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Federal
Reserve Bank of
New York
Quarterly Review
Winter 1992-93
1
Volume 17 Number 4
Corporate Refinancing in the 1990s
28
The Recent Growth of Financial
Derivative Markets
44
Assessing the Exchange Rate’s
Impact on U.S. Manufacturing
Profits
64
Recent U.S. Export Performance in
the Developing World
75
80
Treasury and Federal Reserve
Foreign Exchange Operations
November 1992-January 1993
August-October 1992
Federal Reserve Bank of New York
Quarterly Review
W inter 1992-93 Volume 17 Number 4
Table of Contents
1
Corporate Refinancing in the 1990s
Eli M. Remolona, Robert N. McCauley, Judith S. Ruud, and Frank lacono
U.S. corporations have floated stocks and bonds in unprecedented
amounts in the last year. How much have corporate treasurers reduced their
firms’ interest payments through such refinancing? After assessing the
motives for refinancing, the authors estimate the aggregate interest
savings achieved through equity issuance, bond calls, and bond sales and
compare the effectiveness of refinancing and lower short-term interest
rates in easing the interest burden on U.S. corporations’ cash flows.
28
The Recent Growth of Financial Derivative Markets
Eli M. Remolona
This article examines the reasons for the phenomenal growth of financial
derivative markets in recent years. The author shows how specific demand
forces have largely determined the direction and speed of the derivatives’
spread.
44
Assessing the Exchange Rate’s Impact on U.S. Manufacturing Profits
Juann Hung
Few studies have investigated how the large and persistent swings of the
dollar over the past two decades have affected the profits of U.S.
manufacturing firms. Using an econometric model of manufacturing profits,
this article evaluates the overall impact of exchange rate changes on
aggregate profits and the profits of exporting and import-competing
firms.
Table of Contents
64
Recent U.S. Export Performance in the Developing World
Bruce Kasman
U.S. exports to developing countries have grown remarkably in recent
years, far outpacing our sales increases to the industrial world. The author
seeks explanations for this strong performance in the traditional determi
nants of export growth— relative prices and income growth— and in other
factors linking world economic conditions to developing country demand
for U.S. goods.
Treasury and Federal Reserve Foreign Exchange Operations
75
A report for the period November 1992-January 1993.
80
A report for the period August-October 1992.
85
List of Recent Research Papers
Corporate Refinancing in
the 1990s
by Eli M. Remolona, Robert N. McCauley, Judith S. Ruud,
and Frank lacono
U.S. corporations have floated stocks and bonds in
unprecedented amounts in the past year. Private firms
going public, public firms growing fast, and mature firms
running losses have all sold shares on Wall Street. And
as long-term interest rates have dropped, corporate
treasurers have flooded underwriters with notes and
bonds even though short-term borrowing has remained
much cheaper.
Last year’s full-scale return of U.S. firms to their
traditional role as sellers of equity decisively reversed
seven extraordinary years of firms’ buying their own and
one another’s equity. After 1984 only the most conser
vative corporations refrained from increasing leverage.
Indeed, management often found it in its own interest to
pile on debt in order to discourage corporate raiders
from boot-strapping their way into the executive suite
with borrowed money.
The about-face of corporate treasurers from retiring to
floating equity in 1991-92 has caught the attention of
policymakers trying to understand the anemia in the
U.S. economy since the Gulf War. Observers have
pointed to the preoccupation of U.S. firms with reducing
debt as the chief source of the firms’ extraordinary
caution in planning fixed investment, in managing
inventories, and especially in taking on new employees.
Obsessed with the risks of debt, many firms use higher
business cash flows produced by any spending impulse
in the economy to pay down debt faster rather than to
invest or to hire. For example, the 5 percent rise in
consumer spending in the first quarter of 1992 did not
lead to a surge in production and employment.
This article looks beyond aggregate equity issuance
to identify firms selling equity and the factors motivating
them. It then assesses the progress of corporate refi
nancing by quantifying the interest savings achieved
through equity issuance, bond calls, and bond sales.
Particular attention is given to the relative effectiveness
of corporate refinancing and lower short-term interest
rates in easing the interest burden on U.S. corporations’
cash flows.
We find that surprisingly few of the corporations now
tapping equity investors are seeking funds for the pur
pose of expanding business operations. Many firms
have returned to the equity market because the debt
they took on in the late 1980s has proved difficult to
manage. When bankruptcies surged and bond investors
and banks tightened credit to highly leveraged firms,
organizers of leveraged buyouts welcomed new equity
investors. In addition, unprofitable firms, especially
industrial firms that built up finance company subsidi
aries in the 1980s, have sold equity to offset weak cash
flows and to retain their access to commercial paper
funding. Thus, much of the record financing has served
to strengthen corporate balance sheets, to unburden
cash flows of the weight of debt service, and to forestall
costly credit rating downgrades.
Our analysis further suggests that in the aggregate,
corporate refinancing has only modestly eased the
interest burden on corporate cash flows. Equity sales
and bond calls alone would have reduced the claim of
interest by 1 percent of cash flows. But because corpo
rate treasurers have replaced bank debt with tens of bil
lions of bond debt at a time when long-term rates stand
at twice short-term rates, they have given up much of
the interest savings from equity sales and bond calls.
The reduction of interest rates, rather than corporate
FRBNY Quarterly Review/Winter 1992-93
1
restructuring, has done the heavy lifting in unburdening
corporate cash flows of interest payments. Indeed,
lower rates have done ten times the job of corporate
refinancing. Put differently, corporate refinancing at its
1992 rate is lowering the interest burden of corporate
America only as much as a (permanent) 45 basis point
cut in short-term rates.
Behind the record-breaking flotation of stocks, there
fore, we find corporate treasurers trying to cope with the
debt buildup of the 1980s. Their activities in the stock
and bond markets, however, have partially offset each
other. As a result, lower short-term interest rates over
the last two years have freed up corporate cash flows
much more than the labors of corporate treasurers and
their investment bankers.
Motives fo r restructuring
Estimating how long financial restructuring will continue
requires an understanding of the short-term and long
term motives behind the process. U.S. corporations
have seized the opportunity to infuse equity into their
capital structure in 1991-92 both for cyclical reasons
and for reasons relating to the extraordinary develop
m e n ts in U .S. c o rp o ra te fin a n c e in the 1980s.
The 1991-92 period resembles 1982-83, the correspond
ing phase of the prior business cycle, in two respects:
stock prices rallied to mark the end of a recession, and
corporations, including heretofore private firms, issued
equity aggressively. But 1991-92 also differs from the
earlier period in im portant features. In the 1980s many
U.S. corporations leveraged up, and some firms rapidly
expanded into financial services through their finance
companies. These developments carried unusual risks,
which manifested themselves in 1989-90 and motivated
treasurers to delever their firms’ finances aggressively.
Cyclic influences: the 1982-83 record
Both demand- and supply-side forces contribute to the
rise in equity issuance when a recession ends. On the
demand side, stock market investors, anticipating an
upturn in the economy and an associated surge in
earnings, bid up prices relative to current earnings.
Declining interest rates reinforce the effect of higher
anticipated earnings on price-earnings ratios as inves
tors capitalize anticipated earnings at a higher rate. On
the supply side, corporate treasurers readily issue
shares into a m ore b uo yan t m a rk e t to a ug m e nt
cyclically low cash flows.
Chart 1
Gross Public Equity Issuance and Price-Earnings Ratio of the Standard & Poor’s 500 Companies
U.S. Nonfinancial Corporations
Billions of dollars at an annual rate
Price-earnings ratio
Source: Board of Governors of the Federal Reserve System.
Note: Shaded areas indicate recession periods designated by the National Bureau of Economic Research.
2
FRBNY Quarterly Review/W inter 1992-93
After the 1981-82 recession, these forces combined to
produce an unusually timed burst of equity issuance
(Chart 1) that reduced the burden of interest payments
on U.S. corporations’ cash flows. With little equity being
withdrawn through debt-financed mergers or share
repurchases, U.S. nonfinancial firms’ net equity issu
ance ran at an annual rate of $15 billion in the eighteen
months between July 1982 and December 1983. This
issuance of equity, given the high interest rates then
prevailing, saved the issuers some $3 billion in interest
payments by the fourth quarter of 1983, and sliced Vz of
1 percentage point off the ratio of interest to cash flow.
U.S. corporations’ resort to equity finance in 1991-92
bears some resemblance to equity issuance in 1982-83.
The rates of gross and net equity issuance are about
double those of the earlier period, but taking account of
economic growth and inflation in the intervening years
narrows the difference. Owing to the higher interest
rates prevailing in 1982-83, the interest saved in relation
to corporate cash flows during the earlier cycle was
comparable to that saved in the recent period. The
current surge of equity issuance is distinguishing itself,
however, by its composition and longevity, and by the
high price-earnings ratios underpinning it.
The hangover of the leveraging of the 1980s
The outsize accumulation of corporate debt in the
1980s, the greater than anticipated difficulty of servicing
it, and the resulting unprecedented pileup of business
bankruptcies have also spurred treasurers to issue
equity in the 1990s.1 After the leveraging wave of the
1980s, many managers of large U.S. firms sought pro
tection under Chapter 11 of the bankruptcy code. In
1990, the number of large company bankruptcies— that
is, those involving more than $100 million in liabilities
each— reached twenty-four and accounted for an aggre
gate of over $27 billion in liabilities (Chart 2). The
number of large filings rose in 1991 to thirty-one bank
ruptcies, although total liabilities fell off to $21 billion. In
1992, the third year of extraordinary attrition of large
companies, the number of large bankruptcies declined
sharply but the debts involved only edged down.
Our attempt to piece together a comprehensive mea
sure of default across the whole corporate sector shows
an arresting departure from the difficulties faced by
corporations in the previous business cycle. In 1982
and 1983, corporate defaults on bonds, bank loans,
finance company loans, and other liabilities reached the
range of Vz to 1 percent of liabilities and stayed there
*See Edward J. Frydl, “ Overhangs and Hangover: Coping with the
Imbalances of the 1980s,” Federal Reserve Bank of New York
Annual Report 1992-, and Edward J. Frydl, ed., Studies on
Corporate Leveraging, Federal Reserve Bank of New York,
September 1991.
through 1987 as recession rolled through the farm belt
and oil fields (Chart 3). But in 1991, the default rate
almost doubled its earlier peak.2
Evidence suggests that in 1990-92, U.S. corporations
found managing their debt in a period of weak cash
flows more difficult than anticipated. Perhaps managers
took seriously the argument that highly leveraged firms
with weak cash flows could generally reorganize their
debt without resorting to bankruptcy.3 This argument
held that creditors would grab the controls and pull
highly leveraged firms out of a nosedive while consider
able value still remained in the firm. That is, because
creditors of a very leveraged firm would, by definition,
be exposed to loss early on as the value of a firm
dropped, they would have more incentive than the cred
itors of an unlevered firm to intervene early in a troubled
firm. The argument concluded that creditors would
avoid the deadweight losses of bankruptcy by collec
tively reducing their claims without resorting to the
courts. The argument ignored the difficulty of forging an
agreement among different classes of creditors, a prob
lem that was worsened by the proliferation of creditor
classes during the leveraging boom of the 1980s.
Recent research has confirmed that the strategic
interaction of multiple classes of creditors has made it
harder for firms to manage their debt. A study of dis
tressed firms that had issued junk bonds in the 1970s
and 1980s found that the weakness of cash flow had no
power to predict Chapter 11 filings. The complexity of
the capital structure, as measured by the number of
public debt issues outstanding or the number of priority
tiers among claimants, had considerable predictive
2The numerator, nonfinancial corporate defaults, combines data from
two sources: Dun & Bradstreet’s Monthly Business Failures and First
Boston’s annual High Yield Handbook. Dun and Bradstreet’s
publication provides data on business failure liabilities (which do
not include any long-term, publicly held obligations) by industry.
The first component of nonfinancial corporate defaults consists of
Dun & Bradstreet's annual total for U.S. failure liabilities less the
annual totals for finance, insurance, real estate, and agriculture.
The second component is the difference between the total value of
bonds going into default and the defaults of bonds issued by
financial firms. First Boston’s Handbook contains the data for bond
defaults. For the years 1977-88, First Boston provides one default
total, covering the entire period, for each business sector. The
1977-88 total for financial sector defaults constituted 5.1 percent of
all defaults for the period; therefore, the value of bonds issued by
financial firms was estimated as 5.1 percent of the value of bonds
going into default each year over this period. After 1988, First
Boston gives sector totals on a year-by-year basis. Chart 3 shows
the sum of the adjusted Dun & Bradstreet and First Boston data as
a percent of the sum of total credit market instruments and total
trade debt for nonfinancial corporate business as reported in the
flow of funds data issued by the Board of Governors of the Federal
Reserve System.
3Michael C. Jensen argued that bankruptcy had been privatized in
testimony before the House Ways and Means Committee, Tax Policy
Aspects of Mergers and Acquisitions: Hearings, 100th Cong., 1st
sess. (January 31; February 1,2; March 14,15, 1989), pp. 412-14.
FRBNY Quarterly Review/Winter 1992-93
3
Chart 2
Major U.S. Corporate Bankruptcies, 1990 to 1992
Liabilities over $100 Million
1990
24 Bankruptcies
Total Liabilities = $27.8 billion
1990
| Allied/Federated Department Stores
$7.7 billion
| Continental Airlines
] National Gypsum
3 Ames Department Stores
$2.3 billion
] Integrated Resources
| Others
$1.4 billion
$0.9 billion
| Southland
$1 billionSJj $5.1 billion
1 Others
$3.4 billion
1991
31 Bankruptcies
Total Liabilities = $21.0 billion
$2.3 bil';—
Pan American
$2.7 billion
Columbia Gas
$1.4 billion
$1.8 billion
$1.3 billion
Carter Hawley Hale Stores
America West Airlines
$2 billion
$1 billion
Hills Department Stores
Others
Interco
Others
1992
17 Bankruptcies
Total Liabilities = $18.8 billion
$2.2 billion
U IIIIU II^—
1992
R.H. Macy & Company
^
Zale
$2.1 billion
Wang
El Paso Electric
$1.2 billion 6
m
$1.1 billion
Phar-Mor
$2.2 billion
Others
Memorex Telex
$2
b illio n ^
$2.4 billion
Note: Separated portion of each pie represents prepackaged bankruptcies.
4
FRBNY Quarterly Review/W inter 1992-93
Others
power, however.4 Junk bond issuers and their invest
ment bankers appear to have misjudged how multiple
creditor classes would jinx workouts in the event of
distress.
The rise of the prepackaged bankruptcy (Chart 2)
attests to the difficulty of achieving the near-unanimity
among creditors necessary for less costly debt restruc
turings outside of bankruptcy. When a leveraged firm
with a complex debt structure encounters difficulty in
servicing its debt, bondholders are asked to exchange
their claims for new ones that can more readily be
serviced. When too many creditors in one or more
classes hold out, blocking the restructuring, the firm
enters bankruptcy with a prepackaged plan of reorgani
zation that can be enforced under the bankruptcy
c o u rt’s m a jo rity rule p ro visio ns. Although the pre
packaged bankruptcy may force a minority of holdouts
to accept a deal, it nevertheless burdens firms with
4Paul Asquith, Robert Gertner, and David Scharfstein, "Anatomy of
Financial Distress: An Examination of Junk Bond Issuers,”
unpublished paper, July 1992.
legal costs and disrupts business relations.
In response, perhaps, to accumulating experience,
corporate treasurers gave signs as early as mid-1989
that they were backing away from borrowing and share
repurchasing as strategies for boosting th eir share
prices. A survey conducted then of 118 firms with reve
nues in excess of $1 billion listed strategies for creating
shareholder value in three categories and asked which
ones the firms had pursued in the past and which they
were currently contem plating.5 In the capital structure
category, 66 had chosen to “expand utilization of debt in
capital structure” but, going forward, only 45 contemplated
so doing. Similar reactions to “inaugurate/expand a share
repurchase program” were recorded: 63 had pursued this
course but only 46 foresaw so doing. The author of the
survey concluded, “surprisingly, interest in reducing the cost
of capital through expanding the use of leverage is waning.
And less reliance is being placed on stock repurchase
programs as a future avenue to enhance value.” The record
of defaults makes the change of attitude on the part of
corporate treasurers unsurprising.
Firms with m ajor finance com panies and access to
com m ercial paper
Chart 3
Nonfinancial Corporate Defaults as a Share of
Total Liabilities
Percent
Sources: Dun & Bradstreet, Monthly Business Failures; First
Boston, High Yield Handbook; Board of Governors of the
Federal Reserve System, Flow of Funds data; Federal Reserve
Bank of New York staff estimates.
Notes: Estimate for 1992 annualizes total high-yield defaults as
of June 1992 as well as current failure liabilities and total
liabilities as of 1992-111. Defaults combine Dun & Bradstreet
"failure liabilities" and First Boston bond defaults by nonfinancial
firms. For the years 1977-88, financial sector defaults are
assumed constant at 5.1 percent of total bond defaults.
Another important reason for the extraordinary current
burst of equity issuance is the need felt by a m inority of
industrial and commercial firms to buttress the balance
sheet condition of their finance com pany affiliates.
Finance company balance sheets generally grew faster
than the economy in the 1980s, and finance companies
owned by industrial firms tended to grow faster than
their parent firm s.6 At the same time, finance com pa
nies’ reliance on credit markets for funds increased in
the 1980s. These developments combined to heighten
the importance of retaining a high credit rating to keep
access to the most credit-sensitive bond portfolios and,
critically, to the commercial paper market.
C hrysler’s experience illustrates the costs of a credit
dow ngrade. W hen C h ry s le r F in a n c ia l’s co m m ercial
paper was downgraded to the second tier of prime, the
firm had to turn to its banks for financing, at an imm edi
ate cost of something like Vfe of 1 percentage point on
the funds form erly raised from the commercial paper
market. And when it came time for C hrysler to renegoti
ate its bank credit, the cost rose even further. The
lesson was not lost on other financially strained firms
with finance company affiliates.
5Allen J. Schneider, “ How Top Companies Create Shareholder
Value," Financial Executive, May-June 1990, p. 38. Precise data
from the survey were provided by Schneider.
6See Eli M. Remolona and Kurt Wulfekuhler, "Finance Companies,
Bank Competition, and Niche Markets," this Quarterly Review,
vol. 17 (Summer 1992), pp. 25-38.
FRBNY Q uarterly R eview/W inter 1992-93
5
Tighter supply of cre d it fo r heavily leveraged firms
The junk bond m arket’s seizure in late 1989 not only
elim inated a source of leveraged finance but also
increased the incentive for equity issuance owing to the
structure of outstanding junk bonds. The largest lever
aged buyout, that of RJR Nabisco, provides a telling
example. Part of its debt consisted of so-called reset
notes. This instrument promised to trade close to par
owing to the periodic resetting of its interest rate. In late
1989, however, with junk bonds selling at a deep dis
count, the interest rate required at reset threatened to
climb so high that it would push the firm into default.
The need to refinance these notes spurred the issuance
of equity by RJR Nabisco in February and April of 1991.
In short, engineered into the stock of junk bonds were
features that presumed the junk bond m arket’s health;7
that m arket’s malady forced leveraged companies to
resort to unexpected equity issuance.
The crisis in the junk bond market was reinforced by
the tightening of bank credit in 1990. Banks with sub
stantial claims on troubled real estate projects, as well
as undercapitalized or downgraded banks, started to
restrict commercial and industrial loans.8 For compa7See Andrew E. Kimball and Jerome S. Fons, "Coupon Events in
1991," Moody's Investor Service, February 1, 1991.
8Ronald Johnson, "The Bank Credit ‘Crumble,’" this Quarterly
Review, vol. 16 (Summer 1991), pp. 40-51.
nies seeking loans, this tightening of bank credit meant
wider spreads over banks’ cost of funds, stiffer collat
eral requirements, and in some cases sheer difficulty in
obtaining funds. Equity finance then became more
attractive on grounds of price and availability.
U.S. corporation s’ return to net issuance of equity
Through mergers and acquisitions, leveraged buyouts,
and share repurchases, U.S. nonfinancial corporations
removed more equity from the stock m arket than they
issued into it from 1984 to 1990 (Charts 4 and 5). During
that seven-year period, a net $640 billion dollars of
equity was retired. Net retirements peaked at an annual
rate of almost $200 billion, or about 7.5 percent of the
total outstanding equity, in the fourth quarter of 1988.9
Positive net issuance returned in the second quarter
of 1991 and totaled $18.3 billion for the year. For the first
three quarters of 1992, U.S. nonfinancial corporations
issued equity at a $31 billion dollar annual rate. This
sum reflects not only a surge in gross new issuance but
also a decline in debt-financed m ergers and acquisi
tions, including a virtual disappearance of the lever
aged buyout, and much-reduced share repurchasing.
We first consider briefly the falloff in equity retirement
through mergers and repurchases, and then take a
9For a detailed analysis of equity retirements in the 1980s, see
Margaret Pickering, “A Review of Recent Corporate Restructuring
Activity, 1980-90,” Board of Governors of the Federal Reserve
System, Staff Study no. 161, May 1991.
Chart 4
Net Equity Issuance by U.S. Nonfinancial Corporations
Billions of dollars
Sources: Board of Governors of the Federal Reserve System, Flow of Funds data; Federal Reserve Bank of New York staff estimates.
6
FRBNY Quarterly Review/W inter 1992-93
close look at the extent and nature of equity issuance.
U.S. co rpo ra tion s’ slackened retirem ent of equity
As U.S. corporations chip away at the overhang of debt
built up in the late 1980s, the pace of decapitalization
through mergers and acquisitions has slowed to rates
observed before the break in behavior in 1984. By
contrast, share repurchases, while also much reduced,
give evidence of becoming a more enduring means of
managing leverage and putting cash into shareholders’
hands.
D ebt-financed m ergers and acquisitions
High share prices and tight credit for leveraged deals
have curbed mergers and acquisitions involving the
replacement of equity by debt. Well-capitalized firms
account for much of the remaining merger activity, and
with share prices high, treasurers are more inclined to
use share exchanges in mergers. For example, ATT has
paid for its acquisition of NCR with shares.
Leveraged buyouts. In a leveraged buyout (LBO), a
small investor group, typically consisting of an LBO firm
and a management team, takes on a large amount of
debt to purchase the public equity of a company. In the
largest and most publicized transactions of this type, a
public corporation is taken private. Between 1984 and
1990, over 18,000 U.S. nonfinancial corporations under
went leveraged buyouts, and the total dollar value of
these deals exceeded $250 billion (Chart 6). Of this
sum, approximately $165 billion in equity, or about twothirds of the total, was replaced with debt or otherwise
retired.10
Since the peak in 1989, LBO activity has fallen off
sharply— the result of a collapse in the junk bond mar
ket, the tightening of bank credit, and the surge in the
ratio of stock prices to earnings or, more important,
stock prices to cash flow. Transaction volume in 1990
was comparable to that in 1984 and 1985, but much less
equity was retired in 1990 than in those earlier years. In
the first half of 1992, the dollar value of LBO transac
tions was about $2.3 billion; at this pace, LBOs in 1992
amounted to only 7 percent of the 1989 level. Moreover,
the deals appear to be somewhat less leveraged than
they used to be, probably for the same reasons that
explain the fall in activity. LBO activity is estimated to
have retired about $1 billion in equity in 1992.
10Pickering, “A Review,” p. 2.
Chart 6
Chart 5
Components of Net Equity Issuance by
U.S. Nonfinancial Corporations
Billions of dollars
Equity Retired by U.S. Nonfinancial Corporations
through Leveraged Buyouts
Billions of dollars
80
100
Total transaction value
70
60
Gross issuance
Stock repurchases
Leveraged
buyouts
Other mergers and
acquisitions
50
40
30
20
10
0
Sources: Margaret Pickering, "A Review of Corporate
Restructuring Activity, 1980-90," Board of Governors of the
Federal Reserve System, Staff Study no. 161, May 1991;
Board of Governors of the Federal Reserve System.
1981 82
83
84
85
86
87
88
89
90
91
92
Sources: Securities Data Company; Board of Governors of the
Federal Reserve System.
FRBNY Quarterly R eview/W inter 1992-93
7
Other acquisitions. The total dollar volume of non-LBO
mergers and acquisitions of U.S. nonfinancial corpora
tions exceeded $1.2 trillion between 1984 and 1990
(Chart 7). Of this total, about $420 billion of equity, or
roughly one-third, was retired.11 Mergers and acquisi
tions other than LBOs have fallen off since 1989, though
not as sharply as LBOs. Like LBOs, other mergers and
acquisitions are now relying less on debt for their
financing. Equity retirements from non-LBO mergers
and acquisitions are estimated at $11 billion to $12
billion in 1992.
Stock repurchases
Share repurchases took off in 1984 as a defense
against takeovers but give evidence of having found a
broader, m ore la s tin g role in c o rp o ra te fin a n c e .
R epurchases, m ostly q uiet m arket o p e ra tion s but
sometimes tender offers and occasionally greenmail at
above-market prices, jumped from less than $10 billion
per year in 1983 to $35 billion to $45 billion in 1984-90
"Pickering, “A Review,” p. 2.
Chart 7
Equity Retired by U.S. Nonfinancial Corporations
through Mergers and Acquisitions
Billions of dollars
(Chart 8). By 1991, however, defensive repurchases had
become rare. Still, such disparate firms as Philip Morris
and General Dynamics, apparently enjoying stronger
cash flows than investm ent prospects, continue to
repurchase shares in quantity to put cash in the hands
of shareholders and to manage their leverage.
U.S. corporation s’ record flotation of new equity
U.S. corporations are taking advantage of the relatively
high valuation of current earnings in the stock market.
U.S. nonfinancial corporations issued $45 billion of new
equity in the public markets in 1991 and $48 billion in
1992. The rate of equity issuance appears to have
responded promptly to the m arket’s valuation of a given
stream of earnings (Chart 1). In particular, surges in
gross equity issuance coincided with rising price-earnings ratios in 1982-83, 1985-87, and 1991-92. Both sea
soned public corporations and firms issuing public stock
for the first time (commonly termed initial public offer
ings or IPOs) tend to time their offerings to receive the
most favorable prices for their shares.
While rising valuations have supported heavy stock
issuance both in this cycle and in many previous ones,
forestalling financial distress has emerged as a new
motive in the recent surge of stock issuance. The spate of
reverse LBOs (IPOs that partially unwind the high lever
age of earlier LBO deals) and the heavy volume of both
common and preferred share issues by firms running
losses set the 1991-92 cycle apart from earlier cycles.
Chart 8
Stock Repurchases by U.S. Nonfinancial
Corporations
Billions of dollars
Sources: Securities Data Company; Board of Governors of the
Federal Reserve System.
Notes: Acquisitions exclude leveraged buyouts but include asset
takeovers and partial takeovers.
8
FRBNY Quarterly Review/W inter 1992-93
Source: Board of Governors of the Federal Reserve System.
Ordinary IPOs
Gross proceeds of initial public offerings reached $16.5
billion in 1991 and a record $24 billion in 1992; ordinary
IPOs (as opposed to reverse LBOs) accounted for $9
billion in 1991 and $18 billion in 1992 (Chart 9).
Even within a record year, the tim ing of IPOs closely
tracked the market. Thus, IPO issuance stalled midyear
owing to the weak performance of recent IPOs and
growth stocks in general, as measured by the NASDAQ
index (Chart 10). Consequently, many firms postponed,
canceled, or repriced their offerings. IPOs surged after
the election in November, when small and m edium
sized firms’ share prices jumped.
IPOs are generally thought to provide growing corpo
rations with new funds for expansion and to offer private
investors, such as venture capitalists and top m anage
ment, a means of liquidating their holdings. An analysis
of IPOs, excluding reverse LBOs, by U.S. nonfinancial
corporations in 1991 and the first half of 1992 confirms
this conventional view (Chart 11).12 About 31 percent of
Chart 9
Gross Proceeds of Initial Public Offerings and
Reverse Leveraged Buyouts
Excluding Closed-End-Fund Initial Public Offerings
Billions of dollars
25
1980 81
82
83
84
85
86
87
88
89
90
91
92
12We computed the allocation of proceeds by obtaining from
Securities Data Company the following items for each offering—
gross proceeds, offering price, underwriting spread, legal and
administrative expenses, the number of primary shares, and a
listing of the use of proceeds. We first determined expenses of the
Source: Securities Data Company.
Chart 10
Stock Price Performance
NASDAQ and S&P 500 Indexes
December 27, 1989 = 100
150
NASDAQ A /
140
130
120
110
A
\v
T
a /- ^
*
i
n/
^
S&P 500
/ " 7 s*'
/X
//
/ /
100
90
. A
v v/ /
V J
80
70
l i i l i i i l i i i i l i j L i i i i l i i i i l i i i l i i i i l m l m m i i l i i i m i I i i i I i i i I i i m I m i I m i I i m i I i i i I i i i i I i i i I im I i i i i l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l H I
J F
M A M J
J A S O N D J F M A M J
J A S O N D J F M A M J J
A S O N D
1990
1991
1992
Sources: Wall Street Journal, New York Times, Standard & Poor’s Corporation.
