social security
pensions for past price inflation.
Unlike Germany, however, the United Kingdom
looked for more fundamental reform of its old-age
pension system. The search, which was interrupted by
changes in government,18 culminated in a reform bill
in 1975. The reform retained the two-tier system of
basic benefit and earnings-related supplement but
will produce a major increase in the level of bene­
fits when fully in operation, albeit at higher contribu­
tion rates.
The basis of the reform was a transfer of more
responsibility for providing pensions to the private
sector. The reform approached social security as an
old-age annuity program which the private sector
could provide. The failure of the previous system, which
also had allowed employers to substitute private pen­
sion insurance for the earnings-related social security
benefit, was seen to lie in the inability of private in­
surers to guarantee the purchasing power of future
pensions.19 The government plan, therefore, called for
the continuation of a government-run basic benefit
program but offered employers the option to replace
the earnings-related social security plan with a private

18 Comprehensive reform bills were offered in 1969 and 1973
but were soon withdrawn by new governments.
19 One proposal to enable private pension insurers to guarantee
the purchasing power of pensions would have the government issue
indexed bonds to pension funds. The United Kingdom has begun
to issue them on a modest scale. See James Pesando,

Private Pensions in an Inflationary Climate; Limitations and Policy
Alternatives (Economic Council of Canada, 1979).

FRBNY Quarterly Review/Spring 1983

23

pension plan, that is, to “contract out” of the earningsrelated portion of social security.20 The government
would assume responsibility for the inflation adjust­
ment of these private as well as social security pen­
sions.
To contract out of the earnings-related portion of
the social security system, a company’s pension plan
must provide on a funded basis the earnings-related
benefits which would otherwise be paid by social se­
curity. In return, the firm receives a rebate on social
security contributions of 7 percent of covered wages.
Of this 7 percent, the company keeps 4.5 percent and
returns 2.5 percent to the worker. As foreseen by the
British Government Actuary, the rebate will be re­
duced over the next thirty years from 7 percent to an
estimated 4.8 percent. The first reduction, to 6.25 per­
cent, took place in April 1983.
The major inducement to contract out resulted from
a rise in the social security contribution rate com­
bined with the rebate for contracting out. In addition,
if a firm found the advantages of contracting out
smaller than anticipated, the employer could “buy
back” into the social security system at favorable
terms anytime in the first five years of the new plan
until March 1983. Since the method of calculating
the buy-back differed from the actuarial method used to
calculate the 7 percent tax abatement, many contractedout employers could reenter the state scheme for less
than the accumulated 7 percent abatement. New terms
effective April 1983 are less favorable.
Another major inducement to contract out was that
contributions made by members to a private scheme
are tax deductible, while social security contributions
are not. Further, if an employee leaves a firm before
being vested in the company pension plan, his con­
tributions can be used to buy back into the social
security system. Thus, the new system provided “port­
ability”, the ability to accumulate pension benefits
despite changing employers. Lack of portability con­
tributed to a low average level of pension benefits by
penalizing those who changed jobs frequently.
Contracting out was initially very popular. In April
1978, when the new scheme began, 10.3 million out
of 11.8 million pension scheme members (44 percent
of the work force) were contracted out of the new
earnings-related component.21 Virtually all firms in the
public sector and nationalized industry contracted
20 The basic benefit would provide approximately 100 percent of
earnings up to a lower earnings limit (currently £1,690 per year),
while the earnings-related component is equal to 25 percent of
earnings between the lower earnings limit and seven times
this level.
21 Wyatt International Newsletter, "Contracting-out of U.K.
Social Security— Time for a Change?” (June 1981).

24

FRBNY Quarterly Review/Spring 1983




out as did most large companies. By contrast, most
smaller firms elected to join the government’s earningsrelated plan.
The success of contracting out as a means of pre­
venting a rise in the social security burden will hinge
on the United Kingdom’s success in controlling infla­
tion over the next few decades, especially since the
government will bear the burden of adjustment of pen­
sions after retirement.22 The effect of recent and fu­
ture reductions of the contracting-out rebate and less
favorable buy-back provisions on employers’ decisions
to contract out are still unclear.
Hemming and Kay feel that the government’s obli­
gation to make up the gap between the social security
benefits formula and the formula used in computing
pensions granted by firms is a substantial, but hidden,
burden. Benefits under the earnings-related portion
of social security are based on the best twenty years
of earnings revalued to today’s wages. Benefits to be
paid out by the private contracted-out pension plan
are required to be based only on average lifetime
earnings, revalued to today’s wages. The government
will make up the difference between social security
and private benefits.
In the first twenty years of the plan, social security
benefits and private benefits will be identical since
only the years after 1978 count in computation of
benefits under the reformed system. As the system
matures, however, the benefits will diverge. If earn­
ings grow significantly over the typical work career,
the social security system will once again be bur­
dened by large unfunded liabilities, precisely the situ­
ation that the British government had sought to avoid.
The reform program in the United Kingdom raises a
number of interesting questions about the nature of so­
cial insurance pensions and the distribution of the
burden of their cost. The United Kingdom program
appears to be based on the belief that the role of gov­
ernment pension insurance today is to enforce a mini­
mum standard for pension coverage, to cover those
workers who cannot efficiently be covered by the pri­
vate pension system, and to protect the purchasing
power of future pension benefits from erosion by in­
flation. In doing so, it appears that the United Kingdom
also intends to make the long-run funding of the pen­
sion system more secure by forcing private accumula­
tion. If successful in its aims, the 1975 reform will sub­
stantially increase the burden on the generation
currently working relative to past and future genera­
tions, because today’s workers will be financing their
own as well as the previous generation’s retirement.

® R. T. Hemming and J. A. Kay, “The Costs of the State EamingsRelated Pension Scheme’’, Economic Journal (June 1982).

Conclusion
The experiences of Germany and the United Kingdom
offer valuable lessons for the United States. Moreover,
their experiences have much in common with those of
other major European countries. Briefly summarized:
• The short-term financial problems have not
ended as expected because of much weaker
than anticipated economic growth and the
resulting transfer of some of the burden of
unemployment to the social security pension
fund through early retirement.
• The adoption of short-run palliatives as a so­
lution to the financial problems of the 1970s
has not shown more than temporary success,
and delays in reforms have made necessary
fundamental revision more difficult.
• While not exactly alike, the German experi­
ence with benefit adjustment on the basis of
wages has been no more favorable than the
U.S. experience with price indexing in the last
eight years. Both Germany and the United
Kingdom have moved to reduce the gener­
osity of inflation adjustment.
• Even longer term reforms carry with them con­
siderable uncertainty, since the potential costs
of providing for a sizable elderly population
are so large.
The significance of the success or failure in con­
trolling social security deficits extends far beyond
the problems of annual financing. Because of their
size, rescuing social security programs from insol­
vency can significantly affect a government’s overall
fiscal policy stance. This is clear from the large share
of social security contributions and expenditures rela­
tive to general government receipts and expenditures




(Table 2). Since social security’s difficulties are ex­
acerbated by slow economic growth, a funding crisis
is likely to occur at an inopportune time. For example,
increases in social insurance charges in Germany in
1981 blunted some of the expansionary impact of the
January 1981 income tax reduction.
One strength of the United Kingdom reform is that
it is set out in a unified way to secure adequate pen­
sion provision for the elderly from combined private
and public insurance. In the United States, the social
security retirement fund, the safeguards on fund­
ing introduced in the Employee Retirement Income
Security Act of 1974, and the development of the In­
dividual Retirement Account are trying to meet this
goal separately. The situation in Germany is similar
to that in the United States.
There may be limits on the private-sector role, how­
ever. A conservative view of social security is that it
should provide protection from risks against which
private markets cannot insure. In the late nineteenth
and early twentieth centuries, when the financial sta­
bility of both firms and financial institutions was less
than it is today, social security provided a commit­
ment to future payment no private pension plan could
have offered.23 One social security system that has
had to make good on that commitment is the German
system, which survived the 1923 hyperinflation and
the 1948 currency reform. To the extent that this pur­
pose still has relevance today, there will be a limit
to the increase in the role of the private sector.

23 Of course, a sufficiently diversified portfolio of assets may have
in some cases avoided the problem. This may have required
investment in real as well as financial assets. Pension fund
investments, however, may be restricted to financial instruments.
See the article beginning on page 1 of this Review for a discussion of
foreign pension fund investments.

Christine Cumming

FRBNY Quarterly Review/Spring 1983

25

Charts on New York State and
Local Government Spending

Per capita spending by state and local governments
in New York has long exceeded the average in the
rest of the United States. In 1969, for example, state
and local governments in New York spent $1.49 for
every dollar spent elsewhere. Moreover, before the fis­

cal crisis in 1975, New Y ork’s expenditures grew faster
than the average so that by 1974 it was spending $1.64
for each dollar spent in the rest of the nation. Since
the fiscal crisis, however, the gap has narrowed appre­
ciably.

C hart 1

New York’s Per Capita State and Local Government Expenditures as a Percentage
of the Rest of the United States
Percent

1958

59

60

61

62

63

64

65

66

67

68

69
70
71
Fiscal yea rs

72

73

74

S ources:
U.S. Department of Commerce, Bureau of the Census, Governm ental F inances,
various years, and S tatistical A bstract of the U nited S tates. 1982-83.

FRBNY Quarterly Review/Spring 1983
Digitized for26
FRASER


75

76

77

78

79

80

81

In which areas did New Y o rk’s spending grow faster
than the rest of the nation’s before the fiscal crisis,
and in which areas has New Y ork’s expenditure growth
slowed since then? The five main categories in which
New Y o rk’s state and local government spending most
exceeded the per capita average elsewhere in fiscal
year 1969 were public welfare, local schools, health
and hospitals, police protection, and interest on the
general debt. Prior to the 1975 fiscal crisis, a m ajor
reason New Y ork’s total spending expanded faster than
the rest of the nation’s was much more rapid growth
of its state and local government expenditures on health

and hospitals and interest payments on the debt.
Between fiscal 1974 and 1981, however, New Y ork’s
per capita expenditures converged toward the national
average in each of the five categories. This accounted
fo r much of the lessening of the gap between total per
capita expenditures in New York and elsewhere in the
nation from 1974 to 1981. Despite the slower growth
in recent years, however, New Y ork’s per capita spend­
ing in 1981 fo r these five categories still exceeded the
average in the rest of the country by amounts ranging
from 24 percent more fo r local schools to more than
double for interest payments.

Chart 2

Spending Categories in which New York was Highest, Compared with
the Rest of the United States
New Y ork as a percentage of
the
rest of the U nited States
3 0 0 ---------------------------------------------------------------------------------------------------------------------------------------------------------Fiscal years

1969

□

100

Public w elfare
Source:

Health and ho spitals

Police protection

Interest on debt

Local schools

U.S. Department of Commerce, Bureau of the Census, Governmental F in a n ce s, various years.




FRBNY Quarterly Review/Spring 1983

27

New Y ork’s continuing high level of interest pay­
ments relative to other states reflects both greater per
capita debt outstanding in New York and a higher
average interest rate per dollar of this debt. The latter
rose to 2 percentage points above the rest of the na­

C hart 3

tion in 1981 from 20 basis points below in 1969. This
rise is, in part, a reflection of New Y ork’s higher bor­
rowing costs follow ing its fiscal crisis. In New York
State’s most recent bond offerings, however, its costs
were more in line w ith other states’ debt offerings.

Chart 4

Average Interest Rate on State and
Local Debt

Per Capita State and Local Debt
New Y ork as a percentage of
the rest of the United States

Percent

250----------------------------------------------------------------------

10------------------------------------------------------------New York

Rest of the U.S.

200 —

2—

1969

1974
Fiscal years

1981

Source: U.S. D epartm ent of Commerce, Bureau of the
Census, G overnm ental Finances, various years.

28

FRBNY Quarterly Review/Spring 1983




1969

1974
Fiscal years

1981

Source:
U.S. D epartm ent of Commerce, Bureau of the
Census, G overnm ental Finances, various years.

W hile New Y ork’s state and local spending ex­
ceeded the rest of the nation’s for most categories,
there were a few m ajor areas in which New York spent
less. New Y ork’s per capita expenditures on highways
and institutions of higher learning were lower both
before and after the fiscal crisis, and in 1981 its spend­
ing on parks and recreation was also less.
Compared with five other highly urbanized states,
New Y ork’s growth of state and local spending was
the second fastest from 1969 to 1974. Following its
fiscal crisis, however, New York dropped to last place,

based on the 1974-81 increase in spending. This was
largely due to a marked slowing in New Y ork’s ex­
penditures during fiscal 1977 and 1978. Using the bud­
gets of New York State plus New York City as a rough
indicator since com plete state and local expenditures
figures are not available, the growth of New Y ork’s
governmental spending appears to have slowed further
since fiscal 1981. Despite its slower growth in the
period since 1974, however, New York still spends
more than the rest of the nation on a per capita basis
and also per dollar of personal income.

Chart 5

Annual Average Growth of Per Capita Spending
Percent
2 5 -------Fiscal years

□

1969-74

□

1974-81

20

15

10

New Jersey

S o u rce :

New Y ork

Illinois

M assachusetts

C onnecticut

California

U.S. D epartm ent of C om m erce , B ureau o f the C ensus, G ove rnm enta l F in a n c e s , v a rio u s years.




FRBNY Quarterly Review/Spring 1983

29

U.S. International Trade
in Services
International trade in services has been getting a lot
of attention. At last year’s ministerial meeting of GATT
(General Agreement on Tariffs and Trade), the United
States emphasized the need to resolve the problem
of protectionist policies in the services sector. The
media have also played up the importance of services
to the U.S. balance of payments. And many analysts
are looking to the growing domestic services economy
in the United States to become a dominant force inter­
nationally— one in which the United States is thought
to enjoy a competitive advantage.
U.S. services trade emerged in the mid-1970s as an
important positive contributor to the U.S. current ac­
count. An earlier article in this Review (Reuven Glick,
“U.S. International Service Transactions: Their Struc­
ture and Growth”, Spring 1978) described the many
components of services trade and their role in U.S. eco­
nomic activity and analyzed the reasons for the rapid
growth of services income through 1977.
Since then, net services income continued to grow
rapidly. From $21 billion in 1977, it reached $39 billion
in 1981. Services were a major contributor to the an­
nual U.S. current account surpluses recorded in 1980
and 1981.
Some analysts had presumed that net services in­
come would follow a continued upward trend. Indeed,
the services account appears to have been relatively
unresponsive to the economic factors that have con­
tributed to a widening U.S. merchandise trade deficit
(chart). For example, over the last two years, as the
dollar appreciation contributed for a time to an ex­
panding deficit on merchandise trade (see Robert A.
Feldman, “Dollar Appreciation, Foreign Trade, and the

30

FRBNY Quarterly Review/Spring 1983




U.S. Economy”, Summer 1982 issue of this Review),
the surplus in services income rose.1 However, the
conditions that imparted much of the past upward
momentum to net services income have changed and
the surplus in services transactions turned down last
year. Moreover, some of the past growth may have
been illusory because of reporting inconsistencies and
incomplete data.
This article highlights the main features of U.S. ser­
vices trade over the past five years and focuses on
two questions: (1) What economic factors help explain
recent movements in U.S. services income? And (2)
is it likely that services income will return to suffi­
ciently rapid growth to offset, as in the recent past,
large projected merchandise trade deficits?

Highlights of U.S. trade in services
To start, there are some basic points about recent
U.S. international services transactions:
• Most of the rise in the U.S. services surplus
has been in investment income. Net invest­
ment income almost doubled to $33 billion be­
tween 1977 and 1981. It accounted for over
80 percent of the cumulative net services re­
ceipts over the period. Such frequently thought-

1 Statistical tests suggest that changes in the net investment income
component of services transactions induced by movements in exchange
rates and U.S. and foreign real incomes are much smaller than the
corresponding changes in the merchandise trade balance. See Allen J.
Proctor, "A Forecasting Model of the Services Account of the U.S.
Balance of Payments: Preliminary Results” (Federal Reserve Bank of
New York Research Paper No. 8237, December 1982).

of services trade as tourism, shipping, con­
sulting, and construction reduced net services
income by a small amount.
• Last year net investment income fell (by $4 b il­
lion to $29 billion) because of a substantial
decline in net direct investment income (see
box for definitions). Net direct investment in­
come had been the major, and a steadily grow ­
ing, source of services income. It reached $32
billion and accounted for almost all net ser­
vices income in 1979. But, over the past three
years, net income from direct investment
dropped to $18 billion.
• In contrast to direct investment, net financial
investment income has been rising sharply.
It jum ped from roughly zero over the 1978-80
period to $9 billion in 1981 and then rose fur­
ther to $11 b illion in 1982. However, problems
of measurement and definition, which may af­
fect both direct and financial investment in­
come, are especially severe for the latter, and
the published figures may overstate the growth
of net financial income.

U.S. Merchandise Trade and Services
Accounts
Seasonally adjusted annual rates
Billions o f dollars

Source:

Survey of C urrent Business.




Since investment income accounts fo r most of the
income earned from U.S. services trade and has
shown larger movements in dollar value, it is the focus
of the rest of this analysis. The next section analyzes
which econom ic factors help explain recent move­
ments in net investment income by examining direct
investment income first, then financial investment in­
come.
Sources of change in investment income
D irect investm ent income
During recent years the movements in net direct in­
vestment income have generally tracked the move­
ments in the U.S. net foreign asset position in direct
investment (Table 1). In 1979, rising net income was
associated with an increase in the U.S. net asset posi­
tion. Then, as the net asset position dropped off in
1981 and 1982, so did net direct investment income.
The net asset position has not, however, been the
only factor influencing the size of net direct invest­
ment income flows. U.S. income payments to foreign­
ers, after rising $4 billion in 1980 to a level of $10
billion, fell by an equal amount over the next two
years. U.S. receipts from foreigners fell by $14 billion
during the three years to 1982, virtually all of which
took place over the last two years. World economic
activity, exchange rates, and oil-price developments
have all had significant effects on direct investment
income receipts and payments.
The recession in the United States contributed to
declining income payments over the last two years
even though foreign direct investment holdings in
the United States continued to rise. However, the re­
cession abroad reduced U.S. direct investment income
receipts even more. Earnings on U.S. manufacturing
operations abroad, which have been declining in profit­
ability for a num ber of years, weakened further during
the recession. By 1981, m anufacturing industries held
over two fifths of direct investment assets outstanding
but produced only about one fourth of direct invest­
ment income (Table 2).
By contrast, the petroleum sector has contributed
over a third of income receipts since 1979 even though
less than a fourth of U.S. direct investments is in
this sector. This income stream has been influenced
mainly by developments in international oil markets.
Large o il-price increases in 1979 tended to raise direct
investment income in 1979 and 1980, because they
provided inventory profits and w ider profit margins
since contract prices lagged increases in market
prices. The industry’s overseas earnings rose from
$6 billion in 1978 to $13 billion in each of the three
follow ing years. Then, when the market price of oil

FRBNY Quarterly Review/Spring 1983

31

Table 1

Direct Investment and Financial Investment: Outstanding Stocks and Income Rows
In billions of dollars

Stocks and flows

Direct investment
1980
1981
1982*

1978

1979

U.S. net foreign asset p o s it io n ..........................

120

133

148

137

126

U.S. net incom e re c e ip ts .....................................

21

32

28

24

18

1978

Financial investment
1980
1981
1982*

1979

— 44

-

38

26

23

60

-

-

1

2

9

11

1

-

U.S. a s s e ts .............................................................

163

188

216

227

225

285

323

391

490

604

U.S. incom e r e c e ip ts ............................................

25

38

37

32

24

17

26

36

54

62

U.S. lia b ilitie s .........................................................

42

54

68

90

99

329

361

417

467

544

U.S. incom e p a y m e n ts ..........................................

4

6

10

8

6

17

27

33

45

51

Stocks are measured as of the end of the year.
Preliminary.
Source: Survey of Current Business (August 1982 and March 1983)

Table 2

Contribution of Selected Industries to U.S. Direct Investment Abroad and U.S. Income Receipts
In billions of dollars

Sector

Income
1980

Stocks
1981

Income
1981

Stocks
1982

216

37

227

32

225*

24*

13
8
11

t

t

t
t

t
t

Total U.S. investment abroad
Petroleum

Income
1982

Stocks
1980

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

48

13

52

Manufacturing ..........................................................................
O t h e r ............................................................................................

89
79

11
13

92
83

* Preliminary.
t An industry breakdown for 1982 is not yet available.
Source: Survey of Current Business (August 1982 and March 1983).

fell last year, income receipts dropped to an esti­
mated $10 billion.2
Another important, separate reason for the drop in
direct investment receipts involves the increased use
of finance subsidiaries by U.S. firms. Such transactions
are made by U.S. firms either to raise funds abroad
for their U.S. domestic operations or to reduce the

2 Losses resulted from reselling crude oil, since the contract prices
that some subsidiaries paid to buy crude oil were sufficiently above
the prevailing market prices. In addition, margins on refining and
sales operations were compressed.

32

FRBNY Quarterly Review/Spring 1983




use of U.S. source funds for their operations abroad.
In particular, U.S. direct investment income receipts
were reduced by an increasing volume of interest
paid on borrowings by U.S. nonbank parent compa­
nies through financing subsidiaries located in the
Netherlands Antilles (box). These essentially financial
transactions reduced d irect investment receipts by
$1 billion in 1981 and by an estimated $2 billion last
year.
Finally, foreign currency valuation effects also con­
tributed to the decline in the dollar value of direct
investment income receipts from nonoil industries.

Because income of foreign subsidiaries is usually
earned in foreign currencies, it translated into fewer
dollars after the dollar appreciation of the last two
years.3
In sum, the balance on direct investment income
declined from $28 billion in 1980 to $18 billion last
year. We would very roughly allocate the $10 billion
decline in the net income over the two years as fol­
lows: $3 billion to the petroleum sector, $2 billion to
the impact of recession in other sectors, $3 billion to
valuation effects from dollar appreciation, and $2 bil­
lion to foreign financing activities of U.S. firms.
Financial investm ent income
U.S. net financial investment income has grown rap­
idly over the past five years (Table 1). Both receipts
and payments have at least tripled as both asset and
liability stocks and their respective rates of return
have increased. Higher interest rates applicable to
assets than to liabilities and an expanding net foreign
asset position fueled the growth in net financial in­
vestment income. However, as discussed below, some
of this growth may be illusory as the rise in the net asset
position may be erroneous.
Many types of U.S. international financial transac­
tions have raised both U.S. assets and liabilities and
reflect the large role the United States plays as both
a giver and a taker of funds from the rest of the world.
After the major oil-price increases of the 1970s, for
example, the United States incurred liabilities as it
received funds from oil-producing countries drawn by
the relative safety and depth of U.S. markets. At the
same time, the United States acquired assets by pro­
viding funds to oil-consuming countries. In other
words, the banks and financial markets provided in­
termediation services to the rest of the world, raising
both assets and liabilities.
Assets and liabilities also have grown when U.S.
nonbank residents placed funds at higher yields in the
Eurodollar market and U.S. corporate borrowers tapped
various Euromarkets as a source of funds. Such round-

3 There are some more complicated accounting effects in addition
to these valuation effects Because of accounting procedures
determined by the Financial Accounting Standards Board, some
balance-sheet items of U.S. subsidiaries are exposed to foreign
exchange rate variation and some effects of this exposure are
included in the subsidiaries’ income statements. Consequently, de­
pending on the composition of an individual balance sheet, accounting
gains or losses may occur when the dollar appreciates. Accountina
procedures have been changed (FASB-8 was supplanted by FASB-52),
and U.S. multinationals are presently phasing in new procedures.
Nevertheless, the numbers reported by the Commerce Department
attempt to retain the conventions of FASB-8. The total effect on
U.S. direct investment income receipts from the translation of all
subsidiaries’ income statements into dollars depresses income
when the dollar appreciates.




trip flows could be advantageous to all parties because
the Eurodollar market has been free of the reserve
requirements and interest rate restrictions on deposits
that have applied in the United States (see Edward J.
Frydl, “The Eurodollar Conundrum”, Spring 1982 issue
of \h\s Review).
Rising average rates of return on these growing
stocks of claims and liabilities added further to finan­
cial income receipts and payments. Interest rates on
the outstanding stocks of claims and liabilities (both
almost entirely denominated in U.S. dollars) generally
rose from 1978 to 1981. Over this period, for example,
interest rates on U.S. ninety-day Treasury bills in­
creased from around 6 percent to as much as 15 per­
cent. Other interest rates, such as Eurodollar bid
rates and certificate of deposit (CD) rates, also rose.
The implied average rates of return on U.S. foreign
asset and liability stocks in 1981 were about 11 per­
cent and 10 percent, respectively, or at least 4 per­
centage points higher than in 1978.4 Last year, how­
ever, the average yields dropped about Vz percentage
point, as interest rates remained high through the first
half of the year but fell in the second half.
While both receipts and payments rose, net finan­
cial income grew because the differential between the
average returns on assets and on liabilities widened.
Since interest rates applicable to particular assets
and liabilities may differ, changes in the composition
of total stocks have affected average rates of return.
This has been particularly important during the four
years to 1981.
During those years, the composition of asset and
liability stocks shifted away from international claims
and liabilities of the U.S. Government5 and toward those

4 Most interest income receipts and payments are not reported
directly to the U.S. Government. Rather, receipts and payments are
estimated by the Commerce Department by applying a range of
interest rates to assets and liabilities with a range of maturities and
other characteristics. The implicit average rate of return, derived by
dividing total income receipts by the stock of total assets, and
similarly by dividing income payments by the stock of total liabilities,
is one way of representing the estimated average yield of all
these interest rates.
5 Reflecting the international role of the dollar as a reserve currency,
most U.S. official liabilities, which are at market terms in the form of
Treasury bills, notes, and bonds, are held by foreign governments as
official reserves. U.S. official assets consist of relatively small holdings
of official reserves: gold, special drawing rights, the U.S. reserves
position in the International Monetary Fund, and foreign currency.
Most other U.S. official assets are government aid-related loans to
foreign governments. Since U.S. official assets and liabilities partly
consist of the U.S. Government’s and foreign governments’ official
reserves, respectively, exchange market intervention can alter U.S.
asset and liability stocks. As an example, when foreign
governments intervened in 1981 to resist the decline in their
currencies, the decline in their official reserves was reflected in a
drop in their holdings of U.S. Government securities.