FRBNY Q uarterly Review/W inter 1992-93
9
Footnote 12 (continued)
offering by adding legal and administrative expenses to the product
of the gross proceeds and the underwriting spread, expressed as a
percentage of the offering price. These expenses were assumed to
be allocated pro rata among the primary and secondary
components of the offering. Next we determined the net primary
proceeds by multiplying the number of primary shares by the
Footnote 12 (continued)
offering price and subtracting the portion of expenses that was
allocated to the primary component. Net secondary proceeds were
determined by subtracting expenses and net primary proceeds
from gross proceeds. Lastly, we allocated net primary proceeds
evenly among the primary uses listed Therefore, if an offering with
net primary proceeds of $100 million had listed "general corporate
Chart 11
Uses of Proceeds from Public Stock Offerings by U.S. Nonfinancial Corporations
1991 - June 1992
117 Reverse Leveraged Buyouts
$12.3 billion
519 Initial Public Offerings
$20.4 billion
$0.25 billion
2%
\
$0.39 billion
3%
Top Fifty Equity Offerings Excluding
Initial Public Offerings
$30.3 billion
General purposes
Expenses
Secondary offerings (represents shareholders' sales of stock)
Share repurchase or acquisition
$1.00 billion
3%
Refinancing of other debt
Refinancing of bank debt
\
$0.39 billion
1%
Source: Securities Data Company.
Note: Grey-shaded areas represent portion of proceeds devoted to refinancing.
FRBNY Quarterly Review/W inter 1992-93
Digitized for10
FRASER
gross proceeds were reportedly devoted to “general
purposes,” which includes new hiring and investment in
new plant and equipment. About 28 percent of the
offering value was “ secondary,” meaning that this frac
tion of the proceeds took out existing shareholders and
thus was not available to the offering firms. In addition,
about 28 percent of the proceeds went towards the
retirement of debt (deleveraging).
Reverse LBOs
Reverse LBOs are distinguished from ordinary IPOs by
more than the financial history of the issuer. The pro
ceeds of the $7.5 billion raised in 1991 and the $6 billion
raised in 1992 from reverse LBOs served very different
purposes than the funds raised by ordinary IPOs. Only
2 percent went to general purposes, while almost threequarters went to pay down debt. These observations
confirm that the primary motivation for IPOs by LBO
companies is the retirement of debt taken on in going
private.
It was probably not the original intent of those taking
companies private via LBOs to reverse them under the
circumstances in which many such companies found
themselves during the early nineties. Earlier reverse
LBOs— such as that of Gibson Greeting Cards in
1983— cashed out the existing LBO partners. In recent
reverse LBOs, by contrast, little of the proceeds was
used to cash out existing shareholders. In particular,
only 16 percent of the proceeds went to existing share
holders on average— much less than for regular IPOs or
for the more successful LBOs in the past. Difficulties in
meeting debt payments, in refinancing junk bonds, and
in selling assets at planned prices, combined with a
window of opportunity in the stock market, seem to
have led to premature public equity issuance by the
recent LBOs.
Loss-incurring and deleveraging firms as issuers of
seasoned public offerings
The composition of seasoned equity issuance in the
past two years also has its unusual aspects. New offer
ings of stock by U.S. nonfinancial firms that were
already public totaled almost $30 billion in 1991; in
1992, such issues amounted to $24 billion.13 ApproxiFootnote 12 (continued)
purposes” and “ refinancing bank debt" as uses, $50 million was
assumed to be allocated to each, although in actuality any
allocation of the $100 million would have been possible. The size of
the errors, in percentage terms, produced by this approximation is
lessened by the large number of observations and by the fact that
almost two-thirds of the offerings listed only one use of proceeds.
Offerings that listed no primary use of proceeds were assumed to
allocate those proceeds as did other offerings of the same type
(IPO, reverse LBO, or other offering).
13Securities Data Company.
mately two-thirds of the transaction value for the period
January 1991 through June 1992 was concentrated
among the top fifty deals (Table 1). An analysis of those
deals shows that approximately 44 percent of the gross
proceeds went toward general corporate purposes,
much more than the 31 percent of IPO proceeds
directed toward the same end (Chart 11). Nevertheless,
this finding does not imply that seasoned companies
are investing more in plant and equipment than are IPO
companies.
The largest group of the seasoned firms offering
equity consists of firms losing money at the time of
issuance, epitomized by the auto makers. In these
cases, funds devoted to “general corporate purposes”
are probably being used to make up for sub par cash
flows, not to finance expansion.
We argued above that unprofitable firms owning major
finance company subsidiaries faced particularly sharp
incentives to sell equity to protect their prime commer
cial paper ratings and thereby to maintain their access
to commercial paper funding. We observe that no fewer
than five firms with a sizable finance company subsidi
ary appear on the list of unprofitable stock issuers
(Table 1). To test the relationship between profitability
and equity issuance among firms with major finance
companies, we arrange industrial and commercial com
panies that owned any of the fifty largest finance com
panies by profitability and stock issuance (Table 2).14
No less than five-sixths of the value of equity sales of
this group were by firms suffering losses. By number,
firms running losses were as likely as not to issue
equity, while only one profitable firm among twelve did
so.
Deleveraging has been another force driving equity
issuance. Among the top fifty seasoned issuers of
stock, high-leverage companies—those with a ratio of
debt to book equity above 70 percent— represented the
second largest group. These firms were undoing all the
various modes of leveraging observed in the 1980s.
Some of these firms had swelled their debt by acquisi
tions (Time Warner), others were following up on wellreceived reverse LBOs (Safeway and Duracell), and still
others were paying down debt incurred in massive and
defensive repurchases (Goodyear).
Ordinary motives are represented by secondary
issues and by issues for expansion. When stock prices
are high in relation to earnings, founding families cash
out, as at Reader’s Digest. Or a rapidly growing firm
14Drawing on the list of the fifty largest finance companies that was
published in the December 11, 1991, issue of the American Banker,
we examined the profitability of twenty-two industrial and
commercial parents of twenty-three finance companies (Ford owns
two finance companies). We eliminated Macy’s both because it sold
its credit card affiliate to General Electric and because it entered
bankruptcy.
FRBNY Quarterly Review/Winter 1992-93
11
Table 1
Com position of Top F ifty Equity Issues by Seasoned Firms, January 1991 through June 1992
Firm or Transaction Type
Losses
Deleveraging
Secondary offerings/repurchases
Ranking by Size
Firm
Date
Type*
General Motors
Ford Motor
General Motors
Delta Air Lines
General Motors
General Motors
Westinghouse Electric*
Tenneco*
USX-Marathon Groups
Westinghouse Electric
Federated Department Stores
Delta Air Lines
AMR
Chrysler
Texas Instruments
Burlington Northern*
Viacom*
Texas Utilities
AMR
May 20, 1992
November 13, 1991
February 11, 1992
June 24. 1992
December 5, 1991
June 26, 1991
June 3, 1992
December 17, 1991
January 14, 1992
May 9, 1991
May 20, 1992
April 8, 1991
January 30, 1992
October 2, 1991
September 11, 1991
November 19, 1991
June 4, 1991
January 31, 1991
January 24, 1991
1
4
6
10
17
18
19
22
29
32
34
35
39
40
41
45
Time Warner
RJR Nabisco
Sears Roebuck
Dillard Department Stores#
York International Corporation
International Paper
Goodyear Tire & Rubber
Freeport-McMoRan Resource
Black & Decker
IBP»
Sears Roebuck
Santa Fe Pacific1'
Colgate-Palmolive
Safeway
Duracell International
The Vons Companies
July 5, 1991
November 1, 1991
February 20, 1992
April 3, 1991
March 26, 1992
January 16, 1992
November 13, 1991
February 4, 1992
April 24, 1992
September 5, 1991
November 1, 1991
June 4, 1992
November 19, 1991
April 9, 1991
October 21, 1991
May 30, 1991
2,760
2,025
1,075
789
478
466
465
449
398
360
325
319
300
P
287
276
251
Subtotal 10,736
14
15
16
23
25
28
31
37
42
47
ConAgra
National Health Laboratories
Reader’s Digest Association
Tandy
ConAgra
Marlon Merrell Dow
Long Island Lighting
Reebok International
National Health Laboratories
Santa Fe Pacific
September 26, 1991
April 30, 1991
June 10, 1991
February 14, 1992
May 28. 1992
May 12, 1992
May 21, 1992
December 10, 1991
February 13, 1992
October 8, 1991
507
501
499
443
425
410
363
310
259
242
3,959
2,150
2,128
1,350
1,050
1,000
641
559
516
461
451
437
416
371
349
306
257
239
218
210
Subtotal 13,109
P
P
P
P
P
P
P
P
P
P
P
P
Subtotal
Expansion
Amount
2
3
5
7
9
11
12
13
20
21
24
27
30
33
38
43
48
49
50
8
26
36
44
46
K Mart
Amerada Hess Corp.
Home Depot
MGM Grand
Browning-Ferris Industries
August 16, 1991
June 9, 1992
April 12, 1991
July 16, 1991
June 10, 1992
P
Subtotal
1,012
425
315
256
244
2,252
Total 30,056
Sources: Securities Data Company, Compustat, Reuter's Textline.
fp indicates preferred.
*Debt retirement is listed as use of funds.
^Losses are at consolidated level.
“Parent company used funds to retire debt.
12
FRBNY Quarterly Review/W inter 1992-93
such as K Mart comes to market for the wherewithal to
open new stores and to hire more people. But stock
issues by such firms account for less than a third of the
top fifty issues.
This look at the top issuers of equity indicates that
loss-incurring and quite leveraged firms bulk large on
the list. In the next section, we take a look at the largest
600 firms, some of which issued equity while others did
not, and find that 1991 did introduce a change in the
character of equity-issuing firms.
Equity issuance, leverage, and profitability
To test the hypothesis that the recent boom in equity
issuance has been part of a general deleveraging trend,
we drew selected operating and balance sheet statistics
for the largest U.S. nonfinancial corporations from the
Compustat data base. For each year from 1988 through
1991, the 600 firms with the largest assets were singled
out. They were then broken up into three groups— the
50 with the largest positive net equity issuance, the 50
with the largest negative net equity issuance, and the
other 500.
For each company and each year, six ratios were
constructed. To measure the leverage of each company,
we took the ratio of interest to cash flow and the ratios
of interest-bearing debt to the book and market values
of equity. To measure the profitability of each company,
we took the ratios of net income to book and market
values of equity. However, to the extent that the rank of
a com pany’s income to m arket equity differs from the
rank of its income to book equity, the form er may more
accurately serve as a proxy for the cost of capital.
Finally, to measure the magnitude of investm ent in plant
and equipment, we took the ratio of capital expenditures
to assets.15
Table 3 presents the median of each statistic for each
group in each year. For the two extreme groups of 50
each, we also present the p-value corresponding to the
nonparametric Wilcoxon rank sum test of the null hypothesis
that the ratio for the group of 50 is the same as the ratio for
the middle group of 500 (Table 3). The p-value is the
probability that, given the observations, the medians are the
same. Consequently, p-values close to zero indicate signifi
cant differences, with almost no probability that the medians
are the same.
The largest net issuers do not appear to have differed
consistently from other large firms in their profitability or
debt burden from 1988 through 1990. In 1991, however,
notable differences emerge between the largest net issuers
and the rest of the pack. The large issuers are shown to be
significantly less profitable and more highly leveraged by all
15The ratios of capital expenditures to fixed assets could have been
used, but it would have 'normalized" for the capital intensity of
operations. The intent was to capture those companies that
invested heavily, whether or not they were in capital-intensive
industries.
Table 2
Industrial Firm s w ith Finance Companies: P rofitability and Equity Issuance in 1991-92
Firms reporting a profit*
Firms reporting a loss*
Firms not issuing stock
General Electric
ITT
AT&T
Xerox
Philip Morris
McDonnell Douglas
Pitney Bowes
J.C. Penney
Textron (Avco Financial Services)
Whirlpool
GATX
IBM
Deere & Co.
Caterpillar
Greyhound
Navistar
Firms issuing stock
(Amount issued in parentheses)
Sears Roebuck & Co. ($1.4 billion)
General Motors
Ford
Chrysler
Westinghouse
Tenneco
(Total)
($6 9
($2.1
($0.3
($0.5
($0.5
billion)
billion)
billion)
billion)
billion)
($10.3 billion)
Notes: Computed chi-square statistic is 4.77 with 1 degree of freedom. A statistic in excess of 3.84 allows the rejection of the null
hypothesis that the equity issuance of a firm and its profitability are independent factors with a probability of error less than .05. Equity
issuance by General Motors includes $0.5 billion in Hughes Aircraft shares.
Sources: Wall Street Journal, New York Times, Securities Data Corporation.
*1991 net income.
FRBNY Quarterly Review/W inter 1992-93
13
observations, it would appear that, of those companies
that remained public, the ones that engaged most in stock
repurchases were in fact the ones that could best afford it.
It is also interesting to note that net equity retirements by
more profitable and less leveraged companies continued
through 1991, even as a general deleveraging trend took
hold in the rest of the corporate sector.
Finally, large issuers and large repurchasers do not
consistently differ from the average in the intensity of their
capital expenditures. This finding lends support to the
claim that equity financing since the late 1980s has been
directed prim arily toward fin a n c ia l re stru cturing as
opposed to investment.
measures. These observations lend strong support to the
claim that equity issuance has been concentrated among
those companies that need it most.
In 1991 a behavioral symmetry arises— large equity issu
ers and repurchasers are mirror opposites in profitability and
debt burden. For each year from 1988 through 1991, those
companies that were the largest net repurchasers of equity
show significantly more profitability as measured by the ratio
of income to book equity and a significantly lighter debt
burden as measured by the ratio of interest to cash flow.
However, these companies appear to be no more profitable
than average if the ratio of income to market equity is used,
except perhaps in 1989. This seeming anomaly arises
because income to market equity better proxies the cost of
capital than profitability. The explanation would then be that
while the largest repurchasers were more profitable, they did
not have to meet a higher required rate of return on equity
than other companies. In 1990 and 1991, the large net
repurchasers also show a significantly lighter debt burden
as measured by the ratios of debt to equity. Given these
Interest savings from equity issuance at its current
rate
As noted above, net equity issuance for U.S. nonfinan
cial corporations reached $18.3 billion in 1991, its first
positive showing since 1983. Since equity replaces
debt, the interest savings at an annual rate by the end
Table 3
Leverage, P rofitability, and Investm ent by Magnitude of Net Equity Issuance
Sample: Six-hundred Largest U.S. Nonfinancial Corporations
1988
1989
1990
1991
Debt burden measures (ratios)
Interest/
cash flow
50 largest net issuers
Middle 500
50 largest net repurchases
18.06% (0.100)
23.44%
14 00% (0.004)
20.96% (0.802)
24.05%
14.52% (0.002)
18.32% (0.147)
25.72%
16.07% (0.000)
49.89% (0.000)
25.82%
10.26% (0.000)
Interest-bearing debt/
book value of equity
50 largest net issuers
Middle 500
50 largest net repurchases
69.39% (0.130)
83.11%
77.87% (0 663)
89 80% (0.448)
90.93%
74.54% (0.090)
96.32% (0.725)
93 19%
59.04% (0.007)
154.68% (0.000)
90.55%
49.31% (0.000)
Interest-bearing debt/
market value of equity
50 largest net issuers
Middle 500
50 largest net repurchases
38 07% (0.107)
59.96%
44.96% (0.122)
46.08% (0.871)
53.58%
35.37% (0.030)
48.19% (0.081)
73.96%
35.61% (0.000)
86.02% (0.012)
58.07%
19.02% (0.000)
Net income/
book value of equity
50.largest net issuers
Middle 500
50 largest net repurchases
14.22% (0.486)
13.48%
18.00% (0.000)
11.28% (0.075)
13.10%
16 87% (0.000)
12.98% (0.278)
11.78%
15.04% (0.000)
6.04% (0.001)
10.33%
17.71% (0.000)
Net income/
market value of equity
50 largest net issuers
Middle 500
50 largest net repurchases
7.30% (0.183)
8.88%
9.04% (0.432)
6.14% (0.069)
7.11%
8.62% (0.025)
5.94% (0.029)
7.67%
7.47% (0.880)
3.16% (0.000)
5.14%
4.55% (0.958)
50 largest net issuers
Middle 500
50 largest net repurchases
6.90% (0.977)
6.29%
6.92% (0.975)
7.54% (0.875)
7.24%
7.00% (0.699)
8.72% (0.023)
6.96%
7.47% (0.251)
5.78% (0.162)
6 50%
7.02% (0.451)
P rofit measures (ratios)
Investm ent in te n sity (ratios)
Capital expenditures/
assets
Source: Compustat
Notes: The table shows median values The p-values of Wilcoxon rank sum tests for difference of medians are in parentheses. The p-value is
the probability of observing a value as different from the middle 500's median under the null hypothesis that the medians of the two groups
are the same. Consequently, p-values close to zero indicate significant differences in median values.
14FRASER
FRBNY Quarterly Review/W inter 1992-93
Digitized for
of the year can be calculated as the product of $18.3
billion and the marginal interest rate of 8 percent, or
$1.5 billion (Table 4). For 1992, the net issuance of
equity is estimated to have been $32 billion, yielding
annualized interest savings of $2.4 billion when an
average m arginal interest rate of 7.5 percent on new
debt is assumed (Table 4).
These measures of the savings from equity issuance
do not attempt to capture the full savings on debt that
result from equity issuance. For instance, when an
industrial firm that owns a finance company sells equity
and succeeds in maintaining its access to the commer
cial paper market, it saves more interest payments than
those associated with the debt directly replaced by
equity. This “ saving” does not actually show up in
observed interest paym ents, however: interest pay
ments would have gone up without the equity issue. By
contrast, our measure of the savings from junk bond
calls, described below, does capture some effects of
equity issuance. For instance, RJR Nabisco could call
its 17 percent bonds and refinance them at 10.5 percent
in the spring of 1991 not so much because of generally
lower rates but because of the firm ’s sale of equity.
Debt restructuring
In several respects, corporate treasurers operated in
the credit markets in 1991-92 in a manner fairly typical
of an early recovery. Net issuance of debt weakened;
bank loans and comm ercial paper contracted while out
standing bonds continued to grow. Between 1984 and
1990, U.S. nonfinancial corporations issued a net $1.2
trillion worth of debt, divided almost equally between
bonds and all other forms of debt, including loans and
commercial paper (Chart 12). In 1991, net borrowing fell
to $29 billion, or about 17 percent of its average rate in
1984-90. This drop was entirely due to $50 billion in net
retirements of bank loans, commercial paper, and other
debt; net bond issuance maintained its average 1984-90
rate of about $80 billion. In the first three quarters of
1992, net issuance of bonds kept that pace, but net
retirement of other debt decreased to about $35 billion.
The relatively steady growth of corporate bonds out
standing appears hard to square with the flood of new
bonds that corporate treasurers are selling to Wall
Street underwriters. Indeed, estimated public issuance
of bonds reached $153 billion in 1992 and broke the
record 1986 issuance of $116 billion. Just as corporate
Table 4
C ontrib utio n of Refinancing and Lower Short-Term Interest Rates to
U.S. Corporate interest Savings in 1991-92
Billions of Dollars at an Annual Rate
1991
1992
Refinancing
0.4
2.4
Net equity issuance1
1.5
2.4
3.9
Fixed income
-1 .1
0.0
-1 .1
Bond calls
0.8
1.6
2.4
0.3
0.5
0.9
0.7
1.2
1.2
- 1 .9
- 1 .6
- 3 .5
14.1
13.2
27.3
Investment grade*
Junk§
Maturity extension#
Direct e ffect of
lower short-term rates**
1991-92
2.8
Sources: For net equity issuance— Board of Governors of the Federal Reserve System, Flow of Funds data for nonfarm nonfinancial
corporate business; FRBNY estimates. For investment grade bond calls— Salomon Brothers Corporate Bond Research, "Notice of Corporate
Bonds Called," Industrials' Utilities; Bloomberg data base. For junk bond calls— First Boston High Yield Research. For maturity extension—
Board of Governors of the Federal Reserve System, Flow of Funds data. For effect of short-term rates— Board of Governors of the Federal
Reserve System, Flow of Funds data and Federal Reserve Bulletin.
♦Estimates assume that $18.3 billion in equity replaced 8 percent debt in 1991 and that $32 billion in equity replaced 7.5 percent debt in
1992.
^Estimates are based on $28 billion called in 1991 and $78 billion in 1992.
^Estimates are based on $10 billion called in 1991 and $24 billion in 1992.
“We estimate that $47 billion in net fixed rate debt replaced floating rate debt in 1991 and that $40 billion net fixed rate debt replaced
floating rate debt in 1992.
,1Estimates assume that one-fourth of net short-term debt is repriced each quarter.
FRBNY Quarterly Review/W inter 1992-93
15
treasurers sell equity into surging stock markets (Chart
1), so too they sell bonds into surging bond markets
(Chart 13). What reconciles the steady growth of out
standings and the explosion of bond issuance is matur
ing bonds and especially calls of bonds.
Savings from bond calls
Bond calls over the last two years have been encour
aged by the convergence of two trends— lower interest
rates and less erosion of corporations’ credit standing.16
The latter trend is a consequence of lower interest rates
and net equity issuance.
We estimate that a face value of $106 billion in invest
ment grade bonds and $34 billion in junk bonds has
been called in 1991-92.17 We base our interest savings
calculation on sam ples of called investm ent grade
bonds and junk bonds. The current pace at which U.S.
nonfinancial corporations are calling and refinancing
16Andrea Bryan, “ Corporate Credit Quality Erosion Eases," Standard
& Poor's Creditweek, January 4, 1993, p. 39.
17Amount of junk bonds called is based on First Boston High Yield
Research data. Amount of investment grade bonds called is based
on Salomon Brothers’ Monthly Statement of Bonds Called for 1991
and through November 1992, annualized.
their bonds is saving $1.6 billion a year in interest
payments.
The savings from calls of investment grade bonds
stem from strong refinancing activity and relatively mod
est average savings. A sample of 153 issues called
between January and May 1992 with an aggregate face
value of $10.3 billion18 provides a weighted average
original coupon of 9.3 percent, call price of $102, and a
refinancing cost of 8.04 percent. These averages indi
cate interest savings of $1.10 per $100 of face amount
called: the difference between the original coupon (9.3)
and new coupon scaled by the call price premium (8.04
times 102 divided by 100). This finding suggests that the
annual interest savings on $28 billion of called invest
ment grade bonds in 1991 and $78 billion in 1992 were
$0.3 billion and $0.9 billion, respectively. Our calcula
tion is biased on the side of greater savings because it
neglects the higher principal repayment of refinancing
implied by the call price premium.
The savings from junk bond calls stem from more
modest refinancing activity and very considerable aver
age savings. Companies like RJR Nabisco, which sold
18Bloomberg data base, 153 issues called, January-May 1992.
Chart 12
Net Debt Issuance by U.S. Nonfinancial Corporations
Billions of dollars
300
250
200
150
100
50
0
-50
-100
1980
1981
1982
1983
1984
1985
1986
1987
1988
Source: Board of Governors of the Federal Reserve System, Flow of Funds data.
Note: Shaded areas indicate recession periods designated by the National Bureau of Economic Research.
16FRASER
FRBNY Quarterly Review/W inter 1992-93
Digitized for
1989
1990
1991
1992
new equity to improve its credit standing so as to refi
nance its debt at lower interest charges, derived signifi
cant benefits from refinancing. Thus, savings on junk
bond calls arise from credit upgrades as well as lower
interest rates for a borrower of a given credit.19 A sam
ple of $3.7 billion junk bonds called in 199120 gives a
weighted average original coupon of 15.1 percent, a call
price of $101.8 per $100 of face amount, and a refinanc
ing coupon of 10.1 percent (Table 5). Taking the differ
ence between the original coupon (15.1) and the new
coupon scaled by the call price premium (10.1 times
101.8 divided by 100) yields an interest savings of $4.78
per $100 of face amount called. This finding translates
into annual interest savings of $0.5 billion on $10 billion in
called junk bonds in 1991. Junk bond calls accelerated in
1992 but proved on average less lucrative. First Boston
^ “ Restructurings and refinancings allowed issuers with outstanding
debt to achieve higher credit quality. Among high-yield issuers in
1992, there were 98 upgrades totaling $51 billion and 96
downgrades totaling $37 billion. By contrast, in 1991, downgrades
almost doubled upgrades. There were 75 upgrades totaling $62
billion and 133 downgrades totaling $81 billion” (Diana Vazza,
“ High-Yield Market Sets Record For Issuance in 1992,” Standard &
Poor's Creditweek, January 25, 1993, p. 33).
20Sample from First Boston High Yield Handbook, January 1992,
Appendix III.
High Yield Research reports that in the first half of 1992,
the average coupon on new issues replacing those that
were called or tendered was about 300 basis points
lower.21 We estimate therefore that the $24 billion called
in 1992 saved $0.7 billion in annual interest charges.
The costly extension of debt m aturities
A large offset to these interest savings arises from the
normal cyclical funding of comm ercial paper and bank
debt with bond debt in the face of an extremely steep
yield curve. Of course, if long-term interest rates simply
represent the average of short-term rates over the rele
vant period, the extra interest paid now simply saves
higher interest payments down the road. However, the
power of long-term rates to predict future short-term
rates has proven weak in the past. Corporate treasurers
often view securing long-term, fixed rate financing as
insurance against swings in short-term interest rates,
but such financing also introduces the risk that a drop in
inflation will leave the firm saddled with a very high real
interest rate.
In keeping with our focus on net interest payments,
we consider corporate liabilities net of financial assets.
At the end of 1990, U.S. nonfinancial corporations had
ziFirst Boston High Yield Research, 1992 Mid-year Review, July 28,
1992, p. 3.
Chart 13
Gross Public Debt Issuance by U.S. Nonfinancial Corporations
Billions of dollars at an annual rate
Percent of par value
Sources: Board of Governors of the Federal Reserve System; Moody's.
Notes: Bond prices refer to hypothetical fifteen-year Baa bond with 10 percent coupon. Shaded areas indicate recession periods designated by
the National Bureau of Economic Research.
FRBNY Quarterly Review/W inter 1992-93
17
$1,240 billion in fixed rate debt (net of fixed rate assets)
and $677 billion in net floating rate debt outstanding.22
At year-end 1991, these outstandings were about $1,287
billion and $594 billion, respectively. In 1991, the corpo
rations reduced the ratio of net floating rate debt to total
debt from 35.3 percent to 31.6 percent, partly by shift
ing about $47 billion worth of that debt from a floating
rate to a fixed rate and partly by paying off loans with
internal cash flows. This recent behavior is consistent
with the historical relationship between maturity shifts
and changes in interest rates. During periods of declin
ing interest rates, corporations tend to shift from float
ing to fixed rate debt to lock in favorable interest rates.
Such m oves o ccu rre d in 1970-71, 1975-76, and
1985-87. Conversely, when interest rates rise, as they
did in 1973-75, 1979-81, and 1983-84, corporations tend
to sh ift into floating rate debt to avoid locking in
unfavorable interest rates (Chart 14).
As U.S. nonfinancial corporations shifted out of float22Net floating rate or short-term debt is defined in flow of funds
classifications as the sum of bank loans, commercial paper, and
other loans minus all liquid assets excepting currency and
checkable deposits, U.S. government securities, and tax-exempt
securities. Net fixed rate debt is defined as corporate bonds minus
U.S. government securities and tax-exempt securities.
ing rate debt and into fixed rate debt in 1991 and 1992,23
they undertook higher interest obligations. Although
23The growing use of interest rate swaps by U S nonfinancial
corporations makes balance sheet data less reliable when the
analyst tries to gauge the relative importance of fixed and floating
rate funds The most common interest rate swap involves the
exchange of floating payments, usually based on LIBOR, for
predetermined fixed payments on a notional amount of debt. Hence a
nonfinancial firm borrowing short-term or floating rate funds may enter
a swap that effectively creates a fixed rate liability. However, since
swaps are off-balance-sheet items, the balance sheet (and the flow of
funds data) would still show an exposure to short-term interest rates.
To estimate the effect of interest rate swaps on the composition
of debt, the analyst must know the gross positions in both fixed-tofloating and floating-to-fixed rate swaps of U.S. nonfinancial
corporations If U S nonfinancial corporations are net fixed rate
payers, then the effective ratio of floating rate to total debt would be
somewhat lower than flow of funds data indicate, and vice versa.
According to the International Swap Dealers Association, the
value of interest rate swaps outstanding stood at more than
$3 trillion at the end of 1991, up from about $680 billion just four
years earlier Of this total, U.S. nonfinancial corporations were end
users of about $260 billion, up from $76 billion in 1987, according
to the Bank for International Settlements. Although the data are
insufficient to estimate the aggregate effect of swaps on
nonfinancial corporations' exposure to short-term interest rates,
there is some evidence that these firms tend to be net fixed rate
payers in swaps. See Eli M. Remolona, “ The Recent Growth of
Financial Derivative Markets," in this issue of the Quarterly Review.
Our estimates of the cost of maturity extension from balance sheet
data will understate the true effect if firms are increasingly
swapping into fixed rates.
Table 5
Interest Savings on Junk Bonds Called in 1991
Company
Month
Century Communications
Ferrellgas Inc.
Ferrellgas Inc.
FMC
Illinois Central
Kelsey Hayes
Maxxam Group
Owens-Coming Fiberglass*
Playtex Apparel
RJR Holdings Group
Safeway Stores*
Safeway Stores
Viacom Inc.
Oct.
Dec.
Dec.
Jun.
Aug.
Nov.
Nov.
Dec.
Dec.
Jun.
Nov.
Dec.
Aug-O ct.