FRBNY Quarterly Review/Spring 1983

33

of the private sector. U.S. private claims have earned
more than official (Government) claims, an average
difference of 41/2 percentage points in 1978. Surpris­
ingly, the average return paid on private-sector lia b ili­
ties has actually been less than on official sector lia­
bilities, because of the m aturity structure of U.S.
Government securities that foreigners hold and be­
cause earnings on equity include only the dividend
component of the yield. In 1978, the difference was
1 percentage point on average. As a result, movement
away from official and toward private assets and lia­
b ilities has tended to increase net financial invest­
ment income. From 1978 to 1981, private claim s rose
from 74 percent of total assets to 80 percent, and
private liabilities rose from 54 percent of total lia b ili­

ties to 66 percent. Moreover, the average interest gap
between private and official assets rose to 9 per­
centage points in 1981, and fo r liabilities the gap rose
to 2 percentage points, further enhancing net income
growth.
Last year, however, relative movements in the aver­
age rates of return on assets and liab ilities swamped
the effects of a continuation of the com positional shifts
toward private claim s and liabilities. The average re­
turn on total assets fell by roughly 1 percentage point
from the previous year as the return to private claim s
fell 1.3 percentage points, th eir firs t annual average
drop over the five years to 1982. By comparison, the
average interest on liab ilities remained about the
same. Thus, the spread between assets and liabilities

Investment Income: Definitions and Balance-of-Payments Conventions'*
Direct investment is defined as ownership of 10 percent
or more of the means of control over an enterprise
abroad either through
funding of foreign opera­
tions or through equity claims. To the extent that U.S.
foreign operations are financed using funds raised
outside the United States, they are not considered a
part of the U.S. direct investment stock. The flow of
U.S. direct investment income receipts from foreigners
is in the form of profits and interest derived from the
stock of U.S. investments abroad. Profits retained by
a foreign subsidiary as well as dividends paid are
included in income. The flow of U.S. direct investment
income payments to foreigners represents similar earn­
ings by foreigners on their ownership of enterprises
in the United States.
Financial investment income is a composite of in­
come from several types of international financial
transactions, including principally interest and dividends
on portfolio investments. Most financial income receipts
and payments are earned from the claims on and lia­
bilities to foreigners on the books of U.S. banks.
Receipts and payments are also earned from other
activities, including U.S. Government loans to other
countries, foreign holdings of U.S. Government securi­
ties, U.S. nonbank borrowing from bank offices located
abroad, U.S. purchases of foreign bonds and sales of
domestic bonds abroad, and similar transactions in
equity securities (ownership of less than 10 percent
is treated as financial investment).
There can be a fine line between direct and finan­
cial investment income. U.S. nonbank parent compa­
nies' borrowings from financing susidiaries had a large

direct

* See the June 1978 issue of the Survey of Current Business for
detailed and more tech nical definitions, and the Spring 1978
issue of this Review fo r more discussion.

34

FRBNY Quarterly Review/Spring 1983




impact on direct investment and direct investment in­
come over the last two years and serve as a good
example to highlight this point.
In 1981 and 1982, U.S. nonbank parent companies
borrowed from foreigners by issuing bonds outside
the United States through U.S. financing subsidiaries
in the Netherlands Antilles, who, in turn, re-lent the
funds to the U.S. parent. This type of “ indirect” bor­
rowing increased roughly fourfold from 1980 to 1982
and reflected efforts to raise funds from foreigners
without incurring U.S. withholding taxes on interest pay­
ments to foreigners. Although they resemble “financial”
transactions, loans between a parent and its subsidiary
(also called intercompany accounts) are classified as
direct investment in the U.S. balance of payments. More
specifically, subsidiaries’ loans to domestic parent
companies are treated as negative U.S. direct invest­
ment abroad (a negative direct investment capital out­
flow) and the interest paid by the parents on the loans
is recorded as a negative item in U.S. direct investment
receipts. If, however, U.S. parent companies were to
borrow directly from foreigners rather than through
foreign subsidiaries, financial investment and income
would be affected instead.
More generally, the stock of U.S. direct investment
abroad changes as funds are transferred between the
parent and its subsidiaries. Such transfers mean that
direct investment stocks can move somewhat inde­
pendently of the value of plant and equipment controlled
abroad by U.S. firms. Part of what appears to be a slow­
ing in U.S. direct investment abroad in 1981, and dis­
investment in 1982, reflects movements in intercompany
accounts that are somewhat independent of decisions
to add to plant and equipment abroad controlled by
U.S. resident firms.

in 1982 fell to roughly its 1978 level. Although net fi­
nancial investment income still grew, it did so at a
slower rate.
The other major factor in the rise in net financial
investment income has been the sharply rising re­
corded U.S. net foreign asset position. Moreover, ris­
ing interest rates, even without a differential between
the average rates of return on assets and liabilities,
would increase net financial investment income when
the U.S. net asset position is positive. In 1981, the
U.S. net position in financial investment stocks turned
positive for the first time in over twenty years. The
rising position, however, must be viewed with caution.
In principle, the changes in net financial investment
stocks that contributed to this increase in net income
should mirror the current account plus net direct in­
vestment capital flows. Put another way, if U.S. exports
of goods and services plus direct investment capital
inflows exceed U.S. imports of goods and services
plus direct investment capital outflows, the United
States must be accumulating financial claims on for­
eigners, which is equivalent to a rise in the U.S. net
financial asset position/
In practice, the data do not reflect this. Errors and
omissions in the balance of payments have been large
at times and may result in an overstatement of the
net asset position and, therefore, of net financial in­
vestment income. For the period 1979 to 1982, errors
and omissions averaged about $30 billion per year. If,
in a given year, all of this were attributable entirely to
measurement errors from current account or direct in­
vestment transactions, there would be no effect on the
U.S. net asset position, although the current account
or net direct investment inflows would be larger than
recorded. Alternatively, if errors and omissions were
attributable to measurement errors from financial in­
vestment, the U.S. net foreign financial asset position

♦This is an accounting identity and is not meant to imply causation.
That is, a surplus on current account and net direct investment capital
inflows do not cause U.S. net financial claims to rise. Rather, the
surplus should, in principle, coincide with net financial capital outflows,
or an increase in the U.S. net foreign financial asset position, because
of double-entry bookkeeping in the balance of payments. Frequently,
however, economic analysis has used the assumption that goods
markets are slow to adjust while financial markets adjust rapidly. If
true, some causality in the short run can be argued. In this case, one
part of the current account, the trade balance, can be taken as largely
predetermined. Consequently, a trade deficit, for example, other
things being equal, could force a drop in the U.S. net financial asset
position. With a floating exchange rate and no official intervention,
exchange rates and interest rates would adjust to provide incentives
for money managers to shift the necessary amount of funds. Interbank
flows (often between offices of the same banking family) appear to
have been the most sensitive to small differences in the rate of return
and hence are often viewed as adjusting to other balance-of-payments
flows in the short run. Alternatively, authorities might intervene to
resist the rate movements and to absorb the required shift in net asset
positions in official accounts.




would be lower by an additional $30 billion in net
liabilities. This is especially important since reported
income payments and receipts are estimated from re­
ported stocks and interest rates applicable to various
components.
While it is impossible to identify those components
of the balance of payments from which errors and
omissions emerge, there is some circumstantial evi­
dence of substantial errors and omissions in measur­
ing financial investment transactions. Increased public
familiarity with international financial markets and
numerous financial innovations in the past several
years are increasing the number of financial transac­
tions that occur outside the domestic offices of U.S.
banks. These transactions may not be reported so
completely as U.S. banking transactions. Taking the
errors and omissions of $29 billion in 1980 as finan­
cial liabilities held through the following year and the
1981 average return paid on recorded liabilities of
about 9.5 percent would lower 1981 net financial in­
come about $3 billion. More striking, taking the aver­
age return on liabilities, and the errors and omissions
accumulated since 1978 as financial liabilities, the 1981
U.S. net financial asset position would be roughly
$100 billion lower and net financial income would
move from $9 billion to less than zero. The 1981 cur­
rent account surplus of $5 billion would swing to
deficit. In short, continuing errors and omissions make
it difficult to interpret current account behavior. While
the above example presents the extreme case for the
potential overstatement of net financial investment in­
come, errors and omissions have undoubtedly had a
sizable impact on its growth.

1983 and beyond
The near-term action in U.S. international services
trade will remain in investment income. Domestic reg­
ulation, some overt protection on the part of both the
United States and countries abroad, and natural re­
straints— such as insufficient familiarity with language,
sovereign laws, culture, and other special factors im­
portant to providers of services— limit the potential
for growth of noninvestment services income.
Recovery abroad is the key to a rebound in direct
investment income receipts over the next year or so.
However, most analysts expect the pace of economic
activity to be weaker than in past recoveries. And, as
the U.S. economy recovers, some of the gains to net
direct investment income will be offset by rising in­
come payments.
High levels of interest rates and expansion of U.S.
lending to foreigners are the keys to continued growth
of net financial investment income. But a moderate or
even weak recovery and lower inflation, both here

FRBNY Quarterly Review/Spring 1983

35

and abroad, reduce the likelihood of any significant
increase in interest rates. Current debt problems may
discourage U.S. banks from rapidly expanding lending
to foreigners.
For the services balance to offset a $15 billion wid­
ening of the U.S. merchandise trade deficit this year—
and many analysts are projecting a larger deteriora­
tion— net investment income growth would have to be
unprecedented. The economic environment does not
appear to be conducive to supporting such rapid
growth. Hence, the U.S. current account deficit should
be considerably larger than the $8 billion recorded
in 1982.
Further ahead, however, two-way growth of both
direct and financial investment is likely; asset and
liability stocks will grow as will income receipts and
payments. Some potentially important forces are:
• Two-way diversification of investment port­
folios internationally (see articles by Edna E.
Ehrlich in this issue and the Autumn 1981 issue
of this Review).
• Financial deregulation which may make the
United States more competitive as an inter­
mediation center.
• At the same time, such deregulation provides
opportunities for foreign banks and other fi­
nancial institutions to develop U.S. operations.
• The rebuilding of official reserves from their
current low levels and official financing of de­
veloping countries through multinational insti­
tutions.
• But a larger share of assets and liabilities may

be those of the U.S. Government which could
narrow interest differentials that generated net
income.
• And sustained lower inflation would eventually
mean lower nominal returns on assets and
temper the expansion of receipts and pay­
ments.
Ultimately, the expansion of U.S. n e t investment
income will rest on the expansion of the U.S. net
foreign asset position in both direct and financial in­
vestment: Will the United States be a growing creditor
to the rest of the world as before the dislocations of
the 1970s? If U.S. current account deficits persist, the
U.S. net foreign asset position should turn down, erod­
ing the earnings potential of net investment income in
the future. The recorded position, however, may not
capture the turnaround if errors and omissions con­
tinue to be large. Still, we may not get back to the
position of being a rapidly growing net creditor soon.
A country in current account surplus is generating do­
mestic savings in excess of that required to finance
domestic investment and government budget deficits.
However, U.S. Federal Government budget deficits
could remain large for some time. And, even if the
budget deficits are brought under control, a recovery
of domestic investment could absorb the additional
funds made available for a number of years. The rela­
tive political stability of the United States could con­
tinue to favor a net inflow of funds to this country. It
may be some time before the stylized version of the
United States as a growing creditor country reemerges,
fueling long-run investment income growth.

Robert A. Feldman and Allen J. Proctor

36

FRBNY Quarterly Review/Spring 1983




Monetary Policy and Open
Market Operations in 1982
Monetary policy in 1982 was directed at continuing
to restrain inflation while providing a foundation for
sustainable economic growth. Substantial progress
was made in reducing inflation. The pace of price
increase slowed, by some measures, to less than
one third that seen at its peak. However, economic
activity, which had sagged sharply late in 1981, began
1982 on a weak note and showed little vigor over most
of the year. At the year-end, the economy seemed
poised for recovery, with much of the inflationary mo­
mentum of earlier years wrung out, though financial
market participants remained deeply concerned by
prospects of huge Federal budget deficits projected
for 1983 and beyond. Open market operations during
the year took place against a background of financial
strain and concern about the creditworthiness of bor­
rowers, both domestic and international. The year
was punctuated by several prominent financial failures
which highlighted the desirability of reforms in market
practices and of increased Federal Reserve surveil­
lance of the Government securities market.
The Federal Reserve’s selection and pursuit of
monetary growth objectives was complicated by two
Adapted from a report submitted to the Federal Open Market Com­
mittee by Peter D. Sternlight, Executive Vice President of the Bank
and Manager for Domestic Operations of the System Open Market
Account. Christopher J. McCurdy, Research Officer and Senior
Economist, Open Market Operations Function, and Kenneth J.
Guentner, Chief, Securities Analysis Division, were primarily respon­
sible for preparation of this report, with the guidance of Paul Meek,
Vice President and Monetary Adviser. Connie Raffaele, Robert Van
Wicklen, and Catherine S. Ziehm, members of the Securities Analysis
Division staff, participated extensively in preparing and checking
information contained in this report.




developments during the year. One was an apparently
strong precautionary demand for liquidity in the highly
uncertain economic and financial climate. Over the
year, the velocity of money declined to an unusual
extent, even for a recessionary period. For another,
flows of funds associated with regulatory decisions
and institutional arrangements distorted the monetary
data, particularly M-1, in the fourth quarter. In re­
sponding, the Federal Reserve benefited from the
credibility it had gained in its sustained effort to break
the inflationary momentum of the 1970s. The markets
accepted the logic of permitting money growth above
the Federal Open Market Committee’s (FOMC’s)
ranges for a time and of placing less emphasis on M-1
in reaching decisions late in the year.
As it turned out, M-1 grew by 8.5 percent from the
fourth quarter of 1981 to the fourth quarter of 1982,
compared with the FOMC’s growth range of 2Vz to
51/2 percent.1 Through the third quarter, M-1 was only

1 This report uses the definitions of the aggregates as they applied in
1982, as well as the seasonal factors and benchmarks in place at
the time. In February 1983, new benchmarks and seasonal factors
were introduced. In addition, two changes were made to the defini­
tions of the broader aggregates. For one, balances in IRA (individual
retirement accounts) and Keogh plans at depository institutions and
money market mutual funds were removed from the monetary aggre­
gates. For another, balances in tax-exempt money market funds, which
were not previously included in the aggregates, were treated in a
similar fashion to taxable money market funds: balances in general
purpose and broker/dealer funds entered at the M-2 level; balances in
institution-only funds entered at the M-3 level. Under the new defini­
tions, growth of M-2 came out very slightly above the upper end of the
FOMC’s range at 9.3 percent, while M-3 grew 10.1 percent. The
month-to-month pattern of M-1 growth was modified somewhat, but
for the year as a whole the rate of growth did not change.

FRBNY Quarterly Review/Spring 1983

37

Chart 2

Chart 1

Annual Range and Actual Growth of M-2

Annual Range and Actual Growth of M-1

Billions of dollars
2 0 50-

Billions of dollars

2000

A c tu a l/^ ^ 9 .0 %
1950

1

1900

A nnual ra nge
1850

M o n e ta ry a g greg ate s da ta do no t r e fle c t
sea sonal, b e n ch m a rk, o r d e fin itio n a l
c h a n g e s made in F e b ru a ry 1983.

1800

1750L
J
1981

A

S

Chart 3

Chart 4

Annual Range and Actual Growth of M-3

Annual Range and Actual Growth
of Bank Credit

Billions of dollars.
2450

Billions of dollars
1460

2400
1440
A c t u a l ^ ^ v " ^ .5 %
2350
1420
2 300

1400

22 50

1380
A nnual ra n g e

2200

1360
M o n e ta ry a g greg ate s data do not r e fle c t
s e a s o n a l, be n c h m a rk , o r d e fin itio n a l
c h a n g e s made in F e b ru a ry 1983.

2 1 50-

I
O

38

J

1982

1982

I
N D
1981

J

1 ... 1

1

1

F

A

M

M

J.
J

1
J
1982

1

1
A

S

1

1

1

O

N

D

FRBNY Quarterly Review/Spring 1983




1340

1320
D
1981

J

J

J

1982

O

N

D

slightly above its range, expanding at a 5.8 percent
rate from the last quarter of 1981. There was a par­
ticu la r surge in M-1 in the fourth quarter, as it grew at
about a 16 percent rate. In part, the more rapid
growth reflected shifts of funds out of maturing all
savers certificates (ASCs) beginning in October, pre­
paration by consumers and businesses for new de­
posit accounts initiated late in the year, and a re­
sponse to lower interest rates. M-2 expanded by 9.8
percent over the year, somewhat above its 6 to 9
percent growth range. M-3 also exceeded somewhat
its range of 6 V2 to 91/2 percent, growing by 10.3 per­
cent. Meantime, bank credit increased by 7.1 percent
and ended the year w ithin its associated range of 6
to 9 percent (Charts 1-4).
Interest rates rose very early in the year amid the
Federal Reserve System’s response to money growth
late in 1981 and in January 1982 that was above the
FOMC’s objectives. But rates generally remained
below th eir previous peaks and showed little change
over the rest of the first half. Meantime, money growth
moderated, with M-1 working back within its range
by m idyear while the broader aggregates were only
slightly over path at that point. Against this back­
ground, and also in light of renewed recessionary
forces and fragile financial markets in the second
half, a more accommodative Federal Reserve posture
was appropriate in the latter part of the year, leading
to a substantial decline in rates (Chart 5). The amount
of discount w indow borrowing generated by the re­
serve paths dropped noticeably, and beginning in July
the Board of Governors of the Federal Reserve Sys­
tem approved seven cuts in the discount rate, by Vz
percentage point each time, reducing the rate to 81/2
percent in mid-December.

rates. During the year, businesses found their inven­
tories uncom fortably high and production was cut back
below levels needed to meet current demand. With
factory utilization rates down, firm s saw little need to
spend on plant and equipment. Real spending on
capital projects declined substantially.
U.S. trading partners were also in recession. Com­
posite industrial production among six m ajor in­
dustrialized nations abroad declined, putting a crim p
in U.S. exports. Moreover, the dollar was strong
during much of the year, reducing the com petitive­
ness of U.S. goods. Developing nations, many of
which relied on com m odities exports, also met set­
backs resulting from disinflationary forces in the
industrialized nations. The current account balances
of oil-exporting nations eroded, as oil consumption de­
clined due to the widespread recession and the con­
servation of oil stemming from the more than tenfold
increase in the price of oil in the last decade. Nonoildeveloping countries also suffered from the slack de­
mand in the industrialized nations, and th e ir current

The economy
The nation labored in an extended recession during
1982. Real gross national product (GNP) fell by about 1
percent from the last quarter of 1981 to the final
quarter of 1982. Indeed, taking a longer run view, the
level of real activity at the end of the year was slightly
below the level at the end of 1979, as a sharp but
brief recession in 1980 was followed by a short-lived
recovery. Consumer spending grew at a modest pace
in 1982. With unemployment rising and confidence
falling, consumers displayed a marked reluctance to
take on debt and often held back on purchases of
durable goods. Sales of dom estically produced auto­
mobiles fell to the lowest level in many years, and
spending on other durables declined in real terms.
Only late in the year did activity in the interestsensitive sectors show some life, as mortgage interest
rates fell and auto makers offered attractive financing




FRBNY Quarterly Review/Spring

1983 39

account balances remained in deficit. Some developing
nations that had been able to borrow readily in earlier
years found lenders reluctant to maintain the flow of
new credit or, in some cases, to roll over maturities.
The adjustment process required the cooperation of
private lenders and official lending agencies but, with
debt service large and increasing as a percentage of
export earnings, forced retrenchment became wide­
spread.
The good news was that inflation subsided appre­
ciably in 1982. The rate of consumer price inflation
fell for the third year in a row. The consumer price
index rose slightly less than 4 percent from December
1981 to December 1982, the lowest increase since
1972 when price controls were in effect. In 1979-80
the rates of increase had been around 12 to 14 per­
cent. Part of the decrease reflected declines in the
cost of home ownership, energy, and food— typically
volatile components. Eliminating some of the volatile
items to get an “underlying” rate of inflation suggests
a more moderate pattern of disinflation. Nevertheless,
the progress was substantial. Unit labor costs in the
private nonfarm economy rose by 4.8 percent in the
period from the fourth quarter of 1981 to the fourth
quarter of 1982, about half the increase in 1981.
In part, this reflected a slower rise in compensation
per hour worked as well as a welcome increase in
productivity, compared with a virtually flat performance
in 1981. Many analysts felt that both the moderation in
compensation and the productivity gains would con­
tinue in 1983 and would serve to dampen inflationary
forces further. On the other hand, there was wide­
spread concern that large budget deficits, persisting
long into a recovery period, could undermine the
progress on inflation and impair the recovery process.

fairly slow, the Committee indicated that an outcome
in the upper part of its 2Vz to 51/2 percent range
would be acceptable.
At the same time, the Committee expected that M-2
growth would come out near the upper end of its 6
to 9 percent range. A significant part of individuals’
savings was included in M-2, and it seemed possible
that increased incentives to save could boost growth.
The range represented somewhat slower growth than
that actually achieved in 1981, continuing the FOMC’s
efforts to restrain money growth and inflation. (The
growth range for M-3— 61/2 to 91/2 percent— repre­
sented a marked slowing, compared with growth of
slightly over 11 percent in 1981.) However, later in
the year, as the recession continued and inflation
declined sharply, the FOMC accepted somewhat
faster growth to foster economic recovery.
After its opening bulge, M-1 grew at a very modest
pace well into the year. By July it was back within
the annual growth range, while M-2 and M-3 hugged
the top ends of their ranges through midyear. In July
the Committee reaffirmed its ranges for 1982 but
adopted a more flexible approach toward its growth
objectives. The FOMC noted the continuing strong
demand for liquidity that it had seen earlier in the
year, as NOW accounts made up a substantial portion
of first-half M-1 growth. For the balance of the year,
the FOMC noted that growth around the top end of
the ranges would be fully acceptable. In addition,
growth above the top end of the ranges would be tol­
erated for a time if it appeared that precautionary
demands for liquidity were contributing to strong
demands for money. Late in the year, with distortions
arising in M-1, the Committee retained the broad
framework of monetary targeting but placed greater
emphasis on the broader aggregates.

Monetary policy and implementation
Longer run objectives
In February the Committee adopted the annual mone­
tary growth ranges it had tentatively set in July 1981.
In doing so, it noted that M-1 had grown fairly rapidly
in late 1981 and into early 1982. It seemed possible
that this bulge reflected a temporary shift in con­
sumers’ preferences toward holding highly liquid bal­
ances as a precautionary measure in the uncertain
economic and financial environment. The rapid
growth had taken place in a period of rising interest
rates and declining real output. Much of the increase
consisted of an expansion in negotiable order of with­
drawal (NOW) accounts, which show less transaction
activity than demand deposits. Since M-1 was well
above its fourth-quarter 1981 average early in 1982
and because growth for 1981 as a whole had been

40

FRBNY Quarterly Review/Spring 1983




Shorter run objectives
The Committee’s flexibility extended to its selection
and pursuit of shorter run growth objectives. For the
most part it continued to specify short-run growth ob­
jectives designed to bring the aggregates back over a
period of a few months toward their stipulated ranges.
At the same time, the Committee did not find it so
necessary in an environment of economic weakness
and receding inflation to respond strongly to every
temporary surge in money growth. At times, it chose
monetary growth rates for the intermeeting paths that
allowed for temporary deviations in money growth.
For example, at the March meeting, the Committee
adopted a 3 percent growth rate for M-1 from March
to June, a rate that would bring M-1 back close to the
annual growth range. However, because of uncertain­
ties about the seasonal adjustment of money in April,

which is heavily influenced by flows of funds related
to tax payments, the Committee allowed for fairly rapid
growth of M-1 in April, while maintaining a 3 percent
objective for the quarter. The Committee thus guarded
against a situation in which a “blip” in the money sup­
ply would lead, through the reserve path procedures,
to a temporarily more stringent provision of non­
borrowed reserves and a brief but sizable increase
in borrowing and market pressures.
M-1 did indeed show a substantial increase for the
month of April as a result of a run-up early in the
month; it then retreated late in the month. Because the
paths had allowed for rapid growth in April, the mix
of borrowed and nonborrowed reserves was altered
only moderately. The markets reacted well throughout
this episode. The widely anticipated spurt in money,
viewed by many as tax related, did not rekindle infla­
tionary expectations. The Federal funds rate remained
about 15 percent while most other rates, including
long-term bond yields, fell over the month. The market
seemed to appreciate that quick responses to every
deviation were not necessary to the credibility of the
System’s long-term commitment to moderate money
growth and to dampen inflation.
Late in the year the FOMC adapted the short-run
objectives in light of developments deemed likely to
cause severe distortions in the money data. At the
October meeting, the Committee concluded that M-1
was not likely to be a reliable guide to policy over the
near term. Consequently, the money objectives for
the fourth quarter were specified in terms of growth of
M-2 and M-3 at rates of 8 V2 to 91/2 percent (later, in
November, put at 91/2 percent).
The unreliability of M-1 arose from two sources. In
October about $31 billion of twelve-month ASCs ma­
tured, suggesting a transitional impact on M-1 as funds
were redistributed to other assets. Over the rest of the
fourth quarter, another $10 billion in ASCs was set to
mature, presenting the same difficulty in assessing
how much of the observed increases in M-1 reflected
temporary parking of funds, transactions balances, or
liquidity preferences. Concentrating on M-2 abstracted
from these distributional problems.
Another impending influence undermining reliance
on M-1 was the Congressional mandate to permit de­
pository institutions to offer new Federally insured
accounts similar to and competitive with money
market mutual funds. Since the new account— eventu­
ally called the money market deposit account (MMDA)
— had certain restrictions on access, it would not be
treated as a transaction deposit in M-1 but would be
included in M-2. The new law also permitted the
introduction of other accounts without access restric­
tions, which were included in M-1. Therefore, it ap­




peared that M-1 could be either augmented or dimin­
ished by reallocations of funds, depending on the
introduction of the new accounts, the attractiveness
of the accounts with and without access restrictions,
the rates offered on the alternatives, and the allure
of insurance. Temporary parking of funds in M-1 ac­
counts preparatory to placement in MMDAs was also
considered a possible distorting factor. While M-1’s
usefulness over the near term was questionable, most
of the reallocation was expected to take place within
M-2, possibly making it a more reliable policy guide,
but in fact the MMDAs proved to be so popular that
by the final weeks of 1982 and into early 1983 M-2
was being substantially distorted.
The extraordinary popularity of MMDAs followed as
a consequence of aggressive initial bidding for these
accounts by depository institutions after their introduc­
tion on December 14. A few institutions briefly offered
rates over 20 percent, more than double the rates paid
by money market funds. The MMDAs attracted about
$90 billion during their first two weeks and in excess
of $200 billion by the end of January 1983. A substan­
tial part of these inflows represented switching from
other components of M-2 (including noninstitutional
money market funds) and some from M-3. However,
some of the inflows also represented switching from
market instruments, although the proportion was diffi­
cult to gauge with any precision.
Im plementation
Open market operations in 1982 continued to be aimed
at achieving nonborrowed reserve levels stemming
from the reserve-path targeting procedures. These
procedures, more fully described elsewhere ,2 are
sketched here. After each meeting the staff derived
total reserve levels consistent with the growth of
aggregates voted by the Committee. First, it applied
the relevant required reserve ratios to the desired
levels of reservable deposits in the aggregates. To this
were added the required reserves needed for the pro­
jected growth of certificates of deposit (CDs), Treasury
balances, and other non-M-2 liabilities. An expectation
for excess reserves was added to these required re­
serve levels to make up the intermeeting total reserve
path. The intermeeting nonborrowed reserve path was
obtained by subtracting from the total reserve path
the level initially assumed by the Committee for bor­
rowing. The total reserve path essentially reflected the
2 See for example: Paul Meek, U.S. Monetary Policy and Financial
Markets (Federal Reserve Bank of New York, 1982); "Monetary
Policy and Open Market Operations in 1980", this Quarterly Review
(Summer 1981) pages 56-75; and "Monetary Policy and Open
Market Operations in 1979", this Quarterly Review (Summer 1980),
pages 50-64.

FRBNY Quarterly Review/Spring 1983

41

demand for reserves consistent with the Committee’s
monetary objectives, while the nonborrowed reserve
path embodied the System’s supply schedule.
Each week the actual levels and projected behavior
of money and reserves were compared with the Com­
mittee’s specifications and the reserve paths. As
money and the associated demand for reserves
tended to rise above (fall below) the total reserve
path, then the supply of reserves tended to result in
a higher (lower) level of borrowing. Because of admin­
istratively controlled access to the Federal Reserve
discount window, raising or lowering the pressure to
borrow was transmitted to the market for overnight
lending of reserves, the Federal funds market. As
banks, for example, were forced to the window, they
turned more aggressively to the funds market and bid
up the funds rate. The opposite happened when banks
found that nonborrowed reserves were more plentiful.
Over time, banks’ efforts to adjust their balance sheets
and the associated money market pressures worked
toward returning money growth to the desired rates.
With the shift in emphasis to M-2 late in the year,
the paths reflected primarily the M-2 growth rate ap­
proved by the FOMC; variations in M-1 were accom­
modated. In the weekly reevaluation of the paths,
when M-2 ran above its indicated growth rate, the
paths usually generated additional borrowing com­
mensurate with the overrun. When M-2 growth ap­
peared slower than the Committee was prepared to
see, the paths tended to generate a reduction of bor­
rowing.
The use of M-2 in this way tended to produce more
muted responses since the average level of required
reserves was about 2 percent of the average level of
M-2, compared with a ratio of about 9 percent for M-1.
Moreover, the extent of any “automatic” response de­
pended on the distribution of strength among different
types of deposits, since some nontransactions balances
have low reserve requirement ratios and many have
none at all. Consequently, there was a need for dis­
cretionary adjustments to the paths to generate appro­
priate variations in reserve pressure. In the closing
weeks of the year and into January 1983, when there
was very substantial shifting of funds associated with
the introduction of MMDAs and new super NOW ac­
counts, the paths were adjusted weekly to accommo­
date the ongoing shifts and in effect to maintain the
initial-path borrowing level contemplated at the De­
cember meeting.
Judgmental adjustments to the paths were also
made on a few occasions over the first part of the
year to speed the return of money growth to the
desired rate. In January the nonborrowed reserve
path was lowered to apply more pressure on the

42

FRBNY Quarterly Review/Spring 1983




banking system when money growth was unacceptably rapid. In July, two upward adjustments were
made when money proved to be unexpectedly weak.
Such judgmental shifts were also made to avoid situ­
ations when a mechanical adherence to the path
procedures could produce unwanted results. Thus,
when money growth was acceptably above the rates
incorporated in the paths in September, the non­
borrowed reserve path was raised to prevent a shift
toward even higher borrowing levels than those that
had emerged. From time to time, adjustments to the
nonborrowed reserve path were also made when it ap­
peared that there were shifts in the demand for borrow­
ing or that computer-related problems pushed borrow­
ing to unintended levels.
Over the second half of the year the Committee
gradually lowered the initial level of borrowings used
in drawing the path. By the end of the year the implied
borrowing level was about $200 million, and the Fed­
eral funds rate was generally expected to trade around
the discount rate. By using this approach, the Commit­
tee avoided Federal funds trading far below the dis­
count rate, as had happened in the spring and early
summer of 1980 when path borrowing fell to $75 million
to $100 million. The approach used in late 1982 tended
to focus market attention on the discount rate. Senti­
ment waxed bullish or bearish on prospects for such
cuts, usually with each cut generating expectations of
further cuts.
The actual focus of System open market operations
was attainment of an average level of nonborrowed
reserves for each statement week. Projections of non­
borrowed reserves availability remained subject to
error. On average, the reserve forecast errors were
little changed from the 1981 experience. The average
absolute forecast error at the beginning of the week
was a little over $600 million and declined over the
week to about $130 million on the last day. Given the
short-term ebb and flow of funds in the banking system
from day to day and week to week, the Trading Desk
relied extensively on temporary injections and absorp­
tions of reserves to try to hit the objective. Repurchase
agreements (including those arranged on behalf of
both the Federal Reserve System and foreign central
bank customers) and matched sale-purchase transac­
tions in the market amounted to about $310 billion,
compared with about $270 billion in the previous year.
The number of market entries fell, however, to 143
from 153 in the previous year. The Desk used outright
transactions to address seasonal and secular reserve
needs, such as supporting the growth of currency in
circulation. Outright purchases of Treasury securities
amounted to $19.9 billion, slightly over half in the
market and the rest from foreign accounts. Outright

sales of securities in the market and to foreign ac­
counts totaled $8.6 billion, while redemptions came to
$3.2 billion. On a net basis, outright holdings increased
by $8.1 billion.
The financial markets
Interest rates moved up early in the year and then
showed little net change over the rest of the first half
of the year. In the latter part of 1982 they fell, as
private credit demands softened with the economy
w hile inflationary pressures receded and monetary
policy was more accommodative. On the other hand,
borrowing by the Treasury and state and local bodies
was extrem ely heavy, far surpassing that of earlier
years. Nevertheless, a surge in public borrowing late
in the year was accommodated at the lower yields that
reflected the state of the economy. Throughout much
of the year, the atmosphere in the credit markets was
fragile, reflecting several financial failures and anxi­
eties about the possibility of other problems.
Rates varied over a moderate range in the early
part of the year. The System’s pursuit of its non­
borrowed reserves objectives in January prim arily
affected the short-term markets. The three-month bill
rate at auction rose from 11.69 percent in late De­
cember 1981 to the year’s high of 14.74 percent in
February, while longer term rates rose slightly. The
credit markets showed little overall trend through
the end of June. Business demands fo r short-term
credit remained strong. However, that demand did not
so much reflect spending for investment purposes
as it did efforts to maintain working capital in a poor
business climate.
The financial markets rallied dram atically over the
summer. Short-term yields fell the farthest, as is typical
of recessions (Chart 6). The Federal funds rate fell
from the area of 15 percent in late June to around
10 percent two months later (Chart 7). The relaxation
of pressure in the money market reflected the decline
in discount w indow borrowing imposed on banks by the
Federal Reserve. The discount rate was lowered in
four stages from 12 percent to 10 percent by late
August.
Treasury bill rates fell sharply. The three-month
rate dropped by 5 to 6 percentage points over the
summer. The market fo r short-term private debt, nota­
bly bank CDs, was beset by several worries and the
overall rate declines during the summer were some­
what sm aller than those on Treasury debt. Early in
July, Penn Square Bank, N.A., in Oklahoma failed as a
result of losses on energy-related loans. Several
large banks in other parts of the country also suf­
fered losses on loans they had purchased from Penn
Square Bank. Investors holding the CDs of some of




Chart 6

Yield Curves for Selected
U.S. Treasury Obligations
Percent

Number o f ye a rs to maturity

C hart 7

Money M arket Conditions and
Borrowed Reserves
Percent
16.0
14.0
12.0
10.0
8.0
M illions of d o lla rs
2500

2000
1500

1000
500

0 -

J

F

M

_______ _________ * _____ _________

A

M

J

J

A

S

1982

O

N

D J

1983

* Excludes exte nde d c re d it borrow in g.

FRBNY Quarterly Review/Spring 1983

43

those banks became reluctant to maintain those hold­
ings, so that yields on their CDs rose well above those
of other major banks. Later in the summer, when the
foreign loans of banks worried the markets, Treasury
issues— considered the safest and most liquid of
securities— attracted demand. The spread between
the yield on three-month bills and three-month CDs
widened to about 3 percentage points from an aver­
age of about 1 percentage point earlier in the year.
The anxieties associated with both sets of problems
gradually quieted down over the rest of the year, as
it appeared that the problems with energy loans at
major banks would be manageable while progress was
made in restructuring the loans of certain hardpressed nations. By the end of the year the yield
spread had narrowed to about Vz percentage point.
Long-term rates declined more gradually, as busi­
nesses restructured their balance sheets by selling
long-term debt and paying down short-term debt.
Business loans and commercial paper issuance dropped
over the latter part of the year, while bond issuance
expanded considerably. Late in the year, corpora­
tions also tended to rely more on long-term bonds
than on intermediate-term issues, as investors became
more willing to extend out along the upward sloping
yield curve to improve their returns. For the year,
gross proceeds from the public issuance of bonds
by corporations amounted to about $43 billion, com­
pared with about $38 billion in 1981, even though
issuance early in the year had fallen well below that
in the early part of 1981.
Treasury borrowing expanded sharply to finance a
widening deficit, which in part reflected the effects of
the recession on spending and receipts. The Treasury
raised about $160 billion of new cash through issuance
of marketable debt in 1982, up from about $90 billion
to $100 billion in the two previous years. Participants
expressed concern about the extent of the financings
and the market’s ability to absorb the debt. While a
sizable amount of paper was floated in the third
quarter when rates fell sharply, rates flattened out in
the fourth quarter when the rapid pace of sales con­
tinued and market participants came to feel that further
accommodative moves by the Federal Reserve might
be nearing an end. The Treasury placed heavy reliance
on the coupon sector where new cash raised amounted
to about $95 billion. The Treasury continued to use its
regular schedule of coupon offerings although a few
long-term bond issues had to be omitted when the
legal limit was reached on its ability to sell bonds with
interest rates over 4 !4 percent. After the limit was
enlarged in the summer, bond sales resumed in Sep­
tember.
Gross issuance of tax-exempt bonds was very large

44

FRBNY Quarterly Review/Spring 1983




as well. States and localities tapped the intermediateand long-term sectors for about $76 billion, compared
with about $48 billion in 1981. Activity was particu­
larly hectic toward the close of the year, as borrowers
attempted to sell issues before the legislated intro­
duction of mandatory registration of tax-exempt se­
curities. Issuers felt the cost of registration would be
considerable. (In the “lame duck” session of the
Congress in December, the registration deadline was
postponed until mid-1983.)
F inancial problem s
Several incidents in the spring and summer cast a long
shadow over the market for Treasury securities. The
first of these was on May 17, when Drysdale Gov­
ernment Securities, Incorporated (Drysdale) failed to
make sizable accrued interest payments on Treasury
securities “borrowed” through reverse repurchase
agreements. The interest payments, reported to be
about $190 million, were to be made mainly through
Chase Manhattan Bank and, to a lesser extent, through
Manufacturers Hanover Trust Company and United
States Trust Company to a number of dealer firms from
which the securities had been obtained. The inability
of Drysdale to make good on its transactions, along
with an initial report that Chase would not cover the
amount owed, caused considerable concern over the
possibility that a number of major Wall Street firms
might suffer severe losses. This threatened to disrupt
the orderly functioning of trading and the securities
clearance process as well as to undermine the ability of
dealers to continue to function in a jittery marketplace.
In actions addressed specifically to the Drysdale
problem, the New York Reserve Bank (1) hosted an
informational meeting on the evening of May 17, initiated
by Chase, between Chase and several dealer firms in­
volved in the Drysdale problem, (2) held a meeting on
May 18 with the New York Clearing House banks in
which the Federal Reserve expressed its concern about
the orderly functioning of the markets and noted its role
as lender of last resort to commercial banks facing un­
usual liquidity demands, (3) informed primary dealers
of the meeting with the Clearing House banks, and (4)
held the securities and funds transfer wires open later
than usual to facilitate the workings of the market. In
meeting reserve needs on Tuesday and Wednesday of
the May 19 statement week, the Desk acted a bit more
promptly than usual to fill projected reserve needs andto forestall undesired financing pressures.
The crisis was substantially relieved on May 19 when
Chase announced that it would make good on the in­
terest owed o r transactions that were made through it
and would assume Drysdale’s positions to unwind
them. (Manufacturers Hanover and United States Trust

had already announced a similar policy on interest pay­
ments.) On May 20, the Desk informed dealers that for
the next few days the FOMC would permit a more
flexible policy in lending them securities from the Sys­
tem Open Market Account. The expanded facility, in­
tended to ease the unwinding of very large short
positions taken over from Drysdale by other market
participants, was continued until May 28.
Drysdale had built up very large positions by “bor­
rowing” securities under repurchase agreements (RPs)
in a manner that tended to generate working capital.
Dealers frequently employ RPs in which they sell se­
curities temporarily, against payment of money, and
agree to repurchase them at a later date. This trans­
action is called a reverse RP from the viewpoint of the
firm temporarily obtaining the securities and is common­
ly employed as a means of “borrowing” securities to
cover a short sale. Under the standard market practice
at the time, the firm receiving securities under an RP
paid funds equal to the market price of the securi­
ties but without allowing for the accrued interest on
coupons. Drysdale used RPs to borrow Treasury cou­
pon securities with high accrued coupon payments
coming due. It then sold the securities short, receiving
the market value of the securities including the value
of the accrued coupon. By establishing large short
positions in high coupon issues, Drysdale was able to
generate excess cash, which in turn provided the
margin necessary to set up long positions through pur­
chases of securities financed through RPs. At the time
the firm failed, Drysdale had gross short positions of
about $4 billion and gross long positions of about
$ 21/2 billion. Apparently because of trading losses in
its position management, the firm had lost the working
capital obtained through the reverse RP stratagem and
was thus unable to meet its obligations to pay the
value of coupons coming due May 17. This little known
and inadequately capitalized firm was able to build up
such large positions by arranging its transactions
through intermediaries (primarily Chase Manhattan
Bank) who saw themselves in a passive role and did
not appreciate the risk exposure involved. Firms pro­
viding the securities considered themselves to be deal­
ing with Chase (or the other banks) rather than with
the undisclosed party on the other side of the banks’
transactions (i.e., Drysdale).
In August, following general agreement within the
dealer community, the Federal Reserve Bank of New
York began taking account of the value of the ac­
crued coupon when arranging RPs. The Bank also
informed reporting dealers that it expected them to
include the value of the accrued coupons when they
arranged RPs with their customers beginning in
early October. This change in market practices was




quickly accepted, and the changeover occurred with
virtually no problems. The Bank also took a number
of other steps to improve market practices and to
enhance its monitoring of the markets. It strength­
ened the unit devoted to surveilling the dealers and
market developments, appointing a senior officer to
head the group and expanding its size. The Bank
notified the dealers that it planned to review standards
of capital adequacy. It addressed the problem of credit
exposure in “when issued” trading (i.e., forward trading
in not-yet-issued securities for delivery on the date of
issue), proposing to the dealers several alternative
methods of reducing the exposure.
While the Drysdale episode dramatized the impor­
tance of credit evaluation of counterparties in RPs
and the necessity for proper collateralization of these
agreements, another problem later in the summer
pointed out the importance of liquidity in RPs. In
August, Lombard-Wall, Inc., filed for bankruptcy while
it had sizable amounts of RPs outstanding. In han­
dling the affairs of the company, the court required
many of the firm’s RP customers to hold the secu­
rities rather than to sell them out. The standard market
view of the RP had been that the party holding the
securities could sell them if the other party failed to
perform, thereby being assured of liquidity at the
maturity of the contract and protection against the
possibility of adverse price movements on the secu­
rities. Reflecting its concern about the legal status of
RPs, the Federal Reserve Bank of New York filed an
amicus curiae brief with the court handling the
Lombard-Wall case, arguing that it is preferable for
the orderly functioning of national financial markets
that RPs be regarded as purchase and sale transac­
tions rather than as secured loans, the unwinding of
which might be subjected to a stay in bankruptcy
proceedings.
Meantime, uncertainties about the RP instrument
prompted a number of participants to reconsider their
involvement in providing funds in that market. A few
found other investment outlets for their funds, such
as short-term bills; others restricted the number of
parties they dealt with, and some pursued a diversi­
fication among firms. While there did not seem to be
a severe lasting impact on the total size of the RP
market, in the closing months of 1982 and into 1983
the RP rate tended to run higher in relation to other
short-term rates than might otherwise have been
expected. Legislation to preserve the traditional char­
acteristics of RPs in bankruptcy proceedings was in­
troduced in the Congress late in 1982 but failed to
win passage when the bill it was attached to did not
gain final approval. Similar legislation was introduced
in early 1983.

FRBNY Quarterly Review/Spring 1983

45

Conducting open market operations
January through March
Open market operations early in the year were con­
ducted against a background of strong money growth
which began in late 1981 and spilled over into 1982.
As the year began, the System resisted the undesired
strength of the monetary aggregates through the Trad­
ing Desk’s pursuit of a nonborrowed reserve path
which was lowered several times to speed the return
of money growth to within the longer term ranges
specified by the Committee. By early February, incom­
ing data indicated that money growth was moderating.
At its December 21, 1981 meeting, the Committee
had specified growth for the November-March period
at annual rates of 4 to 5 percent for M-1 (redesig­
nated from M-1B) and 9 to 10 percent for M-2 (table).
The target for M-1, consistent with an earlier Com­
mittee decision, no longer reflected the shift adjust­
ments for conversion of outstanding interest-bearing
assets into NOW accounts. In setting the M-1 target,
the Committee took account of the relatively rapid
growth that had already taken place through the first
part of December and concluded that actual money
growth might need to be evaluated in light of the
behavior of NOW accounts. The Committee assumed
an initial level for adjustment and seasonal discount
window borrowing of $300 million for constructing the
nonborrowed reserve path.
Money growth in January ballooned as a $10 bil­
lion increase during the first week of January did not
wash out over the month. M-2 growth rose moder­
ately above its January path. With the aggregates
showing considerable strength, the demand for total
reserves moved well above the total reserve path
for the period, the six weeks ended February 3. As the
period progressed, the nonborrowed reserve path
was lowered in three stages by a total of $303 million
relative to the total reserve path to accommodate
temporary bulges in borrowing and to speed the re­
turn of money to path. Borrowing consistent with
achieving the nonborrowed reserves objective rose
sharply to about $1.5 billion in the final two weeks of
the period. Open market operations accordingly ab­
sorbed reserves somewhat more than seasonally over
the month. According to latest available information,
total reserves finished $670 million above path; non­
borrowed reserves finished the period approximately
$40 million above the downward revised path .3 The

3 This report uses latest available data on reserves throughout; revisions
from originally available estimates are generally small.