Total/weighted average
Dollar
Savings
(Millions
of Dollars)
Coupon
(Percent)
Amount
(Millions
of Dollars)
Premium
over Par
New
Coupon
(Percent)
12.750
13.375
12.750
12.500
15.500
13.250
13.625
15.000
14.000
17.000
14.500
11.750
15.500
200
61
149
150
150
124
140
208
182
1,500
420
250
200
101.00
106.69
104.78
106.25
100.00
100.00
100.00
100.00
110.89
100.00
102.90
104.61
100.00
11.875
11.375
11.375
7.500
10.210
11.375
12.750
7.400
11.625
10.500
7.930
9.650
10.250
1.5
0.8
1.2
6.8
7.9
2.3
1.2
15.8
2.0
97.5
26.6
4.1
10.5
0 76
1.24
0.83
4.53
5.29
1.88
0.88
7.60
1.11
6.50
6.34
1 66
5.25
15.081
3.734
101.77
10.127
178.4
4.78
Percent
Savings
(Percent)
Sources: Reuter's Textiine; Moody's: First Boston High Yield Handbook, Euromoney Loanware; International Financing Review.
Notes: Amount indicates the amount of the call that could be attributed to a recent debt issue or bank loan. Percent savings are calculated
as the difference between the old coupon rate and the new coupon rate adjusted upwards by the ratio of the call price to 100. Dollar
savings are the percent savings multiplied by the amount.
'Bond was refinanced with a bank loan. New coupon assumes a spread of 75 basis points over LIBOR on the loan converted into an
equivalent fixed rate using the mid-December 1991 five-year interest rate swap spread Seventy-five basis points was the average spread
over LIBOR on syndicated loans for a sample of Baa3-rated borrowers in 1991.
*Bond was refinanced with a bank loan, as in the case of Owens-Coming. New coupon assumes a spread of 83 basis points converted into
an equivalent fixed rate using a seven-year swap spread to match the maturity of the Safeway syndicated loan. Eighty-three basis points
was the average spread over LIBOR for a sample of Ba2- and Ba3-rated borrowers in 1991.
FRBNY Q uarterly Review/W inter 1992-93
Digitized for18
FRASER
continues to remain subdued and interest rates decline,
the maturity extension could prove more expensive u lti
mately than immediately.
this shift may have had the beneficial effect of locking in
lower long-term rates, the immediate effect has been to
increase interest expense. The slope of the corporate
yield curve, defined as the difference between the com
mercial paper rate and the yield on Baa-rated bonds,
has been about 4 percentage points. Therefore, the
e stim ated increase in a nnualized interest expense
resulting from the m aturity shift that occurred in 1991 is
$1.9 billion. The first three quarters of 1992 saw further
shift in debt composition from floating to fixed rate debt
of about $40 billion at an annual rate. Thus, the
increased interest expense for 1992 is estimated to be
$1.6 billion.
In summary, corporate treasurers’ operations in the
debt markets have served not only to pare interest
payments through bond calls but also to lock in higher
payments through maturity extension. Our calculation of
the net cash flow benefits of these operations only
attempts to capture immediate, not ultimate, effects.
Interest rates may rise to leave discounted interest
paym ents unaffected by the m aturity extension. Or
interest rates may rise somewhat less but leave corpo
rate treasurers content that the benefit of stable and
predictable interest payments matches the ultimately
higher cost of fixed rate finance. By contrast, if inflation
Short-term interest rates and the interest burden
Financial restructuring has contributed to reducing the
interest burden of U.S. nonfinancial corporations. But
the decline in short-term interest rates since 1989 has
unburdened corporate cash flows quite apart from any
refinancing. This influence takes effect as interest
charges on floating rate debt are reset to prevailing
market rates on a monthly, quarterly, semiannual, or
annual basis. To compare the effects of refinancing
activity and lower short-term interest rates, we need to
quantify the relation of lower rates to corporate net
interest payments.
Lower interest payments on short-term and floating
rate debt
If almost all floating rate assets and liabilities are reset
at least once a year, then the savings from lower rates
should be roughly equal to the product of the change in
interest rates and the dollar amount of net floating rate
debt outstanding. We employ both simple arithm etic
and regression analysis to estimate interest savings.
Chart 14
Ratio of Floating Rate Debt to Total Debt for U.S. Nonfinancial Corporations
Percent
Floating rate debt as
a share of qross debt
Floating rate debt as
a share of net debt
♦
♦
♦♦
Wi ♦*
...
/
*.
«*
*§#■ ■
♦♦
/
111
1970
I I 1 1 1 I I 1 1 1 1 1 1 1 1 1 1 1 L 1 1 1 1 1 1 1 1 1 1 1, | M i l I I I
71
72
73
74
75
76
77
78
79
80
I I 1 1 1 I I I 1 LI 1 1 I I
81
82
83
84
1 II
85
I I I 1 I I I 1 M i l l l 1 1 1 LL 1 M 1J 1 1J
86
87
88
89
90
91
92
Source: Board of Governors of the Federal Reserve System, Flow of Funds data.
Notes: Floating rate debt includes bank loans, finance company loans, and commercial paper. Net floating rate debt is floating rate debt minus all
liquid assets except currency, checkable deposits, government securities, and tax-exempt securities. Net debt is gross debt minus all liquid assets
except currency and checkable deposits. Shaded areas indicate recession periods designated by the National Bureau of Economic Research.
FRBNY Quarterly Review/W inter 1992-93
19
Box 1: Regression Analysis of the Pass-through of Short-Term Interest Rates to Corporate
Interest Payments
The results of our regression analysis are reported in the
table. The product of the quarterly change in the threemonth commercial paper rate and the lagged quarterend level of net floating rate debt effectively predicts the
change in seasonally adjusted annualized net interest
payments. As the table shows, the estimated relationship
is significant both contemporaneously and lagged three
quarters.+ Moreover, the null hypothesis that the four
coefficients on quarterly lags add up to one can be
accepted at any reasonable level. In other words, a
change in short-term rates exerts its full impact within a
year. Finally, the null hypothesis that the transmission of
short-term market interest rates to corporate interest
payment occurs smoothly (one-quarter per quarter) can
be accepted.
The regression also confirms the linkage of net debt
levels and net interest payments. A proxy for the change
in net interest payments resulting from increasing levels
of debt is computed as the sum of two products: (1) the
change in net floating rate debt outstanding multiplied by
the short-term interest rate, plus (2) the change in net
fixed rate debt outstanding multiplied by the long-term
interest rate. Absent any changes in interest rates, net
tThe product using the first and third lags is significant at the
.5 percent level (the critical value [c.v.] for the two-sided ttest is 2.70), the product using the third lag is significant at
the 2 percent level (c.v. - 2.42), and the contemporaneous
product is significant at the 2.5 percent level (c.v. = 2.02).
E ffects of Short-Term Interest Rates and Debt A ccum ulation on Interest Payments
by U.S. N onfinancial C orporations: Results of Regression A nalysis
Quarterly Data
Dependent variable: change in seasonally adjusted annualized net interest payments (billions of dollars at an annual rate)
Independent variables: change in net floating rate debt times the three-month commercial paper rate plus the change in net
fixed rate debt times the corporate bond yield (billions of dollars)
Intercept suppressed
Change in Commercial Paper
Rate times Floating Rate Debt
No Lag
Coefficient
(t-statistic, HO: x= 0)
({-statistic, HO: x = 1)
(t-statistic, HO: x = 25)
R squared
Adjusted R squared
Observations
Degrees of freedom
Durbin-Watson
0.205
(188)
—
(0.42)
One-Quarter
Lag
Two-Quarter
Lag
Three-Quarter
Lag
0 338
(3.17)
0.27
(2.65)
0.358
(3.63)
—
—
—
(0.83)
(0.24)
(1.09)
Change in
Net Debt
times
Interest Rate
Memorandum:
Sum of
Commercial Paper
Coefficients
0.839
(6.86)
(131)
—
(0.84)
—
1 175
—
0.604
0.564
44
39
1.98
Independent variable: change in quarterly average three-month commercial paper rate times net floating rate debt outstanding
(billions of dollars)
Change in Commercial Paper
Memorandum:
Change in
Rate times Floating Rate Debt
Net Debt
Sum of
One-Quarter
Two-Quarter
Three-Quarter
Commercial Paper
times
Lag
Lag
No Lag
Lag
Interest Rate
Coefficients
20
Coefficient
(t-statistic, HO: x = 0)
(t-statistic, HO: x = 1)
(t-statistic, HO: x= .25)
0.219
(2.03)
R squared
Adjusted R squared
Observations
Degrees of freedom
Durbin-Watson
0.587
0.556
44
40
2.05
—
(0.29)
0.346
(3.29)
_
(0.91)
FRBNY Quarterly Review/W inter 1992-93
0 265
(2.58)
—
(0.15)
Held at 1
1.194
—
—
—
(1.18)
—
(0.94)
—
0.365
(3.76)
—
Box 1: Regression Analysis of the Pass-through of Short-Term Interest Rates to Corporate
Interest Payments (Continued)
interest payments should increase by an amount roughly
equal to this sum. Consistent with this simple hypoth
esis, the expected coefficient value for this variable is
one. As the table shows, the data appear to confirm this
hypothesis.*
To isolate the effect of changes in interest rates, we
repeated the regression, this time holding the value of
*The intercept in the regression was forced to be zero on the
assumption that no factor other than the accumulation of
debt and changes in interest rates would systematically
If we assume that one-fourth of net short-term debt is
repriced each quarter, the savings owing to lower short
term rates (measured by the change in the three-month
commercial paper rate) amounts to $27.3 billion in
1991-92 (Table 4). Regression analysis supports the
assumption that changes in short-term rates transmit
themselves to net interest payments fairly smoothly
over four quarters (see Box 1).
As a result of falling interest rates in 1990 and 1991,
annualized net interest paid by U.S. nonfinancial corpo
rations in the fourth quarter of 1991 was an estimated
$14.1 billion lower than it would otherwise have been.
Similarly, the fall in interest rates in 1991 and 1992 is
expected to lower the interest burden by an additional
$13.2 billion by the fourth quarter of 1992. An additional
$2.8 billion in savings should flow through in 1993 given
current short-term rates. If we measure interest savings
from 1989, when short-term rates were about 9 percent,
the decline in short-term rates by about 6 percentage
points has lowered corporate interest payments by
$36.5 billion.
Comparing low er short-term interest rates and
corporate refinancing
Summing the effects of corporate activity in the stock
market and in the debt markets shows the net impact of
corporate refinancing (Table 4). In 1991, treasurers
extended the m aturity on so much debt while facing
such a steep yield curve that the effect of the $18 billion
in net equity issuance was almost nullified. In 1992, the
extension of m aturities appeared to slow, so that the
$32 billion in net equity issuance served to reduce net
interest payments by about $2.4 billion per year.
Our calculations suggest that in 1991-92, lower short
term interest rates played a dominant role in lowering
corporate interest payments. The immediate relief that
the coefficient on the leveraging variable at one (see
table). Because the results were sim ilar to those for the
unconstrained regression, the coefficients from this sec
ond regression were used to estim ate the effects of
changes in short-term interest rates on aggregate inter
est expense.
Footnote * continued
influence the level of interest payments. This assumption is
not challenged by the data. The intercept in the
unconstrained regression (not reported) is not significantly
different from zero.
lower rates afforded U.S. nonfinancial firms in lightening
the interest burden in 1991-92 was ten tim es the relief
that refinancing provided: $27.3 billion as against $2.8
billion.
Another way to juxtapose the two effects is to draw an
equivalence between a (permanent) change in short
term interest rates and the effect of refinancing activity
at its 1992 pace. Each year that corporate treasurers
restructure their capital at the current rate provides only
as much relief to their cash flows as a permanent cut of
45 basis points in short-term corporate rates.
The relative effectiveness of lower interest rates and
corporate refinancing in unburdening corporate cash
flow can also be dem onstrated by decomposing the
total change in the aggregate ratio of interest payments
to cash flow in the seven quarters since the end of 1990
(Chart 15 and Box 2). This ratio ratcheted up to a record
vulnerability before the start of the recent recession as
firms replaced equity with debt. By the end of 1990, the
ratio had reached 24.25 percent, a level indicating that
in aggregate, cash flow covered interest payments only
four times over. The apparently low level of this ratio (or
the apparently com fortable interest cover) does not by
itself fully reflect the fragile state of corporate finances,
since it must be understood as an average that includes
many firms unable or barely able to cover their interest
payments. By the third quarter of 1992, this ratio had
fallen 3.85 percentage points to 20.4 percent.
Three forces have worked together to bring down this
ratio: macroeconomic factors, lower short-term interest
rates, and co rp orate refin an cing (C h a rt 15). M ac
roeconomic factors include the growth of cash flow and
the need for outside finance. As cash flow increased 6.6
percent over the seven quarters from 1990-IV to 1992MI, the wherewithal to meet interest payments grew and
the ratio declined. Partially offsetting the growth of cash
FRBNY Quarterly Review/W inter 1992-93
21
flow, however, was the need for outside finance— that is,
the gap between retained earnings and depreciation
charges, on the one hand, and investment spending, on
the other. Filling this gap with new debt would tend to
raise interest payments and offset the effect of higher
cash flow in bringing down the ratio. These two mac
roeconomic factors jointly have reduced the burden of
interest payments on cash flows by about 1 percent
(Chart 15).
Lower short-term rates did the job of reducing the
ratio by about 21/2 percentage points through the third
quarter of 1992. Moreover, at present levels of short
term interest rates, corporations can expect to benefit
from even lower interest payments in 1993 as short
term debt rolls over and is repriced at current interest
rates.
The net effects of refinancing activity account for a
surprisingly small share of the decline in Chart 15.
Equity issuance and bond calls alone would have driven
the ratio down by another 3A of 1 percentage point. But
the extension of m aturities from short-term debt to
higher cost long-term debt has offset much of the sav
ings from equity issuance and bond calls.
Conclusion
This article finds that in the aggregate, lower interest
rates have far surpassed corporate refinancing in reliev
ing the burden of interest charges on cash flows. This
finding depends on an often-overlooked feature of cor
porate refinancing: the current expense of corporate
treasurers' replacing bank debt with bonds wipes out
much of the savings from new share issues and bond
calls.
The timing in the business cycle of the 1991-92 surge
in equity issuance has a precedent in 1982-83, but the
classes of firms selling shares bear witness to the
particular risks introduced by corporate leveraging in
the 1980s. Firms running losses, especially parent firms
of major finance companies, assumed unusual prom i
nence among equity issuers. And quite mature busi
nesses that had been put through leveraged buyouts
showed up in the corporate nursery in the “ in itia l”
public offering market.
To be sure, restructuring has improved the financial
health of those firms undertaking it. Equity issuance
has kept some firms out of bankruptcy and has shored
up the commercial paper credit ratings of others. Never-
Chart 15
Ratio of Interest Payments to U.S. Corporate Cash Flow and Factors behind the Ratio’s Recent Decline
Percent
Factors behind
decline in ratio from
1990-IV to 1992-111
26
Macro
effects
Lower
short-term
rates
Net
refinancing
Sources: Bureau of Economic Analysis, Survey of Current Business, National Income and Product Accounts tables; Federal Reserve Bank of
New York staff estimates.
Note: Shaded areas indicate recession periods designated by the National Bureau of Economic Research.
22
FRBNY Quarterly Review/W inter 1992-93
Box 2: The Changing Burden of Interest on Cash Flow
This box defines the ratio of interest to cash flow and
decom poses its decline from the end of 1990 through the
third quarter of 1992. This ratio fell 3.85 percentage
points, from 24.25 percent to 20.4 percent, in the seven
quarters. The exercise is fairly straightforward in con
cept, although it requires some baseline from which to
measure the contribution of equity finance. Our approach
here is to take zero equity finance as the baseline. If, on
average over long periods, U.S. corporations have had a
modest resort to equity finance, our baseline may over
state the size of corporate refinancing somewhat.
Defining the ratio of interest to cash flow
This ratio is constructed to indicate the burden of net
interest payments on cash flows. The measure has been
shown to predict corporate distress and bankruptcy.
The numerator is net interest payments of nonfinancial
corporate business as reported in the National Income
and Product Accounts. We exclude im puted interest
receipts associated with non-interest-bearing deposits
from total interest receipts on the ground that they are
noncash, in-kind receipts that cannot be used to avert
default.
The denominator, also drawn from National Income
and Product Accounts data, is earnings before interest,
taxes, and depreciation (EBITD), adjusted for the effect
of inflation on inventories. These earnings are operating
cash flows available to pay interest. It is im portant that
net interest payments be included in the denom inator if
the effect of economic growth on cash flows is not to be
confused with the effect of lower short-term rates on
interest payments. Consider a company with EBITD of 5
and net interest payments of 2 falling to 1. We would
measure the ratio of interest to cash flow as 2:5 falling to
1:5. If net interest payments are excluded from cash flow,
however, the ratio would be measured as 2:3 falling to
1:4, with cash flows apparently rising by a third.
Decomposition of Change in Ratio of Interest to Cash Flow from 1990-IV to 1992-111
Percentage points
Change in ratio of
interest to cash flow
Savings on
short-term
debt service
-2.6
Effect of change
in interest rates
Savings on
refinanced
bond calls
-0.28
Cost of higher
interest rates in
shift to longer
maturities
0.44
\
I
Refinancing
-0.3
Financial factors
-2.9
Effect of change
in net debt
Savings on
debt repayment
financed by
equity issuance
-0.46
Effect of change
in cash flows
Cost of servicing
higher debt to
fill financing gap
0.4
Increase in
cash flows
-1.35
/
Macroeconomic factors
-0.95
FRBNY Quarterly R eview/W inter 1992-93
23
mmKmtmsmtmmmmmmmmmmmKmmmmmmmmmmmmmtmmaMmmamBmmm
■■■■■■■
Box 2: The Changing Burden of Interest on Cash Flow (Continued)
Decomposing the change in the ratio of interest to
cash flow
The ratio can be decomposed into three partial effects:
the effect of lower interest rates, the effect of lower debt,
and the effect of stronger cash flows (see chart). The
effect of lower interest rates itself is a compound of lower
short-term rates, lower long-term rates on called or
maturing bonds, and the effect of a shift in the mix of
floating rate and fixed rate debt. The effect of lower debt
may be thought of as a compound of debt growth (under
the assumption that external financing exclusively takes
the form of debt) and the separate effect of any net
equity issuance.
It is useful to regroup terms into the economic forces
bearing on the ratio. The two macroeconomic factors are
economic growth’s influence on cash flow and the financ
ing gap's influence on the need for external debt financ
ing. The two financial factors are the direct impact of
lower short-term interest rates on net floating rate debt
and the effect of corporate financial restructuring on the
stock of net debt, the rates on long-term debt, and the
com position of debt.
The chart shows the contributions of each of these fac
tors to the change in the ratio of interest to cash flow
from the end of 1990 through the third quarter of 1991.
We estimate that m acroeconomic factors reduced the
ratio by just under a percentage point. The growth in
cash flow s reduced the ratio 1.35 percent, but the
decrease was partially offset by the effect of the corpo
rate sector’s financing gap, or its need for external funds.
This need would have raised the ratio 0.4 percent had it
been filled entirely by debt finance. Financial factors
lowered the ratio 2.9 percentage points, largely owing to
direct effects of short-term rates, which accounted for
2.6 percent of the decrease. Refinancing activity, the
other main financial factor, reduced the ratio by 0.3
percentage point. Among the refinancing factors, the
retirement of debt with equity shaved 0.46 percentage
point off of the ratio, bond calls saved 0.28 percentage
point, but maturity extension cost 0.44 percentage point.
These calculations clarify the relative im portance of
macroeconomic and financial factors. Essentially, finan
cial factors did three-quarters of the job of relieving the
interest rate burden over the seven quarters, while mac
roeconomic factors did a quarter of the job.
Box 3: The Ratio of Net Interest to Cash Flow— Projected Future Values
by R ichard Peach
Although the ratio of net interest to cash flow for the
n o n fin a n c ia l co rp o ra te s e cto r d e clin ed su b s ta n tia lly
through 1992-111, it now stands just slightly below its
average level for the 1980s (20.7 percent), a period of
relatively high debt growth and interest rates. Some
observers contend that given today s relatively low infla
tion and more conservative attitudes toward debt, the
ultimate goal of corporate treasurers is to reduce this
ratio much further, perhaps to as low as the average level
of the 1970s (15.8 percent). Assuming that this is the
goal, how long would it take to achieve? With interest
rates held constant, optim istic but not implausible projec
tions for cash flow, total debt, the cost of debt, and other
relevant parameters suggest that achieving that result
would take until the year 2000 (see chart). Moreover, no
plausible set of param eter values is likely to achieve this
goal over the next few years.
The accom panying table sets forth the parameters
required to project this ratio and a “ baseline scenario” or
most likely set of values. Each of the parameters is
discussed below.
24
FRBNY Quarterly Review/W inter 1992-93
Growth of total debt
Over the past thirty-five years, the total net debt of the
nonfinancial corporate sector has increased at an aver
age annual rate of 8.9 percent, 1.0 percentage point
faster than the average growth rate of nominal GDP over
the same period. In contrast, over the past three years of
balance sheet restructuring, total net debt has increased
at an average annual rate of just 1.5 percent. In the
future it is quite likely that the growth of debt will acceler
ate, but perhaps remain below that long-run average.
Under the baseline scenario it is assumed that total net
debt increases 1 percentage point slower than the longrun growth of GDP, or 41/2 percent, a rate that presumes a
continued rapid pace of equity issuance.
Ratio of short-term to total debt
Over the twenty-year period from 1956 through 1975, the
ratio of short-term to total net debt averaged 30 percent
and varied relatively little from that average. During the
second half of the 1970s it declined to an average of 26
percent, reaching a low of 24.3 percent in 1976-111. Dur
Box 3: The Ratio of Net Interest to Cash Flow— Projected Future Values (Continued)
ing the 1980s this ratio increased substantially, averaging
35 percent and reaching a high of 38.3 percent in 1985-1.
From its most recent peak of 36.9 percent in 1990-1, this
ratio has fallen to 31.1 percent in 1992-111. Under the
baseline scenario, it is assumed to decline to 30 percent
by 1993-IV and then remain constant at that value.
Cost of debt
The cost of debt is determined by the level of interest
rates and the rate at which the stock of debt is repriced.
The baseline scenario assumes that both short-term and
long-term interest rates remain constant at their 1992-111
levels. Nonetheless, the cost of debt will continue to fall
as earlier interest rate declines are realized through
repricing of the stock of debt. Given the estimated $5
billion to $6 billion decline in interest on short-term debt
due to expected repricing over the period from 1992-IV to
1993-111, the cost of short-term debt is assumed to
decline 70 basis points (17.5 basis points per quarter) by
1993-111 and then remain constant at that level. It is also
assumed that the stock of long-term debt will be gradu
ally repriced over the next ten years, with the average
cost of long-term debt declining a total of 150 basis
points (3.75 basis points per quarter) by 2002-III and
then remaining constant.
Growth of cash flow and GDP
Over the past thirty years the cash flow of the nonfinan
cial corporate sector expressed as a percentage of nom i
nal GDP has been on a gradual decline, averaging 14.1
percent in the 1960s, 13.7 percent in the 1970s, and 13.6
percent in the 1980s. This percentage also varies over
the business cycle, rising during expansions and declin
ing during contractions. During expansions, because
cash flow represents a rising proportion of GDP, the
growth rate of cash flow tends to be quite strong. In
contrast, during a contraction, because cash flow repre
sents a declining proportion of a slowing economy, the
growth rate of cash flow is often negative. During the four
preceding recoveries (excluding the brief recovery of
1980-81), cash flow as a percentage of GDP had risen an
average of 1 percentage point. Most recently, cash flow
bottomed out at 12.4 percent of GDP in 1992-1, while as
of 1992-111 it had risen to 12.6 percent. The baseline
scenario assumes that cash flow will rise a cumulative 1
percentage point of GDP, reaching 13.4 percent by 1994IH, and then will remain constant. Accordingly, through
1994-111, cash flow will increase 60 percent faster than
GDP. Beyond 1995, as cash flow reaches a stable share
of GDP, cash flow and GDP will increase at the same rate
(5.5 percent).
As both the table and the chart dem onstrate, under the
baseline scenario it would take eight years or until 2000
for the ratio of net interest to cash flow to decline to the
average level of the 1970s. This result is quite sensitive
to the assumed parameter values, particularly the growth
Ratio of Nonfinancial Corporate Net Interest to Cash Flow
Ratio
FRBNY Quarterly R eview/W inter 1992-93
Box 3: The Ratio of Net Interest to Cash Flow— Projected Future Values (Continued)
rates of total debt and GDP and the cost of debt. To
highlight this sensitivity, the table shows alternative pro
jections based on changes in individual parameter val
ues. For exam ple, if net debt were to increase 1
percentage point faster than the long-run growth rate of
GDP, or 6.5 percent (A lternative A), the ratio would
decline to 19.6 percent by 1995 and then begin a very
gradual ascent. If the cost of short-term debt were to
decline an additional 50 basis points (for a total decline
of 120 basis points) by 1994-111 while the cost of long
term debt declined an additional 50 basis points (5 basis
points per quarter for a total decline of 200 basis points)
by 2002-111 (Alternative B), it would take six years to
reach the goal. In contrast, if the long-run growth rate of
GDP were 5 percent rather than 51/2 percent, it would
take ten years (Alternative C).
One im plication of this exercise is that it may be
difficult to bring the ratio of net interest to cash flow down
to the average level of the 1970s within a few years. For
example, to achieve that result by the end of 1994 would
require that GDP grow 6 percent per year, the cost of
short-term debt decline 90 basis points (at the rate of 10
basis points per quarter), the cost of long-term debt
decline 135 basis points (at the rate of 15 basis points
per quarter), and the ratio of short-term to total debt
remain constant at its 1992-111 value of 31.1 percent. Such
an outcome appears unlikely. For one thing, a higher rate
of nominal GDP growth than assumed in the baseline
would most likely induce higher interest rates because of
upward pressures on inflation. Moreover, even if the
assumed declines in interest rates were to occur, the
implied rapid rate of turnover of the stock of long-term
debt is implausible.
Parameters A ffecting Projected Future Values of the Ratio of Net Interest to Cash Flow fo r the
Nonfinancial Corporate Sector
Alternative Scenarios
Baseline Scenario
A
C
B
Growth of total debt
4V?%
6’/2%
4'/2%
4'/2%
Ratio of short-term to total debt
Declines to 30%
by 1993-IV
Same as
baseline
Same as
baseline
Same as
baseline
Declines 67 basis
points by 1993-ltl
Same as
baseline
Declines another
50 basis points
by 1994-111
Same as
baseline
Declines 150 basis
points by 2002-III
Same as
baseline
Declines another
50 basis points
by 2002-111
Same as
baseline
Long-run growth of GDP
5'/2%
5'/2%
5'/2%
5%
Years u n til ratio reaches 15.8%
8
Never
6
10
Cost of debt*
Short-term
Long-term
•The cost of debt is determined by the level of interest rates and the rate at which the stock of debt is repriced. The baseline assumes that
interest rates remain at or near recent levels, that the stock of short-term debt will be completely repriced by 1993-111, and that the stock of
long-term debt will be repriced by 2002-111 (at the rate of 10 percent of the stock per year).
theless, reducing the aggregate corporate interest bur
den will take time. If the burden of interest on cash
flows is to be lightened to the 19 percent characteristic
of 1983, it will require another two to three years for
corporate refinancing at its present rate to do the job
alone. If the burden is to be reduced to the 15 percent
characteristic of the late 1970s, then refinancing activity
26
FRBNY Quarterly Review/W inter 1992-93
will take over ten years. (For a consideration of how
cash flow growth or interest rate declines could affect
the outlook, see Box 3.)
Such conclusions are, of course, fraught with uncer
tainty. Corporate treasurers may be targeting a lower or
higher burden, so that the restructuring would take
more or less time. Equity m arket developments could
accelerate or slow down the process of restructuring.
Corporate treasurers may cease to extend maturities, a
move that would render refinancing more potent. A fur
ther bond market rally could make the refinancing of
fixed rate debt more effective in easing interest bur
dens; a bond market sell-off would slow the process.
Monetary policy could further reinforce the restructuring
process or begin to work at cross-purposes. On present
trends, however, the process that started in earnest in
1991 will take until 1995 to reduce corporate interest
burdens to their level in 1983.
FRBNY Quarterly Review/Winter 1992-93
27
The Recent Growth of Financial
Derivative Markets
by Eli M. Remolona
Recent years have seen phenomenal growth in financial
derivative markets. Financial derivatives are instru
ments that derive their prices from the performance of
underlying cash markets, specifically money and bond
markets, the foreign exchange market, and stock mar
kets. This article examines the patterns of growth exhib
ited by the various types of derivative markets and
contracts and seeks to deduce from these patterns the
fundamental forces driving growth.
Financial derivatives have grown strongly in both
organized exchanges and over-the-counter (OTC) mar
kets. In te re st rate co n tra cts, notably fu tures in
exchange markets and swaps in OTC markets, domi
nated the growth of derivatives in the last six years.
During the same period, growth in exchange-traded
currency futures and options slowed, while in the last
four years growth in new equity index options surged in
both exchange and OTC markets. The most successful
exchange-traded derivatives appear to be those that
added liquidity to the underlying markets, while the
most successful OTC derivatives were probably those
that offered new configurations of risk and return.1
Financial derivative markets as a whole seem to have
grown much the way any financial innovation might be
expected to grow as it finds increasing acceptance
among users. But the direction and speed of the deriva
tives' spread have been governed critically by particular
demands for liquidity-enhancing and risk-transferring
’ This article emphasizes the functions of derivatives as liquidityenhancing and risk-transferring innovations; see Bank for
International Settlements, Recent Innovations in International
Banking, Study Group Report, Central Banks of the Group of Ten
Countries, April 1986.