46

FRBNY Quarterly Review/Spring 1983




weekly average Federal funds rate increased to about
14% percent in the final week, compared with a range
of about 12 1/2 to 13 percent in the first half of the in­
termeeting period (Chart 7, top panel).
At its February 1-2 meeting, the Committee selected
short-run objectives envisaging no further growth
of M-1 over the February-March interval and an 8
percent growth rate for M-2 for the period. The Com­
mittee also indicated that some decline in M-1
would be acceptable in the context of reduced pres­
sure in the money market. The initial borrowing level
was continued at $1.5 billion.
During the first subperiod after the February meet­
ing, the four weeks ended March 3, incoming data
indicated a decline in M-1 for February at a modest
rate and below-path growth for M-2. The demand for
total reserves fell below the total reserve path, but
discount window borrowing in the middle weeks of
the subperiod nonetheless bulged to $1.7 billion
(Chart 7, bottom panel). In the third week this was
$400 million above the level consistent with achieving
the nonborrowed reserve path. To allow for the unin­
tentional overshoot in borrowing, the nonborrowed
reserve path was lowered by $100 million in the final
week, leaving average borrowing for the subperiod
implied by the path at about $1.5 billion. For the pe­
riod, total reserves averaged $80 million below path
while nonborrowed reserves were virtually on path.
The Federal funds rate averaged around 14 percent
in the final two weeks of the subperiod, after climbing
to over 151/2 percent earlier.
In the second subperiod, the four weeks ended on
March 31, both M-1 and M-2 were below path for the
two-month period ended in March despite upward re­
visions over the interval. Open market operations had
to adjust to a decline in borrowing which, in the first
two weeks, ran below path levels. To allow for this,
the nonborrowed reserve path was raised by a total
of $80 million and, late in the subperiod, the path was
raised a bit further because of the slow growth of
M-2 by not taking all of the potential technical path
adjustments indicated. During the interval the non­
borrowed reserves objectives were generally con­
sistent with average borrowing for the subperiod of
about $1.2 billion to $1.3 billion. Even so, the Federal
funds rate rose during March, reaching about 15
percent on average in the final week, partly because
market participants were anticipating a money supply
bulge in April which might exert pressure on short­
term rates. Total reserves ended $120 million below
path on average, while nonborrowed reserves ended
$60 million above path.
Over the quarter, interest rate movements were
influenced by monetary developments and concerns

about the Federal deficit. Yields on long-term fixedincome securities moved higher in the first half of
January in the wake of the rapid rise in money and
short-term rates. Although rates on long-term taxable
issues remained below the record levels registered
in the fall of 1981, municipal bond yields set new
record highs early in the month. In view of large pro­
spective Treasury cash needs, investors saw no need
to rush to buy securities and the Treasury’s financ­
ings encountered mixed receptions. The prospect of
continued heavy Treasury borrowing halted a brief
market rally in early February.
Financial markets did take brief encouragement
from Chairman Volcker’s February 10 Congressional
testimony, indicating that money growth high in its
range— or temporarily above— would be acceptable.
Then in late February in the midst of further evidence
of economic weakness, decelerating inflation, and
a decline in money from its high January level, in­
terest rates once more began to decline. This rally
halted in early March when investor support faltered
and attention focused again on the large Federal
deficits.
Corporate borrowers took advantage of temporary
dips in rates to rush a large volume of issues to
market in late February and early March, ending the
lull in issuance that had existed since December.
The municipal sector outperformed the taxable sec­
tors in this period but shared in the mid- and lateMarch weakness. There were some downgradings of
commercial paper issuers during the quarter (most
notably of Ford Motor Credit Company) and yield
spreads between top-rated instruments and lesser
regarded instruments increased, but there was no
sense of widespread problems.
A p ril through June
A bulge in M-1 in early April receded as the quarter
went along, but signs of strength reemerged as the
quarter drew to a close. In late April, Desk operations
had to pump in reserves to offset a sharp run-up of
Treasury balances at the Federal Reserve. After midMay, the Desk also had to bear in mind the disturbed
conditions in the securities markets following the col­
lapse of Drysdale. Desk operations were conducted
flexibly in view of the sensitive state of financial
markets, but without setting aside the System’s basic
reserves objectives.
As part of its continuing effort to achieve its annual
monetary objectives, the Committee at its March 29-30
meeting called for M-1 growth at a 3 percent rate and
M-2 growth at an 8 percent rate over the second
quarter. The Committee noted that M-2 would probably
be less affected over the period than M-1 by deposit




shifts related to the April tax date and by changes in
the relative importance of NOW accounts as a savings
vehicle. It was also recognized that M-1’s growth since
the fall could be traced almost entirely to extraordi­
narily rapid growth in NOW accounts, which have a
slower transactions turnover and might also reflect in­
creased precautionary demands by the public. The
Committee was willing to accept a shortfall in M-1
growth, in the context of appreciably reduced pres­
sures in the money market and relative strength of
other aggregates. The reserve paths subsequently in­
corporated the Committee’s initial borrowing assump­
tion of $1,150 million.
Policy was implemented in this period against a
background of a sluggish economy and evidence of
receding inflation. Mindful of the possibility that M-1
growth might be spurred by precautionary and liquidity
concerns, as well as seasonal adjustment uncertainties
related to the April tax date, the Committee was willing
to tolerate temporary spurts in money growth. In line
with this decision, the reserve paths were constructed
to allow a bulge in M-1 in April, followed by no addi­
tional growth in May and June. Implemented in this
fashion, the reserve-targeting procedure prevented a
transitory spurt in money growth from transmitting
undesired pressures to the money markets. At the
same time, persistent money strength would still gen­
erate appropriate market pressures through increased
borrowing.
Estimates of the aggregates as they emerged during
the first subperiod— the four weeks ended April 28—
revealed M-1 growth in April somewhat above path
and M-2 growth just slightly above path. Reflecting the
strength of the aggregates in early April, the demand
for total reserves in the first subperiod was above
path and the weekly implied borrowing levels con­
sistent with achieving the nonborrowed reserve path
average rose to about $1.4 billion in the final two
weeks. In the final week, the Desk was unable to offset
fully severe reserve drains due to high Treasury bal­
ances because of a temporary collateral shortage in
the market.
In late April the Desk encountered heavy reserve
drains, stemming from a sharp rise in Treasury bal­
ances at the Federal Reserve. The Treasury’s balance
at the Federal Reserve rose as high as $12.4 billion on
April 29, compared with a normal targeted balance of
about $3 billion. To counter the reserve drain, the Desk
bought outright about $5 billion of Treasury securities.
In addition, on April 29 it arranged a record $8.7 billion
of RPs in the market, consisting of one- and four-day
fixed-term agreements to offset short-lived reserve
drains. These efforts fell short of the indicated reserve
need, so that borrowing at the discount window rose.

FRBNY Quarterly Review/Spring 1983

47

Specifications from Directives of the Federal Open Market Committee and Related Information

Date
of
m eeting*

12 /21/8 1

2 / 1 / 8 2 ...............

Specified shortterm annualized
rates of growth
fo r period indicated
(p ercent)
M-1
M-2
M-3

N ovem ber to March
4-5
9-10
—

10-14

300

12

January to March
0
8
—

12-16

1,500

12

3

March to June
8
—

12-16

1,150

12

3

March to June
8
—

10-15

800

12

3 /2 9 /8 2 .

5 /1 8 /8 2 .

6 /3 0 /8 2 .

Initial assum p­
tion for borrowings in
D iscount rate
deriving
on day of
C onsultation nonborrowed
meeting and
range fo r reserve path
subsequent
Federal funds
(m illio n s o f
changes
rate (p ercen t)
d o lla rs) (p ercen t)

June to September
5
9
—

10-15

800

12

1 1 1/2 on
7 /1 9 /8 2
11 on
7 /3 0 /8 2
10% on
8 /1 3 /8 2

48

FRBNY Quarterly Review/Spring 1983




Notes

In setting the M-1 targets, the
Comm ittee took account of the
rapid M-1 growth w hich had already
taken place in early December
and noted that interpretation of
actual money growth m ight require
taking account of the significance
of fluctuations in NOW accounts.

The Comm ittee indicated that some
decline in M-1 would be acceptable
in the context of reduced pressure
in the money market.

Some shortfall in M-1 from the
3 percent growth rate objective was
deemed acceptable by the
Com m ittee in the context of appre­
ciably reduced pressures in the
money market and relative strength
of other aggregates. Moreover, the
Com m ittee noted that deviations
from the short-run grow th o b je c­
tives should be evaluated in the
light of the probab ility that M-2
w ould be less affected over the
period than M-1 by deposit shifts
related to the A pril tax date and by
changes in the relative im portance
of NOW accounts as a savings
vehicle.

The C om m ittee noted that
som ewhat more rapid grow th than
indicated in the short-term objectives w ould be acceptable depending on evidence that econom ic and
financial uncertainties were leading
to exceptional liq u id ity dem ands
and changes in financial asset
holdings.

Specifications from Directives of the Federal Open Market Committee and Related Information

S pecified short­
term annualized
rates of growth
fo r period indicated
(percent)
M-1
M-2
M-3

Date
of
m eeting*

8 /2 4 /8 2 .......

June to September
5
9
—

Initial assum p­
tion fo r bor­
rowings in
deriving
C onsultation nonborrowed
range for reserve path
Federal funds
(m illio n s of
rate (percen t)
d o lla rs)

7-11

350

D iscount rate
on day of
meeting and
subsequent
changes
(percen t)

10 1/2
10 on
8 /2 6 /8 2

1 0 /5 /8 2 .

Septem ber to December

7 - 10 1/2

300

10
9 1/a on
1 0 /8 /8 2

September to December
—
9 1/2
9Vz

6-10

250

9 ’/z
9 on
1 1 /1 9 /8 2
8 1/a on
1 2 /1 3 /8 2

Decem ber to March
—
9 1/2
8

6-10

200

81/2

—

1 1 /1 6 /8 2 .

1 2 /2 0 /8 2 .

8 1/ z -

8 1/ z -

9Vz

9 1/a

(continued)

Notes

Money growth som ewhat greater
than the short-run objectives was
again viewed as acceptable, depending on evidence tha t econom ic
and financial uncertainties were
leading to exceptional liquid ity
demands and changes in financial
asset holdings.

The Comm ittee agreed that it w ould
tolerate growth som ewhat above
the target range in the event of
unusual precautionary demands
fo r money and liq u id ity and that
there was a need for fle x ib ility in
responding to M-1 developm ents
because of probable disto rtions in
that measure stem m ing from
institutional developm ents.

The Com m ittee decided that much
less than usual w eight be placed
on movements in M-1 during the
fourth quarter because of continued
d ifficu ltie s in interpreting that
aggregate.

The Com m ittee’s short-term ob je ctive fo r M-2 growth allow ed for
m odest shifting into the new MMDAs
from non-M -2 instruments; greater
growth was acceptable if analysis
o f incom ing data indicated that the
MMDAs were generating more sub­
stantial shifts of funds into broader
aggregates from market
instrum ents.

* When meetings cover two days, first day is given.




FRBNY Quarterly Review/Spring 1983

49

For the subperiod, total reserves exceeded path by
about $150 million on average: nonborrowed reserves
averaged approximately $60 million under path and
borrowing about $210 million over path. The Federal
funds rate generally averaged between about 141/2
percent and 151/4 percent during the subperiod.
In the three weeks ended May 19, the monetary ag­
gregates weakened relative to the associated path
levels. Consequently, the implied average borrowing
level for the subperiod fell to about $ 1.1 billion by the
final week. However, the Committee at its May 18
meeting decided to aim for a nonborrowed reserve
level consistent with $800 million of borrowing for the
week, in line with the average of the first six days.
(Retention of the original nonborrowed reserves ob­
jective would have implied a sharp increase in bor­
rowing on the final day.) Largely as a result of the
change, nonborrowed reserves over the three-week
period averaged about $110 million above the path set
earlier in the week; total reserves were a shade below
path.
Desk activity during the latter part of the May 19
statement week sought to cushion the immediate mar­
ket impact of the failure on Monday, May 17, of Drysdale to make sizable accrued interest payments on
borrowed Treasury securities. As described earlier in
this article, this collapse threatened to disrupt securi­
ties trading and the ability of dealers to continue to
finance their positions. On Tuesday and Wednesday
of the May 19 statement week, the Desk acted a bit
more promptly than usual to fill projected reserve
needs. To forestall undesired financing pressures, it
also resolved doubts regarding the size of reserve
needs on the side of meeting indicated needs fully.
At its May 18 meeting, the Committee retained the
3 percent M-1 and 8 percent M-2 growth rate objec­
tives set in March for the second quarter. Given April
developments and the likely indications for May, re­
serve paths were drawn up based upon a decline in
M-1 in May and modest growth in June.
Early in the six-week period ended June 30, esti­
mates of the aggregates were generally on, or slightly
above, path. However, in early June greater strength
in the aggregates pushed the May-June growth rates
for M-1 and M-2 moderately above path. In line with
these developments, the demand for total reserves
generally ran slightly above path during the period,
producing some upward pressure on rates at a time
when market participants were expecting rates to fall.
In the last two weeks of June, however, the estimates
of M-1 were revised downward closer to path, although
the stronger performance of earlier weeks continued
to affect reserve needs in the period because of
lagged reserves accounting. In view of this and the

50

FRBNY Quarterly Review/Spring 1983




proximity of the July Committee meeting, not all tech­
nical adjustments to the reserve paths were taken.
Implied borrowing in the final two weeks rose only to
a level of about $1 billion, compared with the $800
million initial assumption adopted at the May meeting.
The complications that arose around the quarter end
serve to illustrate some of the operational issues in­
volved in implementing policy. As is typically the case
in the June 30 statement week, window-dressing pres­
sures developed, with the end-of-quarter publishing
date in this case coinciding with the week’s settlement
date. Banks typically build up excess reserves on an
end-of-quarter statement publishing date and the path
allowed for this likelihood. In these circumstances, the
Desk responded to a moderate estimated reserve
need by adding reserves in size on each day before
the weekend. Even so, the money markets remained
firm and borrowing bulged to $2 billion on Friday,
June 25. After the weekend, with borrowing averaging
well above the implied path level, the Desk had to
allow for the reserves already provided through the
window, being willing to permit nonborrowed reserves
to come out below the objective. Otherwise, reserves
would have been much more plentiful than was con­
sistent with the degree of restraint being sought at that
time. When projections of a reserve surplus were
confirmed by an easier money market early on the final
day, the Desk absorbed reserves. However, the funds
rate firmed again late on the final day, reflecting as it
turned out a reserve shortfall and even higher excess
reserve holdings by banks than had been allowed for.
In the following statement week, encompassing the
Independence Day holiday weekend, the Desk again
allowed for excess reserve holdings above normal.
Moreover, to forestall unwanted firming in the money
market, the Desk responded to estimated reserve
needs by supplying reserves abundantly on each day.
Nevertheless, borrowing ran high as the banking sys­
tem sought even larger excess reserves than expected
to accommodate the financial flows and uncertainties
of the week. The funds rate eased only grudgingly
during the week until late on the settlement day when
it dropped to as low as 2 percent. For the period, total
reserves were above path by $110 million while non­
borrowed reserves fell $80 million short of path.
In the money markets over the period, the Federal
funds rate dipped to around 13Vfe percent in early June
from the 14Vi to 15 percent area prior to the May
meeting. As money strengthened, the funds rate firmed
to somewhat over 14 percent later in the month and
still higher in the June 30 statement day week.
Interest rates worked irregularly lower during the
early part of the quarter but then turned around sharply
in June. In April and early May, the markets were

buoyed by continued indications of economic weak­
ness and very encouraging inflation statistics, which
buttressed the view that interest rates were significant­
ly higher than seemed consistent with the economic
fundamentals. The Treasury’s quarterly refunding auc­
tion in early May of $9.25 billion of notes met good
demand even though the size of the operation was
somewhat more than had been anticipated. Despite the
decline in rates, corporate and municipal new issue
volume was only moderate as many treasurers hoped
for better opportunities down the road.
Despite the nervousness in financial markets result­
ing from the Drysdale incident, price changes in the
immediate aftermath of the incident were modest. In
fact, Treasury bill rates benefited as investors ex­
hibited greater concern than usual over safety and
liquidity. However, as heavy prospective third-quarter
Treasury financing needs drew nearer, without the ex­
pected decline in short-term rates, market sentiment
deteriorated and yields moved sharply higher in June.
Debt ceiling constraints forced the Treasury to reduce
the size of two bill auctions and to postpone the fouryear note auction scheduled for late in the quarter.
Legislation to enlarge the debt ceiling was passed on
June 23, the same day that saw final passage of a
budget resolution, but these events provided only
modest support to the markets amid lingering doubts
that the Congress would achieve its goals for reducing
the deficit.
July through Septem ber
Open market operations were conducted against a
troubled financial background, while money growth
was restrained in July but strengthened in August and
September. Financial markets had to cope with several
well-publicized bankruptcies and growing concerns
regarding the banking sector’s loan exposure to hardpressed domestic and international borrowers. Large
loan losses suffered by several major banks high­
lighted the potential for difficulties in this area, and
some major banks encountered investor reluctance to
purchase their CDs. Nevertheless, the markets for
fixed-income securities were able to sustain a strong
rally in the face of a substantial volume of Treasury,
corporate, and municipal debt offerings.
At its meeting of June 30-July 1, the Committee
specified third-quarter growth for M-1 and M-2 at an­
nual rates of about 5 percent and 9 percent, respec­
tively. Somewhat more rapid growth was acceptable,
depending on evidence that economic and financial
uncertainties were leading to exceptional liquidity de­
mands and changes in financial asset holdings. It was
noted that seasonal uncertainties, together with in­
creased social security payments and the initial impact




of the tax cut on cash balances, might lead to a tem­
porary bulge in M-1 in July. Using likely indications of
July growth, the reserve paths for July and August
allowed for a temporary bulge in M-1 in July and re­
flected the Committee’s $800 million initial borrowing
assumption.
There was a large increase in M-1 in the first week
of July, but the bulge was less than had been antici­
pated at the time of the meeting and incoming data
suggested no further strength as July progressed. By
the end of the first subperiod— the four weeks ended
July 28— M-1’s July growth was modest. M-1 was well
below path, and M-2 was expected to be close to path
in July. In these circumstances and in view of the
sensitive conditions in financial markets, the non­
borrowed reserve path was raised by $85 million dur­
ing the interval to accommodate the resumption of
money growth. With the weakening in money growth,
total reserves ran $120 million below path for the sub­
period. The average level of borrowing implied by the
nonborrowed reserve path declined to about $630 mil­
lion in the final week, down from $8C0 million initially.
Reflecting this and a cut in the discount rate on
July 19 from 12 to 1116 percent, the money market
eased markedly. The average Federal funds rate fell
steadily from 14.47 percent in the first week to 11.02
percent in the last week of the subperiod.
Early in the second subperiod, the four weeks
ended August 25, data indicated additional weakness
in M-1. Therefore, an additional upward adjustment
of $100 million was made to the nonborrowed re­
serve path. Moreover, against the background of
continuing economic weakness, the discount rate was
trimmed by 1 1/2 percentage points to 10 percent in
three Vz percentage point moves by the end of Au­
gust. Despite some strengthening of M-1 and M-2 in
the first half of August, these aggregates remained
below path. Consequently, the demand for total re­
serves in the subperiod ran $240 million below path.
Reflecting this and upward adjustments to the non­
borrowed reserve path, the average borrowing level
for the subperiod implied by the reserve paths de­
clined to $410 million in the final week.4 In line with
these events and the discount rate cuts, the Federal
funds rate declined to around 10 percent or a bit
lower as the period progressed, compared with just
over 11 percent in the first week of the subperiod.

4 Part of the decline in implied borrowing reflected a $61 million
upward adjustment made to the nonborrowed reserve path to
account for the reclassification of borrowing by a merged bank to
the extended credit category, which occurred on August 9. For
reserve path construction purposes, extended credit is treated as a
source of nonborrowed reserves since such borrowing does not
result in normal reserves adjustment pressure on the banks involved.

FRBNY Quarterly Review/Spring 1983

51

At its August 24 meeting the Committee retained its
third-quarter monetary growth rate objectives of 5
percent for M-1 and 9 percent for M-2. The reserve
paths allowed for more rapid growth than projected
for August. While the September M-2 path growth
rate appeared lower than was likely to occur, the
directive allowed for acceptance of some above-path
growth of this aggregate. The nonborrowed reserve
path reflected a $350 million initial borrowing level.
In the six-week intermeeting period ended on Octo­
ber 6, M-1 strengthened in August and came in above
path in September. Meanwhile, M-2 came in slightly
below the August path level but was estimated to be
moderately above path in September. Actual borrow­
ing was frequently bolstered by special-situation bor­
rowing, which was not considered to be reflective of
normal reserves availability pressures. In practice,
some allowance was made for this in adjusting the
paths; however, it was usually difficult to ascertain the
exact magnitude of the special-situation borrowing,
complicating the determination of appropriate Desk
action.
In the three weeks ended September 15, the de­
mand for total reserves ran $120 million above path,
reflecting M-1 strength in August. Nonborrowed re­
serves averaged $60 million below path. Further ap­
preciable strengthening appeared for September in the
three weeks ended October 6. By the middle week of
the second subperiod, it was clear that mechanical
adherence to reserve path procedures would result in
a borrowing gap in the final two weeks of around
$900 million (even before any allowance for specialsituation borrowing), implying considerable upward
interest rate pressure. The Committee reviewed recent
developments at a conference call on September 24.
It was the Committee consensus that some accommo­
dation of the more rapid growth of money was con­
sistent with the directive adopted at the August meet­
ing in view of the strength in NOW accounts, the
overall background of weakness in the economy, and
the fragility of worldwide financial conditions. Hence,
the nonborrowed reserve path was adjusted to limit
implied borrowing to the $500 million to $550 million
area. Average nonborrowed reserves were just slightly
above the adjusted path; total reserves finished about
$570 million above path.
The strengthening of money growth in August and
September arrested the substantial easing trend in the
money markets which had characterized July and
August. In the six weeks following the August 24
meeting, the weekly Federal funds rate fluctuated in
a range of about 10% to 10% percent until the week
of October 6, when the funds rate jumped to about
10% percent.