28
FRBNY Quarterly Review/Winter 1992-93
tools. This article identifies four developments giving
rise to such demands: sustained shifts and temporary
surges in market volatility, the emergence of important
but relatively illiquid cash markets for government
bonds, new inducements for financial institutions and
nonfinancial firms to deal with interest rate risks, and
the international diversification of institutional equity
portfolios.
Patterns of growth in derivative markets
G r o w th b y ty p e o f m a r k e t
The stock of financial derivatives outstanding world
wide, as measured by open interest and notional
principal,2 multiplied fivefold in five years to approach
$10 trillion by the end of 1991 (Chart 1). In organized
exchanges, open interest in financial derivatives rose an
average of 36 percent a year from 1986 to reach $3.5
trillion at the end of 1991. Even so remarkable an
expansion was apparently surpassed by the growth of
financial derivatives in OTC markets; here total notional
principal grew an estimated 40 percent a year during
the period to soar above $6 trillion by the end of 1991.3
As explained below, however, it is hard to compare the
2Most OTC derivatives involve no actual exchange of principal, but
payments are computed on the basis of the "notional principal"
amounts specified in the contracts,
3Forward rate agreements (FRAs) make up the largest estimated
component. These are agreements on future interest rates that
involve no exchange of principal amounts. Surveys by the Bank for
International Settlements suggest that forward rate agreements
represent a third of interest rate swaps outstanding in the United
States and two-thirds of interest rate swaps outstanding in Europe.
We exclude from our estimates the very large traditional market for
foreign exchange forward contracts, which appears to be very
much a part of the foreign exchange cash market.
size of the two markets, in part because the unwinding
of positions adds to notional principal in OTC markets
while it adds to turnover in exchange markets.
Exchange markets
Organized exchanges such as the Chicago Board of
Trade (CBOT) and the London International Financial
Futures and O ptions Exchange (LIFFE) trade stan
dardized financial futures and options contracts. An
important feature of these trades is the interposition of
a clearinghouse as a counterparty to reduce the credit
risk in each transaction. The arrangement has the vir
tue of providing for clearinghouse offset, a mechanism
that allows a participant to close out a position simply
by undertaking an opposite trade.4 Closing out a posi
tion reduces open interest in the market. More impor
tant, the standardization of contracts together with
clearinghouse offset serves to limit transactions costs
and thus fosters high degrees of liquidity in exchange
markets.5
■♦First introduced at the Minneapolis Grain Exchange in 1891, the
mechanism for clearinghouse offset has become a standard feature
of organized exchanges in derivatives.
sit has been said of futures contracts, for example, that they “ are
designed and introduced by exchanges with basically one
Chart 1
Exchange-traded and Over-the-Counter Derivatives
Trillions of dollars at year-end
10--------------------------------------------------------------= = —
I
'
I Notional principal of
' over-the-counter derivatives
__ I
l Open interest of
_____________
WWW exchange-traded derivatives
Indeed, as argued below, the prim ary economic func
tion of exchange-traded derivatives appears to be the
provision of liquidity in excess of the liquidity in the
cash markets.6 If these derivatives succeed prim arily by
serving as a source of liquidity, then trading volumes
rather than open interest would be the more relevant
measure of market size.
The tra d in g vo lu m e s of fin a n c ia l d e riv a tiv e s in
exchange markets have always dwarfed changes in
open interest, a pattern that reflects the markets’ liqui
dity and the fact that most positions are closed out
before maturity. In 1992, more than 600 million con
tracts were traded in organized exchanges around the
world. This figure represents an increase in turnover
exceeding 11 percent a year since 1986 (Chart 2). The
total value of such trading volumes exceeds $35 trillion
per quarter, roughly a hundred tim es the change in
open interest over the quarter.
OTC markets
OTC markets trade customized swaps, options, and
forward contracts in bilateral deals without the inter
position of a clearinghouse. The custom ized contracts
and lack of clearinghouse offset both inhibit liquidity in
OTC markets. Indeed, unlike the derivative exchange
markets, the OTC derivative markets tend to be less
liquid than the underlying cash markets. It appears that
OTC derivatives are designed prim arily to reconfigure
market risk rather than to provide liquidity.
When an OTC participant unwinds an initial position
by means of an opposite trade, the original contract
typically remains in place and the new transaction adds
to total notional principal in the m arket.7 Thus the por
tion of notional principal growth in the OTC markets that
consisted of trades to unwind positions would be more
akin to the growth in trading volumes in exchange
markets than to the growth in open interest.
Footnote 5 continued
consideration in mind: low-cost trading.” See Merton Miller,
"Financial Innovations and Market Volatility,” a talk given in London,
England, at a seminar sponsored by Dimensional Asset
Management, Ltd., March 24, 1987.
1986
1987
1988
1989
1990
1991
Sources: For exchange-traded derivatives, Bank for International
Settlements (BIS); for over-the-counter derivatives, International
Swap Dealers Association, Federal Reserve Bank of New York
staff estimates, and BIS estimates.
derivatives, of course, vary in the degree to which they serve the
functions of liquidity and risk transformation. The liquidity of the
underlying cash market helps determine the use of a derivative.
The spot market for foreign exchange, for example, is itself so
liquid that risk transformation is probably a more important function
of exchange-traded currency derivatives than of other exchangetraded derivatives.
7Netting rules currently under development for the OTC markets
would allow the offsetting of contracts between two counterparties
but only in the event of default. Some OTC contracts provide for
early termination, but the difficulty of pricing contracts after
origination seems to make it easier to unwind a position by taking
on another contract.
FRBNY Q uarterly R eview/W inter 1992-93
29
Growth by type o f contract
Interest rate contracts
In both organized exchanges and OTC markets, the
growth in derivatives has been dominated by contracts
based on interest rates. The contracts on short-term
interest rates have as their underlying cash markets the
various money markets around the globe, most notably
the Eurocurrency markets and the short-term sterling
market. The underlying markets for derivatives on long
term interest rates are the w orld’s major bond markets,
most notably the U.S. Treasury bond market, the French
government bond market, the Japanese government
bond market, the German bund and Treuhand market,
and the U.K. long gilt market.
In exchange markets, turnover in interest rate con
tracts grew 21 percent a year from 1986 to 1992 and
accounted for 90 percent of the absolute increase in
total exchange market turnover (Chart 2). The great
bulk of this growth came from futures contracts, most
notably futures on three-month Eurodollars at the Inter
national Money Market (IMM) of the Chicago Mercantile
Exchange (CME), futures on the notional French gov
ernment bond at the Marche a Terme International de
France (MATIF), and German bund futures at LIFFE and
the Deutsche Terminborse (DTB).8
As in the exchange markets, most of the derivatives
growth in the OTC markets consisted of interest rate
contracts (Chart 3). Interest rate swaps, the dom inant
OTC derivative from the outset, grew an average of 41
percent a year in notional principal from 1986 to 1991
and alone accounted for possibly half of the absolute
increase in total notional principal of all OTC derivatives
during the period (Chart 4).9 We estimate that forward
rate agreements (FRAs) grew roughly as fast as interest
rate swaps and accounted for perhaps another quarter
of the total market increase. O ption-like interest rate
contracts, including caps, floors, collars, and swaptions,
probably grew the fastest of all OTC contracts, with
notional principal rising 81 percent a year during the
period to account for 10 percent of the total increase in
the OTC m arket.10
Currency contracts
Next to interest rate contracts, currency contracts con
tributed the most to the growth in derivatives, albeit in a
comparatively small way. The underlying cash market
for these contracts is the global foreign exchange mar
ket. In organized exchanges, trading in currency con
tracts rose about 8 percent a year and accounted for
less than 7 percent of the absolute increase in total
exchange market turnover from 1986 to 1992 (Chart 2).
In the OTC market, currency swaps more than kept
pace with interest rate swaps by growing 42 percent a
year from 1986 to 1991, but traditional currency options
probably expanded at only a fraction of that rate (Chart
3). Currency swaps may have shown much stronger
Chart 2
Exchange-traded Derivatives
Annual Trading Volume of Futures and Options Contracts
Millions of contracts
700
-------------------------------------------------------
sThree-month Eurodollar contracts are also traded at LIFFE, the
Singapore Mercantile Exchange (SIMEX), the Sydney Futures
Exchange (SFE), and the Tokyo International Financial Futures
Exchange (TIFFE).
9A popular new type of interest rate swap is the “ diff" or “ quanto”
swap, which exchanges payments based on interest rates in two
currencies but makes both payments in a common currency. For
example, firm A pays the Eurodollar rate while firm B pays the
Eurolira rate less a spread, but all payments are made in U.S.
dollars.
Currency
1986
1987
1988
1989
1990
1991
Sources: Bank for International Settlements; Futures Industry
Association; Options Clearing Corporation; Philadelphia
Stock Exchange.
Note: Values represent combined global volume of
exchange-traded futures and options.
30
FRBNY Q uarterly Review/W inter 1992-93
1992
’ “ Options on less developed country (LDC) debt are one of the
fastest growing segments of this market. The International Monetary
Fund estimates that annual turnover in the secondary market for
this debt exceeds $200 billion, and market participants estimate
that turnover in the options may be a tenth of this amount. See
Richard Waters, “ Derivatives Rush to Catch Up with Emerging
Markets,” Financial Times, December 29, 1992; and International
Monetary Fund, Private Market Financing for Developing Countries,
December 1992. Note that LDC debt options may be more like
equity options than bond options because LDC debt is commonly
used for equity investments in the debtor country through debtequity swaps.
growth than other currency contracts because they are
in part interest rate contracts, involving the exchange of
fixed rate payments in one currency for floating rate
payments in another.
Equity index contracts
Equity index contracts remain a small part of the whole
derivatives market, but their recent growth has been so
explosive that they promise to become a major part of
the market in the near future. These index contracts
have as their underlying markets the major stock mar
kets around the world, most notably the New York,
Tokyo, and Frankfurt stock markets.
Exchange trading in equity index contracts showed no
expansion over the period 1986 to 1992 as a whole
because the tu rn o ve r in U.S. exchanges declined
sharply after the O ctober 1987 stock m arket break
(Chart 2). Since 1988, however, equity index contracts
have recovered so strongly that turnover in these con
tracts has grown faster than turnover in interest rate
contracts. From 1988 to 1992, trading volumes in equity
index contracts increased 14 percent a year. Even with
growth coming from a small base, index contracts still
accounted for a quarter of the absolute increase in total
exchange market turnover in the four-year period. The
recovery was led by new index contracts, notably Nikkei
Index futures and options at the Osaka Securities
Exchange (OSE) in Japan, options on the Deutsche
Aktienindex (DAX) at DTB in Germany, Swiss Market
Index options at the Swiss O ptions and Financial
Futures E xchange (SO FFEX ) in S w itze rla n d , and
Bovespa Stock Index futures at the Bolsa de Mercadorias e Futuros (BM&F) in Brazil.
In the OTC market, equity index options and equity
swaps made up a small fraction of the market, but the
last few years witnessed such tremendous growth in
these contracts that they accounted for perhaps 5 per
cent of the absolute expansion of notional principal in
the OTC market from 1986 to 1991 (Chart 3). The OTC
equity derivative market has two segments, the “ off-thepeg” and the “ bespoke” segments. In the off-the-peg
segment, the older market, investment houses write
covered equity warrants not specifically requested by
investors.11 In the bespoke segment, the newer and
11The Swiss Bank Corporation, for example, offers guaranteed return
Chart 3
Over-the-Counter Derivatives
Year-end notional principal in trillions of dollars
Chart 4
Over-the-Counter Interest Rate Derivatives
Equity contracts
Year-end notional principal in trillions of dollars
6 ------------------------------------------------------------
| H | Currency contracts
Caps, collars, floors, and swaptions
Interest rate contracts
Forward rate agreements
Interest rate swaps
r
I I I
1986
1987
I
1988
1989
1990
1991
Sources: International Swap Dealers Association; Bank for
International Settlements; Federal Reserve Bank of New York
staff estimates.
H
=1
1986
1987
1988
1989
1990
1991
Sources: International Swap Dealers Association; Bank for
International Settlements; Federal Reserve Bank of New York
staff estimates.
FRBNY Quarterly Review/W inter 1992-93
31
apparently faster growing market, some dealers offer
equity swaps but most concentrate on highly custom
ized equity index options, predominantly Nikkei Index
options.
G eographical grow th
The geographical growth of financial derivatives man
ifested itself largely in the opening of new derivatives
exchanges and the widening share of nondollar curren
cies in OTC derivatives.
New derivatives exchanges
The growth in the turnover of exchange-traded derivaFootnote 11 continued
on investment contracts (GROIs), which have the structure of
portfolio insurance or put options on a stock market index. Eli
Remolona and Stephen King analyze such contracts in “ The Pricing
and Hedging of Market Index Deposits,” this Quarterly Review,
Summer 1987.
tives was concentrated in exchanges outside the United
States, most of them new ones (Chart 5). Between 1986
and 1992, a period when turnover on U.S. derivatives
exchanges was barely growing, turnover in European
exchanges rose 47 percent a year and contributed the
largest share of the growth in turnover worldwide. Turn
over in exchanges in the Far East grew 29 percent a
year during the period and contributed the next largest
share of global turnover growth. The turnover increase
was spurred by the opening of new exchanges and the
launching of interest rate and equity index derivatives
(Chart 6). Since 1985, at least eighteen new derivatives
exchanges have been organized around the world,
including already established stock exchanges that only
recently began trading derivatives (Table 1). Trading
volumes at the MATIF, established in 1986, have cata
pulted it to the ranks of the w orld’s five largest derivative
exchanges. Other major new exchanges are the Tokyo
International Financial Futures Exchange (TIFFE) in
Chart 5
Exchange-traded Derivatives by Region
Chart 6
Interest Rate and Equity Index Contracts by
New and Old Exchanges
Annual trading volumes in millions of contracts
700 --------------------------------------------------------
Annual trading volumes in millions of contracts
600
200
United States
100
Other
=k
0 i= =
1986
32
1987
1988
_L
1989
0
T
1990
1991
1992
1986
1987
1989
1990
Sources: Bank for International Settlements; Options Clearing
Corporation; Futures Industry Association; Philadelphia
Stock Exchange.
Sources: Bank for International Settlements; Options Clearing
Corporation; Futures Industry Association; Philadelphia
Stock Exchange.
Notes: The Far East comprises Japan, Hong Kong, and
Singapore. "Other" comprises Australia, Brazil, Canada, and
New Zealand.
Note: New exchanges are exchanges founded after 1985 or
exchanges that opened trading in financial derivatives
after 1985.
FRBNY Q uarterly Review/W inter 1992-93
Japan, DTB in Germany, and SOFFEX in Switzerland.12
Forces driving derivatives growth
OTC derivatives in nondollar currencies
The OTC m arkets operate internationally over te le
phone lines without the benefit of a central clearing
house to fix geographical locations. Transactions made
in London may well be booked in Frankfurt. Nonethe
less, the increasing importance of nondollar currencies
in OTC contracts indicates the geographical diffusion of
these derivatives.13 The share of the nondollar sector in
interest rate swaps widened from 20 percent in 1986 to
51 percent in 1991. The Japanese yen has been the
most im portant nondollar currency; its share of interest
rate swaps has doubled since 1987 to 16 percent in
1991. The pound sterling and German mark have been
the next two most im portant currencies.
The growth and geographical diffusion of financial
derivatives seemed to follow the pattern set by earlier
innovations that found increasing acceptance among
users. But the derivatives’ spread was rooted in specific
demand forces that largely determ ined the direction and
speed that the spread took.14 The analysis below sug
gests that the growth in exchange-traded derivatives
arose primarily from the demand for liquidity-enhancing
innovations and the growth in OTC derivatives from the
demand for m arket-risk-transferring innovations.15
At least four broad developments gave rise to these
demands. First, sustained shifts and tem porary surges
in market volatility differentially affected the demands
for the various derivatives. Second, the emergence of
important cash markets for government bonds and the
12The trading systems used by the new exchanges appear to
indicate a trend away from trading pits toward floorless electronic
systems. The largest exchanges, however, have continued to open
new trading pits, convinced that the open outcry is still the most
effective system for active trading. London's LIFFE did develop its
own electronic system for futures trading, called Automated Pit
Trading (APT), but uses it only to supplement pit trading activity.
The CME, CBOT, and Reuters use their electronic system, GLOBEX
in a similarly supplemental fashion.
13The Bank for International Settlements provides a careful discussion
of the share of nondollar currencies in "Derivative Financial
Instruments and Banks' Involvement in Selected Off-Balance-Sheet
Business,” International Banking and Financial Market
Developments, May 1992, pp. 22-26.
14Supply factors, of course, contributed to the spread of derivatives.
Such factors include advances in communication and informationprocessing technologies and the development of option pricing and
simulation models. The fact that currency option models were
developed before fixed-income option models, for example, may
help explain why currency options seem to have found acceptance
sooner than bond options. Nonetheless, demand factors appear to
have been more significant in the recent growth of derivatives.
15These are two of five types of financial innovation discussed in
Bank for International Settlements, Recent Innovations. The other
types are credit-risk-transferring, credit-generating, and equitygenerating innovations. In their early stages, interest rate and
currency swaps may be viewed largely as credit-generating
innovations.
Table 1
D erivatives Exchanges Established after 1985
Exchange
Country
Date
Trading System
Botsa de Mercadorias & Futuros (BM&F)
European Options Exchange (EOE)*
Marche k Terme International de France (MATIF)
Stockholm Options Exchange (OM)
Swiss Options & Financial Futures Exchange (SOFFEX)
Financial Futures Market Amsterdam (FTA)
Finnish Options Market (FOM)
Guarantee Fund for Danish Options (FUTOP)
Irish Futures & Options Exchange (IFOX)
Osaka Securities Exchange (OSE)*
Tokyo Stock Exchange (TSE)*
March6 des Options Negociables de Paris (M0NEP)T
Tokyo International Financial Futures Exchange (TIFFE)
Deutsche Terminborse (DTB)
Mercado Espanol de Futuros Financiers (MEFF)
Belgian Futures & Options Exchange (BELFOX)
Austrian Futures & Options Exchange (OTOB)
Mercato Italiano dei Futures (MIF)
Brazil
Netherlands
France
Sweden
Switzerland
Netherlands
Finland
Denmark
Ireland
Japan
Japan
France
Japan
Germany
Spain
Belgium
Austria
Italy
1986
1986
1986
1986
1986
1987
1988
1988
1988
1988
1988
1989
1989
1990
1990
1991
1992
1992
open outcry
open outcry*
open outcry
electronic
electronic
open outcry*
electronic
electronic
electronic
electronic
electronic
open outcry
electronic
electronic
electronic
electronic
electronic
electronic
4
t£OE, OSE, TSE, and MONEP existed before 1985, but TSE began trading bond futures in 1988, while EOE, OSE, and MONEP began
trading equity index contracts in the indicated years,
*EOE and FTA have announced plans for an electronic system.
FRBNY Quarterly Review/W inter 1992-93
33
growth of OTC derivatives fostered a demand for the
liqu id ity provided by exchange-traded interest rate
futures. Third, interest rate risks faced by financial insti
tutions and nonfinancial corporations created a demand
for risk-transferring OTC interest rate contracts. Finally,
the global diversification of institutional equity portfolios
led to a demand for risk-transferring OTC stock index
options.
The life cycle of innovations
The acceptance and spread of new products can be
said to follow a life cycle composed of different stages.
Trading volum es in Treasury bond fu tu re s at the
CBOT— the w orld’s most actively traded contract— illus
trate what may be the typical shape of an innovation’s
life cycle (Chart 7). The growth in the bond contract’s
turnover since its introduction in 1977 appears to follow
the S shape of a logistic growth curve.16 In general,
growth in the use of a contract begins slowly, then
surges as the contract becomes popular, and finally
slows down as the contract matures and saturates its
market.
Thus a derivative’s growth rate may depend simply on
the date of its introduction and consequently on the
stage it has reached in its life cycle. The growth rates in
the turnover of U.S. exchange-traded derivatives do
seem to fit a rough life cycle explanation. The CME
launched its currency futures and options in 1972; hav
ing been introduced early, these contracts may now be
growing slowly because they have reached the stage of
market saturation. The CBOT started trading its Trea
sury bond contracts in 1977 and the CME its Eurodollar
contracts in 1981; these interest rate contracts may now
be surging because they are still at the stage of gaining
popularity and capturing new users. Finally, the Chi
cago Board Options Exchange (CBOE) launched its
S&P 100 options and the CME its S&P 500 contracts in
1983; growth of these equity index contracts may now
be accelerating because they are so new.
The life cycles of derivatives, however, have not been
uniform. Demand factors have shaped and stretched
the various S curves to cause some contracts to grow
much faster and others much slower than might be
indicated by a simple life cycle explanation.
explain the recent growth of financial derivatives. But
major shifts in volatility that occurred in certain markets
years ago do help to explain the differential perfor
mance of currency contracts and interest rate contracts.
In addition, more recent tem porary surges in volatility
have clearly boosted the growth of exchange-traded
interest rate and equity index derivatives.
Sustained shifts in volatility
The timing of volatility-inducing shifts in policy regimes
helps explain why currency contracts reached the slowgrowth stage so much earlier than interest rate con
tracts. These policy shifts brought volatility first to the
foreign exchange market, then to the money and bond
markets. In the foreign exchange market, the advent of
floating exchange rates in 1973 ushered in a new era of
volatility (Chart 8). In the money and bond markets, the
Federal Reserve’s shift to targeting monetary aggre
gates rather than interest rates in October 1979 was the
watershed event that lifted interest rate volatility to
unprecedented levels (Chart 9). M arket volatility, as
measured by the standard deviation of Treasury bond
returns, rose from an average of 8 percent a year in the
1970s to 15 percent in the 1980s. Thus the currency
contracts gained popularity first and now appear to
have reached the slow-growth stage of maturity, while
Chart 7
Growth of U.S. Treasury Bond Futures
Annual trading volum es in m illions of contracts
Shifts and surges in m arket volatility
The volatilities of underlying markets in the last six
years have not shown a sufficiently steep rising trend to
16Zvi Griliches finds that this S-shaped pattern applies to the use of
hybrid corn, new farm equipment, new drugs, and new ideas; see
“ Hybrid Corn: An Exploration in the Economics of Technological
Change," Econometrica, October 1957; also Nathan Rosenberg,
ed., The Economics of Technological Change (Middlesex, England:
Penguin Books, 1971), pp. 211-28.
34 FRBNY Quarterly Review/W inter 1992-93
Sources: Chicago Board of Trade; Futures Industry Association.
Note: Only contracts traded on the Chicago Board of Trade
are included.
the interest rate contracts are still gaining popularity
and continuing to grow strongly in trading volumes.
est rate contracts grew 41 percent from 1991 to 1992. It
remains to be seen whether such increases in turnover
will be sustained in 1993.
In one case, an extreme surge in volatility seems to
have actually reduced turnover permanently. Specifi
cally, the October 1987 stock market break was followed
by a sharp decline in the turnover of equity index con
tracts in U.S. exchanges. The demand for such transac
tions was driven in large part by portfolio insurance
programs that relied on index futures and options for
dynamic hedging. When the stock market crashed, the
abrupt loss of liquidity in the cash and derivative mar
kets made the large trades required by the programs
hard if not impossible to execute. Since then, concerns
about execution risk have dampened trading in index
contracts in U.S. exchanges.
Temporary surges in volatility
Temporary surges in volatility often induce temporary
surges in turnover. It is also conceptually possible that a
tem porary volatility surge can increase demand perma
nently by bringing new converts to the market. Dramatic
political events in 1991 sharply increased turnover in
e q u ity in d e x o p tio n s at th e E u ro p e a n O p tio n s
Exchange, SOFFEX, the MATIF, and the Stockholm
Options Exchange (Chart 10). Global turnover in equity
index contracts grew 10 percent in 1991, but the 4
percent growth in 1992 belies the possibility of a perma
nent increase in demand. Similarly, the currency turmoil
of September 1992 produced record turnover in interest
rate contracts at LIFFE, the MATIF, and DTB (Chart
11).17 Having grown 4 percent from 1990 to 1991, inter-
The demand for liq u id ity
Demands for liquidity help explain the strong growth of
futures on both long-term and short-term interest rates
17Somewhat surprisingly, activity in exchange-traded currency
contracts seemed little affected by the event. Accounts of the
actions of major players suggest that they took most of their
positions in the spot foreign exchange market and in fixed-income
and equity markets. See, for example, Thomas Jaffe and Dyan
Footnote 17 continued
Machan, "How the Market Overwhelmed the Central Banks,” Forbes,
November 9, 1992, p. 40.
Chart 8
Exchange Rates
Value of the U.S. Dollar in Terms of Foreign Currency
Index 1960 = 100
*. British pound
1
/
\
\
/
/
%
:
'*-•
A s
.
/
\ r. f
\ A \ !
v \/
V v'
V
/
H
r
/ - w
/
V
/
Vs
/
i
!
/ V
■■■
^ / v ,> s v ^
Japanese yen
JK.
** *
German mark
III l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l 1 1 1 I U i l l 111 111 11111111
1960
62
64
66
68
70
72
74
76
78
80
i i i Ii m
82
Ii i i Ii i i Ii m I i m Ii
84
86
ii
I i i i I m i I mi m i l l . I
88
90
92
Source: Board of Governors of the Federal Reserve System.
FRBNY Quarterly Review/W inter 1992-93
35
and the weak growth of currency futures, although these
contracts are, of course, also used for transforming
market risk.
The function of exchange-traded derivatives
The prim ary econom ic function of exchange-traded
derivatives seems to be to provide liquidity.18 Liquidity is
the a bility to alter exposure to market movements
cheaply and quickly. This ability would depend on trans
action s co sts, inclu d in g co m m issions and bid-ask
spreads, and the m arket’s capacity to absorb large
tra d e s w ith s m a ll p ric e m o ve m e n ts. D e riv a tiv e s
exchanges use technology, clearinghouse and margin
arrangem ents, and dealer com petition to m inimize
transactions costs.19 The m arket’s capacity to absorb
18These derivatives also offer investors the opportunity to take
leveraged positions. A futures contract, for example, is structured
to have zero value at origination, while call options are equivalent
to positions in the underlying securities financed partly by
borrowing. These contracts do not merely save on the transactions
costs of borrowing but also reduce the credit risks entailed by an
equivalent leveraged position in the cash markets.
19William Silber, for example, emphasizes that transactions costs are
much lower in exchange-traded derivatives than in the cash
markets. See “ The Economic Role of Financial Futures," in Anne E.
Peck, ed., Futures Markets: Their Economic Role (Washington, D C.:
American Enterprise Institute, 1985), pp. 83-114.
Chart 9
U.S. Interest Rates
36
FRBNY Quarterly Review/W inter 1992-93
large trades would depend on the market-m aking capa
bility of dealers, the depth of both the cash and deriva
tive s m arket, and the e ffe c tiv e n e s s of a rb itra g e
between cash and derivatives. In general, exchangetraded derivatives allow only a less than perfect replica
tion of positions in the underlying market, but they are
useful precisely because their liquidity makes it easier
to change those positions.20
The most dramatic advantage in transactions costs
seems to be provided by exchange-traded equity index
derivatives, which have found enormous success in
spite of an underlying cash market that is itself largely
an exchange m arket and a p p aren tly rath er liqu id .
Equity index contracts sharply reduce the cost of trans
actions motivated by market events rather than by com
pany-specific events. The savings in transactions costs
are delivered in part by trading a standard basket of
stocks as defined by the index. One study, for example,
has estimated that the commission and spread costs of
a transaction in the stocks making up the S&P 500
Index were thirty times the comparable cost for the
20The less-than-perfect replication of cash positions is reflected in the
'basis," the difference between the derivative's actual price and the
theoretical price implied by cash market prices.
equivalent position in index futures at the CME.21
Liquidity in governm ent bond markets
The liquidity provided by exchange-traded derivatives
has recently found a place in two newly important cash
markets. Trading in the cash markets for French and
German government bonds was relatively inactive when
interest rate futures for these bonds were introduced,
suggesting that these markets lacked liquidity at that
time. Table 2 reports a rough measure of liquidity, the
ratios of secondary market transactions to amounts of
government bonds outstanding in several of the major
m a rke ts.22 The ratios ind icate that liq u id ity in the
211nterest rate futures are estimated to save 40 percent of the
transactions costs of the equivalent positions in the cash markets.
See Arnold Kling, “ Futures Markets and Transactions Costs,"
Financial Futures and Options in the U.S. Economy, Federal
Reserve System staff study, December 1986, pp. 41-53.
22Data are available only for secondary market transactions in the
French and German governm ent bond m arkets has
been lower than in the U.K. market, and liquidity in the
U.S. and Japanese markets higher than in the Euro
pean markets.
The strong dem and for bond futures
Thus a pent-up demand for liquidity in the new govern
ment bond markets helps explain the strong growth of
exchange-traded futures on long-term interest rates.
The growth of such contracts has been strongest where
the underlying cash m arket seems most deficient in
liquidity. In absolute terms, the fastest growing such
contracts in terms of turnover have been the futures on
Footnote 22 continued
home country. French and German bonds are actively traded also
in London. Nonetheless, even doubling the amounts reported for
France and Germany to account for foreign activity would not
change the general pattern across countries.
Chart 11
Chart 10
Impact of September 1992 Currency Turmoil on
Exchange-traded Derivatives
Impact of 1991 Events on Exchange-traded
Derivatives
Monthly Volumes of the Five Most Affected Major Contracts
Monthly Volumes of the Most Affected Major Contracts
Millions of contracts
Thousands of contracts
2000 ------- ----------------------------
1800
Beginning of
O peration
Desert Storm
Soviet coup
attem pt
Euromark
Futures
1600
EOE Stock
Index Options
Short Sterling
Futures
1400
1200
1000
Swiss Market
Index Options
Notional French
Bond Futures
Notional French
Bond Options
CAC 40 Options
German Bund Futures
OMX Options
D
J
1990
F
M
A
M
J
J
A
1991
Source: Futures Industry Association.
1992
Source: Futures Industry Association.
Note: Figures on bund futures combine trading at LIFFE and DTB.
FRBNY Quarterly Review/W inter 1992-93
37
the notional French government bond and those on the
German bund. In relative terms, the ratio of futures
turnover to cash market turnover has been highest for
the French and German markets and lowest for the U.S.
market (Chart 12). Note that growth in the use of bond
futures was accompanied by a decline in cash market
transactions relative to bonds outstanding in Japan,
France, and the United Kingdom from 1987 to 1991
(Table 2).
The demand for new ways to transfer interest rate
risk
It appears that demands by both financial and nonfinan
cial firms for new ways of dealing with interest rate
movements help explain the huge expansion in interest
rate swaps, just as demands for liquidity help explain
the growth of certain exchange-traded derivatives.
The strong dem and for short-term interest rate futures
The growth of OTC derivatives has also helped boost
turnover in certain exchange-traded derivatives. The
liq u id ity of e x c h a n g e -tra d e d d e riva tive s g e n e ra lly
makes them convenient hedging tools for OTC deriva
tives d e a le rs. In p articu la r, the strong growth of
Eurodollar futures and other interest rate futures may
be traced to their use by swap dealers for hedging
tem porary positions in interest rate swaps. Turnover in
Eurodollar futures has come to overshadow turnover in
U.S. Treasury bill futures, not least because most dollar
floating rate payments in swaps are based on LIBOR
instead of Treasury bill rates.
Chart 12
Ratio of Futures to Cash Transactions in
Government Securities
Ratio
France
Germany
■
Japan
; § | United Kingd om
_ [ f | : | United State
The weak dem and for currency futures
Liquidity also seems to be a factor in the poor growth of
currency futures relative to interest rate futures. The
spot market for foreign exchange is apparently already
so liquid that it has created little need for the liquidity
enhancement of exchange-traded derivatives. It is a
telling fact that for the most part OTC dealers hedge
their currency option positions in the spot m arket
instead of the futures market.23
23Certain hedging strategies may still call for the use of exchangetraded options. In general, options can be hedged in either the
cash or futures market by a technique called dynamic hedging or
“ delta” hedging. The technique requires frequent changes in
positions to respond to changes in the sensitivity of the option
price to the underlying asset price. These position changes can
become costly during periods of high volatility, but exchangetraded options can be used to further hedge against the
adjustment costs with a technique called "gamma” hedging.
BJj
L
1987
J,
1988
1989
m
B
j
.
1990
J
1991
Source: Bank for International Settlements calculations.
Table 2
Ratio of Transactions to Am ounts of Government Debt Outstanding
United States
Japan
Germany
United Kingdom
France
1987
1991
14.4
22.1
3.3
10.4
1.9
13.5
8.9
3.3
7.6
1.4
■ ■ ■ ■ ■
Securities Included
H jB B B
Treasury notes and bonds
Long-term interest-bearing government bonds
Bunds, railways, and post office bonds
Long-term government and government-guaranteed securities
Central government marketable debt
Sources: Board of Governors of the Federal Reserve System, Bank of Japan, Deutsche Bundesbank, U.K. Central Statistical Office, London
Stock Exchange, Bank for International Settlements, Banque de France, and Federal Reserve Bank of New York estimates.
38
FRBNY Q uarterly Review/W inter 1992-93
The function of OTC derivatives
OTC derivatives have served to transform market risk,
or equivalently, to provide new ways of transferring that
risk.24 Interest rate swaps, for example, were innovative
because they functionally allowed the exchange of two
notes paying two different types of interest streams—
most commonly a floating-rate note and a fixed-rate
note— w ithout an exchange of principal amounts. The
swap was designed essentially to allow a transfer of
interest rate risk that entailed no credit risks associated
with the principal 25
The rapid growth in OTC interest rate contracts, par
ticularly swap contracts, may be attributed to financial
institutions’ and nonfinancial corporations’ desire to deal
with interest rate risks in new ways. Financial institu
tions turned to these derivatives to replace traditional
hedging operations executed in the cash market, while
nonfinancial corporations, some facing increased lever
age, turned to the derivatives for general hedging and
positioning purposes rather than just for saving on bor
rowing costs.
Developm ent of the swap m arket
A movement towards greater market integration pro
moted the rapid rise of interest rate swaps. Throughout
most of the 1980s, the swap market seems to have
divided itself between a short-term segment (of matu24ln the terminology of finance theory, the function of derivatives is to
help "com plete’’ financial markets. Stephen Ross, for example,
demonstrates that in a world of uncertainty, options may often be
the most effective way to widen investors' range of choices. See
“ Options and Efficiency,” Quarterly Journal of Economics, vol. 90
(February 1976), pp. 75-89.
rities up to three years) catering largely to financial
institution end-users and a long-term segm ent (of m atu
rities longer than three years) catering to mainly nonfi
n a n cia l e n d -u s e rs . In re c e n t ye ars, however, the
division has blurred as nonfinancial end-users have
increased their share of the m arket (Table 3) by m igrat
ing to the short-term segment, which has thus grown
faster than the long-term segment (Chart 13).
The broadening of the market has been supported by
stronger market-making activity, a trend evident in a
wider share of interdealer swaps relative to end-user
swaps and in narrower bid-ask spreads. Swap inter
mediation evolved from a business of simply bringing
end-users together to one in which dealers acted as the
c o u n te rp a rty to each side of a swap tra n s a c tio n .
Assuming the role of counterparty allowed dealers to
take swaps before matching positions could be found
and to sell parts of the transaction to other dealers who
could reach matching customers. As the m arket grew,
the customers them selves began to see the importance
of a dealer’s credit rating, so that the business became
in c re a s in g ly c o n c e n tra te d in th e h ig h e s t ra te d
interm ediaries.26
26The importance of credit ratings has led investment houses to form
triple-A-rated subsidiaries to deal in OTC derivatives. Although
Chart 13
Interest Rate Swaps by Maturity
Billions of dollars of notional principal
3500 -----------------------------------------------------------j j Short-term (under three years)
25ln fact, credit risks are only associated with net interest payments.
Katerina Simons simulates these risks in “ Measuring Credit Risk in
Interest Rate Swaps,” New England Economic Review, NovemberDecember 1989.
3000 — (_ ^ § | Long-term (three years or more)
2500 ------------------------------------------------------------
2000
1500
Table 3
End-Users of Interest Rate Swaps
1000 ■
(Percent Share of Total Notional Principal)
1989
1991
Corporations
24
31
Financial institutions
62
57
Government
7
11
Other
7
1
Source: International Swaps Dealers Association
500
1985
86
87
88
I
I I
I I
89
90
91
Source: International Swap Dealers Association.
Note: Values for 1985 and 1986 are estimates based on reports
by fifteen dealers.
FRBNY Q uarterly Review/W inter 1992-93
39
Credit m arket arbitrage
Some analysts have argued that borrowers most often
turn to swaps to obtain the cost savings from arbitrage
between credit m arkets.27 Fixed rate debt markets are
seen as demanding higher credit risk premiums relative
to the floating rate debt markets. Thus interest rate
swaps would lower borrowing costs through specializa
tion by comparative advantage: a higher rated borrower
would issue in the fixed rate market and a lower rated
borrower in the floating rate market, each seeking the
market where it was relatively favored. They would then
switch interest payments net of a spread.
Such credit market arbitrage, however, fails to explain
Footnote 26 continued
dealers themselves may need high credit ratings, they can still
choose to serve customers with lower ratings or even unrated
customers.
27D.K. Hargreaves, “ Swaps: Versatility at Controlled Risk," World
Financial Markets, Morgan Guaranty Trust Company, April 1991; J.
Bicksler and A.H. Chen, “An Economic Analysis of Interest Rate
Swaps,” Journal of Finance, July 1986.
a surge in swaps issuance that goes well beyond the
gross issuance of all Eurobonds and U.S. corporate
bonds (Chart 14). The swap market has developed to
the point where good opportunities for credit market
arbitrage come only in occasional windows, so that
swaps are now more often used for general hedging and
positioning purposes than for saving on borrowing
costs. Indeed the perceived savings in borrowing costs
through swaps may now merely compensate for the
added credit risk taken on by the swap counterparties.28
Swaps by financial institutions
End-user swap activity grew as financial institutions
started using swaps for their own risk m anagement and
positioning purposes. The increased im portance of
funds management from the mid-1980s on and new
re g u la to ry c a p ita l s ta n d a rd s la te r in the d eca de
prompted many banks to turn to swaps as a way to deal
with increased interest rate risks.
28A fixed rate borrower, for example, has two alternatives: (a) it may
borrow directly in the fixed rate market, or (b) it may borrow in the
floating rate market and swap into fixed rates. Alternative (b) may
offer the lower all-in cost of funds, but unlike (a), it will also entail
some credit risk from the swap counterparty.
Chart 14
Bond and Swap Issuance
Notional Value of Gross Interest Rate and Currency Swap
Issuance and Gross Eurobond and U.S. Corporate
Bond Issuance
Billions of dollars
Chart 15
Total International Interbank Lending
Four-Quarter Moving Averages of Exchange-Rate-adjusted
C hanges in International Bank Assets
Billions of dollars
200------------------------------------------------------------------
Sources: International Swap Dealers Association; Board of
Governors of the Federal Reserve System; Organization for
Economic Cooperation and Development.
Notes: Chart shows bond issuance by financial and nonfinancial
companies. Swap issuance excludes interdealer transactions.
40
FRBNY Quarterly Review/W inter 1992-93
Source: Bank for International Settlements (BIS), International
Banking and Financial Market Developments.
Notes: Chart shows both cross-border lending and local foreign
currency lending. International lending refers only to lending
among banks in countries reporting to the BIS.
During the 1980s, pension funds, insurance compa
nies, mutual funds, and employer thrift plans joined the
contest for household savings and forced banks to
attract deposits by paying more competitive and vari
able interest rates.29 At the same time, a loss of bor
rowers to the securities markets led banks to make the
best of the situation by offering credit guarantees such
as standby letters of credit and loan commitments.
Funds m anagement assured the availability of funds in
case of need, but it also required the payment of inter
est rates sensitive to the money market. With the cost
of funds so sensitive to the market, banks learned to
separate funding risk from price risk by hedging their
interest rate exposures, particularly by using interest
rate swaps. In Europe, the need for funds management
and hedging may have been more acute than in the
United States. The deregulation of deposit rates in
France and Switzerland and the efforts of the various
m onetary authorities to defend exchange rates under
the European M onetary System added to the volatility
of short-term interest rates and drew banks to swaps
and forward rate agreements.
New regulatory capital standards also encouraged
financial institutions to use derivatives rather than cash
markets for the management of interest rate risks. The
Basle accord of 1989 required banks to assign a 20
percent weight to interbank credit for calculating riskbased capital requirem ents but to apply the same
weight only to “ cred it-e qu ivale nt” amounts of OTC
derivatives.30 Hence an interbank swap would require
only a small fraction of the capital required by an equiv
alent interbank cash position on the balance sheet. In
the early 1980s, the most important cash market used
by banks for hedging was the international interbank
credit market. In recent years, the interbank market has
plunged, in part because banks now use the market
narrowly for funding and use OTC derivatives for hedg
ing (Chart 15).31
the primary motivation and as the corporations began to
appreciate the derivative’s general usefulness for hedg
ing and speculating. An im portant factor in the growth of
swaps was the rise in U.S. corporate leverage (Chart
16).32 While the most leveraged corporations probably
did not use sw aps— fo r lack of the cred it q u a lity
required by the m arket— more moderately leveraged
firms evidently found swaps useful. A recent study by
Anuradha Dayal of 356 publicly traded firms, for exam
ple, shows that the swap end-users were on average
more leveraged than the nonusers (Table 4).33 Most of
the swap end-users in the sample were apparently
hedging against interest rate risk by swapping into fixed
rates.
The uncoupling of swaps issuance from bond and
note issuance suggests that many end-users were bor
rowers from banks rather than from securities mar32Another measure of leverage, the ratio of net interest payments to
cash flows, declined sharply in the last two years. Most of this
decline, however, resulted from the fall in short-term interest rates
during the period; see Eli Remolona, Robert McCauley, Judy Ruud,
and Frank lacono, "Corporate Refinancing in the 1990s," in this
issue of the Quarterly Review. Debt-asset ratios have remained
high, and many firms still fear the risk of a rise in interest rates.
33Anuradha Dayal, “ Firm Participation in the Interest Rate Swap
Market: An Empirical Investigation," unpublished paper, Brown
University, November 1992.
Chart 16
Ratio of U.S. Nonfinancial Corporate Debt to GNP
Percent
Swaps by nonfinancial corporations
The use of interest rate swaps by nonfinancial corpora
tions expanded as credit market arbitrage ceased to be
^See Federal Reserve Bank of New York, Funding and Liquidity:
Recent Changes in Liquidity Management Practices at Commercial
Banks and Securities Firms, July 1990.
30The credit-equivalent amount for an interest rate derivative with
remaining maturity of more than a year, for example, would be half
a percent of notional principal plus the mark-to-market value (if
positive), which would be on the order of perhaps another 1
percent of notional principal.
31Svein Andresen provides a good discussion of the development of
the interbank market for OTC derivatives; see "The Growth of
Interbank Markets for OTC Derivative Instruments," Bank for
International Settlements, November 1992
Source: Board of Governors of the Federal Reserve System,
Flow of Funds data.
FRBNY Quarterly Review/W inter 1992-93
41
Table 4
C haracteristics of U.S. Nonfinancial End-Users
and Nonusers of Swaps
Number of firms
Fixed Rate
Payers
Floating Rate
Payers
Nonusers
140
30
186
0.42
0.31
0.34
0.24
0.28
0.14
Leverage
Ratio of debt to assets
Ratio of interest to cash flow
Type of debt hedged (percent)
Bank loan
Floating rate or commercial paper
Fixed rate
No information
49
22
—
47
53
29
Source of basic data: Anuradha Dayal, “ Firm Participation in the Interest Rate Swap Market," unpublished paper, Brown University,
November 1992.
kets.34 The Dayal study does find that most fixed rate
swap payers reported hedging bank loans rather than
floating rate notes (Table 4). Indeed, recent theory sug
gests that instead of issuing floating rate notes, a nonfi
nancial firm will roll over short-term loans to swap into
fixed rates if the management expects the firm ’s credit
rating to improve over time or if a bank creditor believes
it can reduce credit risk by monitoring the firm .35 At the
same time, the recent disappearance of the once-ubiqu ito u s call fe a tu re of U.S. c o rp o ra te b o n d s may be
explained in part by the availability of swap floors,
collars, and interest rate options as alternative means of
protecting fixed rate issuers from a fall in interest rates.
Chart 17
Bonds and Warrants Issued Overseas by
Japanese Corporations
Billions of yen
12000
r n
Bonds with warrants
1V C I
10000
m
8000
U U I IU O
-------------
Straight bonds
6000
The global diversification of equity p o rtfo lio s
In the 1980s, moves by institutional investors to diver
sify their equity portfolios contributed to the growth of
the OTC equity index option market. Modern portfolio
theory had persuaded these investors that diversifica
tion could reduce risk without sacrificing return.36 They
^ If bank borrowers tend to be poorer credit risks than bond and
note issuers, the swaps market may now be subject to greater risks
of default than before.
35See Robert H. Litzenberger, “ Swaps: Plain and Fanciful," Journal of
Finance, July 1992, pp. 831-50; Larry Wall, "Interest Rate Swaps in
an Agency Theoretic Model with Uncertain Interest Rates," Journal
of Banking and Finance, May 1989; and Marcelle Arak, Arturo
Estrella, Laurie Goodman, and Andrew Silver, "Interest Rate Swaps:
An Alternative Explanation,” Financial Management, Summer 1988.
^Indeed, the capital asset pricing model (CAPM) suggests that in an
efficient market, investors would hold the market portfolio
consisting of all securities offered in the market; see William
Sharpe, Portfolio Theory and Capital Markets (New York: McGraw
Hill, 1970).
42
FRBNY Q uarterly Review/W inter 1992-93
.
4000
2000
0L
1986
1 1
1 u
1987
1988
1989
L
.
1990
1991
J
Source: Tokyo Stock Exchange.
saw that in the absence of transfer risks, settlem ent
risks, and substantial transaction costs, a global diver
sification of equity portfolios could provide considerable
gains over purely dom estic diversification, especially
when correlations between stock m arkets remained
low.37 In the 1980s, the Japanese stock market had
become one of the world’s major stock markets, and
exposure to it was an im p o rta n t com ponent of
diversification.
During the period, burdensome rules for issuing
equity directly in the Tokyo stock market drove capitalseeking Japanese firms to Europe, where they issued
equity implicitly by attaching equity warrants to their
Eurobonds. Issuance of these equity-linked bonds
peaked in 1989 when Japanese firms issued over 9
trillion yen in face value (Chart 17). Investors found it
convenient to detach the warrants from the bonds and
to trade them separately as a way of trading the under
lying Japanese equities. Japanese investors bought up
most of the warrants, but enough found their way into
the trading accounts of investment houses and the
globally diversifying portfolios of institutional investors
to form a viable market in Japanese equities outside
Japan.
The development of the Japanese equity warrant mar
ket gave investment houses a convenient underlying
market for OTC index derivatives, especially Nikkei
Index options. Demand for these options surged when
volatility began to beset the Tokyo stock market in 1990.
Experience with trading the Nikkei contracts has appar
ently whet the appetite of investors and writers for OTC
37Bruno Solnik and B. Noetzlin estimate these gains in "Optimal
International Asset Allocation,” Journal of Portfolio Management,
Fall 1982.
index options on the world’s other major stock markets,
notably the New York and Frankfurt markets.
Conclusions
The growth and geographical diffusion of financial
derivatives seem broadly consistent with the spread of
other innovations. Nevertheless, powerful forces of
demand played a decisive role in shaping the spread of
derivatives in recent years. The growth in exchangetraded derivatives reflected primarily a demand for liqui
dity-enhancing innovations and the growth in OTC
derivatives a demand for risk-transferring innovations.
Four broad developments contributed to the demand
for these innovations in recent years. The volatility cre
ated by shifts in policy regimes led first to the growth of
currency contracts, then to the growth of interest rate
contracts, while recent temporary surges in volatility
intensified activity in exchange-traded interest rate and
equity index contracts in the last two years. The
emergence of major new government bond markets and
the growth of OTC derivatives created a demand for
liquidity that exchange-traded interest rate futures were
designed to provide. New inducements to financial insti
tutions and nonfinancial corporations to deal with inter
est rate risks led to the growth of OTC interest rate
contracts, most notably interest rate swaps and forward
rate agreements. Finally, the global diversification of
equity portfolios and the trading of Japanese equity
warrants led to a demand for OTC Nikkei Index options
and for OTC index options on other stock markets.
FRBNY Quarterly Review/Winter 1992-93
43
Assessing the Exchange Rate’s
Impact on U.S. Manufacturing
Profits
by Juann Hung
The large and persistent swings of the dollar over the
past two decades have generated much discussion
about the causes of these movements and their conse
quences for the U.S. trade balance and U.S. competi
tiveness. R elatively little e ffo rt has been made,
however, to assess the effect of exchange rate move
ments on U.S. manufacturing profits.1 This article will
examine the exchange rate-profits relationship since the
introduction of floating rates in 1973, evaluating not only
the overall impact of exchange rate changes on aggre
gate manufacturing profits but also the effects on the
profits of exporting and import-competing firms.2
Undertaking such a study is important for many rea
sons. Most obviously, the effects of large and prolonged
exchange rate swings on profits will, over time, have
significant ramifications for the employment and welfare
of manufacturing workers. In addition, fluctuations in
manufacturing profits will affect investment and savings,
and consequently long-term U.S. economic growth. An
increase in profits tends to boost investment by enhanc
ing firms’ confidence in potential returns on new invest1One recent exception is Richard Clarida, “ The Real Exchange Rate
and U.S. Manufacturing Profits: A Theoretical Framework with Some
Empirical Support," Federal Reserve Bank of New York, Research
Paper no. 9214, 1992.
M anufacturing profits here refer to profits of domestic U.S.
manufacturing firms only. Exchange rate movements also affect
profits of overseas subsidiaries of U.S. manufacturing firms.
Consequently, the total impact of exchange rate change on U.S.
manufacturing profits ought to include the impact on both domestic
profits and overseas profits. Data problems, however, make it
necessary to limit this study to the exchange rate's effect on profits
of domestic manufacturing firms.
44
FRBNY Quarterly Review/Winter 1992-93
ment and by relaxing firms’ budget constraints. A rise in
corporate profits may increase gross savings through
corporate retained earnings, personal savings of divi
dend income, and government tax revenues.
Of course, exchange rate swings are only one deter
minant of manufacturing profits at any point in time.
Other macroeconomic conditions at home and abroad
and factors such as management skills and production
efficiency may also affect manufacturing profits, and
hence employment and investment. Nevertheless,
because exchange rate swings have been so sizable
and persistent in the past two decades, their contribu
tion to the evolution of profits in the same period is
likely to have been important. Thus, studying the impact
of exchange rate swings on profits seems critical to
understanding how exchange rates have helped to
shape the economy’s course.
This article begins by explaining why U.S. manufac
turing profits are likely to have a negative correlation
with exchange rate movements— that is, why a rise in
the dollar is likely to lower profits. The article’s second
section shows that U.S. manufacturing profits over the
past fifteen years do appear to have been negatively
correlated with the exchange value of the dollar. The
third section introduces an econometric model of man
ufacturing profits that makes it possible to assess more
precisely the quantitative impact of the dollar exchange
rate on manufacturing profits. The model focuses on the
direct transmission of exchange rate changes to profits
through shifts in export and import prices.
Our econometric results show that a sustained appre
ciation of the dollar does have a significantly negative
direct effect on U.S. manufacturing profits in the long
run, affecting exporters’ profits more than those of
import-competitors. Simulations based on the model
further suggest that the rise in the dollar in the first half
of the 1980s cut manufacturing profits substantially.
Although the return of the dollar in the second half of
the decade to its 1980 level reversed the decline in the
profit rate due to the earlier rise of the dollar, the
cumulative effect of the 1981-86 high dollar still resulted
in a substantial manufacturing profit loss of about $230
billion (in 1987 constant dollar terms) for the 1981-90
period as a whole. Even if one assumes away the multi
plier effect on the economy, this loss is large; indeed, it
is equivalent in size to about 10 percent of total gross
manufacturing profits during the 1980s.
To be sure, these quantitative findings capture only
the direct impact of exchange rate changes on profits.
Because exchange rates may influence other determi
nants of profits, our estimates are suggestive rather
than precise.3 Nevertheless, the dollar’s impact on man
ufacturing profits in the 1980s is shown to be of such a
magnitude that the conclusion appears inevitable: a
huge and sustained swing in the dollar exchange rate
will have a substantial impact on U.S. manufacturing
profits.
The linkage between exchange rates and
manufacturing profits
Because manufactured goods dominate both U.S.
exports and imports, the profits of U.S. manufacturing
firms are more susceptible to exchange rate movements
than are other components of U.S. corporate profits.4
This section briefly describes the mechanism through
which changes in the exchange rate are transmitted to
profits in the exporting and import-competing sectors. A
formal derivation of the linkage between manufacturing
profits and the exchange rate— how and to what extent
a change in the dollar’s value affects exporters’ and
import competitors’ profits— is given in the appendix.
From the perspective of a U.S. exporting firm, an
appreciation in the dollar is always bad news, whether
or not the dollar appreciation results in an increase in
(foreign currency) export prices. To be sure, an export
ing firm that has market power abroad can try to mini
mize its profit loss by choosing the extent to which the
(foreign currency) export price of its goods adjusts to a
dollar appreciation.5 Nevertheless, a firm’s “ pricing to
3A change in the exchange rate may indirectly affect profits through
its impact on GNP and other variables.
4For example, manufactured goods constituted 76 percent of total
U.S. exports and 79 percent of total U.S. imports in 1990.
5See Richard Marston, "Pricing to Market in Japanese
Manufacturing,” Journal of International Economics, vol. 29 (1990);
market” strategies can only mitigate, but not eliminate,
the negative impact of a dollar appreciation.
The firm may choose a strategy of “ complete pass
through” and raise the foreign currency price of its
exports to the full extent of the dollar’s appreciation. In
this case, the firm leaves the unit dollar profit of its
exports unchanged by holding its dollar export price
fixed.6 The firm’s profits are still likely to fall with this
strategy, however, because its goods become less price
competitive relative to foreign goods and hence its
export volume drops.
Alternatively, the firm may choose a strategy of “ zero
pass-through” and keep the foreign currency price of its
exports unchanged, allowing the dollar price of its
exports to fall to the same extent that the dollar has
appreciated. With this strategy, the firm seeks to pre
vent its export volume from declining, thereby preserv
ing its market share. In this case, both the firm’s export
volumes and its profits measured in foreign currency
terms are unchanged; however, these foreign currency
profits will translate into fewer dollars. In other words,
the firm ’s profits measured in dollar terms will fall
because of a dollar translation effect.
In general, the exchange rate pass-through is likely to
be incomplete but more than zero, so that an apprecia
tion of the dollar hurts export profits both by lowering
the volume of exports and by translating (foreign cur
rency) profits into fewer dollars. There is, in fact, a
trade-off between the price/volume effect and the trans
lation effect: as the exchange rate pass-through to U.S.
export prices (that is, the increase in the foreign cur
rency price of U.S. exports in response to a dollar
appreciation) becomes larger, a given appreciation of
the dollar hurts export profits more through a loss in the
volume of sales but less through a dollar translation
effect.
An appreciation of the dollar also tends to be bad
news for U.S. import-competing firms, but good news
for foreign exporters. Let’s first discuss the effects on
foreign firms by supposing that the yen depreciates
against the dollar but the production costs (in yen
terms) of Japanese goods are not affected.7 A JapaFootnote 5 continued
Alberto Giovannini, “ Exchange Rates and Traded Goods Prices,"
Journal of International Economics, vol. 24 (1985); Paul Krugman,
"Pricing to Market When the Exchange Rate Changes," in S. W.
Arndt and J. D. Richardson, Real-Financial Linkages Among Open
Economies (Cambridge, Mass.: MIT Press, 1987).
•The production costs of U.S. exports tend not to be affected by
changes in the dollar exchange rate because petroleum and other
major imported commodity inputs are priced in dollars.
7Because commodities tend to be priced in dollars, exchange rate
pass-through to U.S. import prices may stem not only from foreign
firms’ pricing-to-market strategies, but also from changes in their
FRBNY Quarterly Review/Winter 1992-93
45
nese exporting firm is going to benefit no matter what it
does, although the extent of its benefit will depend on
its pricing strategy. The Japanese firm may choose to
keep its price competitiveness by leaving the dollar
price of its goods unchanged. In this case, its yen
profits would rise as yen sales revenue increases rela
tive to yen production costs, even though its sales
volume would not change. That is, with a “zero pass
through” strategy, the Japanese firm would benefit from
the dollar’s appreciation purely as a result of a yen
translation effect. Alternatively, the firm might allow the
appreciation of the dollar to pass through fully to the
dollar price of its goods (that is, it might maintain the
yen price of its goods by allowing the dollar price to
fall), thereby increasing the price competitiveness of its
goods and expanding its market share in the United
States. In this case, the firm benefits through increased
sales volume owing to its enhanced price competi
tiveness.
Of course, Japanese firms’ production costs are likely
to rise as the yen’s depreciation (against the dollar)
pushes up the cost of their imported raw material. In
this case, Japanese firms are not likely to pass through
fully the yen’s depreciation to the dollar price of their
goods (that is, they are not likely to lower the dollar
price of their goods to the full extent of the yen
depreciation), since such a strategy would entail a
decline in the yen profit margin of their goods sold in the
United States. Therefore, the exchange rate pass
through to the U.S. im port price is likely to be
incomplete in general.
The extent of the loss incurred by U.S. import-com
peting firm s because of the dollar’s appreciation
depends on the extent to which foreign suppliers pass
through their currency’s depreciation (against the dollar)
to U.S. import prices, as well as the sensitivity of
demand for U.S. manufactured goods with respect to
the ratio of U.S. prices to import prices. If foreign
exporters do not lower the dollar price of their products
as the dollar appreciates— the case of zero pass
through— U.S. import-competing firms’ profit will not be
lowered by the dollar’s appreciation, since U.S. goods
will not become less price competitive relative to foreign
goods. Short of zero pass-through, however, U.S.
im port-com peting firm s will tend to suffer from a
stronger dollar through the erosion in the price competi
tiveness of U.S. goods. Indeed, as the appendix shows,
the greater the extent to which foreign suppliers pass
Footnote 7 continued
production costs induced by changes in the dollar exchange rate.
As a result, the total exchange rate pass-through elasticity for
import prices tends to derive from the impact of exchange rate
changes both on foreign production costs and on firms' pricing-tomarket considerations.
46
FRBNY Quarterly Review/Winter 1992-93
through their currency’s depreciation, the greater the
loss incurred by U.S. import-competitors for the same
degree of appreciation in the dollar.