52

FRBNY Quarterly Review/Spring 1983




Despite strong crosscurrents— and indeed partly be­
cause' of them— the fixed-income securities markets
rallied sharply during the quarter with many rates
dropping to their lowest levels in about two years.
Many short-term rates, notably on Treasury issues,
reached their lowest levels in mid-August when wide­
spread concerns over creditworthiness and liquidity
were greatest. Longer term rates continued to decline
through the quarter’s end, however, despite some oc­
casional backups. Price gains were supported early in
the period by slow M-1 growth, a sluggish economy,
and cuts in the discount rate. Although money growth
strengthened in August and September, most market
participants felt that the weak performance of the
economy would moderate private credit demands and
keep System policy from a tighter course.
In the quarter, financial markets witnessed a height­
ening of concern about the quality of U.S. bank loan
portfolios. The failure of Penn Square Bank in Okla­
homa in July had cast a shadow on a number of major
commercial banks that had participated in loans initi­
ated by Penn Square. In September, anxiety mounted
as Mexico’s deteriorating financial situation under­
scored the sizable exposure of banks through foreign
loans in a deteriorating world economic situation.
Rates on three-month CDs rose to a spread of about
3 percentage points over Treasury bills in September,
compared with about 1 percentage point earlier in
the year.
The Treasury sold to the public $230 billion of debt
in the quarter, while raising about $55 billion of new
cash (exclusive of foreign gross purchases of about
$3 billion). Nevertheless, yields on three-year Treasury
issues declined about 3Va percentage points over the
quarter to about 11 Vi percent, while thirty-year bond
yields declined about 2 Ve percentage points to 11%
percent. Corporate debt issuance picked up signifi­
cantly in August and September, while municipal bor­
rowing was substantial throughout the quarter. The
substantial volume of new issues generally met good
receptions.
O ctober through the year end
In formulating monetary policy in the fourth quarter,
the Committee concluded that M-1 would be subject
to unusually large uncertainties over the remainder of
the year (and for at least some time in 1983) because
of the substantial effects of maturing ASCs and the
introduction of new money-market-type accounts. Ac­
cordingly, the FOMC decided to accommodate M-1
changes during the balance of the year, looking instead
to M-2 which was expected to be affected to a much
smaller extent by these developments. The resultant
reliance upon M-2 for drawing reserve paths implied

that equivalent money deviations from path would
generate smaller changes in borrowing pressure, since
the average M-2 reserve requirement was about 2 per­
cent compared with 9 percent for M-1.
At its October 5 meeting, the Committee set mone­
tary objectives over the September-to-December period
for M-2 and M-3 growth rates in a range of 8 1/a to 91/2
percent. The paths were constructed on the basis of
quarterly growth rates of 5 percent, 91/2 percent, and
8 V2 percent, respectively, for M-1, M-2, and M-3. How­
ever, deviations in the M-1 growth rate would be
accommodated. The reserve paths were drawn up
with a monthly growth pattern which reflected pro­
jected slow growth for the broader aggregates in
October but large increases in M-1 as a result of the
maturing ASCs. The nonborrowed reserves objective
incorporated an initial borrowing assumption of $300
million.
Early in the October-November intermeeting period,
available data on the monetary aggregates indicated
that M-1 in early October was stronger than had been
anticipated at the time of the October meeting. NonM-1 components of M-2 appeared sufficiently weak,
however, to compensate for the M-1 strength, so that
estimates of M-2 indicated a close-to-path perform­
ance for that aggregate. In these circumstances, and
in line with the Committee’s desire to accommodate
variations in M-1, adjustments were made to the paths
to leave seasonal and adjustment borrowing around
$300 million. Total and nonborrowed reserves aver­
aged about $30 million and $40 million below path,
respectively. By the second subperiod, the three weeks
ended November 17, M-1 in October appeared to be
considerably stronger and estimates of M-2 in October
also were revised upward to levels above those built
into the path. The directive, however, called for tolera­
tion of somewhat more rapid growth of the broader
aggregates if economic and financial uncertainties led
to exceptional liquidity demands. Thus, in addition to
accommodating M-1 developments, path adjustments
were taken so as to result in only a modest widening
of the implied borrowing gap to about $340 million for
the second subperiod. As the subperiod progressed,
actual borrowing ran high, largely reflecting a $3 bil­
lion bulge in borrowing on November 10 which auto­
matically carried into the November 11 Veterans Day
holiday. In the final week (November 17), the non­
borrowed reserves objective for the week was set
consistent with borrowing in that week of $550 million.
For the subperiod, nonborrowed reserves were essen­
tially equal to the revised path while total reserves
were $150 million above path.
Conditions in the money market during the inter­
meeting period generally moved in line with develop­




ments in money growth. Federal funds traded around
the discount rate, which was cut from 10 to 91£ percent
on October 8. With M-2 close to path during the first
subperiod, the Federal funds rate eased from slightly
above 91/2 percent at the period’s outset to slightly
below 91/2 percent in the middle weeks of the period.
Consistent with the strengthening in M-2 and higher
borrowing levels in the second subperiod, the funds
rate backed up to slightly over 91/2 percent in the
November 17 week.
At its November meeting, with institutional develop­
ments continuing to cloud the interpretation of M-1,
the Committee reaffirmed its earlier decision to re­
spond flexibly to M-1 developments, continuing to focus
primarily on M-2 and to some extent on M-3. The
Committee established monetary objectives of 91/2 per­
cent growth rates for both M-2 and M-3 over the
September-to-December period and opted for an initial
borrowing assumption of $250 million.
The five weeks ended December 22 were character­
ized by M-2 and M-3 growth which was relatively close
to path, while M-1 continued to show considerable
strength. By the period’s close, M-2 was estimated to
be slightly above path for the month of November but
a shade below path in the five weeks underpinning
reserve needs for the period. M-3 was estimated to be
a bit below path in November. During the period, less
than the full amount of potential M-2-based technical
adjustments were taken, which had the effect of less
than fully accommodating the strength in M-1. In addi­
tion, stronger than anticipated demands for excess
reserves during a period of seasonal churning led to
higher than intended levels of borrowing at the dis­
count window and an increase in money market pres­
sures. The nonborrowed reserve path was lowered by
$105 million to allow for this rise in actual borrowing.
After these adjustments, average borrowing implied by
the reserve paths was about $340 million for the pe­
riod. Implied borrowing levels in the final two weeks
of $230 million were about equal to the level consis­
tent with the below-path performance of M-2 in the
five weeks determining reserve needs in the period.
Total reserves fell about $40 million short of path, and
nonborrowed reserves about $50 million below path.
The Federal funds rate edged downward irregularly
over the interval, but by less than the discount rate
which was cut from 91/2 to 9 percent in the first week
of the period and then to 81/2 percent in the week of
December 15. The weekly average funds rate fell from
8.91 percent in the first week to 8.69 percent in the
final week, a bit above the new discount rate.
Over the remainder of the year, interpretation of the
monetary aggregates data was complicated further by
very rapid growth of the new MMDAs which were intro­

FRBNF Quarterly Review/Spring 1983

53

duced at banks and thrift institutions on December 14.
By late December, it was estimated about $90 billion
of these deposits— included in M-2— was outstanding.
In early 1983 the MMDAs continued to expand rapidly,
while additional uncertainty over interpretation of the
alternative money measures resulted from the intro­
duction on January 5 of the new super NOW accounts
(included in M-1). At its December meeting the Com­
mittee set growth rates of 9Vfe percent and 8 percent
for M-2 and M-3, respectively, from December to
March. The M-2 growth rate allowed for modest shifting
of funds into the new MMDAs from large-denomination
CDs or market instruments (that is, from non-M-2
sources). But the Committee indicated that greater
growth was acceptable if incoming data indicated that
the MMDAs were attracting more substantial shifts of
funds into the broader aggregates from market instru­
ments. As the period proceeded, it became clear that
a significant portion of the funds pouring into the new
MMDAs was coming from sources outside M-2. Con­
sequently, in line with Committee desires, adjustments
were made to the reserve paths to accommodate the
emerging growth.
Desk operations in the first subperiod, the four weeks
ended January 19, were complicated by year-end pres­
sures and implementation of two mandated reductions
of required reserves. (Reserve requirements were
ended for the first $2.1 million of each institution’s
reservable deposits and for personal MMDAs at mem­
ber banks.) In these circumstances, holdings of excess
reserves tended to run well above expected levels
(even though higher than normal levels were allowed
for in the paths) and required reserve levels were
frequently revised, complicating efforts to achieve
weekly nonborrowed reserves objectives. Around the
year-end, while the Desk frequently more than met the
expected reserve needs, the extraordinarily high de­
mand for excess reserves persistently forced discount
window borrowing above the levels allowed for in the
paths. In the face of these uncertainties, it seemed
appropriate to adjust for that borrowing and aim for
nonborrowed reserves in subsequent weeks consistent
with the initial $200 million borrowing level assumed
by the Committee. As underestimates of excess re­
serves and end-of-week reserve projection errors per­

54

FRBNY Quarterly Review/Spring 1983




sisted, borrowing turned out higher than $200 million
each week, especially in the week that included the
year-end. Despite the Desk’s actions to counter the
year-end pressures, the Federal funds rate began to
firm late in the December 29 statement week with a
significant volume of trading in a 10 to 14 percent
range in the January 5 statement week. Year-end pres­
sures finally unwound in the final two weeks of the
subperiod, and funds eased back to the vicinity of the
8V2 percent discount rate. Total reserves averaged
about $20 million under path and nonborrowed re­
serves about $60 million under path.
Yields on most fixed-income securities fell sharply
during the first half of October. Markets began to rally
in reaction to newspaper articles that strongly sug­
gested the FOMC had decided at its October meeting to
ease credit conditions and set aside its M-1 targets at
least temporarily. Market sentiment was bolstered
further by the Vz percentage point cut in the discount
rate on October 8, and a statement by the Chairman
indicating that the FOMC would pay less attention to
M-1 because of technical difficulties in interpreting its
movements. Over the remainder of the quarter, most
rates exhibited little overall trend but fluctuated largely
in response to speculation regarding possible further
cuts in the discount rate. With additional cuts in the
discount rate already largely built into the price struc­
ture, the two additional reductions that occurred in
November and December elicited only subdued market
reaction. Very heavy Treasury borrowing, amounting
to about $57 billion net in marketable debt over the
quarter, contributed to the bottoming-out of interme­
diate and longer term yields. A very large volume of
municipal debt was offered as the year-end ap­
proached, and corporate bond issuance was also fairly
heavy. Private-sector demand for short-term credit was
restrained by the recession. This, combined with a
revival of confidence that collective action by banks,
national authorities, and the International Monetary
Fund would contain the downside risks of country
lending, contributed to a considerable narrowing in
quality spreads. CDs, for example, were trading by late
December at yields only about 50 basis points or so
above Treasury bills, compared with about 300 basts
points in September.

August 1982-January 1983 Semiannual Report
(This rep ort was released to the Congress
and to the press on M arch 3,1983.)

Treasury and Federal Reserve
Foreign Exchange Operations
The dollar rose against all major foreign currencies
from August through mid-November 1982, exceeding
the peaks of the previous year and reaching the high­
est levels on a trade-weighted basis of the floating
rate period. The dollar then reversed course through
the middle of January, ending the six-month period
lower on balance against the Japanese yen and the
Swiss franc but higher against most other major for­
eign currencies.
The dollar was strongly bid in the exchange markets
early in the period under review even as U.S. interest
rates dropped sharply and as interest differentials
favoring dollar-denominated assets narrowed appreci­
ably. In part, bidding for dollars reflected a deepening
apprehension about the international banking system.
As evidence emerged of the liquidity pressures facing
first Mexico and then other developing countries, doubts
spread in the markets about the willingness or the
ability of one or several of these borrowers to meet
their external obligations. In response, individual in­
stitutions sought to augment their liquidity positions,
especially in dollars, against potential funding or cash­
flow problems and in advance of important statement
dates, particularly around end-September. In this en­
vironment, market participants became wary about the
credit exposures of potential counterparties in the

A report by Sam Y. Cross. Mr. Cross is Executive 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.




interbank market. Their heightened perception of risk
was reflected to an extent in the widening yield spread
between U.S. Government obligations and private
credit instruments.
In part, the dollar’s buoyancy also reflected market
perceptions that the outlook for the U.S. economy was
favorable relative to those for other countries. Infla­
tion in the United States was rapidly receding in prod­
uct and labor markets, and the previously adverse
inflation differentials which the United States had ex­
perienced vis-d-vis Germany and Japan were quickly
eroding. Widely anticipated shifts in balance-ofpayments positions against the United States following
the dollar’s two-year rise were slow to materialize.
Moreover, the outlook for economic growth remained
more positive for the United States than elsewhere.
Meanwhile, the prospects of recovery in the near
term and of looming fiscal deficits over the medium
term were seen as limiting the scope of future interest
rate declines in the United States. To be sure, Federal
Reserve authorities had indicated during the summer
that they would tolerate monetary expansion at some­
what higher than the targeted annual rate in view of
economic uncertainty and strong liquidity demands.
Short-term interest rates had declined from their mid­
year peaks in response to the sluggishness of the
economy and of credit demands by some 6% per­
centage points through late August and then, after
some backing-up in September-October, by a further
Vz percentage point by late October. In the meantime,
the Federal Reserve lowered its discount rate in five

FRBNY Quarterly Review/Spring 1983

55

Chart 1
Chart 2

The D ollar A g ain st S e lecte d
F oreign C urrencies

S e le c te d In te re st Rates
Three-month maturities *

Percent

Percent
18

\
\

Eurodollars
London market

London interbank
s terlin g

Euromark deposits
'L on d o n mark et"

Percentage change of weekly average bid rates
for dollars from the average rate for the week of
December 28, 1981-January 1, 1982. Figures calculated
from New York noon quotations.

J F
1983

J
J
1982
* Weekly averages of daily rates.

Table 1

Federal Reserve Reciprocal Currency Arrangements
In m illions of dollars

Amount of fa cility
January 1, 1982

Institution

Bank of M exico
special fa cility
effective
August 30,1982

A m ount o f fa cility
January 31,1983
250

National Bank of Belgium ................................................................ .............
.............

1,000
2,000

1,000
2,000

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

250

250
3,000

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

2,000
6,000

2,000

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

3,000

3,000

6,000
5,000

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

700

700
325

325

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

500

500

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

250

250

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

300

300

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

4,000

4,000

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

1,250

1,250

Bank for International Settlements:
600

325

56

FRBNY Quarterly Review/Spring 1983




30.425

steps from 12 percent to 91/2 percent in three months.
But no fundamental change in Federal Reserve oper­
ating procedures had been indicated. Compared with
other countries, the decline in U.S. nominal interest
rates still lagged behind the reduction of inflation so
that real interest rates remained high, both absolutely
and relative to other countries. Furthermore, because
of the weakness of economies abroad, foreign mone­
tary authorities were expected to take full advantage
of any decline in U.S. interest rates that appeared to
be sustainable to ease credit conditions in their own
economies. These expectations were confirmed when
official and market interest rates in major European
countries declined in late August and again in October.
For all these reasons, the dollar was bid higher
in the exchange markets in frequently active trading
through mid-November. The uptrend was uneven. In
view of the heightened perception of risk that prevailed
at the time and uncertainty over the timing and profile
of the anticipated recovery in the United States, the
markets were susceptible to abrupt shifts in sentiment
or movements in exchange rates. Under these circum­
stances, the U.S. authorities intervened on one day in
early August and on three days early in October, when
the dollar was bid up sharply to higher levels in unset­
tled markets. The Federal Reserve and the U.S. Trea­
sury purchased $57.0 million equivalent of Japanese
yen and $45.0 million equivalent of German marks. Of
the total Japanese yen acquired, $38.5 million was for
the Federal Reserve and $18.5 million for the U.S.
Treasury. The German mark purchases were evenly
split between the Federal Reserve and the Treasury.
At the dollar’s peak, it had risen 11 and 71/2 percent
from late-August levels against the yen and the mark,
respectively, to levels not seen in five years or more.
Against some of the other Continental currencies, the
dollar had moved up to record levels.
By mid-November, the international economic cli­
mate had changed significantly. Expectations of a
U.S. economic recovery had been disappointed, and
recent statistics were suggesting that recession, while
deepening further abroad, had not yet ended in the
United States. The unemployment rate in the United
States had shot up quickly to 10 1/2 percent just before
Congressional elections, and a number of political
campaigns had focused on economic issues, leaving
market operators sensitive to the possibility that more
policy initiatives might be undertaken to stimulate the
economy. By this time, also, the U.S. trade position
had posted several large monthly deficits. The antici­
pated deterioration in net exports not only appeared
to have materialized but, coming at a time of weak
domestic demand, suggested that the potential drop
into deficit and the resulting drag on the U.S. economy




might be far deeper than previously envisaged. Press
and official commentary associated the dollar’s past
appreciation with the weakness of U.S. trade and em­
ployment.
In addition, market participants came to the judg­
ment that the prospects and priorities for the interna­
tional financial system had changed. The immediate
risks of a major international loan default receded, as
first Mexico and then other countries negotiated ad­
justment programs with the International Monetary
Fund (IMF) and established procedures for arranging
near-term financing needs. However, the success of
these countries’ stabilization programs and of their
efforts ultimately to meet their heavy external obliga­
tions was seen as requiring a more buoyant interna­
tional economy and substantially reduced financing
costs.
Accordingly, market participants continued to antici­
pate further easing of U.S. short-term interest rates for
a time. But, during the winter, they began to question
the scope for further substantial interest rate drops
in light of recent behavior of the monetary aggregates.
In the event, the Federal Reserve reduced its dis­
count rate in two more steps to 81/2 percent by midDecember. But, at least in the market for medium- and
longer term securities, the downtrend in interest rates
was beginning to meet resistance.
Under these circumstances, market participants
were willing to diversify their portfolios by liquidating
some of their dollar-denominated assets. Investors
chose to realize the capital gains they had earned on
their investments in the United States and to partici­
pate in the rallies in capital markets abroad that were
being triggered by expectations of further interest rate
cuts there. In addition, market professionals were will­
ing to take positions on expectations that a longawaited reversal of the dollar’s sustained advance had
finally arrived.
Consequently, the dollar declined from midNovember through mid-January by 19 percent against
the Japanese yen and by 141/2 and 10 1/2 percent, re­
spectively, against the Swiss franc and German mark.
Of all the major currencies, the dollar rose only
against the pound sterling which, like the dollar, had
begun a decline in mid-November and then depreci­
ated more rapidly in response to the prospect of de­
clining oil prices to touch a record low in terms of
the dollar by the second week of January.
After mid-January, the decline in the dollar stalled
or was partially reversed. Whereas industrial econo­
mies abroad remained weak, the first clear signs ap­
peared that the U.S. recession was bottoming out.
Moreover, the prospect of large, projected U.S. fiscal
deficits, together with the recent, more rapid mone­

FRBNY Quarterly Review/Spring 1983

57

favorable to dollar assets once again widened. By the
close of January, the dollar was trading sligh tly higher
against most European currencies than at the begin­
ning of the six-month period under review. It remained
lower, however, against the Japanese yen and the
Swiss franc than it had been on July 30. In tradeweighted terms, the dollar rose slightly over the six
months. The U.S. authorities did not intervene after
early October.

tary growth, raised uncertainty whether the Federal
Reserve m ight tighten credit market conditions again.
Both Treasury and Federal Reserve officials stressed
the longer term need to reduce the deficits and to
maintain the anti-inflationary resolve of monetary pol­
icy. Thus, expectations faded of further interest rate
declines and, in fact, m arket yields edged up some­
what during January. With interest rates abroad gen­
erally holding steady or declining slightly, differentials

Table 2

Drawings and Repayments by Foreign Central Banks and the Bank for International Settlements
under Regular Reciprocal Currency Arrangements
In m illions of dollars; draw ings ( + ) or repayments (—)

Bank draw ing on
Federal Reserve System

1983
January

Outstanding
January 31,
1983

f + 1 , 400.0
900.0

- 2 1 7 .4

-1 0 9 .6

373.0

-0-

-0-

1 + 1 2 4 .0
{-1 2 4 .0

-0-

-0-

J + 8 0 0 .0
( — 600.0

f + 1,400.0
900.0

f + 1 24.0
1— 341.4

— 109.6

373.0

1982
I

1982
II

1982
III

-0-

-0-

r + 800.0
|-6 0 0 .0

Bank of M e x ic o .........................................
* Bank fo r International Settlem ents
(against German marks) ....................
Total

1982
IV

O utstanding
January 1,
1982

-0-

-0-

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

Data are on value-date basis.
* BIS draw ings and repayments of dollars against European currencies other than Swiss francs to meet tem porary cash requirements.

Table 3

Drawings and Repayments by the Bank of Mexico under Special Swap Arrangements
In m illions of dollars; draw ings ( + ) o r repayments ( — )
O utstanding
January 1,
1982

1982
IV

/+

825.0
825.0

*

*

/+

89.8
43.8

+ 2 1 1 .2

+

42.0

299.3

*

*

f+

166.8
81.3

+ 3 9 2 .2

+

78.0

555.8

*

*

f + 1 , 081.6
950.0

+ 6 0 3 .5

+ 120.0

855.0

1982
II

*

*

*

Federal Reserve special fa c ility
for $325 m illio n .................................

*

*

United States Treasury special
fa c ility for $600 m illio n ....................

Total

Drawings on
United States Treasury special
tem porary fa c ility for $1,000
m il l i o n ...................................................

1983
January

Outstanding
January 31,
1983

1982
III

1982
I

*

*

Drawings on special combined
credit facility:

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

Data are value-date basis. Because of rounding, figures may not add to totals.
* Not applicable.

58

FRBNY Quarterly Review/Spring 1983




Table 4

Drawings and Repayments by the Central Bank of Brazil under Special Swap Arrangements
with the United States Treasury
In m illions of dollars; draw ing ( + ) o r repayments ( — )
Drawings on
United States Treasury
special fa c ilitie s fo r

Outstanding
January 1,
1982
*

$500 m il l i o n ........................................
$280 m il l i o n ........................................

.......

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

*

1982
II

1982
III

*

*

*

*

★

*

1982
1

$450 m illio n ........................................

*

*

$250 m illion

*

★

Total

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

*

★

*

1982
IV

1983
January

Outstanding
January 31,
1983

f+
\ —
+

500.0
500.0
280.0

*

♦

+

450.0

-0-

280.Of

-0-

450.0

*

*

f+

250.0
104.2

- 1 4 5 .8

*

*

*

f + 1,480.0
604.2

- 1 4 5 .8

730.0

Data are on a value-date basis.
* Not applicable.
f T h is swap draw ing repaid at m aturity on February 1, 1983.

As discussed in the body of this report, the Federal
Reserve and the U.S. Treasury provided credits to
Mexico through a com bination of long-standing fa c ili­
ties and new arrangements. On the first day of the
period under review, the Bank of Mexico repaid a
one-day $700 m illion drawing on its swap line under
the Federal Reserve’s reciprocal currency arrange­
ment, used to finance a short-run liquidity need. Then,
with the Mexican authorities proceeding with discus­
sions with the IMF of a new stabilization program, the
Bank of Mexico requested and was granted on Au­
gust 4 a $700 m illion drawing on that same swap line.
As of January 31, $373 m illion was still outstanding
under that facility. Also, over the August 14-15 week­
end, the Mexican authorities arranged a temporary
new $1 b illion swap fa cility with the Exchange S tabili­
zation Fund (ESF) of the U.S. Treasury to meet imme­
diate cash needs pending the conclusion of an agree­
ment fo r a $1 billion advance payment for oil from the
U.S. Department of Energy fo r the U.S. strategic
reserves. The Mexican authorities drew $825 m illion
against the ESF fa cility and then, on August 24, repaid
the entire drawing. The Treasury and the Federal Re­
serve participated on August 30 in a $1.85 billion
m ultilateral financing program for the Bank of Mexico
in cooperation with several other monetary authorities,
under the aegis of the Bank fo r International Settle­
ments (BIS), through swap arrangements of $600 m il­
lion and $325 m illion, respectively. The Bank of Mex­
ico had outstanding drawings of $299 m illion on the




Federal Reserve and $556 m illion on the U.S. Trea­
sury under the fa cility as of January 31.
During the period, the U.S. monetary authorities
provided or participated in the provision of short-term
bridging credits to Brazil and Argentina also.
With respect to Brazil, the U.S. Treasury provided
in October and November $1.23 billion of short-term
financing follow ing adoption of econom ic policies at the
October meeting of B razil’s National Monetary Council.
The financing was provided under three swap fa c ili­
ties in anticipation of Brazil’s drawings under the
compensatory financing fa cility of the IMF as well as
on its reserve position with the IMF. The first $500
m illion fa c ility was drawn on O ctober 28 and Novem­
ber 3 and repaid on December 28. Other facilities to­
taling $730 m illion were made available in November
and remained outstanding at the end of the period.*
Meanwhile, on December 23 the BIS, acting w ith the
support of the U.S. Treasury and monetary authorities
in other industrial countries, provided the Central
Bank of Brazil with a $1.2 billion credit facility, which
was subsequently increased to $1.45 billion. In antici­
pation of this arrangement, the Treasury through the
ESF provided on December 13 an advance of $250
m illion through a swap arrangement, which has since
been repaid. As part of the liquidity-support arrange-

* Of this amount, a swap drawing of $280 million was repaid at maturity
on February 1, 1983.

FRBNY Quarterly Review/Spring 1983

59

ments fo r the BIS provided by the participating mone­
tary authorities, the ESF has agreed to be substituted
fo r the BIS fo r $500 m illion of the total credit fa cility
in the unlikely event of delayed repayment by the
Central Bank of Brazil.
With respect to Argentina, on January 24 the BIS
announced, with the support of a group of its member
central banks and the U.S. monetary authorities, a
$500 m illion bridging loan to the central bank of
Argentina to be repaid by the end of May as other
funds become available to that country. In this case,
the Federal Reserve has agreed to be substituted for
the BIS at its request fo r up to $300 m illion of the

total credit fa cility in the unlikely event that the credit
remains outstanding fo r a longer period of tim e than
is now contemplated.
In other operations, the U.S. Treasury redeemed at
m aturity on September 1 and December 14 German
mark-denominated securities equivalent to $671.2
m illion and $664.1 m illion, respectively, and on Janu­
ary 26 the Treasury redeemed at m aturity the last of
its Swiss franc-denom inated securities equivalent to
$458.5 m illion. After these redemptions, the Treasury
had outstanding $1,275.2 m illion equivalent of notes
(public series), which had been issued in the German
market with the cooperation of the German authorities

Table 5

United States Treasury Securities, Foreign Currency Denominated
In m illions of dollars equivalent; issues ( + ) or redem ptions ( — )

1983
January

A m ount of
com m itm ents
January 31,
1983

— 664.1

-0-

1,275.2

-0-

- 4 5 8 .5

-0-

-6 6 4 .1

- 4 5 8 .5

1,275.2

A m ount ot
com mitments
January 1,1982

1982
I

1982
II

1982
III

1982
IV

G e r m a n y .....................................