In sum, the above partial equilibrium analysis sug
gests that an appreciation of the dollar would hurt U.S.
manufacturing profits regardless of the pricing behavior
of U.S. and foreign exporters. By the same token, a
depreciation of the dollar would increase manufacturing
profits. What accounts for these findings is not only that
changes in the dollar exchange rate tend to alter the
price competitiveness of U.S. manufactured goods at
home and abroad, but also that the dollar profit margin
of U.S. exports may change through a dollar translation
effect.
U.S. manufacturing profits since the mid-1970s
Our discussion suggests that if other macroeconomic
variables remain roughly unchanged, we should
observe a negative co-movement between U.S. man
ufacturing profits and the value of the dollar. When
examining the relationship between gross manufactur
ing profits as a share of GDP and the dollar exchange
rate over the past fifteen years, however, we find only
some weak evidence of this inverse relationship (Chart
1). The dollar appreciated by about 40 percent from
1980 to its peak in early 1985, and then more or less
returned to its 1980 level by 1987. Since then, it has
remained in a relatively narrow range. Over that period,
the ratio of manufacturing profits to GDP declined con
siderably during the first half of the 1980s from its 1970s
level, as the dollar appreciation would have led one to
expect, but then hardly recovered by the late 1980s
despite the dollar’s fall.
When we recall that manufacturing profits are also
subject to other influences, however, the weak inverse
mapping between profits and the dollar exchange rate
displayed in Chart 1 appears less surprising. To obtain
a clearer picture of the correspondence between
exchange rate changes and manufacturing profits— in
aggregate and across industries— over the past fifteen
years, let us now turn to a more detailed, although still
impressionistic, analysis. Table 1 traces the evolution
not only of the gross profit share in GNP, but also of
profit margins, export shares of total sales, and import
penetration of major manufacturing industries since the
mid-1970s.8 It presents period averages for each of the
above indicators during three subperiods marked by
huge shifts in the dollar. The value of the dollar against
major foreign currencies in the second period (1981-86)
•Gross profits in Table 1, as in Table 2, refer to profits before
depreciation and taxes but after net interest payments. The
definition of gross profits in these two tables differs from that in
Chart 1 and other parts of this article because data for net interest
payments are not available at a disaggregate industry level.
the first to the second period despite growing world
trade, but then increased sharply from the second to the
third period. Chart 2 gives a clearer picture of this
inverse relationship between the value of the dollar and
manufacturing export performance: export sales as a
share of total sales increased about 0.4 percentage
point each year in the first period, declined about 0.5
percentage point annually in the second period, but
then increased rapidly— 1.1 percentage points each
year— in the third period.
On the domestic market side, the import penetration
ratio rose markedly in the period of the sustained dollar
appreciation but hardly declined when the dollar
depreciated (Table 1). In particular, the import penetra
tion ratio rose from about 9 percent in 1981 to 13
percent in 1986, increasing about 0.8 percentage point
annually in the second period. The high ratio of import
penetration continued up to 1990, only to decline
sharply in 1991 (Chart 2). The persistence of foreigners’
inroads into the U.S. market as the dollar receded from
its appreciated level may have been caused by lingering
effects from earlier dollar appreciation. But it could also
have stemmed from other developments, such as grow
ing competition from newly industrialized and develop
ing countries in the 1980s and an increase in world
trade effected by other factors.
was on average about 22 percent higher than in the first
period (1975-80), and subsequently fell back about 24
percent, on average, between the second and the third
(1987-91) periods.9
The table shows that although the correspondence
between the ratio of profits to GNP and the value of the
dollar was not clear by the late 1980s, profit margins
appeared to be significantly and inversely correlated
with the dollar over the past fifteen years.10 The profit
margin of the nonpetroleum manufacturing sector as a
whole declined by 0.5 percentage point from the first
period to the second, and then increased by 1 full
percentage point in the third low-dollar period.
To identify the factors underlying the seemingly insuf
ficient revival in the ratio of profits to GNP in the late
1980s, it is useful to examine the manufacturing perfor
mance on both the exporting and import-competing
fronts. For the exporting sector, Table 1 shows that the
average ratio of exports to sales hardly increased from
9The occurrence of a recession in each subperiod helps to average
out cyclical influences on the ratio of profits to GNP across the
three subperiods.
1°As noted earlier, for a given volume of export sales, a dollar
appreciation would lower the profit margin of U.S. exports in dollar
terms (that is, the dollar profit per unit of exports) as a result of a
dollar translation effect.
Chart 1
U.S. Manufacturing Profits and the Nominal Dollar Exchange Rate
index: 1985 = 100
................................................... 110
Percent
7.5
7.0
5.5
/
\
6.5
6.0
Nominal effective
exchange rate »
Scale-----► / \
Gross profits as a
percent of GDP
-«----- S c a le
1. , X
| X< \V
7T
*
•
i
\
\
/
L
T V
' \
1
'
'
\
v
V-
\
N
'
\ 2A
/
v
v
1
1
'
I
1
' ^
/
V
'
/
"1
K
W
\l
.
«■*
x \
\
'
\
'«
^
N
1
1 1
I /
1
'
9
i
/ t
•
yv?
/ 1 #
J
100
\\
*
~
a
V
90
V
A
'
80
1V
\
X V
'
w Yw/ v /
\
5.0
70
\\
60
«
4.5 I i n
1970
1 1 11 1 1 11 II 1 1 II 11 1 11
71
72
73
74
75
1 I I 11111 1 1 1 1 1 1 1 1 1 I I
76
77
78
79
80
I I l 1I l I 1I I l 1l l l 1l I l
81
82
83
84
85
1 1 1 1 1 1 1 1 1 I I 1 1 1 1 1 1 1 1 1 50
89
90
86
87
Notes: Gross profits refer to profits before depreciation, interest payments, and taxes. The nominal exchange rate is a trade-weighted average of
the dollar relative to the currencies of thirteen industrial countries.
FRBNY Q uarterly Review/W inter 1992-93
47
The evidence in Table 1 and Chart 2 suggests that the
exporting sector has been adversely influenced by
exchange rate movements: both the profit margin and
the volume of exports appear to have been inversely
related to exchange rate changes. The relationship
between the import penetration ratio and the exchange
rate is not clear, however. The import-competing sector
does not seem to have benefited greatly from the sharp
depreciation of the dollar in the late 1980s. Indeed,
these import developments may be one major factor
underlying the apparently weak response of the man
ufacturing profits-GNP ratio to the dollar’s fall during
this period.
Table 2 provides further evidence of the adverse
effects of the dollar appreciation on manufacturing prof
its in the first half of the 1980s. It traces changes in the
rate of return for major manufacturing industries from
the low-dollar 1978-89 period to the high-dollar 1985-86
period. (The years 1978-79 are chosen as the beginning
period for this exercise to control for uneven impacts of
the 1980 recession on different industries. The dollar
exchange rate in 1978-79 was about the same as the
1980 rate.) The question at issue in Table 2 is whether
industries that were more vulnerable to international
competition showed a greater decline in the rate of
return between these two periods.
The data indicate that the appreciation of the dollar
between the 1978-79 and 1985-86 periods was accom
panied by a decline in the real rate of return in most
manufacturing industries. Moreover, the index of “ loss
in market share,” calculated as the average of the
increase in import penetration and the decrease in the
ratio of exports to sales, shows that all U.S. manufactur
ing industries’ market shares declined during this period
of dollar appreciation. Aside from the primary metals
industry, all listed industries experienced a distinct
deterioration in their ratios of export sales to total sales
while facing greater foreign competition in their respec
tive domestic markets in 1985-86 relative to 1978-79.
Overall, the table suggests that the decline in an indus
try’s profit rate was positively, albeit roughly, correlated
with the erosion of that industry’s international competi
tiveness as measured by the loss in market share index:
industries that incurred higher market share loss tended
Table 1
Perform ance of Major U.S. M anufacturing Industries since the Mid-1970s
Percent, Subperiod Average
Total
Nonpetroleum
Primary Fabricated Machinery & Electric
Motor
Food Chemical
Other
Manu
Subperiods Metals
facturing
Metals
Equipment Equipment Vehicles Products Products (Nonpetroleum)
Ratio of gross profit to GNP+
75-80
81-86
87-91
0.3
0.1
0.2
0.3
0.2
0.2
0.6
0.4
0.4
0.4
0.4
0.4
0.4
0.4
0.4
0.5
0.5
0.5
0.6
0.5
0.6
1.5
1.4
1.4
4.7
3.9
4.0
75-80
81-86
87-91
6.3
3.8
5.9
6.9
6.8
7.6
9.3
7.2
7.8
10.2
8.8
111
8.4
8.7
9.0
5.3
5.6
6.9
10.1
9.2
11.6
7.1
7.0
7.3
7.6
7.1
8 1
75-80
81-86
87-91
5.0
52
8.5
5.4
5.5
6.0
18.9
18.7
22.6
12.8
11.9
17.0
10.6
9.5
11.9
4.0
3.7
4.1
10.3
11.1
12 8
6.7
6.8
9.0
8.3
8.4
10.6
75-80
81-86
87-91
10.2
15.3
15.2
3.5
4.9
6.9
7.5
12.8
21.9
12.7
18.4
25.5
16.4
23.5
28.5
3.7
3.8
4.1
4.1
5.6
7.8
6.6
8.6
10.7
7.3
10.4
13.5
Profit margin*
Ratio of exports to sales
Import penetrations
Memo:
The nominal dollar effective exchange rate
(Index: 1985=100)
1975-80
72.06
1981-86
88.08
t Qross profits in this table are profits before taxes and depreciation, but after interest payments.
*The profit margin is calculated as the ratio of gross profits to total sales.
§lmport penetration is calculated as imports/f total sales + im p orts-exp o rts].
48
FRBNY Quarterly Review/W inter 1992-93
1987-91
67.42
to show greater erosion in their rates of return.11
11The notable anomalies are the auto and food industries. The
surprisingly good performance of the auto industry is largely due to
the choice of the 1978-79 period as the base period for our
comparison. The auto industry's profit in 1979 was substantially
lower than its normal profit because of the 1978-89 oil crisis.
Chart 2
U.S. Manufacturing Sector’s International
Competitiveness
Percent
Import
penetration
♦♦
#
*
♦
Export/sales
ratio /
♦
L/
i - r T ’ i
1975
77
*
i
i i
79
/
81
i
The long-run im pact of the exchange rate on U.S.
m anufacturing p ro fits — an econom etric analysis
This section uses an empirical model to assess the
long-run impact of the dollar exchange rate on U.S.
gross manufacturing profits.12 The formal derivation of
the model and estimation methodologies are described
in the appendix. Here an intuitive explanation of the
model is given, and the estimation results are analyzed.
A brief description of the model
i
83
The impressionistic evidence presented in Tables 1
and 2 and Charts 1 and 2 appears to support the
theoretical claim that U.S. manufacturing profits are
inversely correlated with the exchange value of the
dollar. Nonetheless, because factors such as business
cycles here and abroad may have simultaneous but
different influences on exchange rates and profits, the
correspondence between manufacturing profits and the
exchange rate is not strong. The analysis in the next
section will provide a more complete and quantitative
understanding of the relationship between manufactur
ing profits and the exchange rate in a framework that
controls for the impact of other factors.
I
i
85
I
87
I
The behavior of manufacturing profits in an open econ
omy is best understood by regarding total profits as the
sum of two components: profits on domestic sales and
I
89
Note: Manufacturing sector excludes the petroleum industry.
91
12Gross profits refer to profits before depreciation, interest payments,
and taxes.
Table 2
P ro fitability Changes of Major U.S. M anufacturing Industries between 1978-79 and 1985-86
Percentage Changes
Industry
Nonpetroleum manufacturing
Electric
Motor vehicles
Machinery
Primary metals
Fabricated metals
Chemicals
Food
Other
Change in
Real
Rate of
Return*
Index of
Loss in
Market
Share*
Increase in
Import
Penetration
Decrease in
Ratio of
Exports to
Sales
-2 .1
- 10.6
2.2
-1 7 0
-6 .3
- 2 .0
- 0 .7
3.1
1.3
2.4
5.5
5.3
4.3
3.3
1.1
1.0
0.6
1.5
4.3
8.0
9.9
8.1
6.1
1.8
2.1
0.1
2.8
0.6
3.0
0.7
0.5
0.4
0.5
-0 .1
1.1
0.3
tReal rate of return is calculated as the ratio of gross profit to capital stock. Change in rate of return is the difference between the average
rate of return in 1978-79 and that in 1985-86. Gross profits in this table are profits before taxes and depreciation, but after interest
payments.
*lndex of loss in market share is calculated as 1/2 [increase in import penetration + decrease in exports/sales ratio]. Import penetration is
calculated as im ports/[total sales + imports - exports].
FRBNY Q uarterly Review/W inter 1992-93
49
profits on export sales. Domestic profits are affected by
the exchange rate through a price/volume effect on the
import-competing sector’s profits: the greater the extent
to which exchange rate changes are passed through to
import prices, the greater the effect of exchange rate
changes on the volume of, and profits from, importcompeting sales. Export profits are affected by the
exchange rate through some combination of a price/
volume effect and a dollar translation effect, depending
on the degree to which exchange rate changes are
passed through to export prices.
Our model is built to capture the two channels
through which exchange rate changes affect profits: the
price/volume effect (on both the import-competing and
the exporting sectors), and the dollar translation effect
(on the exporting sector).13 Correspondingly, the key
equation in this model relates changes in manufacturing
profits to changes in three exchange-rate-related prices:
the ratio of (foreign currency) U.S. export prices to
foreign prices (to capture the price/volume effect in the
exporting sector), the ratio of import prices to U.S.
domestic prices (to capture the price/volume effect in
the import-competing sector), and the dollar price of
exports (to capture the dollar translation effect in the
exporting sector). Other factors affecting profits such as
U.S. and foreign activities and unit variable costs are
also included in this profit equation.
In addition, the model has two subsidiary equations
that estimate the exchange rate pass-through to U.S.
export and import prices. The exchange rate pass
through coefficients estimated by these two equations
are necessary inputs into our key profit equation, allow
ing us to trace the long-run effect of a change in the
dollar exchange rate through changes in export and
import prices and ultimately to changes in manufactur
ing profits.
Our model of long-run U.S. manufacturing profits thus
comprises three long-run equilibrium equations. Details
of the three equations and their estim ations are
reported in Box 1. Here a brief discussion is provided of
the estimation results for the main variables and the
overall effects of exchange rate changes on manufac
turing profits.
Estimation results
Estimation results for the export price equation show
that when production costs and foreign prices are held
13Corporate hedging strategies for dealing with exchange rate
movements— strategies such as entering into forward contracts or
swap arrangements to offset the short-run effect of dollar
fluctuations— are not considered in our model, since these
strategies have the effect of smoothing cash flows as opposed to
shaping long-run corporate performances.
50
FRBNY Quarterly Review/Winter 1992-93
constant, a 1 percent appreciation of the dollar would
result in a 0.19 percent decline in dollar export prices.14
In other words, as the dollar appreciates by 1 percent,
unit export price measured in foreign currency terms
would increase by about 0.81 percent, thereby resulting
in a mere 0.19 percent decrease in dollar export
prices.15
Estimation results for the import price equation show
that when foreign production costs and U.S. goods
prices are held constant, a 1 percent appreciation of the
dollar would result in a 0.47 percent decrease in U.S.
import prices. This finding indicates that foreign sup
pliers, compared with U.S. exporters, tend to absorb
more of the exchange rate shocks by adjusting their
profit margins than by passing through exchange rate
changes to the dollar price of their goods. Overall, the
results on exchange rate pass-through to both export
prices and import prices are consistent with other
researchers’ findings.16
Turning to the manufacturing profits equation, let’s
first note that the coefficients on U.S. and foreign activi
ties are reassuringly reasonable. The coefficient on
foreign activity weighted by the share of exports in total
sales is estimated to be 3. (This weighting is necessary
because foreign activity only affects the export compo
nent of total U.S. profits.) This finding means that a 1
percent increase in foreign activity would raise real total
manufacturing profits by 3 percent times the share of
exports in total sales. The share of exports in total sales
averaged about 0.09 during the floating rate period
(Chart 3). The coefficient on the foreign activity variable
thus suggests that a permanent 1 percent increase in
growth abroad is estimated to increase U.S. manufac
turing profits by about 0.27 percent (that is, 3 percent
times 0.09).
By the same token, a sustained 1 percent growth in
the U.S. economy is estimated to increase manufactur
ing profits by 1 percent. That is, it would raise total
14A coefficient estimate in regression analysis using data in log terms
can be interpreted as a percent change in a dependent variable in
response to a 1 percent change in the independent variable
associated with that coefficient.
’ sThe data indicate a very slight break in this relationship after the
mid-1980s. The export price pass-through coefficient has declined
from 0.81 percent to 0.80 percent since the third quarter of 1985.
16See Catherine Mann, “ Prices, Profit Margins and Exchange Rates,”
Federal Reserve Bulletin, 1986; Peter Hooper and Catherine Mann,
"Exchange Rate Pass-Through in the 1980s: The Case of U.S.
Imports of Manufactures," Brookings Papers on Economic Activity,
1989:1; Ohino Kenichi, “ Export Pricing Behavior of Manufacturing: A
U.S.-Japan Comparison,” International Monetary Fund Staff Papers,
vol. 36 (September 1989); and Michael Knetter, “ Price Discrimination
by U.S. and German Exporters,” American Economic Review,
vol. 79 (March 1989).
Box 1: An Open-Economy Model of U.S. Manufacturing Profits in the Long Run
Our model of long-run U.S. manufacturing profits com
prises three long-run equilibrium, or so-called cointegrating, regression equations (Exhibit 1).T In all three
equations, variables are entered in natural log terms.
The nominal exchange rate (S) is defined as the dollar
price of foreign currency, so that an increase in the
exchange rate means a depreciation in the dollar.
Because the derivation of the profit equation is more
involved than that of the export and import price equa
tions, let’s briefly consider the two price equations before
we turn to the profit equation.
The export price equation (equation 2) shows that in
the long run, U.S. export prices measured in dollar terms
(SPX) are positively related to unit labor costs in the
United States (U), the price level abroad (P'), and the
nominal dollar exchange rate (S). This equation is
derived from the notion that dollar export prices are
determined by a markup over unit variable costs (here
measured as unit labor costs). As noted in the text,
export markups (or profit margins) are affected by the
dollar exchange rate to the extent that changes in the
rate are not passed through to export prices. In addition,
export markups adjust to prices of competing goods in
the foreign market (P'). One final term in the export price
equation, DVS, is a slope dummy variable that tests
whether the relationship between export prices and the
exchange rate has changed significantly as a result of
the sharp appreciation of the dollar in the early 1980s.
By the same token, the import price equation (equation
3) shows that in the long run, U.S. import prices mea
sured in dollar terms (Pm) are positively related to unit
variable costs abroad (U'), prices of U.S. manufactured
goods (Ph), and the dollar exchange rate (S). This equa
tion is derived from the notion that dollar import prices
are equal to the product of the dollar exchange rate and
foreign currency import prices and that foreign currency
import prices are in turn determined by a markup over
unit variable costs of imports. Import markups are
affected by the dollar exchange rate to the extent that
changes in the exchange rate are not passed through. In
addition, import markups respond to prices of U.S. goods
that compete with foreign goods in the U.S. market.*
Equations 2 and 3 together allow us to estimate the
Mn a cointegrating regression equation, the nonstationary
dependent variable and nonstationary independent variables
drift together over time, so that the unexplained "residuals”
of the regression equation are stationary over time. The
projected value of the equation’s dependent variable
represents its long-run equilibrium value given the underlying
values of independent variables. The residuals of the
regression represent the deviation of the actual value from
the long-run equilibrium value of the dependent variable.
response of export prices and import prices to a change
in the dollar exchange rate. To complete the assessment
of the impact of a change in the dollar exchange rate on
profits, we still need to estimate the impact of a change
in export prices or import prices on manufacturing prof
its. To that end, let us now turn to the principal equa
tion— the equilibrium profit equation.
The profit equation (equation 1) is built on the idea that
profits are the difference between revenue and costs.
Revenue increases either when sales volume increases
at a given profit margin or when profit margins increase
for a given sales volume. Our regression variables are
devised to capture these effects. On the export volume
side, an increase in foreign activity (Y ) or a decrease in
the ratio of (foreign currency) export price to foreign price
(Px/P ) would increase export revenue by increasing the
volume of export sales. Exporting revenues are also
positively related to the (real) dollar export price (SPX/P):
an increase in the dollar price of exports would increase
export profit margins in dollar terms for a given export
volume, thereby raising export revenues purely through a
dollar translation effect.§
On the import-competing side, an increase in U.S.
activity (Y) or in the ratio of import prices to U.S. prices
(Pn7Ph) would increase domestic revenue by raising the
volume of domestic sales. Finally, as to costs, an
increase in real unit variable costs (U/P) would reduce
the total profits by increasing total variable cost for any
given volume of sales. This cost variable is the last term
of the regression.
Because the profit equation explains total manufactur
ing profits rather than export profits and domestic sales
profits separately, however, scaling adjustments must be
made to the above variables in the regression. Thus, the
variables affecting export volume are scaled by the
export share in total sales, and the variables affecting
domestic sales volumes are scaled by the share of
domestic sales in total sales. More specifically, the fac
tors affecting export volume— the foreign activity variable
*A slope dummy term was initially included in the import
price equation to test whether the relationship between
import prices and the exchange rate changed in the second
half of the 1980s. This slope dummy term turned out to be
insignificant and was dropped from the equation.
§ln the zero pass-through case, a 1 percent dollar
depreciation (1 percent increase in S) would leave Px and
export volume unchanged while raising the dollar export
price (SPX/P) by 1 percent. Consequently, if other variables
are held constant, the percent change in manufacturing
profits due to a 1 percent increase in the dollar export
price—the coefficient on 1n(PxtS,/Pt) in the regression—would
be equal to the pure translation effect.
FRBNY Quarterly R eview/W inter 1992-93
Box 1: An Open-Economy Model of U.S. Manufacturing Profits in the Long Run
and the ratio of (foreign currency) export price to foreign
price— are scaled by the share of exports in total man
ufacturing sales (X). The factors affecting domestic sales
volume— U.S. activity and the ratio of import price to
U.S. goods price— are scaled by the share of domestic
sales in total manufacturing sales (1-X).
The (real) dollar export price (SPX/P) is not scaled by
export share in total sales, however, since it affects total
profits through a translation effect rather than a price/
volume effect. The dollar export price is instead scaled
by the ratio of export revenue to total manufacturing
profits (SPXX/I1). For a given export volume, a 1 percent
increase in the (real) dollar export price would increase
real export revenues by exactly 1 percent. Therefore, if
the unit variable cost of production is unchanged, this 1
percent rise in the dollar export price would increase
total manufacturing profits by 1 percent times the contri
(Continued)
bution that export revenues make to total profits (that is,
by [SPXX/II] percent). According to this theoretical rela
tionship, a 1 percent increase in the dollar export price
(SPX/P) for a given export volume would increase total
profits by (SPxX /Il) percent exactly. To test whether the
data support this theoretical correlation, the coefficient
on (SPxX /Il)ln(S P x/P) is restricted to be one in the
regression.
Overall, our model appears to fit the data quite well.
The high R2’s for all three equations suggest that most of
the variations in the dependent variables are explained
by the independent variables included in each equation.
The augmented Dickey-Fuller statistics for the three
equations further suggest that each equation is reasona
bly cointegrated. The coefficient estimates and their
implications are discussed in the text.
E xhibit 1: Long-Run Equations for an Open-Economy Model of U.S. M anufacturing Profits
(Sample period: 1973-111 to 1990-IV; t-statistics in parentheses)
(1) The long-run m anufacturing profits equation
(3) The long-run im p o rt price equation
Jn(ll/P)t = -8.41 + 1 (SPXX/1I), ln(SPx/P)t + 3.0 Xt In(Y'),
(-5 .3 2 )
(t)
(3.67)
ln(Pm), = 1.90 + 0.47 ln(S), + 0.39 In(U’ ),
(14.91) (14.76)
(9.99)
+ 0.48 ln(Ph), + (x3,
(12.08)
-2 .2 2 X, ln(Px/P‘)t + 1.14 (1-X), ln(Y)t
( - 2 .1 1 )
(6.06)
+ 0.57 (1-X), ln(Pm/Ph), - 1.42 ln(U/P),
(2.46)
(-3 .5 3 )
+
ADF statistic = -4 .5 7
f : the null hypothesis that this coefficient equals one
cannot be rejected (t-statistic = O.2.).
(2) The long-run export price equation
ln(SPx), * 1.90 + 0.19 ln(S) + 0 .0 1 DVS, + 0 .2 2 ln(U),
(11.39) (4.97)
(2.27)
(2.61)
+ 0.57 In(P'), + pi2,
(6.91)
Adjusted R2 = 0.99
52
ADF statistic
FRBNY Quarterly Review/W inter 1992-93
3.93
ADF statistic = -4 .2 5
Variables:
II
M-\
Adjusted R2 = 0.93
Adjusted R2 = 0.99
= gross nominal profits of domestic U.S. manufac
turing firms in dollar terms
P
= U.S. wholesale price level, 1987=100
Ph = U.S. manufactured goods price, excluding food
and energy
P'
= foreign price level
Pm = U.S. import price in dollar terms
Px = U.S. export price in foreign currency terms
Y
= real U.S. domestic demand
Y'
= real foreign domestic demand
U
= unit labor cost in the U.S. manufacturing sector
U'
=* unit variable cost of foreign goods (in foreign
currency): a weighted average of unit labor cost,
world commodity price, and oil price
S
= the nominal exchange rate (d o lla r/fo re ig n
currency)
DVS = slope dummy for ln(St) for 1985-111 to 1990-IV
X
=? the share of exports in total sales
1 - X = the share of domestic sales in total sales
|x'
= residual for equation i.
manufacturing profits by the estimated coefficient (1.14)
times the share of domestic sales in total sales, which
averaged about 0.91 during the floating rate period.17
Coefficient estimates on the three price variables of
concern also appear plausible. The coefficient on the
ratio of (foreign currency) export price to foreign price
weighted by the export share in total sales is -2 .2 2 .
This finding suggests that, on average, a 1 percent
increase in the ratio of export prices to foreign prices
would lower manufacturing profits about 0.21 percent
(-2 .2 2 times 0.09, the average share of exports in total
sales during the floating rate period) through the price/
volume effect in the exporting sector.
Similarly, the coefficient on the ratio of import price to
U.S. price weighted by the share of domestic sales in
total sales is 0.57. This estimation suggests that a 1
percent increase in the ratio of import price to U.S.
goods price on average would increase manufacturing
profits about 0.53 percent (0.57 times 0.91, the average
share of domestic sales in total sales during the floating
rate period) through the price/volume effect in the
import-competing sector.
The coefficient on the (real) dollar export price
weighted by the ratio of export revenue to total profit is
1, suggesting that a 1 percent increase in real dollar
17lt is interesting to note that the influence of foreign economies on
manufacturing profits appears to be growing gradually more
important: export sales as a share of total sales have been
increasing slightly over the past two decades as the U.S. economy
has become increasingly open.
export prices would raise total real manufacturing prof
its by 1 percent times the ratio of export revenue to total
profits.18 Because the ratio of export revenue to total
profit averaged about 0.84 during the floating rate
period (Chart 4), this finding suggests that a 1 percent
increase in the real dollar export price would raise
manufacturing profits by about 0.84 percent through the
dollar translation effect. All these coefficient estimates
appear plausible.
We can now combine these three equations to under
stand the magnitude and distribution of the long-run
effect of a dollar appreciation on manufacturing profits.
Let’s start by gauging the effect of a 10 percent dollar
appreciation on total profits through the exporting sec
tor. The export price equation suggests that a 10 per
cent appreciation of the dollar would result in about an 8
percent increase in foreign currency export prices and
hence an 8 percent increase in the ratio of foreign
currency export price to foreign price (for a given for
eign price level). The profit equation tells us that an 8
18For a given export volume, a 1 percent increase in the (real) dollar
export price would increase real export revenues by exactly
1 percent. Therefore, a 1 percent increase in the dollar export price
(SPX/P) for a given export volume would increase total profits
exactly 1 percent times the ratio of export revenues to total profits.
To test whether or not this theoretical relationship is consistent with
the data, the coefficient on the dollar export price weighted by the
ratio of export revenue to total profits, (SPxX/ll)ln(SPVP), was
restricted to be one (see Box 1 for details).
The t-statistic, estimated on the basis of the null hypothesis that
the coefficient is one, is extremely low (0.2), suggesting that the
null hypothesis cannot be rejected.
Chart 3
Ratio of Export Sales to Total Sales in U.S. Manufacturing Sector
Ratio
FRBNY Q uarterly R eview/W inter 1992-93
53
percent increase in the ratio of foreign currency export
price to foreign price would lower profits by about 1.7
percent (that is, 0.21 times 8 percent) through its price/
volume effect on export sales. Similarly, the export
price equation suggests that a 10 percent appreciation
of the dollar results in about a 2 percent decline in
dollar export prices. From the profit equation, we also
know that a 2 percent decline in dollar export prices
would lower manufacturing profits by about 1.7 percent
(that is, 2 times 0.84 percent) through a dollar transla
tion effect. Overall, a 10 percent dollar appreciation
would lower manufacturing profits about 3.4 percent
through the exporting sector, half through a price/vol
ume effect and half through a dollar translation effect.
With coefficient estimates for the profit equation and
the import price equation, we can also calculate the
impact of a dollar appreciation on manufacturing profits
through a price/volume effect on the import-competing
sector. The import price equation indicates that a 10
percent dollar appreciation would result in a 4.7 percent
decline in U.S. import price, and hence a 4.7 percent
decrease in the ratio of import price to U.S. price for a
given U.S. price level. From the profit equation, we also
know that a 4.7 percent decline in the ratio of import
price to U.S. price would tend to lower manufacturing
profits by about 2.5 percent (that is, 0.53 percent times
4.7) through a price/volume effect on the import-competing sector. An appreciation of the dollar thus appears
to have hurt the import-competing sector substantially,
although not quite as much as it hurt the exporting
sector.19
In aggregate, we find that a 10 percent sustained
appreciation in the dollar would eventually result in
about a 6 percent decline in gross U.S. manufacturing
profits. Applying this estimate to the actual amount of
real gross manufacturing profits during the 1981-90
period, which averaged about $245 billion (in constant
1987 dollars) per year, we see that a sustained 10
percent dollar appreciation would lower manufacturing
profits by roughly $14.5 billion per year. On the basis of
this estimate, we can roughly assess the long-run
impact of the dollar’s swings in the 1980s on manufac
turing profits. If we use 1980 as the base year, as many
analysts do, then the average real dollar in the 1981-90
period was about 13.2 percent higher than the real
dollar’s base-year level. Our model suggests that the
manufacturing profit loss caused by a 13.2 percent real
dollar appreciation sustained over a ten-year period
amounts to about $190 billion (that is, $1.45 billion
times 13.2 percent times 10) in the long run.
Two qualifications should be added to this summary
of our findings. First, the estimated long-run impact of a
19Exchange rate changes have a substantial impact on domestic
manufacturing profits mainly because the U.S. manufacturing sector
relies more heavily on the domestic market than on the foreign
market. Domestic sales constitute about 88 percent, while exports
constitute about 12 percent, of total U.S. manufacturing shipments
during the floating exchange rate period.
Chart 4
Ratio of Export Revenue to Total Profits in U.S. Manufacturing Sector
Ratio
54
FRBNY Q uarterly Review/W inter 1992-93
dollar appreciation on profits would depend on the size
of the two changing ratios— the ratio of export sales to
total sales and the ratio of export revenue to total
profits— in any given period. Chart 5 shows that as the
export sector became more important in the 1980s, the
impact of exchange rate changes on manufacturing
profits through the exporting sector gradually increased.
Second, the above estimates alone do not tell us the
length of time it takes for the long-run effect of
exchange rate changes on profits to be fully realized. To
obtain a more precise estimate of the evolution of the
high dollar’s impact on manufacturing profits in the
1980s, we need to extend the above model to include
short-run dynamic relations between the exchange rate
and profits.
Chart 5
Estimated Percent Change in Gross U.S.
Manufacturing Profits Due to Ten Percent
Dollar Appreciation
Period Averages
Percent
L I Price/volume effect: import-competing sector
L 1 Price/volume effect: export sector
L _ | Translation effect
| |
1
-----
—
■
-----
1 1
—
-----
—
I
L .................
1975-80
l
1981-86
I
_J
1987-90
The impact of the d o lla r’s sw ings in the 1980s on
m anufacturing profits in the sh o rt run and the
long run
This section conducts simulations to assess how profit
losses of U.S. manufacturing firms have evolved in
response to the sharp swings of the dollar in the 1980s.
The analysis requires two steps. In the first step, our
model is expanded to include both the short-run effect
of exchange rate changes on profits and the long-run
impact of exchange rate changes on the two adjustment
ratios—the ratio of export sales to total sales and the
ratio of export revenue to total profits. The estimations
and results of these five equations are discussed in Box
2. The second step entails using the expanded model to
project the path that manufacturing profits would have
taken if the real dollar exchange rate had stayed at its
1980 level throughout the 1980s. These hypothetical
“ equilibrium” profits are compared with our baseline
profits to project the path of manufacturing profit losses
attributable to the dollar’s movements in the 1980s.
The base year chosen is 1980, in part because many
analysts believe that the dollar was roughly at its equi
librium purchasing power parity level that year. Purchas
ing power parity holds when a dollar can buy roughly
the same amount of goods abroad as it can in the
United States. That is, the prices of goods at home and
abroad, if translated into a common currency, are about
the same.
Of course, the dollar moved sharply during the 1980s.
From 1980, the real dollar rose about 40 percent to
reach its peak in the first half of 1985, then started to
fall sharply until it was more or less restored to its 1980
level in 1987. On average, the real dollar was 25 percent
above its 1980 level during the 1981-86 period and was
slightly below its 1980 level (by about 1 percent) during
the 1987-90 period (Chart 6).
Hypothetical nominal exchange rates, computed on
the assumption that the real exchange rate had stayed
at its 1980 level, are plugged into our expanded model
to project the hypothetical profits that would have
resulted from a stable real dollar during the 1980s.
Baseline profits are obtained by fitting actual exchange
rates in the 1980s to our model. Finally, the hypothetical
profits are compared with the baseline profits to assess
the impact of exchange rate developments on manufac
turing profits over the past decade.
Simulation results are summarized in Table 3 and
Chart 6. Chart 6 shows that the dollar’s rise in the first
half of the 1980s did result in a large and lingering profit
loss in the manufacturing sector. Because of the compli
cated dynamics involved, however, the time profile of
the profit loss did not exactly mirror the evolution of the
dollar’s rise and fall. Although the dollar translation
effect was felt almost immediately, the price/volume
FRBNY Quarterly R eview/W inter 1992-93
55
Box 2: Expanding the Open-Economy Model of U.S. Manufacturing Profits
This box expands our model by estimating the short-run
dynamic counterpart of the three long-run equilibrium
equations, as well as two auxiliary regressions. The
short-run equations are necessary since the three longrun equations alone will not allow us to estimate the time
profile of the impact of exchange rate changes on man
ufacturing profits. The two auxiliary regressions are
included to ensure that the simulation results incorporate
the effect of exchange rate changes on profits through
their effect on the two adjustment factors.
Exhibit 2 presents the estimation results of these five
new equations. Equation 4 shows the error correction
model of manufacturing profits .1 Equations 5 and 6 show
the error correction model of U.S. export prices and
import prices, respectively. Overall, the three equations
fit the data reasonably well: the R2’s are reasonably high
for these types of regression. Together, these three
equations provide insights into the short-run dynamic
effect of the exchange rate on manufacturing profits.
Equation 4 suggests that the rate of change in real
manufacturing profits, A ln(Il/P)„ is driven not only by the
deviation of actual from long-run equilibrium real profits
in the past period (|x1t - 1 ) , but also by lagged U.S.
economic growth and lagged changes in the ratio of
import price to U.S. goods price, the ratio of export price
to foreign price, the domestic real interest rate, and
manufacturing capital stock.* The coefficient estimate on
jx1,., implies that on average about 2 2 percent of the
deviation of profits from their long-run equilibrium level is
eliminated each quarter. Lagged changes in the dollar
e x p o rt p ric e — A ln (S P x)t.1— do not a p p ea r sig n ifica n t in
the regression, suggesting that changes in the exchange
rate affect manufacturing profits faster through the trans
lation effect than through the price/volume effect. Equa
tion 4 also indicates that the price/volume effect of
exchange rate movements on import competitors’ profits
takes longer to be fully realized than that on exporters’
profits: changes in the ratio of import price to U.S. price
+An error correction model ot a stochastic variable X
characterizes the short-run dynamic adjustment process of X
around its long-run equilibrium level. Typically, the first
difference of X, AXt, is regressed on the equilibrium error
(that is, the deviation between the actual X and the long-run
equilibrium X) in the past period, and on lagged changes in
AX and in independent variables. A parsimonious
representation is usually achieved by eliminating most
insignificant lag terms. The coefficient estimate on the
equilibrium error in an error correction model reflects the
average speed of adjusting to the equilibrium level. See the
appendix for details.
♦Variables affecting the short-run movements of profits but not
included in the long-run profit equation should also be
included in the error correction model The model thus
includes capital expenditure, inflation, and changes in the
real interest rate.
FRBNY Quarterly Review/W inter 1992-93
have a lagged effect on profits that lasts at least five
quarters, while most lagged effects of changes in the
ratio of export price to foreign price are realized after
three quarters.
Equation 5 is based on the idea that the rate of change
in dollar export prices— Aln(SP*)t— is driven not only by
the deviation of the actual from the long-run equilibrium
dollar export price in the past period
but also by
changes in lagged dollar export prices and in lagged
domestic and foreign prices. The coefficient estimate on
ix2,., suggests that on average only about 16 percent of
the deviation of the dollar export price from its long-run
equilibrium level is eliminated each quarter. Most of the
lengthy adjustment time, however, is required for export
prices to respond to factors other than the exchange
rate. The high coefficient estimate on lagged dollar
export prices— Aln(SPx),.1— implies that the bulk of
exchange rate pass-through is actually achieved rapidly
following changes in the exchange rate.
Similarly, equation 6 tells us that the rate of change in
import prices— Aln(Pm),_— is driven not only by the devia
tion of the actual from the long-run equilibrium import
price in the past period (tx3t- 1 ), but also by lagged
changes in the exchange rate, import prices, U.S. man
ufacturing goods prices, and unit variable costs abroad.
About 44 percent of the dollar import price’s deviation
from its long-run equilibrium level is eliminated each
quarter. Changes in the exchange rate— Aln(S)— have
an impact on import price even after four-quarter lags,
suggesting that it takes at least five quarters to achieve
the bulk of the long-run exchange rate pass-through to
import prices.
This discussion points to two conclusions. First, the
exchange rate’s long-run translation effect on profits is
achieved more quickly than its long-run price/volume
effect. Second, the long-run price/volume effect on
exporters’ profits is realized more rapidly than that on
import competitors’ profits.
Now let’s briefly discuss the two auxiliary long-run
equations linking the exchange rate and the two adjust
ment factors in the profit equation. Equation 7 shows that
the ratio of export revenue to total profits is positively, but
only slightly, affected by a dollar depreciation. Equation 8
indicates that the ratio of export sales to total sales is not
significantly affected by changes in the dollar exchange
rate in the long run. This finding is plausible because a 1
percent appreciation of the dollar would eventually lower
domestic sales almost as much as export sales. The
regression results of the two auxiliary equations suggest
that exchange rate changes in the long run have only a
trivial effect on the two adjustment factors. For the sake
of completeness, however, these two equations are
included in the model simulation.
Box 2: Expanding the Open-Economy Model of U.S. Manufacturing Profits
(Continued)
E xhibit 2: Short-Run A djustm ents and A u xilia ry Equations fo r an Open-Economy Model of U.S. M anufacturing
Profits (Sample period: 1973-111 to 1990-IV)
(4) The sh ort-run dynam ics of m anufacturing profits
Two auxiliary long-run equations:
Aln(n/P)t = -0 .2 2
(7) (SPxX /lI)t i
- 0.03 ARt_2
-2 .0 6 tn(Y), + 0.18 ln(Ph)t + |ji7f
+ 0.62 (1-X) Aln(Y)^
-1.16 (1-X) Aln(Pm/P h),.2
-1.46X Aln(Px/P ' ) t_2 lo
Adjusted R2 = 0.87
t0 ,5
Adjusted R2 = 0.93
ADF statistic = 4.44
Variables:
Adjusted R2 = 0.38
(5) The short-run dynam ics of U.S. export prices
Aln(SPx)t = -0 .1 6 (x2,^ + 0.52 Aln(SPx)M
+ 0.34 Aln(Ph)t_, - 0.05 Aln(P ’ )t.2 to
+ p .5 ,
,6
Adjusted R2 = 0.70
(6) The short-run dynam ics of U.S. im port prices
Aln(Pm)t = -0 .4 4 ^ 3t.t + 0.42 Aln(Pm)M
+ 0.13 Aln(S)M to ,4 + 0.36 Aln(Ph)t„4
)t_2
ADF statistic = 4.14
(8 ) Xt = 0.79 + 0.001* ln(S)t + 0.37 ln(Y*)t - 0.28 ln(Y)t
+ ^8t
-3
+ 2.94 Aln(P h)t_3 - 5.40 Aln(K)M + (x4t
+ 0.25 Aln(U
7.96 + 0.18 ln(S)t + 2.20 ln(Y*)t
to -4 +
A
Adjusted R2 = 0.63
K
= U.S. manufacturing capital stock
= gross nominal profits of domestic U.S. manufac
turing firms in dollar terms
P
= U.S. wholesale price level, 1987 = 100
Ph = U.S. manufactured goods price, excluding food
and energy
P*
= foreign price level
pm = U.S. import price in dollar terms
px
= U.S. export price in foreign currency terms
R
= the real interest rate in the United States
Y
= real U.S. domestic demand
u*
= unit variable cost of foreign goods (in foreign
currency)
S
= the nom inal exchange rate (d o lla r/fo re ig n
currency)
X
= the share of exports in total sales
1 -X = the share of domestic sales in total sales
= residual for equation i.
11
Note: All coefficients shown are statistically different
from zero, except the one noted by *.
effects on both exporters’ and import competitors’ prof
its, which accounted for about three-quarters of the
total long-run impact of dollar appreciation on profits,
took about three years to be fully realized. Conse
quently, the real manufacturing profit loss due to the
dollar appreciation in the early 1980s was not significant
until the beginning of 1983. It then climbed steadily as
the dollar continued to rise, reaching $55 billion (mea
sured in 1987 dollars) in 1984. The profit loss then
lingered at about $50 billion during 1985-86 because of
continuing price/volume effects, even though the dollar
started to plunge in the second half of 1985. In 1987,
two years after the plunge of the dollar, the profit loss
began to fall sharply.
The latter half of the 1980s highlights the complex
timing dynamics more dramatically. The rapid positive
translation effect on profits of the dollar’s 1985-87 fall
resulted in a slight profit gain for the manufacturing
sector by 1988. The persistent negative lagged price/
volume effect of the earlier high dollar, together with the
negative translation effect of the rise in the dollar from
its low 1987 level, then caused the profit loss to resur
face in late 1988 and early 1989. During the second half
of 1989 and the first half of the 1990, however, the
lagged price/volume effects of the dollar’s mid-1980s
fall again led to a profit gain.
Table 3 shows that the average annual profit loss
reached $51 billion (in 1987 constant dollars) in the
highest dollar period (1984-86), remained around $17
billion in 1987-88 when the dollar was already back to
FRBNY Q uarterly R eview/W inter 1992-93
57
its base year level, and was reversed by 1989-90 as the
dollar remained low and lagged price/volume effects of
the earlier high dollar tapered off. On average, man
ufacturing profit losses amounted to about $23 billion
per year over the past decade. Our calculations suggest
that this profit loss was distributed somewhat more
heavily on exporters than on import competitors. The
exporting sector’s profit loss, stemming more or less
Chart 6
Estimated Manufacturing Loss Due to Changes in
the Dollar in the 1980s
Billions of 1987 dollars
50 --------------------------------Changes in the Dollar
4 0 ---------------------------------
equally from the price/volume effect and the translation
effect of the dollar’s appreciation, was about $13 billion
per year. Import com petitors’ profit loss, deriving
entirely from the price/volume effect of the dollar’s rise
on profits, was about $10 billion per year. Overall, the
cumulative dollar profit loss for the entire 1981-90 period
was about $230 billion, or 10 percent of total manufac
turing profits.
These estimates appear reasonable, given that the
price/volume effects of the dollar’s appreciation take
time to be fully realized and that the average value of
the real dollar over the 1981-90 period was still about
13.2 percent higher than the value of the real dollar in
1980. The long-run effect of the high dollar in the 1980s
on manufacturing profits drops noticeably, however,
once the lagged price/volume effects of the 1987-90
dollar’s return to its 1980 level are completed. Our
previous estimate, based on the three long-run equi
librium equations alone, indicates that the cumulative
manufacturing profit loss amounts to about $190 billion
when all the lagged effects are realized (roughly by
1993).20
In sum, the simulation results imply that the manufac
turing profit loss caused by the high dollar during the
1981-85 period has been sizable, enduring, and wide
spread. In view of the substantial degree of the dollar’s
rise during the first half of the 1980s relative to 1980,
these results are not surprising. If the degree of the
dollar’s appreciation during the 1980s had been trivial,
its cumulative impact on manufacturing profits would
have been negligible in the long run.21
Our results also indicate that the complex and pro
longed adjustment of profits to exchange rate move
ments may have contributed significantly to the evolu
tion of profits over the last ten years. Admittedly, devel
opments in the dollar exchange rate do not fully explain
the low level of manufacturing profits in the late 1980s.
Nevertheless, the prolonged adjustment of profits to the
1981-85 dollar appreciation, together with the still
incomplete adjustment of profits to the subsequent dol
lar depreciation, appears to have been a major factor
underlying the weakness in U.S. manufacturing profits
“ Of course, if the average value of the dollar during the entire 1980s
had not differed from the value of the dollar in 1980— that is, if the
dollar had depreciated substantially from its 1980 level in the late
1980s to compensate for its earlier appreciation from its 1980
level—the dollar’s swings in the 1980s would not have resulted in a
cumulative profit loss over the long run.
1981
82
83
84
85
86
87
88
89
Note: Changes in the dollar are measured relative to a
benchmark dollar level that would hold the real exchange rate
at its 1980 level.
58
FRBNY Q uarterly Review/W inter 1992-93
90
21For example, if we choose 1981 rather than 1980 as the base year
for comparison, then the average value of the 1982-90 real dollar
was about 1 percent higher than the base-year real dollar.
Consequently, if we use 1981 as the base period, the real
manufacturing profit loss eventually amounts to a mere $70 billion
for the 1982-90 period as a whole, and only about $15 billion in the
long run when all lagged adjustments are completed.
Table 3
The Estim ated Im pact of Exchange Rate Development on U.S. M anufacturing Profits
Yearly Average
Total loss due to dollar’s swings in the 1980s (billions of 1987 dollars)
Loss as share of total manufacturing profits (percent)
Degree of real dollar appreciation relative to 1980 real dollar (percent)
throughout much of the 1980s.
Conclusion
This article investigates the effect of exchange rate
changes on U.S. manufacturing profits since the advent
of the floating exchange rate system. It first demon
strates that an appreciation of the dollar is likely to
lower U.S. manufacturing profits, regardless of the ways
in which U.S. or foreign exporters adjust their pricing
strategies to changes in the dollar exchange rate.
Changes in the exchange rate are transmitted to man
ufacturing profits through a combination of two chan
nels: a price/volume effect (on both import-competing
and exporting profits) and a dollar translation effect (on
exporting profits).
Next, an econometric model is built and estimated to
assess the direct impact of exchange rate changes on
manufacturing profits. Estimation results from this
model show that over the long run, a 10 percent nominal
appreciation of the dollar directly reduces U.S. man
ufacturing profits by about 6 percent: about 3.4 percent
through losses in the exporting sector and about 2.5
percent through losses in the import-competing sector.
1981-83
1984-86
1987-88
1989-90
1981-90
15.1
51.2
17.2
- 3 .4
22 6
7.4
22 2
7.2
- 1 .3
10.1
20.3
24 8
- 1 .3
-0 2
13.2
Expressed in constant (1987) dollar terms and based on
profit levels in the 1980s, these estimates imply that a
sustained 10 percent dollar appreciation would lower
manufacturing profits on average by more than $14
billion per year.
The results indicate that even though the bulk of the
decline in the profit rate caused by the high dollar in the
first half of the 1980s was restored by the late 1980s, the
cumulative profit loss caused by the dollar’s swings in
the 1980s remained substantial for the 1980s as a
whole. If we use 1980 as the base year, the average
profit loss due to the high dollar in the 1980s was about
$23 billion per year in that decade, or 10 percent of total
manufacturing profits. At its peak during 1984-86, the
manufacturing sector’s loss reached about $50 billion
per year, or about 22 percent of actual profits. In sum,
the cumulative profit loss from the dollar’s swings in the
1980s totaled about $230 billion for the entire 1981-90
period. The cumulative loss is expected to decline to
about $190 billion over the long term (roughly 1981-93),
when all the lagged price/volume effects of the dollar’s
depreciation in the second half of the 1980s will have
been completed.
FRBNY Quarterly Review/W inter 1992-93
59
Appendix: The Relationship of the Exchange Rate to Pricing Behavior and Manufacturing Profits
The exchange rate and exporters’ profits
The relationship between exporters’ profits, the export
price pass-through elasticity, and the exchange rate can
be represented by the following profit identity:
(A1) Ux = S Px X - U X
X = X(PX/P')
Px * PX(S),
where
l l x = exporting firms’ gross nominal profits from sales to
the foreign market, in dollar terms
X = export volume
U = the unit variable cost of U.S. manufactured output
S = the exchange rate (dollar/foreign currency)
Px = the (foreign currency) unit price of U.S. exports
P' = the foreign price level.
depreciation will be equal to the ratio of export revenue
to total profits.
In the case of complete pass-through (0 X = -1 ), when
U.S. firms allow Px to fall to the full extent of the dollar’s
depreciation (or to rise by the full extent of the dollar’s
appreciation), the dollar translation effect will be zero. In
other words, dollar receipts for each unit exported will
not be affected by the change in the dollar exchange
rate. However, in this case, export profits will increase by
\ x percent through a price/volume effect. That is, the
elasticity of export profits with respect to the exchange
rate will be equal to the price elasticity of foreign demand
for U.S. exports (Ax).
The exchange rate and im p o rt co m p e tito rs’ profits
The relationship between import competitors’ profits, the
import price pass-through elasticity, and the exchange
rate can be expressed by the following profit identity:
We can obtain the following equation by taking the deriv
ative of l l x with respect to the exchange rate (S):
(A4) l l H - PhtjH - U H
H = H(Pm/Ph)
(A2) ailx/3S = Px X + S X (aPx/aS)
+ S Px (ax/a(Px/P')Hd(Px/P‘)/fiS)
- U (3X/a(Px/P'))(d(Px/f)P‘)/S).
where
Let 0 X be the elasticity of the U.S. export price (in foreign
currency terms) with respect to the exchange rate, and Xx
be the elasticity of demand for U.S. exports with respect
to the ratio of (foreign currency) U.S. export price to
foreign price. If we assume that f)P7fiS = 0, then after
some algebraic manipulation, equation A2 becomes
(A3) (AIIX/I1X)/(AS/S) = SPxX /lix (1 +
0 X)
+ 9X \ x,
where
pm
=
p m (S )
11H = the gross nominal profits of U.S. manufacturing
firms in the import-competing sector
H = import-competing firms’ output sold domestically
Ph = the (dollar) unit price of U.S. output sold
domestically
Pm = the (dollar) unit price of U.S. imports.
If we assume that Ph remains unchanged when the
dollar exchange rate changes (that is, aPh/<5S = 0), then
we can obtain equation A5 by taking the derivative of l l H
with respect to the exchange rate (S):
(A5) ^ lIM/r>S - Ph (3H/a(Pm/Ph))(a(Pn7Ph)/f!S)
6X =
(APX/AS)/(PX/S), - 1 ^ 0 X ^ 0.
Xx = {AX/A(PX/P‘))/((PX/P’)/X), Ax < 0.
Equation A3 indicates that a 1 percent depreciation in the
dollar will always increase U.S. exporters' profits by
SPxX /llx (1 + 0X) percent through the translation effect
and by 0 X Ax percent through a price/volume effect.
In the case of zero exchange rate pass-through (0 X =
0), when U.S. firms fully prevent the depreciation of the
dollar from passing through to P \ export volume will
remain unchanged as the dollar depreciates. As a result,
a depreciation of the dollar will boost exporters’ dollar
profit purely through a translation effect: a 1 percent
dollar depreciation will raise the dollar export price (SPX)
by 1 percent, and a translation effect of 1 percent dollar
60
FRBNY Q uarterly Review/W inter 1992-93
+ U (c>H/a(P"7Ph))(d(Pm/Ph)/aS).
Let 0 m be the pass-through elasticity of U.S. import
prices (in dollar terms) with respect to the exchange rate,
and \ h the elasticity of U.S. domestic demand for man
ufactured goods with respect to the (Pm/Ph) relative price.
Then it is easy to understand how the gain in 1IH relates
to the pass-through elasticity of Pm by deriving the fol
lowing equation from equation A5:
(A6 ) (AI1H/IIH)/(AS/S) = 0m \ h,
where
em = (APm/AS)/(S/(Pm));
0
«
0m « 1
Appendix: The Relationship of the Exchange Rate to Pricing Behavior and Manufacturing Profits
(Continued)
Xh
~ (AH/A(Pm/Ph))/((Pm/Ph)/H);
\ h > 0.
From equation A 6 , it is clear that a dollar depreciation
would raise the profits of U.S. import-competing firms
purely through a price/volume effect. Indeed, a t percent
dollar depreciation would increase U.S. import competi
tors’ profits by 6 m Xh percent. If foreign exporters passed
through the full extent of the dollar’s depreciation to the
price of their goods in the United States, so that 0m = 1,
the elasticity of import competitors' profits with respect to
the exchange rate would simply equal the price elasticity
of domestic demand for manufacturing goods (Xh). If
foreign exporters kept Pm unchanged when the dollar
depreciated against their currencies (that is, 0m = 0 ), the
profits of U.S. import-competing firms would not rise,
because the depreciation of the dollar would not make
their goods more price competitive. Indeed, it is clear
from equation A 6 that (AI1H/IIH)/(AS/S) is equal to zero in
this case.
An Open-Economy Model of U.S. Manufacturing
Profits
To examine the effect of the exchange rate on gross U.S.
manufacturing profits, let’s divide gross manufacturing
profits into two components: profits accrued from export
sales and profits accrued from domestic sales. Domestic
sales includes sales in the import-competing sector as
well as sales not in competition with imports. We can
then analyze the impact of the exchange rate by making
the following assumptions:
(A7)
(A 8 )
(A9)
(A10)
(A11)
11, =
IIX, =
I I D, =
Q, =
X, =
I l x, + I l Dt
S, Pxt X, - U, X,
Pht Q, - U, Q,
Q(Y„ P"yPht>
X(Y'„ p y p \)
(A 1 2 ) Pm,= S, <|>m U \
(A13) Px, - (1/St) 4>x Ut,
where all profits are in dollar terms, and
II = gross nominal profits of the manufacturing industry
I l x * gross nominal profits accrued from export sales
I l D * gross nominal profits accrued from domestic sales,
including sales in both the import-competing sec
tor and the nontrading sector
X = export volume
Q = total volume of U.S. manufactured goods sold
domestically
U = the unit variable cost (in dollar terms) of U.S.
manufactured output
U' = the unit variable cost (in foreign currency terms) of
U.S. imports
■■■■■■■■■■■■■■■■MB
S
Ph
Pm
P‘
Px
P
Y
Y*
4>m
<j>x
- the exchange rate (dollar/foreign currency)
= the (dollar) unit price of U.S. output sold
domestically
= the (dollar) unit price of U.S. imports
- the (foreign currency) unit price of foreign
output sold in the foreign market
= the (foreign currency) unit price of U.S.
exports
= the general U.S. price level
= real U.S. national income
= real foreign income
= the markup that foreign suppliers impose on
goods sold in the U.S. market
= the markup that U.S. exporters impose on
U.S. exports.
Equations A7 through A9 are identities. Equation
A10 assumes that domestic demand for U.S. manufac
tured goods (Qt) is a function of U.S. activity (Y,) and the
price competitiveness of U.S. manufactured goods rela
tive to imported goods (Pm/Ph). Similarly, equation A11
assumes that demand for U.S. exports (X,) is a function
of foreign activity (Y ) and the price competitiveness of
U.S. goods abroad (Px/P ). Equation A12, the U.S. import
price equation, specifies that foreign firms set the price
of their goods in their own currency (Pm/S) at a markup
(<|>m) over their marginal cost of production (U ), so that
(Pm/S) = 4>m U \ or Pm = S 4>m U'. Finally, equation A13,
the U.S. export price equation, maintains that U.S. firms
set the price of their goods in dollar terms (SPX) at a
markup (4>x) over their marginal cost of production (U), so
that (SPX) = V U, or Px = (1/S) <j>x U.
If we substitute equations A 8 through A11 into equa
tion A7, take total differentiation, and assume that the
unit profit margin of export sales equals the unit profit
margin of domestic sales (that is, SPX - U = Ph - U),
then after some algebraic manipulation we can obtain
the following real long-run profit equation expressed in
log terms:
(A14) ln(II/P), = constant + p, (SXPX/I1), ln(PxS/P),
+ 02 X, ln(Px/P‘), + P3 X, In(Y'),
+ 04 (1-X), ln(Y), + ps (1-X),
ln(Pm/Ph), + p6 ln(U,P), + |x„
where * = X/(X + Q), or the share of exports in total
sales; and fx is the residual. And if we define X(Z1,Z2) as
the elasticity of Z1 with respect to Z2— that is, let X(Z1,Z2)
= (aZ1/ciZ2)/(Z1/Z2)— then the coefficients in equation
A15 can be expressed as follows:
■ msssBBMni
FRBNY Quarterly Review/W inter 1992-93
61
Appendix: The Relationship of the Exchange Rate to Pricing Behavior and Manufacturing Profits
(Continued)
Pi - 1
p 2 = X(X,PX/P‘)
P3 = X(X,Y*)
P4 = HO, Y)
(3S = X(Q,Pm/Ph)
p 6 = - ( X + Q)U/11.
Equation A14, the profit equation, shows the long-run
relationship between real gross U.S. manufacturing prof
its and a host of variables: the ratio of (foreign currency)
export price to foreign price (Px/P‘), the (real) dollar
export price (SPX/P), U.S. activity (Y), foreign activity
(Y‘), the ratio of import price to U.S. goods price (Pm/Ph),
and the real unit variable cost (U/P).