3,622.3

-0-

—451.0

-1 ,2 3 1 .9

S w itz e rla n d .................................

458.5

-0-

-0-

-0-

4,080.8

-0-

—451.0

-1 ,2 3 1 .9

Issues
Public series:

Total

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

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

Table 6

Net Profits ( + ) or Losses ( —) on United States Treasury and Federal Reserve
Current Foreign Exchange Operations
In m illions of dollars

Period

Second quarter 1982 ................................................................

Federal
Reserve
-0-

+

15.9

-

4.2

-0-

+

1.5

+

78.5

-0-

-

2.3

+
+

4.3

+
+

89.4

-0-

0.5

+

38.3

-0Valuation profits and losses on outstanding assets and
liabilities as of January 31, 1983 ..........................................
Data are on a value-date basis.

FRBNY Quarterly Review/Spring 1983
Digitized for60
FRASER


United States Treasury
Exchange
S tabilization
General
account
Fund

- 5 7 3 .7

- 9 6 5 .2

16.0

+ 3 6 0 .6

in connection with the dollar-support program of No­
vember 1978. All these notes are scheduled to mature
by July 26, 1983.
In the six-month period from August through Janu­
ary, the Federal Reserve had no profits or losses on
its foreign currency transactions. The ESF recorded a
gain of $4.2 m illion in connection with sales of foreign
currency to the Treasury general account which the
Treasury used to finance interest and principal pay­
ments on foreign currency-denominated securities.
The Treasury general account gained $84.9 m illion on
the redemption of German mark- and Swiss francdenominated securities. Valuation gains or losses, as
presented in Table 6, represent the increase or de­
crease in the dollar value of outstanding currency
balances if valued at end-of-period exchange rates as
compared with those at which the assets and liabilities
were acquired. As of January 31, 1983, valuation losses
on outstanding balances were $573.7 m illion fo r the
Federal Reserve and $965.2 m illion for the ESF. The
Treasury general account had valuation gains of
$360.6 m illion related to outstanding issues of securi­
ties denominated in foreign currencies.
The Federal Reserve and the Treasury invest foreign
currency balances they acquire as a result of their
foreign exchange operations through a variety of in­
vestments that yield market-related rates of return and
provide a high degree of quality and liquidity. Linder
the authority provided by the Monetary Control Act of
1980, the Federal Reserve had invested some of its
own foreign currency resources and those held under
warehousing agreements w ith the Treasury in securi­
ties issued by foreign governments. As of January 31,
the Federal Reserve’s holdings of such securities was
$1,367 m illion. The Treasury had invested $2,536 m il­
lion in such securities as of end-January.

Japanese yen
Japan’s econom ic performance, though still impres­
sive by international comparison, had by midsummer
fallen short of earlier expectations in many im portant
respects. Externally, exports had declined under the
influence of the w orldw ide recession, increasing bar­
riers to Japanese goods, and import cutbacks by sev­
eral financially strapped developing countries previ­
ously among Japan’s fast-growing export markets.
Although im ports had also dropped and the current
account remained in surplus, the trend of continuous
trade balance improvement, which had reemerged
after the second oil-price rise late in the 1970s, was
now broken. Moreover, the current account surplus
was overshadowed by large outflows of capital that
reflected in part lower interest rates in Japan than in




Chart 3

Japan
Movements in exc h an ge rate and official
foreign currency re serves
Yen per dollar

Billions of dollars

1982

1983

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.

other centers. Internally, efforts to generate a dom estic
econom ic recovery faltered, as a modest upturn in
consumer expenditures earlier in the year petered out
and investment stagnated. With slower than expected
growth leading to a renewed shortfall in tax revenues
and an overrun in the governm ent’s borrowing re­
quirement, Japan’s bond m arket came under pressure
while the stock m arket was depressed by the deterio­
rating econom ic outlook. These developments also
contributed to the outflows of capital from Japan.
Thus, the Japanese yen had become a victim of
repeated disappointm ent about the prospects fo r the
economy and large net capital outflows. Commercial
leads and lags built up strongly against the currency.
By end-July it had fallen 20 percent against the dol­
lar from the highs of November 1981 to ¥ 255.60,
while easing 8 percent against the German mark.
The authorities had intervened at times to cushion
the yen’s decline, and Japan’s foreign currency re­

FRBNY Quarterly Review/Spring 1983

61

serves had dropped $3.2 billion during the eight
months to $21.8 billion.
Meanwhile, monetary policy was being relied on to
provide stimulus to Japan’s economy while fiscal
policy was constrained by concern over the budget
deficit and the commitment to eliminate the borrowing
gap by 1984. But the yen’s continued weakness greatly
reduced the maneuverability of the monetary authori­
ties to respond during the summer months to evidence
of a further weakening of demand and a rise in un­
employment. The yen’s steep fall had boosted the inter­
national competitive position of Japanese industry and,
in the current recessionary environment, this develop­
ment was attracting strong criticism from abroad and
aggravating trade frictions. Thus, the authorities were
reluctant to risk any further easing of interest rates for
fear of stimulating even greater outflows of capital,
even though a rapid deceleration in inflation had left
Japan’s interest rates in real terms high by historical
standards. Instead, the Bank of Japan kept short-term
rates around 7 percent. Against this background the
yen remained on offer, fluctuating closely in response
to changes in liquidity conditions in the United States.
When interest rates abroad fell sharply during midAugust, the yen firmed temporarily only to give way to
renewed selling pressures when the downtrend in
foreign interest rates later seemed to lose momentum.
During September-October, sentiment toward the
yen remained cautious as the markets’ earlier pre­
sumption that the dollar would soon ease came to
be challenged. In the United States, the scope for
further interest rate cuts in the near term had come
into question. More importantly, the flare-up of debt
problems in Mexico and other developing countries
triggered a strong demand for dollar-denominated
assets, even though market participants were initially
concerned about the credit exposures of individual
U.S. banks. The Japanese yen became caught up in
these concerns. Meanwhile, at home, attention again
focused on the government’s efforts to wrestle with its
fiscal deficit, especially after Prime Minister Suzuki
announced that the government’s finances were in a
“state of emergency” and the goal of balancing the
budget by 1984, to which his government had empha­
sized its strong commitment, would have to be aban­
doned. Steps were taken to cut some expenditures to
make room for selective stimulus via new public
works spending and housing loan subsidies. But these
measures were viewed as not sufficient either to con­
tain the growing deficit or to revive private demand.
In October, the Prime Minister’s surprise announce­
ment that he would not seek reelection led to a diffi­
cult four-way succession struggle.
In this atmosphere the yen fell irregularly, dropping

62

FRBNY Quarterly Review/Spring 1983




9 percent from end-July levels to a 5 % -year low of
¥ 278.60 on' November 4 against the generally strong
dollar. It had weakened also against other currencies,
falling 4 percent against the mark by early November.
The Bank of Japan at times sold dollars both in Tokyo
and in New York to support the currency in the
exchange markets. These sales were greater than the
$2.8 billion decline in Japan’s foreign exchange re­
serves over the three months to $19.1 billion by endOctober. The U.S. authorities joined in concerted in­
tervention operations with the Japanese authorities to
counter disorderly markets on August 4 and October 4-6,
as the dollar rose sharply. A total of $57.0 million of
yen was purchased, of which $38.5 million was on
behalf of the Federal Reserve System and $18.5 million
was for the account of the U.S. Treasury.
During November the Japanese yen finally began
to recover, buoyed at first by a major shift in inter­
national investment flows. By this time, the four-month
rally in U.S. capital markets showed signs of peaking,
encouraging many investors from Japan and elsewhere
to take profits on dollar investments and to shift into
other markets. Since the Japanese monetary authori­
ties had so far refrained from following interest rate
cuts abroad, market participants assessed that there
might be considerable latitude now for rates in Japan
to ease, generating expectations of potential capi­
tal gains. At the same time, the outlook for economic
growth globally had deteriorated considerably, and
the prospect that Japan’s economy would still expand,
however slowly, made investment in the stock market
in Tokyo relatively more attractive than in other fi­
nancial centers. Foreign investors, therefore, became
large net purchasers of Japanese securities, contribut­
ing to a strong rally in the Tokyo stock and bond mar­
kets. Long-term bond yields were brought down nearly
1 percentage point in the rally, even though the Bank of
Japan’s discount rate was unchanged and short-term
interest rates held steady. Net overseas investment by
Japanese residents declined, and long-term capital out­
flows slowed. Although these tendencies had begun
to appear in earlier months, the turnaround in invest­
ment had a particularly strong impact in November,
when the long-term capital account registered its first
surplus in eighteen months. This news was viewed
in the market as evidence that' the yen was finally
embarked on a sustainable recovery.
Before long, the bidding for yen broadened. Reports
circulated that some large Japanese exporting firms,
which had postponed dollar sales in earlier months
when the yen was weak, had begun actively to sell
dollars forward. The election of a new prime minister
by an unexpectedly wide margin in late November and
Prime Minister Nakasone’s first statements affirming

continuation of most of the previous government’s
policies helped dispel earlier political uncertainties.
Japan was seen as relatively free of the im m obilizing
policy disagreements that were taking place in so
many other countries and as continuing to follow a
clear and consistent path of m acroeconom ic restraint.
The yen thus came into demand and rose nearly
19 percent against the dollar between early November
and early January to ¥ 226.55 by January 10. Against
the German mark the currency rose some 10 percent
over the same period.
By early January, m arket participants began re­
assessing the outlook for further interest rate declines
abroad in light of indications that the U.S. economy
might be recovering more quickly than had been
thought and the prospect that the U.S. fiscal deficit
might again exert upward pressure on long-term U.S.
interest rates. Meanwhile, expectations had become
firm ly entrenched that the Japanese authorities would
soon lower official short-term interest rates. Also, Japa­
nese institutional investors had already begun to invest
once more abroad. After locking in some capital gains
on their dom estic securities, many took advantage of
“ partly paid” bonds in the Eurobond market to make an
initial instalment on a new issue and, if the yen were
to strengthen, benefit from this before completing their
subscriptions. Once the balance in the market began to
tip against the yen, many traders in the interbank mar­
ket and on C hicago’s International Monetary Market
(IMM) who apparently were holding large long yen
positions moved to cover their positions. The ensu­
ing selling brought the yen down quickly to ¥ 242.10
on January 24. In these circumstances, the Japanese
authorities did not proceed with the discount rate
cut which the market had come to expect would occur
after Prime M inister Nakasone’s visit to the United
States. As a result, the Japanese yen moved up to
close the period at ¥ 240.90, well below its earlyJanuary highs but up almost 6 percent on balance over
the six-month interval. The Bank of Japan made only
modest intervention sales of dollars in the last three
months of the period. Therefore, the country’s foreign
exchange reserves closed at $19.5 billion, little changed
from the end-of-October level but still down $2.3
billion from their end-July level.

gaining balance-of-payments equilibrium . Capital out­
flows continued to weigh against the dollar-m ark ex­
change rate, however, attracted by higher U.S. interest
rates and concern that Germany was more vulnerable
to the political and financial strains then developing.
Internally, proposals for dealing with persistently large
fiscal deficits had led to protracted debates within
Germany’s coalition government. Also, financial strains
in the private sector had left m arket participants
wary about individual German financial institutions.
Moreover, the openness of Germany’s economy ex­
posed it to possible disruptions of oil flows arising
from conflict in the Middle East, the spread of reces­
sion among industrialized countries, and repercus­
sions of econom ic sanctions adopted by the United
States against the Soviet Union.
Consequently, the mark, which had already fallen
from its November 1981 high by 11 percent against
the dollar to DM 2.4430 by end-July, dropped further to
a low of DM 2.5315 by early trading in the Far East
on August 11. During August the German authorities
continued to sell dollars in modest amounts to fa c ili­
tate the fixings in Frankfurt. Early in the month the
U.S. authorities operated once, purchasing $5 m illion

C hart 4

G erm any
M ovem ents in exch a n g e rate and o ffic ia l
fo re ig n c u rre n c y re se rve s
M arks pe r d o lla r

B illions o f do lla rs

2.20---------------------------------------------------------------------------1-5

1982

German mark
By August 1982 the German mark had strengthened
against most foreign currencies, w hile continuing to de­
cline against the U.S. dollar. The m ark’s performance
vis-a-vis other European currencies reflected prim arily
a moderation of inflation and the greater progress
made by Germany than by most of its neighbors in




1 9 83

See exch a n g e ra te fo o tn o te on C h a rt 3.
♦ F o re ig n exchange re s e rv e s fo r G erm any and other
m em bers o f the European M o neta ry S ystem , including
the United Kingdom , in c o rp o ra te a d ju stm en ts for
gold and fo re ig n exchange sw aps ag ainst E uropean
c u rre n c y units (ECUs) done w ith the European
M onetary Fund.

FRBNY Quarterly Review/Spring 1983

63

equivalent of marks for the Federal Reserve and the
U.S. Treasury.
The continued decline of the mark through mid­
summer was one of the complications facing the au­
thorities as they tried cautiously to steer the economy
out of protracted stagnation. For almost a year, the
Bundesbank had taken advantage of improvements in
Germany’s external position and price performance,
together with the rise in the mark in effective terms,
to lower its official discount and Lombard rates. At the
same time, fiscal policy was geared to a reduction of
the public-sector deficit.
Another complication was an unexpected deteriora­
tion in the economic climate in Germany. As foreign
demand weakened sharply after midyear, Germany’s
economic stagnation gave way to recession. The sag
in new foreign orders reflected the weakness of the
global economy, dwindling Organization of Petroleum
Exporting Countries (OPEC) surpluses, and severe
financing constraints facing many nonoil-developing
countries. Already liquidity difficulties had emerged
for a number of firms including AEG-Telefunken, gen­
erating talk of the need for governmental action to
support the economy and employment. But, at the
same time, an accord on the 1983 federal budget
reached just weeks before was beginning to be ques­
tioned on the grounds that it rested on overly opti­
mistic assumptions for the economy. Thus, prospects
grew of enlarged official borrowing needs, and Ger­
many’s bond market again had come under pressure.
Against this background, market participants ex­
pected that the authorities would take advantage of
any opportunity that might arise to lower interest rates
and thereby deflect pressure for further fiscal stimulus.
When U.S. interest rates resumed their downtrend after
mid-August, interest differentials adverse to the mark
sharply narrowed. As a result, the interest differential
for three-month Eurodeposits shrank to 2Vz percentage
points from more than 71/2 percentage points two
months before. Under these circumstances, the mark
recovered strongly to DM 2.41. The Bundesbank then
moved on August 27, in concert with the Swiss and
Dutch central banks, to cut the discount and Lombard
rates to 7 percent from 71/2 percent and to 8 percent
from 9 percent, respectively. The action was de­
scribed by Bundesbank President Poehl as an impor­
tant step to provide support to the domestic economy.
Except for the short-lived recovery late in August,
the mark continued to decline through early November.
Although the mark’s continuing weakness during the
fall reflected in part the overall strength of the dollar,
the situation at home also contributed. The market’s
expectation that the German authorities would take
advantage of any opportunity to cut interest rates in

64

FRBNY Quarterly Review/Spring 1983




Germany was confirmed by the Bundesbank’s action
of late August. The renewed drop in economic activity
was a source of discouragement in Germany and was
reflected in a rise in unemployment close to the psy­
chologically important two million level for September.
In October, the government recognized that the weak
performance of the economy would necessitate revi­
sion of the government’s budget forecasts, and debate
intensified over the choice to accept a larger than ex­
pected deficit or to cut welfare expenditures drasti­
cally. The Bundesbank continued to ease monetary
conditions after interest rates abroad moved lower and
adverse interest differentials began to narrow. Effective
October 1, it reduced banks’ minimum reserve require­
ments, thereby releasing about DM 5.5 billion of liquid­
ity on a permanent basis. Effective October 22, the
Bundesbank cut its discount and Lombard rates, both
by 1 percentage point to 6 percent and 7 percent, re­
spectively.
Thus the mark remained under fairly steady down­
ward pressure against the dollar. It fell to DM 2.6050
in European trading on November 11, shortly after
news of the death of Soviet President Brezhnev, down
nearly 8 percent from its highs touched in late August.
Operating on two occasions early in October when
the mark fell abruptly in unsettled market conditions
through the low levels of early August, the U.S. au­
thorities purchased a total of $40 million equivalent
of marks, shared equally between the Federal Reserve
and the U.S. Treasury.
In mid-November, when the demand for dollardenominated liquidity subsided and sterling came on
offer, the German mark appeared to market partici­
pants as an attractive alternative currency for invest­
ment. Germany’s current account was again improv­
ing, with most forecasters expecting balance for 1982.
The November current account registered one of the
largest surpluses on record. In addition, German banks
were no longer alone in having international exposures
which, even if an immediate problem had been di­
verted, might impinge on earnings later on. Reflecting
the more favorable outlook for the mark and declining
adverse interest differentials, German portfolio man­
agers moved quickly to shift funds out of dollars and
sterling into mark-denominated investments. Mean­
while, German exporters, who had previously post­
poned hedging their dollar receipts, moved to sell
dollars forward.
In this environment, the German mark strengthened
considerably against most currencies. Against the dol­
lar it rose steadily, surpassing by early December its
high point of August and moving to a seven-month peak
of DM 2.3295 by January 10. At this level, it was up
nearly 101/2 percent from its mid-November lows. With­

in the European Monetary System (EMS), the mark had
previously moved from the bottom of the new interven­
tion points established after the last realignment. Now,
as the dollar weakened and funds were shifted into
German marks, the mark emerged near the top of the
EMS band. As the mark strengthened, it was used in­
creasingly as an intervention currency by other EMS
countries.
After January 10, however, the mark lost some of its
gains. At this time, the dollar generally rose as signs
of a bottoming-out of the U.S. recession and the pres­
sures of large Treasury financing needs seemed to
limit prospects for further declines in U.S. interest
rates. Moreover, the outlook for the mark was clouded
by political uncertainties and capital again flowed out
of Germany. In addition, German stock and bond prices
dropped, reports circulated in the market that German
residents were moving to hedge or repay their Swissfranc liabilities, and foreign entities postponed planned
investments in Germany. At the end of January the
mark was trading at DM 2.4735, down about 6 percent
from its early-January highs and down about 1 percent
from end-July levels.
The earlier strengthening of the mark afforded an
opportunity for the Bundesbank again to reduce its
discount and Lombard rates a full percentage point to
5 and 6 percent, respectively, on December 3, while
providing liquidity to bring short-term interest rates in
line with the new Lombard rate. In addition, it an­
nounced that it would maintain the 4 to 7 percent tar­
get range for the growth of central bank money,
continuing to aim at the upper half of the range as
long as economic activity remained weak and the infla­
tion performance and external situation permitted. In
the wake of these actions, domestic money market
rates eased significantly so that, despite some further
softening in U.S. rates, the mark’s adverse interest
differential widened slightly. During January, however,
no further cuts in official interest rates were made,
though the Bundesbank raised rediscount quotas by
DM 4 billion effective February 1.
From August through January, Germany’s foreign
currency reserves were subject to diverse tendencies.
For the most part, the Bundesbank intervened only
modestly as a seller of dollars in support of the mark
throughout the period, with most of the operations
undertaken to settle imbalances at the fixings in Frank­
furt. The German authorities also acted as sellers of
German marks in modest amounts against EMS cur­
rencies and, on occasion, against .dollars to alleviate
strains within the joint float. Germany’s reserves stood
at $40.6 billion at end-January, up about $4.1 billion
on balance from the $36.5 billion end-July level.
During the period, the U.S. Treasury redeemed at




maturity $1,335.3 million equivalent of its German
mark-denominated securities. These redemptions,
which occurred on September 1 and December 14,
left the Treasury with $1,275.2 million equivalent of
mark-denominated notes (public series) outstanding.

Swiss franc
For much of the first eight months of 1982, the Swiss
franc had declined from its strong levels of late 1981
under the weight of heavy capital outflows. With Swit­
zerland’s earlier policies of restraint having moderated
inflation and the Swiss economy weakening, the Swiss
National Bank aimed at providing sufficient liquidity
to prevent any further drag on economic activity by
keeping central bank money on a 3 percent targeted
average growth path during the year. In the event, cen­
tral bank money growth had fallen short of the target
during the early months, so that fairly substantial in­
jections of liquidity were required during the spring.
Interest rates fell and rate differentials adverse to franc
placements became extremely wide. In response, for­
eign official and corporate borrowers placed heavy de­
mands on Switzerland’s capital market. These, to­
gether with other capital outflows, more than offset
the demand for Swiss francs arising from Switzerland’s
current account surplus. Consequently, by end-July,
the franc had fallen 19 percent against the dollar and
8 percent against the German mark from its peak in
the closing months of 1981. Meanwhile, Switzerland’s
foreign exchange reserves had risen to $11.8 billion,
largely reflecting the use of foreign exchange swaps
to provide liquidity to the banking system.
By early August, signs of weakness in Switzerland’s
economy were spreading. Exports, which had held up
well earlier in the year and cushioned the impact of
the recession, were falling victim to the sluggishness
of demand abroad, especially in Germany, and the
lagged effects of the franc’s appreciation the year
before. Nevertheless, market participants began to
sense that the monetary authorities might have less
leeway than before to continue forcefully to ease
monetary conditions. Inflation, which had slowed to
about 5 percent, remained stubbornly high by compari­
son with both historical experience and other indus­
trial countries. The persistence of inflation in the face
of a declining economy partly reflected the impact of
recent declines in the franc on domestic prices of
imported products. Moreover, the growth of central
bank money had begun to rise toward the authorities’
target.
As a result, the franc, while fluctuating widely
against the dollar in response to day-to-day shifts in
current and prospective money market conditions and

FRBNY Quarterly Review/Spring 1983

65

international liquidity strains, traded narrowly against
the German mark during August. Although against the
dollar the franc had declined a further 4 percent to a
low of SF 2.1650, it bounced back quickly later in the
month. Under these circum stances, the National Bank
joined with other European central banks in a con­
certed move to take advantage of the continued de­
cline in interest rates in the United States to cut raies
in their respective countries, effective August 27. But,
in view of the already low level of interest rates in
Switzerland, the National Bank cut its discount and
Lombard rates only Vz percentage point to 5 percent
and 6 V2 percent, respectively.
After late August, when all currencies were declining
against the dollar, the Swiss franc again began to fall
more rapidly than the German mark. Although short­
term interest rates in Switzerland declined less rapidly
than elsewhere, by late O ctober at 3 to 31/2 percent
they remained the lowest in all the industrialized coun­
tries. As a result, nonresidents continued to borrow
heavily in the Swiss capital markets and to convert
the proceeds to other currencies. To be sure, the at­
traction of Switzerland as a safe haven increased
during the fall, as concern deepened about the poten­

66

FRBNY Quarterly Review/Spring 1983




tial ram ifications of the growing list of international
debt problems, and Swiss financial institutions were
believed to be less threatened by liqu id ity strains than
many others. But much of the flows into Swiss banks
were into dollar-denom inated deposits. On balance,
therefore, the persistent interest-sensitive capital out­
flows continued to weigh against the franc.
As the Swiss franc resumed its decline w ith little
apparent resistance from the Swiss authorities, market
participants came to the view that the National Bank
had put p riority on achieving its monetary target for
the year and was w illing, at least w hile the Swiss
economy was weak, to accept a continued gradual
decline of the franc, especially against the mark. On
O ctober 22, however, the Swiss National Bank un­
expectedly did not join other European monetary
authorities in a reduction of official lending rates. Sub­
sequently, senior officials from the Swiss National
Bank, w hile indicating concern that the recession not
be exacerbated, underscored the divergent forces
operating on monetary policy and pointed to the need
to avoid a weakening of the franc and an aggravation
of inflation. Before long, most Swiss money market
rates steadied or firmed slightly, and by early Novem­
ber the Swiss fra n c’s slide against the mark began to
slow. Against the dollar, however, the Swiss franc
continued to decline through November 8, when it hit
a five-year low of SF 2.2410. By this tim e the franc was
71/2 percent down from end-July levels vis-a-vis the
dollar and at SF 0.86, down 1 percent against the mark.
Following the shift in sentiment against the dollar
around mid-November, the franc rebounded more
strongly than other European currencies. As investors
sought to shift funds out of dollars and to a lesser
degree also out of German marks, Sw itzerland’s tra d i­
tional role as a safe haven and its relative political
stability made the Swiss franc an attractive alternative.
Unlike most countries, Switzerland had a sizable cur­
rent account surplus, buoyed by investment income
and tourist receipts. The Swiss governm ent’s fiscal
discipline compared favorably with the experience of
most other countries. Renewed tensions in the EMS
prompted some sw itching of funds out of participating
currencies and into the franc. Also, m arket participants
came less to expect further easing of monetary policy.
The Swiss National Bank had kept the same 3 percent
growth target for central bank money fo r 1983 as in
1982. Although it again lowered official lending rates on
December 3 in coordination with sim ilar measures by
other European central banks, the V2 percentage point
declines of the bank rate to 41/2 percent and of the
Lombard rate to 6 percent were again less than those
abroad. The authorities were anxious to keep official
lending rates above m arket rates in order to control

better the level of liquidity over month ends and, with
the approach of the im portant end-December report­
ing date, banks were positioning to ensure adequate
levels of cash resources in Swiss francs.
As a result, during December and early January the
Swiss currency came into strong demand in the ex­
changes. As the fra n c’s rise continued and as the
dollar depreciated against all currencies, market par­
ticipants began to w orry that much of the earlier
borrowings in the Swiss capital markets remained un­
hedged. Therefore, they came increasingly to expect
that, if the dollar were to continue to decline, earlier
borrowers of Swiss francs would bid fo r francs to
cover their liabilities. Thus, the upward potential for
the franc was seen as greater than for most other
currencies, prompting m arket professionals and par­
ticipants on C hicago’s IMM to take substantial long
franc positions. The franc came strongly in demand
in the exchanges, rising to SF 1.9150 on January 10
against the dollar, up 141/2 percent from its November
lows. Against the mark, which was undermined by
p olitical uncertainties and expectations that the Bun­
desbank would again lower official rates, the franc
rose to SF 0.8144 on January 21, up almost 5Vz percent
since early November.
After mid-January, the Swiss franc pared back some
of its gains first against the dollar and then against
the German mark as well. Money market conditions
in Switzerland remained comfortable, and interest
rates continued to ease, dropping below 3 percent for
three-month Euro-Swiss franc deposits. Though the
interest differentials adverse to the franc were not so
w ide as they had been in mid-1982, the low level of
rates continued to provide an inducement to borrow ­
ers to raise funds in Swiss francs. As a result, the
franc eased back to trade by the end of January at
SF 2.0250 against the d ollar and SF 0.8187 against
the mark. At these levels the franc was down nearly
6 percent against the dollar from its earlier January
highs and Vz percent lower against the mark.
Nevertheless, on balance fo r the six-month period
under review, the franc rose 2Vi percent against
the dollar and 4 percent against the mark to stand
near its record high on a trade-weighted basis. Be­
tween end-July and end-January, Sw itzerland’s foreign
exchange reserves rose $368 m illion to $12.2 billion
in response to foreign currency swap operations, in­
terest earnings on outstanding reserves, and net mar­
ket purchases of dollars in intervention operations.
Intervention by the authorities was infrequent and
limited for the most part to replenishing reserves
which had been run down by earlier sales to cus­
tomers.
On January 26 the United States Treasury redeemed




at m aturity franc-denom inated securities equivalent to
$458.5 m illion, thereby com pleting the redem ption of
franc-denom inated securities totaling the equivalent
of $1,203.0 m illion issued in connection with the dollarsupport program of November 1978.

Sterling

Coming into the period, sterling was trading steadily
against other European currencies and declining
against the dollar. At end-July the pound was holding
around 91.5, according to the Bank of England’s tradeweighted effective index, but had eased to $1.7475
against the dollar.
Sentiment toward the pound reflected in part market
confidence in the Thatcher governm ent’s resolve to
maintain the stringent financial policies that were al­
ready seen to be producing results. The growth of the
monetary aggregates had slowed to the governm ent’s
8 to 12 percent target range. Inflation had decelerated
to below double-digit rates. And the borrowing require­
ment of the public sector was declining and apparently
falling short of the £91/2 billion rate projected for the
current fiscal year. To be sure, disappointm ent had
deepened about the prospects that Britain would sus-

C hart 6

U nited Kingdom
M o ve m e n ts in e x c h a n g e ra te and o ffic ia l
fo re ig n c u rre n c y re s e rv e s
D o lla rs p e r po u n d

B illio n s o f d o lla rs

0.6
0.4

0.2

0
0.2

-

-0 .4

J

F M A M J

J
1982

A

S

O

N

D

J

-

0.6

-

0.8

-

1.0

F
1983

See fo o tn o te s on C h a rts 3 and 4.

FRBNY Quarterly Review/Spring 1983

67

tain a recovery from its protracted recession, as evi­
dence accumulated that output had posted little gain
from its low point of 1981. But progress on infla­
tion, the fiscal situation, and monetary control, together
with the decline of interest rates abroad and sterling’s
stability as measured by the trade-weighted index,
were seen in the market as conditions which would
permit a further cautious easing of interest rates and
help stimulate the economy.
Additional factors also helped sustain sterling rela­
tive to most other currencies during the late summer
and early fall. There were worries over potential dis­
ruption to the flow of oil from the Middle East as the
result of fighting in Lebanon and between Iran and Iraq.
More important, intensifying financial strains and grow­
ing concerns over international credit exposures made
traders and investors more conscious about the credit­
worthiness of counterparties and the safety of their
assets. In these circumstances, both Britain’s oil selfsufficiency and the favorable reputation of London’s
financial system made sterling a relatively secure asset.
With the market expecting British interest rates to ease
— but to ease more gradually than in many other coun­
tries— investment funds were attracted to London to
take advantage of the perceived potential for capital
gains. By late October a major rally had become estab­
lished in the market for United Kingdom government
securities and successive records were being set in
British indexes of stock prices, attracting further capital
inflows.
These factors did not prevent sterling from easing
further against the dollar which was buoyed even more
than the pound by concern over liquidity strains. By
end-October, sterling had moved irregularly lower by
41/2 percent to $1.6725. But, against other currencies,
the pound held steady or even strengthened so that,
in trade-weighted terms, it rose to 92.5 by endOctober. The Bank of England’s intervention opera­
tions were only partly reflected in the three-month
$93 million increase in foreign exchange reserves
from July’s level of $10.88 billion.
As the autumn progressed, however, concern inten­
sified about the outlook for the economy. Neither con­
sumption nor investment had gained during the early
part of the year as had been expected and, with the
shakeout of labor continuing, the unemployment rate
took a sudden jump to 14 percent in September.
As market participants perceived a possible shifting
from the policy requirements of fighting inflation to those
of rekindling economic growth, currencies thought to be
overvalued came under suspicion. Meanwhile, a boom
in retail sales led to fears that rising imports might
contribute to a deterioration in the British foreign trade
balance. Although actual trade figures published to­

68

FRBNY Quarterly Review/Spring 1983




ward the end of the year did not show any such de­
terioration, attention was drawn to a government
forecast that Britain’s current account surplus, which
mainly reflected oil exports, would disappear by 1983.
Consequently, considerable commentary focused on
Britain’s competitive position, all the more so after the
Scandinavian devaluations in early October.
The government argued that the problems of un­
employment and competitiveness were closely linked:
improvement of Britain’s trade position required both
continued progress on inflation and more rapid decel­
eration of pay increases. But critics of government
policy argued that, despite the recent moderation of
labor costs, deceleration of inflation, and depreciation
of the pound, British industry over a period of several
years had suffered a considerable net loss of compet­
itive position, ground that would be difficult to make up
in the future since inflation and productivity were also
improving in competitor countries. Early in November,
the Confederation of British Industry proposed a major
program to create jobs and stimulate the economy,
including a sharp cut in interest rates. Some industri­
alists continued to advocate overt government mea­
sures to devalue sterling by 5 to 10 percent. These
proposals, coming from a group thought to support
the Thatcher program, brought the government’s politi­
cal support into question.
In mid-November, the Chancellor presented a mid­
year budget review in which limited fiscal measures
were announced to make up for some of the shortfalls
in government expenditures and the public-sector bor­
rowing requirement. In this way the government at­
tempted to counteract the tendency for fiscal policy
to be more restrictive than intended, aiming new
actions at the need to increase the competitiveness
of the corporate sector. The accompanying economic
projection, however, pointed to a continuing deteriora­
tion in Britain’s current account, largely because any
modest recovery or buildup of inventories was ex­
pected to give strong stimulus to manufacturing im­
ports. In the Parliamentary discussion, government
officials deflected proposals for explicit action to de­
value sterling. But reports that appeared in the press
over the November 13-14 weekend left market partici­
pants with the clear impression that the British gov­
ernment would prefer a lower, more competitive ex­
change rate for the pound.
After that weekend, sentiment toward sterling turned
decidedly bearish. Foreign investors and British resi­
dents, including large institutional investors, began to
shift funds out of longer term sterling-denominated
securities and into assets denominated in other cur­
rencies, taking profits from the recent sharp price ap­
preciation in the London capital market. The pound

also came under broad-based selling pressure from
m arket professionals, corporations, and traders on
the IMM. Against the dollar the pound fell to $1.5950
by November 17, w hile in trade-weighted terms it
dropped to 87.8.
Several days after the sharp break in the sterling
rate, United Kingdom money m arket interest rates rose,
British banks raised their base lending rates by 1 per­
centage point or more, and the Bank of England then
increased its own dealing rates to reflect the rise.
Thereafter, sterling recovered somewhat to trade
against the dollar around $1.6332 by end-November.
But it had broken stride against other currencies which
now were rising against the dollar.
The m arket fo r sterling remained unsettled during
December. By then, the Labor Party had issued its
own policy recommendations, calling for a sharp ac­
celeration in public spending, substantially lower inter­
est rates, and a 30 percent devaluation of the pound
over two years. In addition, there was increasing talk
that oil prices m ight decline substantially, raising the
possibility of sharply reduced oil-export receipts and
government revenues. Investment funds continued to
be shifted out of sterling assets, despite a further
w idening of interest rate differentials favoring the
pound. In effective terms, sterling declined.
Against the dollar, however, sterling traded w ithout
clear direction until early January, when the pound
turned lower once again. Although the Bank of En­
gland’s intervention during December had been de­
tected in the market, publication in early January of
December’s official reserves, showing a decline slightly
in excess of $1 billion, was a surprise. Political ele­
ments also played a role in shaping sentiment, first
when strains developed between the United Kingdom
and several Middle East oil-producing nations over the
Palestine Liberation Organization issue and then as
some observers predicted that the Thatcher govern­
ment would decide to call elections well before the
mandated tim e in 1984. Also, growing expectations of
a deterioration in British oil-export revenues as a con­
sequence of OPEC’s apparent failure to agree to
production quotas added to the bearish sentiment
toward sterling. Thus, the spot rate resumed its decline
against all currencies, dropping in effective term s as
low as 80.6 on January 11.
By mid-January, however, pressures on sterling
began to abate. In part, interest rate differentials
favorable to the pound had widened further follow ing
an additional rise in British banks’ base lending rates.
Also, the im pact of declines in oil revenues appeared
to have been largely discounted. Moreover, evidence
of increasing support fo r the government and reaffir­
mation of its policy approach in a white paper on




fiscal year 1983-84 expenditures helped reassure the
markets. Thus, on an effective basis, sterling steadied
to close the six-month interval at 80.9, a net decline of
111/2 percent. However, sterling continued to decline
against the dollar w hich appreciated generally after
January 10. The pound set a series of historic lows
toward the end of the month before closing near the
last of them at $1.5210. With sterling trading more
steadily on a trade-weighted basis, the Bank of En­
gland scaled back its intervention in January. Never­
theless, B ritain’s reserves declined by $1.8 billion
during the three months of November to January to
close at $9.2 billion.

French franc
The French franc was trading firm ly near the top of
the EMS as the period opened, although at FF 6.8025
it was declining to successive lows against the dollar.
The franc had moved to the upper portion of the jo in t
float after its mid-June devaluation, supported by strin­
gent foreign exchange controls and w ide favorable
interest differentials over most other European cur­
rencies. But reflows which in the past had often fo l-

FRBNY Quarterly Review/Spring 1983

69

lowed such devaluations proved in this instance to be
relatively modest, thus limiting the authorities’ scope
to rebuild reserves or to lower domestic interest rates
in an effort to stimulate economic recovery. This cau­
tious response reflected market participants’ concern
that the franc’s new EMS parity rates might not be
sustainable in light of France’s inflation and its rapidly
rising budget and current account deficits.
Inflation in France remained over 10 percent at
midyear in contrast to other industrial countries, espe­
cially Germany. Although at the time of the June EMS
realignment, the French government froze wages and
prices for four months, and price and wage increases
dropped significantly during the summer, many antici­
pated pressure for “catch up” increases when the
scheme expired at the end of October. Governmental
efforts pressing both employers and unions to accept
voluntary price restrictions to replace the freeze met
opposition.
Meanwhile, French economic policy had continued
to stress economic stimulus relative to inflation reduc­
tion through the spring, clouding prospects that infla­
tion differentials could be reduced soon. Even if pro­
posals made in June were adopted in the September
budget to cut expenditures and increase revenues, the
government faced a large and growing fiscal deficit
expected in fiscal 1983 to climb over 3 percent of
gross domestic product (GDP). Thus, market partici­
pants worried that inflationary fiscal pressure would
intensify just as the wage and price freeze was being
phased out.
Moreover, the French current account deficit had
increased sharply and, for the year as a whole, the
deficit more than doubled to $12 billion. The dete­
rioration reflected a steep decline in export volumes,
an acceleration of imports buoyed by domestic de­
mand pressure, and a shrinking of the invisibles sur­
plus mainly because of rising interest charges on
foreign debt.
In this context, beginning in mid-August and extend­
ing over the fall and winter months, the franc came
under intermittent bouts of pressure. Speculative sell­
ing was particularly intense before weekends, when
most EMS realignments had occurred in the past.
There was concern, not only that the franc might be
devalued within the EMS, but that it might be with­
drawn altogether from the currency arrangement or
that the French authorities might institute a two-tier
exchange rate system. By late August the franc
dropped to the middle of the EMS band, and by early
September it had moved down toward its central rate
against the German mark. The Bank of France inter­
vened frequently in the exchanges to support the
currency, selling both dollars and German marks.

FRBNY Quarterly Review/Spring 1983
Digitized for70
FRASER


During August-September France’s foreign currency
reserves declined $2.3 billion to $11 billion, and
the authorities announced a ten-year $4 billion syndi­
cated Eurocurrency line of credit to bolster reserves.
The franc remained on offer subsequently, but any
further decline of the franc against the mark was lim­
ited. Against the dollar, however, the franc declined
to a low of FF 7.3250 in November, down 7Vz percent
from its end-July level.
After the dollar turned lower in November, the franc
experienced difficulty keeping pace with the strength­
ening mark. The Bank of France stepped up its inter­
vention, especially in dollars, and the franc emerged
along with the mark in the upper portion of the EMS
band. At one point in December, however, the francmark cross rate fell to a low of FF 2.8385 which was
still, however, only Ye percent below its bilateral parity.
Meanwhile, France’s domestic economy, which had
shown modest growth during the first half of 1982,
stagnated thereafter, disappointing the authorities’
hopes of a consumer-led recovery. Real private con­
sumption spending decelerated, most categories of
investment expenditures declined, industrial production
fell further, and unemployment remained high at around
2 million. The French authorities introduced several
new measures over the fall to spur investment and
employment and had been quick to lower domestic
interest rates when it appeared that exchange market
conditions permitted. They had also announced mea­
sures to promote exports and slow imports. But at the
same time the authorities acted to contain inflationary
pressures. They introduced modified price controls
following the expiration of the freeze on November 1,
and announced in December a substantial reduction
of the 1983 M-2 growth target and a tightening of ceil­
ings for growth of bank lending. In remarks before the
National Credit Council, Finance Minister Delors stated
that monetary policy for 1983 would be geared to de­
fending the EMS parity of the franc and to continuing
the battle against inflation, while also permitting a con­
tinued decline in interest rates.
In the exchange markets, selling pressures against
the French franc faded somewhat in mid-January, as
market participants concluded that any EMS realign­
ment would not occur before French and German
elections in the spring. As the period drew to a close,
the usual month-end demand for francs emerged, en­
abling the Bank of France to scale back its interven­
tion support and make modest net purchases of dol­
lars. By end-January the franc was trading in the
upper portion of the joint float, as it had been when
the period opened. Against the dollar the franc was
trading at FF 7.0100, 3 percent lower on balance for
the period under review but some 4 percent higher

than its early-November lows. Meanwhile, France’s
foreign exchange reserves increased from the endSeptember lows to post a net $4.3 billion gain over
the six-month period to $17.6 billion.
Throughout the period, French enterprises contin­
ued to borrow in foreign markets and to convert the
loan proceeds into francs in the exchange market.
During February, Finance M inister Delors affirmed that
France’s public external debt increased during 1982
by $8.8 billion, not including the $4 billion syndicated
loan announced in September.

C hart 8

Italy
M ovem ents in e xch a n g e ra te and o ffic ia l
fo re ig n c u rre n c y re s e rv e s
L ira pe r do lla r
1100
1150

B illio ns of d o lla rs
■

1.0

Foreign c u rre n c y
___ r e s e r v e s .
m S ca le -------►

1200
1250

Italian lira

The Italian lira was trading firm ly above the narrow
EMS band at the end of July, but against the dollar
it had fallen to a new low of Lit 1,367.00. The lira sus­
tained its position in the EMS on the basis of seasonal
tourist inflows, exchange control measures introduced
earlier in the year to discourage unfavorable shifts in
leads and lags, and the attraction of high interest
rates. Since interest rates elsewhere were trending
down, differentials favorable to the lira widened and
Italian residents stepped up their borrowings abroad.
The Bank of Italy had taken advantage of the lira ’s
relative strength to rebuild foreign currency reserves
to a level of $13.9 billion by end-July.
The Bank of Italy’s policy of monetary restraint was
aimed at reducing Italy’s persistent high inflation rate,
countering the effects of seemingly uncontrollable fis­
cal deficits and preventing a sharp drop of the lira
which would exacerbate inflation. During the period
under review, the Italian economy, like others among
the industrialized countries, fell more deeply into
recession, thereby com plicating efforts to contain the
fiscal deficits. But Italy was one of the few industri­
alized countries not to experience a sharp reduction
of inflation. Indeed, the hope fo r any improvement di­
minished as proposed programs to rein in fiscal defi­
cits failed to meet parliam entary approval, leading to
successive governmental crises and, as negotiations
remained deadlocked on reforms to Italy’s wage in­
dexation system, the seal a m obile.
Consequently, the burden of fighting inflation con­
tinued to fall to the Bank of Italy, which operated to
lim it the expansion of credit and to keep liqu id ity un­
der control. During August and early September, the
high interest rates together with tourist inflows re­
mained sufficient to keep the lira firm w ithin the EMS
w hile it continued to decline against the dollar. The
lira ’s relative position w ithin the EMS permitted the
authorities to rebuild reserves and to ease short-term
dom estic interest rates to help take pressure off the
weak economy. On August 24 the monetary authorities




1300
1350
1400
1450
1500
1550
1 6 0 0 ------------------------------------------------------------------------- ----- -—
J
F M A M J
J
A S O N D J F
1982
1983
S ee fo o tn o te s on C harts 3 and 4.

lowered the discount rate and the base rate fo r ad­
vances by the central bank by 1 percentage point to
18 percent, the first change in nearly 1 1/2 years, and
the Italian Banking Association follow ed by cutting
prime rates by 1 percentage point to 20.75 percent.
But these cuts were generally more than matched by
reductions of official and m arket rates elsewhere on
the Continent so that the lira ’s w ide interest rate d if­
ferential was largely maintained.
A fter mid-September, the lira eased back w ithin the
EMS w hile continuing to fall against the dollar through
mid-November. With the lira easing and prospects
of a resolution of Italy’s fiscal and labor problems be­
coming increasingly remote, the lira became caught
up in the pressures w ithin the EMS. As rumors spread
of an imminent realignment, the lira was identified as
a candidate fo r downward adjustment, prom pting Italian
exporters to repay foreign currency debt and to shift
into lira financing. Thus, the lira eased back to within
the narrow EMS band beginning in mid-October, while
also declining to anew record low of Lit 1,489.60against
the d ollar in mid-November. The Bank of Italy tightened
dom estic credit conditions, pushing up short-term in­

FRBNY Quarterly Review/Spring 1983

71

terest rates even as comparable rates abroad were
declining. The authorities required exporters to borrow
70 percent of their financing needs in foreign curren­
cies. In addition, the Bank of Italy began to inter­
vene heavily and, in the three months of SeptemberNovember, Italy’s foreign exchange reserves dropped
$3 billion from $14.8 billion to $11.8 billion.
The firming Italian interest rates, together with the
change in sentiment toward the dollar, helped bring
the market into better balance after mid-November.
By end-December the lira had once again moved
above the narrow EMS band, a position it generally
maintained through the end of January.
Meanwhile, the pressure of the government’s huge
financing needs not only added to the strains in Italy’s
financial markets but also generated an acceleration of
total credit expansion, thereby undercutting the Bank
of Italy’s policy of monetary restraint. Accordingly, on
December 23 the authorities announced proposed
measures to improve control over money creation
in future years by shifting from administrative mech­
anisms toward monetary base control. The new sys­
tem was designed in part to force the Treasury to
compete for funds with the private sector. In the mean­
time the government proposed measures designed to
hold the 1983 borrowing requirement to Lit 70 trillion,
some 16 percent of GDP and, since it had exceeded
its legal monthly borrowing limit at the central bank,
it asked Parliament to approve a special one-year
advance.
In January, agreement was finally reached between
Italian employers and labor unions over ways to re­
form the scala m obile. It was agreed to cut automatic
inflation-linked wage increases by 15 percent and to
undertake further negotiations about the exclusion
from indexation of those elements of inflation ema­
nating from future increases in value added taxes, as
well as from exchange rate depreciation if inflation
exceeds the target rate for the year. The pact raised
hopes for reducing inflation and appeared to diminish
the threat of industrial strife by clearing the way for
negotiations over new three-year wage contracts.
Partly in response to these developments, the Bank
of Italy was able first to scale back its intervention sup­
port and subsequently to make some net dollar pur­
chases to rebuild reserves, except for a brief time in
mid-December. By end-January the lira was trading at
Lit 1,418.00, up nearly 5 percent from its November
lows. Nonetheless, over the six-month period under
review, the lira declined 3 1/2 percent against the dollar
and 21/2 percent against the mark. Meanwhile, Italy’s
foreign exchange reserves increased by $2 billion
during the last two months of the period to $13.8 billion
by end-January.


72 FRBNY Quarterly Review/Spring 1983


European Monetary System
Early in August, the currencies participating in the in­
tervention arrangement of the EMS were holding to
the pattern that first emerged from the realignment
of June 12-13. In this adjustment, the central parities
of the German mark and Dutch guilder were revalued
by 4 1/4 percent, those of the French franc and Italian
lira were devalued by 5% percent and 2% percent,
respectively, and the bilateral central rates of the re­
maining currencies were otherwise left unchanged.
Since this realignment, the Italian lira had traded above
the top of the 2 Va percent limit applied to other EMS
currencies, utilizing its freedom to trade in a wider
band. The French franc and Irish pound were near
the top of the 21/» percent band, followed closely by
the Danish krone. The Belgian franc remained near
the middle, while the German mark and Dutch guilder
traded at the bottom of the joint float.
This latest parity adjustment was the third in eight
months. Yet considerable skepticism remained that,
despite major policy adjustments in many participating
countries, there was sufficient willingness to harmo­
nize economic policies and to narrow the divergent eco­
nomic performances to permit even the new currency
structure to last. Most participating countries had
adopted some degree of restraint during preceding
years to stabilize their economies from the ravages of
inflation following the oil-price increases of the late
1970s. But substantial inflation differentials remained,
and market participants worried that extraordinarily
high rates of unemployment in some countries would
force the authorities there to compromise these efforts.
Moreover, most countries were attempting to bring
public-sector deficits under better control but with
varying degrees of success, and some found them­
selves in divisive internal debates over priorities for
economic policy. During the period under review, these
divergencies reemerged to exert strain on the currency
relationships within the EMS. But, as long as another
realignment was thought not to be imminent, modest
amounts of funds flowed back into those currencies
which offered the highest interest rates.
After mid-August, the currencies of France and
Denmark began to weaken within the EMS. Both coun­
tries had experienced above-average real growth ear­
lier in the year, boosted in part by the continuing
impact of earlier fiscal stimulus and reflected in wid­
ening trade deficits, together with persistently high
inflation. The French government had pledged fiscal
restraint and imposed a price freeze following the
mid-June realignment, but market participants still
doubted that policy priority had in fact shifted from
supporting employment to reestablishing internal and
external balance to the economy. The Danish govern­

ment was locked in parliamentary debate over budget
proposals for 1983, including expenditure cuts and tax
increases to curtail the government’s borrowing re­
quirement. When the government resigned early in
September, speculation developed that a new govern­
ment might devalue the krone. Under these circum­
stances, both currencies fell to around the midpoint
of the 214 percent band toward the end of August amid
frequent bouts of rumors that another realignment was
imminent. The pressure against the French franc sub­
sided following the government’s presentation of a
budget early in September which confirmed its deter­
mination to contain government spending. The pres­
sures against the Danish krone were renewed during
the first half of October by news of devaluations of
other Scandinavian currencies before being put to rest
by a substantial tightening of Danish monetary and
fiscal policies.
The renewed pressures against these two currencies
spread to the Belgian franc. The Belgian government
had taken forceful action earlier in the year to redress
the imbalances in Belgium’s economy by devaluation,
suspension of wage indexation, a price freeze, and fis­
cal restraint. Already some progress had become
apparent as domestic restraint began to cut into im­
ports, reducing the trade deficit. But Belgium’s huge
public-sector deficit had yet to decline in the face of
a weak economy, and questions remained whether the
stabilization policies would be sufficient to offset ear­
lier losses in competitiveness. Thus the Belgian franc
became identified in the rumors of realignment as a
candidate for devaluation and headed for the bottom
of the EMS band, where it traded during the entire
second half of the period under review.
Meanwhile, the German mark and Dutch guilder be­
gan to move up from the bottom of the band, partly
in response to bidding in anticipation of a further re­
alignment. In addition, both countries had compara­
tively good price and trade performance. Of the two
currencies, the guilder was the stronger just as the
Netherlands was the only participating country whose
current account was in surplus.
By mid-September, all the currencies in the narrow
band were clustered closely around the middle of the
band. This arrangement contributed to a relatively
calm mood in the European markets through October.
At this point, the French franc had eased to about
parity vis-k-vis the German mark, a relationship that
the French authorities chose to retain for the rest of
the six-month period.
Beginning late November, however, pressures within
the EMS became more frequent and intense. The Ger­
man mark was strengthening as the dollar depreci­
ated generally in the exchanges and the mark moved




quickly to the top of the EMS. The guilder had already
been trading firmly at the upper limit. Isolated at the
bottom was the Belgian franc which at times required
intervention support.
Other currencies also became subject to selling
pressures at this time. The Irish pound joined the Bel­
gian franc at the bottom of the band temporarily, after
the British pound began to drop in the exchanges from
mid-November. The French franc came on offer and
was given official support to keep pace with the Ger­
man mark while it rose within the joint float, as concern
developed in the market over the adequacy of France’s
official reserves. Also, the Italian lira weakened, falling
toward the middle of the band.
In this environment, expectations revived of an EMS
realignment to include revaluation of the German mark
and Dutch guilder against the currencies then requir­
ing frequent intervention support either at their man­
datory limits or intramarginally. Thus, from late Novem­
ber through December, there was a pattern of intense
market speculation ahead of most weekends.
These pressures eased in early January after a meet­
ing of European Community finance ministers passed
without a realignment. Thereafter, most market partici­
pants concluded that a change of official parities would
be postponed at least until after elections were held
early in March in both Germany and France. Moreover,
after mid-January the mark eased considerably against
the dollar and other EMS currencies because of politi­
cal uncertainties ahead of these elections. Even so, the
band continued to be frequently stretched to its limit
between the Dutch guilder at the top and the Belgian
franc at the bottom.
Against the dollar, the EMS currencies as a group
showed little net change over the six-month period
under review. All EMS central banks, however, took
advantage of the opportunity provided by a worldwide
decline in interest rates to reduce their own lending
rates during the period. The easing in official and
market interest rates came later and was less exten­
sive in the other countries than it was in Germany and
the Netherlands.
EMS-related intervention was undertaken fairly con­
stantly during the period and was heaviest during late
August-early October and again in late November-midJanuary. Although substantial intervention support was
conducted in EMS currencies, especially the German
mark and the Dutch guilder, sizable amounts were
also done in U.S. dollars. Official dollar sales were
particularly large, as it turned out, briefly in late August
and during the winter months— times when the dollar
was declining in the exchange markets.

FRBNY Quarterly Review/Spring 1983

73

Canadian dollar
As the period began, the Canadian dollar was recov­
ering from a protracted and deep decline. The Cana­
dian currency touched a historic low of U.S.$0.7683
(Can.$1.3016) late in June, but by the end of July
had moved up nearly 4 percent to U.S.$0.7987
(Can.$1.2520). The Canadian dollar continued rising to
about U.S.$0.8130 (Can.$1.23) in September, after which
it traded for the most part w ithin a 2 percent range
around that level for the rem ainder of the period.
The recovery and subsequent steadier performance
of the Canadian d ollar reflected the subsiding of con­
cerns that had clouded the currency’s prospects for
several years. Among these was a long-standing and
harsh debate over the appropriate priorities for eco­
nomic policy. Faced with deepening recession and
clim bing unemployment, on the one hand, and a per­
sistent double-digit inflation rate fueled by high wage
settlem ents on the other, the government chose to
retain a strong anti-inflationary posture for both fiscal
and monetary policy. The choice was convincingly
evident in a summer budget message which had called
for lim its on salary increases of government employ­
ees and price increases in federally regulated sectors
of the economy, as well as other measures designed
to brake inflation during the next two years. Moreover,
the governm ent’s initiative to restrict public-sector
wage increases was quickly adopted by some pro­
vincial governments and helped set a pattern for
private settlements. Monetary policy was also geared
to forestalling inflation, including inflationary pressure
from a further sharp decline in the Canadian dollar.
Thus, interest differentials favorable to the Canadian
currency had widened considerably, prompting Ca­
nadian provincial governments and some private con­
cerns to borrow more abroad and to convert the pro­
ceeds in the exchange market.
In addition, foreign concerns over Canada’s contro­
versial National Energy Policy had also faded. The
policy was adopted in the fall of 1980 to stim ulate
Canadian ownership and development of the nation’s
natural resources. The pace of implementation had
been significantly retarded in 1981, reducing what
had been heavy capital outflows. By mid-1982 the
government had gone further, with the Foreign Invest­
ment Review Agency cutting red tape and long delays
in processing applications in an effort to rekindle
direct private investment inflows. These develop­
ments eased m arket w orries that Canada faced an
extended reversal of the capital inflows which tra­
ditionally finance development and offset current ac­
count deficits.
Moreover, Canada’s strong trade performance bol­
stered the Canadian dollar. Exports overall held steady

74

FRBNY Quarterly Review/Spring 1983




C h a rt 9

Canada
M o vem en ts in exch a n g e ra te and o ffic ia l
fo re ig n c u rre n c y re s e rv e s
C anadian d o lla rs p e r d o lla r

B illio n s o f do lla rs

See e xch ange ra te fo o tn o te on C hart 3.

C h a rt 10

Interest Rates in the United S tates, Canada,
and the Eurodollar M arket
Th ree -m on th m a tu r itie s *
P erce nt

J

F

M

A

M

J

J

A

1982
* W e e k ly ave rage s o f d a ily rates.

S

O

N

D

J

F
1983

as shipments of automobile, grain, and energy products
remained robust enough to offset declines in demand
for other products susceptible to declining competi­
tiveness and shrinking foreign markets. Meanwhile,
imports had plummeted, reflecting weak domestic de­
mand. Canada’s current account was heading toward
surplus for 1982, the first since 1973. Just on the basis
of the first eight months of the year, Canada’s trade
surplus had cumulated to double the $5.5 billion total
for all of 1981.
Against this background the Canadian dollar con­
tinued to move up gradually from early-August levels
through the fall. However, it faltered at times when
the decline in U.S. interest rates stalled or temporarily
was reversed. The Canadian authorities were attempt­
ing to maintain a relatively smooth trend for interest
rates, so that any temporary increases in U.S. rates
resulted in a narrowing of the rate differentials favor­
able to the Canadian dollar, reawakening concerns
that the recession at home would limit the scope of
the authorities to follow should U.S. rates continue to
rise. But, at the same time, the currency gained sup­
port as evidence accumulated that the weakness of
the economy was finally showing through in a reduc­
tion of inflation and an easing of wage pressures. In
late October the government issued an economic
statement stressing its anti-inflation posture and in­
cluding only minor changes to the budget for 1982,
easing worries that significant new fiscal stimulus
would be announced. The Canadian dollar then
climbed to its highest point of the period at
U.S.$0.8213 (Can.$1.2176) on November 10, a 6V2 -month
high and a rise of some 2 1/2 percent from end-July.
With the Canadian dollar firm in the exchanges, the
Bank of Canada made substantial net purchases of
U.S. dollars during August-October. Canadian foreign
exchange reserves rose $364 million to $2.4 billion,
even though the authorities had by end-October re­
paid all the $2.4 billion drawings made by the end
of June under standby facilities with commercial
banks. Also, the government’s revolving credit agree­
ment with international banks had been enlarged by
$1 billion to $4 billion during September.
After mid-November, the Canadian dollar eased.
As a substantial deceleration of inflation in both con­
sumer prices and wage settlements became more fully
established and Canada’s external position continued
to improve, market participants became wary that the
principal justifications for high Canadian interest rates
would erode. At the same time, real GNP was reported
to have declined at an annual rate of 4 percent in the
third quarter— the fifth consecutive quarterly decline—
while the unemployment rate had climbed to a post­
depression high of 12.7 percent in October. Conse­




quently, through early December, the Canadian dollar
came off its highs, falling more than 2 percent to
U.S.$0.8029 (Can.$1.2455), even as the U.S dollar was
declining against most other major currencies.
Beginning early in December, however, the Canadian
dollar steadied. Bank of Canada Governor Bouey force­
fully ruled out a policy of pushing interest rates lower
or depreciating the exchange rate and stressed the im­
portance of consolidating hard-won gains on the in­
flation front. With the Canadian dollar remaining gen­
erally firm through December and January, domestic
interest rates declined slightly more than those in
the United States. The Canadian dollar closed the
six-month
period
under review at U.S.$0.8086
(Can.$1.2367), down about 1% percent from its No­
vember highs but nevertheless 1 percent above its
end-July level. The Bank of Canada was a net pur­
chaser of U.S. dollars over the three months ended
in January so that Canadian foreign currency reserves
rose $475 million. Over the entire six-month period
under review, Canadian foreign currency reserves rose
$839 million to close the period at $2.9 billion.

Mexican peso
At midsummer the Mexican authorities were imple­
menting an economic program, announced in April,
designed to redress the cumulative effects of several
years of large fiscal deficits and aggressive industriali­
zation efforts, slowing oil-export revenues, and heavy
servicing costs on Mexico’s large external debt. Al­
though the peso had been allowed to depreciate to
Mex.$49 by end-July from around Mex.$27 six months
earlier, and other measures had been taken to reduce
the fiscal and balance-of-payments deficits, concern
remained that the policy measures in place were insuf­
ficient to meet announced intentions or the problems
at hand. Commercial bank and Eurobond lending to
Mexico had dried up, significant arrears had devel­
oped in private-sector debt payments, and consider­
able private capital had flowed out of Mexico apparent­
ly in expectation of further devaluation of the peso.
In addition, Mexican foreign currency reserves had
fallen to dangerously low levels over the preceding
months. The Bank of Mexico had on three occasions
drawn on its swap line with the Federal Reserve to
meet month-end liquidity needs. The third of those
drawings was for $700 million on July 30, which was
repaid the following business day. In view of Mexico’s
worsening liquidity position and the government’s un­
dertaking to speed up implementation of its economic
program after the presidential election had been com­
pleted, the Bank of Mexico requested, and was granted
on August 4, a drawing of $700 million on its swap

FRBNY Quarterly Review/Spring 1983

75

line with the Federal Reserve to replenish reserves
while an adjustment program was worked out with the
IMF. The drawing was for three-month maturity with
possible renewal.
As part of its program, the government of Mexico
announced a series of increases in prices of basic con­
sumer goods, effective August 1, to reduce large sub­
sidies that had bloated the government’s deficit. The
prospect of a further acceleration of Mexico’s roughly
60 percent inflation rate generated a renewed surge of
capital outflows.
With exchange market pressure at an intense level,
the Mexican government announced on August 5
the introduction of a two-tier exchange system. De­
signed to avoid formal exchange controls while never­
theless channeling scarce foreign currency resources
to priority uses, a preferential rate of Mex.$49 was
established, to apply to the Mexicans’ payments of
interest and principal on public-sector and “produc­
tive” private debt, as well as for “essential” imports.
All other foreign exchange purchases were to be
executed in a free market where the peso would
float. On the inflow side, the proceeds of Mexican
exports of petroleum products and new public borrow­
ings abroad were to be converted in the “preferential”
market, the free market to receive other sources of
revenue. The free market peso rate immediately
dropped to over Mex.$70 but the capital flight con­
tinued, forcing the peso rate rapidly downward. In
response, on August 12 the authorities temporarily
closed the foreign exchange market in Mexico and
announced that henceforth any withdrawals from de­
posit accounts at Mexican banks denominated in
U.S. dollars (so-called Mexican dollar accounts) would
be permitted only in pesos.
Following high-level negotiations that weekend be­
tween the Mexican and the U.S. governments, the U.S.
Government arranged guarantees from the Commodity
Credit Corporation for $1 billion in private credit to
finance exports of basic foodstuffs to Mexico during
the subsequent year, as well as a $1 billion advance
payment by the Department of Energy for oil to be
added to the U.S. strategic reserves. To meet immedi­
ate cash needs, the U.S. Treasury arranged a tempo­
rary swap facility with the Mexican government for
$1 billion until August 24, the date on which the
Department of Energy advance oil payment would
be executed. A drawing of $825 million was made and
repaid under this facility. With the emergency funding
from the U.S. authorities in place, the government of
Mexico reopened the exchange market on August 19,
this time on a three-tier basis. The priority rate of
Mex.$69.50 was established to apply to withdrawals
in pesos from Mexican dollar accounts. When the mar­

76

FRBNY Quarterly Review/Spring 1983




ket reopened, the free market rate fluctuated between
Mex.$100 and Mex.$130.
Meanwhile, negotiations with the monetary authorities
of other countries proceeded, leading to the conclu­
sion, on August 30, of a $1.85 billion multilateral financ­
ing arrangement, with $925 million through the BIS,
$600 million from the U.S. Treasury, and $325 million
from the Federal Reserve. The funds provided by the
U.S. authorities were to be drawn on a p a ri passu basis
with those of the BIS. Drawings were to be provided in
line with progress toward an agreement between Mex­
ico and the IMF on an adjustment program which would
enable Mexico to qualify for drawings under the IMF’s
Extended Fund Facility.
The provision of official financing dealt with only part
of the problem. By this time, considerable worry had
developed in the international financial community that
Mexico would be unable to service its roughly $80
billion in external indebtedness, and private-sector
external finance remained difficult if not impossible to
arrange. With a heavy burden of international debt
obligations maturing in coming months, Mexico’s Sec­
retary of Finance met on August 20 with 115 financial
institutions with significant exposure to Mexico to
solicit the banks’ cooperation in accepting a ninetyday grace period, commencing August 23, in which ma­
turing loans would be renewed for ninety days at cur­
rent market rates. In return, the Mexican government
would bring all public-sector interest arrears current,
pay in full at maturity all publicly issued bonds and
notes, and develop an economic adjustment program
acceptable to the IMF. An advisory group of commer­
cial banks was established to conduct negotiations on
debt restructuring and arrange for a new financing of
$1 billion from the commercial banks. The response of
the banking community to this initiative was positive.
On September 1, however, outgoing President
Lopez Portillo surprised the international financial
community when he announced in his final state of
the nation address decisions to nationalize Mexico’s
private commercial banks, to impose formal exchange
controls, and to adjust interest rates in Mexico. Inter­
est rates on several categories of loans were reduced
significantly, while rates on small bank deposits were
increased. The new exchange controls had the effect
of eliminating the free foreign exchange market, all
transactions to be conducted at a new "preferential”
rate of Mex.$50 or an “ordinary” rate of Mex.$70. For­
eign exchange would be sold to Mexican residents at
the ordinary rate as available.
Following these initiatives, interbank trading in
pesos continued outside Mexico for a time, even
though the free peso market in Mexico was closed.
But, before long, virtually all foreign exchange receipts

other than those derived from oil exports or official
borrowings were left abroad, either to pay for imports
or to be held in liquid form. Thus, there was little
foreign exchange available through the official “ordi­
nary” rate market established under the exchange con­
trols. In addition, the overseas branches of Mexican
banks encountered considerable difficulty maintaining
interbank deposit lines, and the withdrawals at times
placed pressure on Mexican foreign exchange re­
serves. In these circumstances, the peso gradually
dropped to Mex.$125.
On November 12, the government agreed in princi­
ple with the IMF management on an economic adjust­
ment program which would, if approved by the IMF
executive directors, provide Mexico with about $3.9
billion of IMF financing over a three-year period. The
program, considerably more stringent than the April
one, called for a sharp reduction of Mexico’s fiscal
deficit as a share of gross national product, progres­
sive reduction of Mexico’s net external borrowing
though 1985, exchange rate and interest rate policies
to assure competitiveness of Mexican exports and to
promote domestic savings, and a substantially reduced
current account deficit. The program was expected to
result in a sharply lower rate of real domestic eco­
nomic growth at least through 1984. It was designed to
reduce drastically Mexico’s inflation rate then running
at nearly 100 percent, so as to build a foundation from
which Mexico could resume the stable and sustainable
real economic expansion required to service its ex­
ternal obligations and to meet domestic demands for
improved living standards. The letter of intent was
signed by the outgoing Lopez Portillo administration
but carried the full endorsement of Miguel de la Madrid,
scheduled to take office as president of Mexico on
December 1.
With the letter of intent signed only about two weeks
prior to the expiration of the ninety-day grace period on
maturing external debt obligations, the government of
Mexico asked international banks to extend the grace
period through March 23, 1983 under roughly the
same terms as before. During much of the balance of
the period under review, the government worked with
the banks on the outlines of a program for dealing
with Mexico’s external indebtedness and financing
needs through 1983, to include not only public-sector
needs but also arrears of interest payments on privatesector debts. The main elements in the proposal in­
volved restructuring about $20 billion in public-sector
debts and the raising of $5 billion of new money from
the banks to meet Mexican financial needs for 1983.
Any new funds were to be drawn in phase with the
availability of funds under the IMF agreement, i.e., sub­
ject to the condition that Mexico remain in compliance




with the economic adjustment program agreed with
the IMF. It was also envisaged that banks would main­
tain the level of their interbank deposits with Mexican
banks operating in overseas markets.
The new president, in his inaugural address, en­
dorsed the undertakings Mexico had made with the
IMF, while also indicating that the exchange controls
would be modified. On December 13 and December 20,
respectively, a presidential decree was signed and
Bank of Mexico procedures were published to establish
exchange controls intended to direct more foreign ex­
change into Mexico’s official reserves and banking
system. Toward this end, effective December 20 two
separate markets were established, one controlled and
the second free of controls. The controlled market was
to include all commercial exports, the foreign currency
costs of border trading firms, all operations with re­
spect to public and private debt, costs of diplomatic
and consular services, and contributions by Mexico to
international organizations. The Bank of Mexico spec­
ified initial buying and selling rates for the controlled
market at Mex.$95.00-95.10 with the rate to be de­
preciated steadily in line with the inflation differential
between the United States and Mexico, calculated ini­
tially at an annual rate of about 50 percent. It was
intended that over time the controlled and free market
rates would converge. The free market was intended
for all transactions not specifically eligible for the
controlled market. It was initially set up with guidance
from the central bank to facilitate an orderly opening,
the guidance to be eliminated as soon as possible.
When the market opened on December 20, the rate
was set at Mex.$148.50-150.00. The free market elimi­
nated the special border zone for foreign exchange
established in early November. After some nervous­
ness, markets settled down and the peso quotations on
the interbank market in the United States moved in line
with the free market rate in Mexico.
On December 23, 1982, the IMF announced that its
execuitve board had approved the Extended Fund Fa­
cility for Mexico, and initial drawings under the facility
were made immediately thereafter. The Bank of Mexico,
using the proceeds of these borrowings, made partial
repayment of its drawing on its regular swap line with
the Federal Reserve in December and January so that,
as of January 31, $373 million was outstanding.
For the remainder of the period under review, the
peso traded relatively quietly and narrowly in the over­
seas interbank market, quoted generally in line with
the free market rate in Mexico. Between December 20
and January 31, 1983, the free market rate in Mexico
was adjusted toward the controlled market on three
occasions to Mex.$147.90-149.40 at the close of the
period, while reflows of capital— largely from individuals

FRBNY Quarterly Review/Spring 1983

77

— permitted the Mexican commercial banks to purchase
a sizable amount of dollars in the free market through
end-January. At the same time, the controlled rate was
adjusted lower daily to Mex.$100.46, a depreciation of
51/2 percent as compared with the December 20 level.
The steadiness of the rate in the U.S. overseas inter­
bank market during this interval reflected general
market perception that the de la Madrid administration
had made an effective beginning on dealing with the
problems at hand. This positive response helped Mex­
ico husband its reserves and, by the close of the pe­
riod, a small amount of the combined $1.85 billion
U.S.-BIS credit facility remained to be drawn. Negotia­

78 FRBNY Quarterly Review/Spring 1983



tions were not yet complete on the debt restructuring
or on details of the $5 billion loan, but a total of about
$4.7 billion in new money had been pledged by banks
that were participants in those negotiations. These
matters remained of critical priority, however, as signs
of stress were accumulating in Mexico. Production
bottlenecks were widespread, due to limited availa­
bility of imported goods. In addition, commercial
banks abroad remained concerned about the need to
deal with overdue principal payments on private-sector
debt. Thus, more work remained to be done before all
necessary elements of a successful adjustment pro­
gram could be said to be in place.




NEW PUBLICATIONS
The Federal Reserve Bank of New York is pleased to
announce the recent publication of:
Foreign Exchange M arkets in the United States
by Roger M. Kubarych, Senior Vice President.
This 52-page book explores the foreign exchange mar­
ket’s structure, the types of trade and how they are
executed, comm ercial bank trading decisions, the eco­
nom ic factors that help determ ine exchange rates, and
the dynamics of rate movements. This revised volume
highlights the main changes that have taken place
since 1978 when the first edition was published.
This publication is free. The Bank reserves the right
to lim it bulk orders.

Central Banking Views on Monetary Targeting
edited by Paul Meek.
This 140-page volume is a collection of papers pre­
sented by central bank representatives from nine coun­
tries at a May 1982 meeting at the Federal Reserve
Bank of New York. The papers indicate many common
central bank concerns about monetary targeting in
recent years. This book is intended fo r economists.
A single copy is available free. Additional copies
are $7 each. For shipment outside the United States
the charge is $12. Foreign residents must pay in U.S.
dollars w ith a check or money order drawn on a U.S.
bank or its foreign branch.

A ll orders must be prepaid.
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33 Liberty Street
New York, N.Y. 10045

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'

111

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PUBLICATIONS ALSO AVAILABLE FROM
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U.S. M onetary Policy and Financial M arkets by Paul
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prehensive review of the form ulation and execution of
monetary policy. Published in late 1982, this 192-page
book examines open m arket operations w ith prim ary
emphasis on the post-O ctober 1979 period. The finan­
cial institutions and markets w ithin w hich the Federal
Reserve operates are also described.
This book is intended prim arily fo r econom ists, seri­
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financial markets, and other “ Fed w atchers” .
Single copies are available free of charge. A dditional
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selection of the published and unpublished w riting of
the third chief executive officer o f the Federal Reserve
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