Because foreign activity (Y*) and the ratio of (foreign
currency) export price to foreign price (Px/P‘) affect man
ufacturing profits through their impact on export sales
volume, the effect of a change in either of these two
factors on aggregate profits is greater when export sales
constitute a larger share of total manufacturing sales.+
Consequently, in the regression, ln(Y ) and ln(Px/P ) are
scaled by the share of export sales to total manufactured
goods sales (X). By the same token, ln(Ph/Pm) and ln(Y)
are scaled by the share of domestic sales to total sales
(1 —x), since the impact of a given change in these
factors on profits is bigger when domestic sales con
stitute a greater share of total sales.
The (real) dollar export price, ln(SPx/P), is scaled dif
ferently in equation A14 because it affects total manufac
turing profits through a translation effect but not a price/
volume effect. For a given export volume, a 1 percent
increase in the (real) dollar export price (SPX/P) would
increase real export revenues by 1 percent without rais
ing total costs, so that the amount of increase in total real
manufacturing profits would be exactly equal to the
amount of increase in real export revenue. In other
words, the percent increase in total real manufacturing
profits (II/P) due to a 1 percent increase in (SPX/P) would
be equal to (SPxX /lI) percent. Consequently, in the
regression, ln(SPx/P) is scaled by (SPxX/II), and the
coefficient on (SPxX /ll) ln(SPx/P) is restricted to be one.
The last factor included is real unit variable costs
(U/P), which is assumed to be the same whether the
output is for exports or for domestic sales. If we assume
(Both Y‘ and P*/P‘ affect export profits through the volume
effect. For a given dollar export price (SPX) and unit variable
cost (U), a 1 percent increase in export volume (X) would
increase both export revenue (SP*X) and total export cost
(UX) by 1 percent, thereby increasing total manufacturing
profits by ((SPX - U)X/II) percent, or the percent share of
export profits in total manufacturing profits. Under the
assumption that profit margins are the same for exports as
62
FRBNY Q uarterly Review/W inter 1992-93
that dollar profit margins on exports and domestic sales
are roughly the same, the impact of a 1 percent change
in unit variable costs on total profits would depend only
on the size of the profit margin, not on the relative size of
export sales to domestic sales.* Consequently, we do not
scale this variable in the regression.
To estimate the impact of the exchange rate on total
manufacturing profits, we still need to estimate the rela
tionship between export prices and the exchange rate,
and that between import prices and the exchange rate. In
the case of the export price equation, if we assume that
the markup (<J>X) is a function of competitive pressures in
the foreign market and use foreign prices (P ) as a proxy
for the competitive pressure faced by U.S. exporters,
then U.S. export prices become a function of the nominal
exchange rate, the foreign price level, and the U.S. cost
of production (U). We can then derive the following longrun export price equation:
(A15) ln(SPx) = constant + -yt ln(S), +
ln(U)t
+ 13 ln(P‘)t + Mm,
where we expect 1 > 7 , > 0 , and (7 , - 1 ) is the (pass
through) elasticity of Px with respect to the exchange rate
(S).
Similarly, in the case of the import price equation, if we
assume that the markup (4>m) is a function of competitive
pressures in the U.S. market and use the price level of
U.S. manufactured goods (Ph) as a proxy for competitive
pressure faced by foreign suppliers, then U.S. import
prices become a function of the nominal exchange rate,
the price of U.S. goods, and the foreign unit cost of
production (U‘). We then can derive the following longrun import price equation:
(A16) ln(Pm)t = constant + a, ln(S)t + a 2 In(U'),
+ a3 ln(Ph)t + fj."1,,
where we expect 1 > a, > 0 , and a, is the (pass-through)
elasticity of Pm with respect to the exchange rate.
Together, equations A14, A15, and A16 constitute an
empirical model that enables us to determine the long-
Footnote f continued
for domestic sales, the ((SPX of export sales to total sales.
U)X/I1) ratio equals the ratio
*A 1 percent increase in the unit variable cost would increase
total variable cost by (X + Q)U percent, and lower total
manufacturing profits by ((X + Q)U/I1) percent. If we assume
that the profit margins for export sales and domestic
sales are the same, then (X + Q)U/I1 would be equal to
1/((P/U) - 1), where P is the price of the good.
Appendix: The Relationship of the Exchange Rate to Pricing Behavior and Manufacturing Profits
(Continued)
run impact of a sustained change in the nominal
exchange rate on real gross U.S. manufacturing profits.
All three equations, with coefficients assumed to be timeinvariant, are estimated in two stages using data over the
floating exchange rate period from 1973-111 to 1990-1V.
In the first stage, the parametric correction suggested
by Saikkonen (1990) and Stock and Watson (1989) is
used to obtain consistent estimates of the three long-run
equations.§ Then GLS is used to correct for serial cor
relation among residuals that may still be present. With
these corrections, we can use standard t-statistics as a
basis for hypothesis testing. The estimation results are
reported in Exhibit 1 (Box 1).
The second stage involves estimating the short-run
dynamic counterparts of the three equations. For exam
ple, we can estimate the short-run adjustment processes
of real U.S. manufacturing profits around the long-run
equilibrium profit path by estimating the error correction
model (ECM) of real U.S. manufacturing profits. More
specifically, the first difference of real profits, A1n(ll/P)„
is regressed on the equilibrium error (that is, the devia§That is, leads and lags of the first differences of the
regressors are added to the right-hand side of each of the
three equations to correct for the simultaneity bias that may
be caused by the endogeneity of the regressors. See Pentti
Saikkonen. "Asymptotically Efficient Estimation of
Cointegration Regression," Econometric Theory, vol. 7 (March
1991); and James H. Stock and Mark W. Watson, "A Simple
MLE of Cointegrating Vectors in Higher Order Integrated
Systems,” National Bureau of Economic Research, Technical
Working Paper no. 83 (1989).
tion of actual profits from long-run equilibrium profits, or
the residual from the cointegrating long-run profit equa
tion) in the past period, along with lagged changes in the
dependent variable and all independent variables in
equation A14. Variables not included in the long-run
equation should be included in the error correction model
if they affect the short-run movements of manufacturing
profits; thus, capital expenditure, inflation, and changes
in the real interest rate are also included in the model. A
parsimonious representation is achieved by eliminating
most insignificant lag terms. The same method is used to
estimate the error correction model of export prices and
that of import prices. The estimation results of these
three error correction models are reported in Exhibit 2
(Box 2).
Equation A14 shows that a proper assessment of the
dollar exchange rate’s effect on manufacturing profits
should take into account the impact of the dollar on both
the ratio of export sales to total sales and the ratio of
export revenue to total profits. Consequently, we include
the following two supplemental equations in the model:
' '
'
•
(A17) (SPxX /lI)t = constant + a1 ln(S)t + a2 ln(Y)t
^
+ a3 In(y'), + a4 ln(Ph)„
(A18) x» - constant + b1 ln(S)t + b2 ln(Y), + b3 ln(y')t.
The estimation results of A17 and A18 are reported in
Exhibit 2 (Box 2).
FRBNY Q uarterly R eview/W inter 1992-93
63
Recent U.S. Export Performance
in the Developing World
by Bruce Kasman
Exports have been a major source of strength for the
U.S. economy in recent years. The nation’s sales
abroad have more than doubled since 1986, prompting
a large reduction in the U.S. merchandise trade deficit
and substantially boosting output and employment
growth. Many analysts had expected a surge in exports
because of the acceleration of growth in Europe and
Japan and the dollar’s sharp decline against these
countries’ currencies during the second half of the
1980s. What had not been anticipated, however, was our
remarkable export performance in developing country
markets. U.S. sales increases to developing countries
have far outpaced export growth to the industrial world
since 1986, and over the past three years, the develop
ing world has been the primary source of U.S. export
growth.
This article investigates the reasons for the recent
strong performance of U.S. exports to the developing
world. The analysis suggests that macroeconomic
developments in the industrial world have greatly con
tributed to this strength. Specifically, during the second
half of the 1980s, the combination of declining world
interest rates, faster industrial world growth, and the fall
in the dollar boosted foreign exchange earnings in a
developing world beset by high debt burdens and only
limited access to external financing. This increase in
earnings greatly expanded the spending capability of
developing countries and largely explains their growing
appetite for U.S. and other industrial country goods.
The close linkages between developing countries’ for
eign earnings and their import demand also helps
explain why, until recently, these countries suffered no
deterioration in their balance of trade with the industrial
world. Indeed, from 1986 through 1990 the developing
64
FRBNY Quarterly Review/Winter 1992-93
world’s trade balance with the United States actually
improved.
Renewed access to international capital flows has
sustained the developing w orld’s demand for U.S.
goods in the face of an industrial world downturn during
the past two years. The resiliency of developing world
demand is limited, however, and the continued strength
of our export performance to developing countries
remains tied to the ability of developing countries to sell
their products to the industrial world.
U.S. export performance since the mid-1980s
Although our export sector accounts for a relatively
small share of the U.S. economy, exports have been a
key source of output and employment growth in recent
years. From 1986 onward, exports of goods and ser
vices grew at an average 8 percent annual rate in
volume terms (Chart 1). Foreign sales contributed, on
average, more than a percentage point to GDP growth
per year during 1987-92, in sharp contrast to the first
half of the 1980s, when exports placed a drag on activ
ity.1 Estimates made in a recent Commerce Department
study suggest that our sales in foreign m arkets
accounted for nearly all of the job creation in the U.S.
manufacturing sector during this period.2
1Net exports, which measure foreign sales less purchases of goods
and services from abroad, contributed slightly less than 1/2
percentage point per year, on average, to GDP growth from 1986
through 1992.
2Lester Davis, “ U.S. Jobs Supported by Merchandise Exports," U.S.
Commerce Department, April 1992. Davis estimates that export
growth accounted for all manufacturing employment growth and
one-quarter of all civilian employment growth from 1986 to 1990.
U.S. exports grew most rapidly over the three-year
period from 1987 through 1989, when volume increases
exceeded 10 percent each year. Since that time, export
growth has slowed steadily, falling to about 6 percent in
1992. Despite this slowdown, our foreign sales played a
particularly important role in U.S. activity during the
more recent period. At a time when other major compo
nents of activity stalled or declined, exports contributed
2.1 percentage points to growth over 1990-92, an
amount exceeding the increase in GDP during these
years.
The acceleration in U.S. export sales since the
mid-1980s extended to all regions of the world. Ship
ments of merchandise goods to countries in Europe,
Asia, the Middle East, and the Western Hemisphere all
grew rapidly during the second half of the 1980s, in
most cases at double-digit annual rates (Table 1).
Underlying this broad-based acceleration, however, we
observe a pattern of surprising strength in U.S. export
growth to developing countries. This record of growth
Chart 1
Export and GDP Growth
Constant Dollars, National Income and Product Accounts Basis
Annual percentage change
Real exports of
goods and sen/ices
A
/
\
/
/
\
\
\
/
/
\
\
/
/
!
/
V
A
/
1
!
/
/
\ \7
\ v
»
1
1
'V
' •
v
*— i f — i n
1
1
1 r ^ _ 1— /
s /
Real GDP
/
\
i
1980 81
>
\
/
/
/
\
Contribution of
exports to GDP
has made developing country markets an increasingly
important destination for U.S. goods.
Following the 1982-86 period, in which our merchan
dise exports to developing countries declined, exports
to the developing world expanded at an average annual
rate exceeding 16 percent in current dollar terms from
1986 to 1992. Exports to developing countries in Asia
(hereafter called Asia) and in Latin America and the
Western Hemisphere more generally (hereafter termed
Latin America)— countries that are the destination for
almost one-third of our total foreign sales and over 80
percent of our trade with the developing w orld—
increased at about this rate.3 Within these broad
regions, sales to the four Asian NICS, or newly indus
trialized countries (Hong Kong, Taiwan, South Korea,
and Singapore), and Mexico were particularly strong,
increasing annually by 17.4 and 22.7 percent, respec
tively, during 1987-92.
An examination of U.S. export growth by product
category indicates that our export boom to the develop
ing world has extended across a wide range of products
(Chart 2). In each of the four major export end-use cate
gories— capital goods, industrial supplies, consumer
goods, and autos— exports to Latin America and Asia
grew, on average, at double-digit annual rates over 1987-92.
The success of U.S. auto sales to these regions is
particularly notable, although auto sales make up a
relatively small share of our trade with these regions.4
Our sales to industrial countries also grew rapidly
following a period of prolonged weakness during the
first half of the 1980s. The pace of U.S. export growth to
industrial countries (9.7 percent per year since 1986)
was, however, only th re e -fifth s as fast as sales
increases to the developing world. In none of our major
industrial markets (Western Europe, Canada, and
Japan) did U.S. exports grow as fast as they did to Latin
America or Asia during this period. As a result, the
share of U.S. foreign sales directed to developing coun
tries rose steadily, from 32 percent in 1986 to 40 per
cent in 1992.
The disparity in our export performance in industrial
and developing country markets became more marked
after 1989. U.S. sales to the industrial world slowed
over 1990-92, increasing only 3.5 percent annually. In
contrast, sales to developing countries remained
/
\i
/
1 *,
,
,
82 83 84 85
86
......1 ..... 1.....J____
87 88 89 90
i
91
92
Note: Contribution of exports to GDP is measured by the change
in exports as a share of GDP.
3Throughout this article, Latin America refers to all countries in the
Western Hemisphere excluding the United States and Canada. Asia
refers to all non-middle-eastern Asian countries excluding Japan,
Australia, and New Zealand. In general, the regional groupings
used here conform to the country classifications described in the
International Monetary Fund's International Financial Statistics.
4ln 1990, U.S. exports of automotive products accounted for
2 percent of our total exports to Asia and 10 percent of our total
exports to Latin America.
FRBNY Quarterly Review/W inter 1992-93
65
Table 1
U.S. M erchandise Export Growth by Region
Annual Average Percentage Changes, Current Dollars, Balance of Payments Basis
Total
Percentage Share of Total
in 1990
1982-86
1987-92
1987-89
1990-92
100
- 1 .2
119
17.4
6.6
34
16
10
6
-5 .1
1.8
3.4
00
16.2
15.5
17.4
12.8
19.8
25.0
29.6
18.4
12.7
6.7
6.3
7.4
14
7
7
- 6 .4
-7 .5
-5 .6
16.6
22.7
11.4
16.7
26 1
9.4
16.5
19.5
13.4
3
-1 3 .2
12.9
8.6
17.4
66
29
12
21
1.1
-1 .5
39
4.2
9.7
11.4
10.2
8.3
16 3
17.7
18.5
12.6
3.5
5.4
2.5
4.1
Developing countries
Asia
Newly industrialized countries'
Other Asia
Latin America
Mexico
Other Latin America
OPEC
Industrial countries
Western Europe
Japan
Canada
Note: Figures for 1992 are based on data through the third quarter.
'South Korea. Hong Kong, Taiwan, and Singapore
robust, particularly to Latin America, where our exports
continued to increase more than 16 percent per year.
Overall, two-thirds of total U.S. export growth since
1989 can be attributed to sales to developing countries.
This figure represents a dramatic increase from the
sales’ nearly 40 percent contribution to overall export
g r o w th during the previous three years and their less
than 20 percent contribution from 1980 to 1986.
Sources of U.S. export growth to developing
countries
Most recent studies of U.S. export performance have
emphasized traditional macroeconomic fundamentals—
in particular, relative prices as determined by exchange
rates and inflation trends, and foreign income— in
explaining the surge in U.S. exports following 1986.
Such analyses appear to explain U.S. exports to indus
trial countries relatively well. However, efforts to apply
these determinants to developing countries suggest
that this standard macroeconomic approach is not ade
quate to account for the strength of U.S. export growth
to the developing world.
Chart 3 indicates that movements in U.S. relative
prices and foreign GDP correspond closely to the
observed pattern of U.S. export growth to industrial
countries. The acceleration in our sales to the industrial
world during 1987-89 was accompanied by a pickup in
the pace of economic activity abroad. Foreign industrial
66
FRBNY Q uarterly Review/W inter 1992-93
Chart 2
U.S. Export Growth by Major End-Use
Category: 1987-92
Current Dollars, Census Basis
Average annual percentage change
50----------------------------------------------------------------I
40
Industrial world
Developing Asia
Latin America
Capital goods
Industrial
supplies
Consumer
goods
Note: Figures for 1992 are based on data through the
third quarter.
Autos
world GDP increased, on average, by close to 4 percent
per year over 1987-89, its fastest three-year rate of
expansion during the post-1973 period. Similarly, export
growth slowed from 1990 onward in an environment of
weakening activity abroad.
Our exports to industrial countries have also been
boosted by U.S. relative price gains. Following the dol
lar’s decline in 1985, foreign industrial country whole
sale prices rose substantially faster than comparable
U.S. prices. Through 1988 our relative gains amounted,
cumulatively, to more than 30 percent. Since that time,
the United States has continued to make modest gains
in its competitive position in the industrial world.
Activity growth and relative price movements in the
developing world do not seem to be as strongly linked
to U.S. export performance. Developing countries’ eco
nomic growth did not accelerate at the same time as
U.S. exports to this region. In fact, developing world
Chart 3
Macroeconomic Determinants of U.S. Exports
Percentage change
Percentage change
12
30 ....................... ..........................................-........ ... ....
U.S. Export* and Foreign GDP: Industrial Cou ntries
Percentage change
Percentage change
12
30
U.S. Exports and Foreign GDP: All Developing Countries
10
10
8
8
6
6
4
4
2
2
0
0
-2
-2
25
20
U. S. export volume ^
---------- S c a le
/
15
10
,/
x .
G D P**’ ’ ’^
/ ♦
* * * * .
v
(O E C D c o u n trie s
5
U n ite d S ta te s )
S c a le --------- ►
0
-5
i
I
1984
I
85
86
I
87
I
I
I
89
90
91
92
Index 1985 = 100
■ - .. . "
Relative Wh olesale Prices Measured in Dollars
"•*
United States relative
**»*to developing countries
V
.....................
\
\
I
1984
85
United States relative
to industrial countries
...... I ....... I ...... I ..........I ..........
86
87
88
89
90
I
91
92
Sources: U.S. Commerce Department; Organization for Economic Cooperation and Development, Economic Outlook; International Monetary
Fund, International Financial Statistics.
Notes: In both upper panels, U.S. exports are adjusted by the U.S. aggregate export price deflator to compute export volumes. The lower panel
presents trade-weighted indexes comparing U.S. wholesale prices with those of twenty-two developing countries (dashed line) and seventeen
industrial countries (solid line). A decline in the index indicates that U.S. prices are rising more slowly than those of our trading partners. Values
for 1992 are either through the third quarter or full-year estimates.
FRBNY Quarterly Review/W inter 1992-93
67
sideration of the competitive gains made by U.S. expor
ters in the developing world cannot be limited to com
paring our prices with those of developing country
producers. U.S. exports to developing countries com
pete more with exports from other industrialized coun
tries than with goods produced in the developing
countries themselves. As a result, the greater than 40
percent improvement in our price position against other
industrial countries since 1985 may be a better predic
tor of competitive gains made by U.S. exporters in the
developing world.5
growth slowed during 1987-89 from its pace during the
previous three years. Moreover, the relative price gains
made by the United States against developing countries
during this period were comparatively modest, amounting to
slightly more than 15 percent cumulatively since 1985.
Examining the 1987-92 period in its entirety, we find
that the relative strength of U.S. export growth outside
industrial countries reflects a sharp rise in the demand
for U.S. goods relative to income in the developing world.
Following five years in which U.S. exports to the developing
world grew considerably more slowly than developing coun
try income, our exports increased more than four times as
rapidly as developing country income after 1986; in the
industrial world our sales increased roughly 21/2 times as fast
as income since 1986.
These differences seem particularly surprising given the
more modest relative price gains made by the United
States in developing world markets. However, any con
5For a detailed analysis of measures assessing the competitiveness
of the United States relative to other industrial countries, see Susan
Hickok, Linda Bell, and Janet Ceglowski, “ The Competitiveness of
U.S. Manufactured Goods: Recent Changes and Prospects,” this
Quarterly Review , Spring 1988; and Martine Durand, Jacques
Simon, and Colin Webb, “ OECD’s Indicators of International Trade
and Competitiveness,” Organization for Economic Cooperation and
Development, Working Paper no. 120, 1992.
Chart 4
Industrial Country Exports to Developing Countries
Index 1985 = 100
Index 1985 = 100
250 .................. ■
All Developing Countr ies
U.S. exports
200
V **"
150
X ’ ’ ’ * Other inclustrial
country ;xports
*•
100
50
i
1982
i
83
I
i
84
85
86
I
I
Index 1985 = 100
. .. .
Latin America
I
89
87
1
90
91
1
92
■
U.S. jxports/
U.S. Share of Industrial World Exports
to Developing Countries
(Percentage points)
200
X
1986
150
.•***
%
Other in justrial
country sxports
100
i
j
50 1.
1982 83
i
84
85
., ,1.........1 . 1
1.....
86
87
88
89
90
Source: International Monetary Fund,
1
91
1
92
Direction of Trade Statistics.
Note: Figures for 1992 represent data through the first half of the year, annualized.
68for FRASER
FRBNY Q uarterly Review/W inter 1992-93
Digitized
1989
1992
28
28
22
26
25
50
58
59
All developing countries
24
Developing Asia
Latin America
If an improvement in our competitive position relative
to that of other industrial world exporters explains the
surge in U.S. exports to developing countries, then we
should observe a shifting in developing country import
demand away from other sources. As Chart 4 shows,
the United States did make inroads in developing econ
omy markets following the dollar’s decline. From 1987
through 1989 our exports to developing countries grew
faster than those of other industrial countries. As a
result, the U.S. share of industrial country sales to the
developing world rose about 4 percentage points from
its 1986 level. U.S. exports grew more rapidly than other
industrial countries’ exports in both Latin American and
Asian markets; our market share gains were greatest in
Latin America, where in 1989 U.S. exporters’ market
share was 58 percent of industrial world sales, a full
eight percentage points above 1986 levels.6
Since 1989, however, U.S. exporters have been
unable to make further market share gains. Our exports
to the developing world have grown rapidly, but these
sales increases have generally been matched by those
of other industrial countries. Although small market
share gains were recorded by U.S. exporters in Latin
American markets, these gains were offset by a deterio
ration in our share of industrial world exports to Asia.
Overall, increases in the U.S. share of industrial world
exports to developing economies do not account for a
large part of the strength in U.S. export growth to the
developing world. As Chart 4 clearly shows, developing
countries have sharply increased their demand for
industrial world products generally since 1986, following
a prolonged period of weak demand. Other industrial
countries, whose currencies swung sharply against the
dollar during the 1980s, recorded export growth similar
to that of the United States both before and after 1985.
Indeed, if U.S. exports had increased only as rapidly as
the rate of growth of developing world demand for all
industrial country goods, our exports to developing
countries would have grown at an annual rate only 3
percentage points slower than they actually did since
1986; over the past three years, U.S. exports would
have increased at about their actual pace.7
6U.S. exporters' large share of the Latin American market is
overstated because it includes inputs to the Mexican Macquilidora
sector, whose output in large part must be shipped back to the
United States. Currently, Macquilidora inputs represent more than
10 percent of total Latin American purchases of industrial world
goods.
7Although the improvement in relative prices achieved through dollar
depreciation did not lead to large market share gains in the
developing world, it did enable U.S. exporters to reverse the
pattern of market share losses that took place in the first half of
the 1980s.
Further evidence of the developing world’s increased
demand for industrial world products is presented in
Table 2. Following five years in which purchases of
industrial country goods fell, the developing world’s
appetite for imported goods increased rapidly after 1986
in both absolute terms and relative to income growth.
This acceleration in import demand is observed across
regions in the developing world, but the change is
sharpest for Latin American countries. Although GDP in
Latin America grew at almost the same rate over
1987-92 as during the previous five-year period, the
region's imports from the industrial world increased by
over 7 percent annually in volume term s during
1987-92, compared with a decline of more than 4 per
cent per year in the earlier period.
Developing economy imports and industrial world
economic conditions
We have seen that the rapid increase in developing
country demand for U.S. goods is not fully explained by
such standard macroeconomic forces as income growth
and competitiveness gains. We now consider other
developments since the mid-1980s that may have
Table 2
Developing C ountry Im ports from Industrial
Countries
Annual Average Percentage Change
1982-86
1987-92
- 2 .6
- 1.4
11.4
64
Real GNP growth
3.3
4.2
Asia
Imports from industrial
countries'*
Value
Volume
5.4
6.8
13.6
8.7
Real GNP growth
7.1
6.7
- 5 .0
-4 .1
12.3
7,4
1.4
1.5
All developing countries
Imports from industrial
countries*
Value
Volume
Latin America
Imports from industrial
countries*
Value
Volume
Real GNP growth
*Measures of developing country imports are based on indus
trial world export data from International Monetary Fund,
Direction of Trade Statistics. Import value growth is deflated
by the average of the change in industrial country export unit
values and regional import unit values to compute import
volume growth.
FRBNY Quarterly Review/W inter 1992-93
69
played a role in boosting developing country demand.
One significant change in the developing world has
been a shift away from restrictive, inward-looking pol
icies. Since the mid-1980s, several developing coun
tries have undertaken com prehensive adjustm ent
programs combining measures to deregulate domestic
markets, reduce the size of the public sector, and foster
greater integration of domestic with world markets.
A significant liberalization of trade policies has been
a central part of this shift in orientation. A recent study
by the International Monetary Fund identified seventeen
regionally important countries that since the mid-1980s
have moved from tightly controlled trading systems to
systems characterized as open or relatively open.8 That
ten countries in this group are in the Western Hemi
sphere highlights the dramatic changes taking place in
this region. Nearly all major countries in Latin America
are now committed to open trading systems, and most
have bound their tariff schedules in the General Agree
ment on Tariffs and Trade (GATT).
These internal reforms have opened developing econ
omy markets to industrial world exporters. Nonetheless,
the surge in purchases of industrial world goods could
not have occurred without a significant improvement in
the external economic conditions confronting develop
ing countries. From the early 1980s onward, many
developing countries, particularly those in Latin Amer
ica, faced severe debt repayment problems and had
only limited access to international credit markets. As a
result, their capacity to import was largely tied to their
foreign exchange earnings. During the early 1980s,
earnings were depressed in an environment of weak
industrial world growth and high dollar interest rates
(Chart 5).9
From the mid-1980s onward, however, changing mac
roeconomic conditions in the industrial world provided a
significantly more favorable environment for developing
country import demand. As Chart 5 demonstrates,
industrial country demand remained above its long-term
trend growth rate of about 3 percent for each year from
1984 through 1989. In addition, developing countries
were able to improve their price competitiveness after
1985, despite the appreciation of their currencies
against the dollar noted earlier. By limiting the degree to
which their currencies rose relative to the dollar, devel8See Margaret Kelley and Anne Kenny McGuirk, "Issues and
Developments in International Trade Policy,” World Economic
Financial Survey, International Monetary Fund, 1992.
and
9For a detailed analysis of the impact of industrial world economic
conditions on developing country performance during the early
1980s, see Rudiger Dornbusch, “ Policy and Performance Links
between LDC Debtors and Industrial Nations, Brookings Papers on
Economic Activity, 2:1985, pp. 303-68; and Carlos F. DiazAlejandro, "Latin American Debt: I Don’t Think We Are in Kansas
Anymore," Brookings Papers on Economic Activity, 2:1984,
pp. 335-403.
70 FRASER
FRBNY Quarterly Review/W inter 1992-93
Digitized for
Chart 5
External Conditions Facing Developing Economies
Index 1985 = 100
Sources: Organization for Economic Cooperation and
Development (OECD), Economic Outlook; Morgan Guaranty
Trust Company, World Financial Markets', International Monetary
Fund, International Financial Statistics.
Notes: The top panel measures demand for all OECD countries.
The middle panel shows the U.S. trade-weighted average of real
effective exchange rates for five Latin American and eight Asian
economies. In the bottom panel, nominal interest rates are sixmonth dollar LIBOR rates. Real rates are obtained by deflating
nominal rates by the average annual change in export unit
values for non-fuel-exporting developing countries.
oping countries made significant relative price gains
against Europe and Japan. Finally, dollar interest rates,
both in nominal terms and when deflated by developing
country export prices, fell substantially after the
mid-1980s.
The rise in export earnings and reduction in debt
service resulting from these developments directly
eased foreign exchange constraints limiting the devel
oping countries’ spending on industrial world goods,
thus increasing dem and indepe ndent of incom e
growth.10 Indeed, as Table 3 shows, increases in these
sources of foreign exchange closely correspond to the
rise in imports in the developing world since 1986. In
the developing world overall as well as in Asia and Latin
America individually, foreign currency income gains—
defined as the increase in exports and the decline in
debt service payments as a share of GDP— roughly
matched the rise in imports from the industrial world
between 1987 and 1991. In Asia, the increase of more
than 4 percentage points in industrial world imports as
a share of output was financed entirely through export
earnings. In Latin America and elsewhere in the devel
oping world, export earnings and declining debt service
payments contributed about equally to the rise in import
shares.
Increased foreign earnings may also have stimulated
demand for foreign goods through other channels. In a
number of developing countries, the improved prof
itability in the traded goods sector that accompanied
rising export earnings revived investment demand,
much of which was met by capital goods exports from
^Increased earnings and reduced debt service payments also
boosted import demand through their direct effect of raising
income.
the industrial world.11 In addition, because the external
creditworthiness of a country is generally assessed by
the ratio of debt service to exports, the expansion in
export earnings, independent of income levels, proba
bly reduced borrowing constraints in debt-burdened
countries.
Several developing countries that had experienced
debt-servicing difficulties have recently, in fact, been
able to reenter the international market for capital.12
During 1991 and 1992, inflows of foreign private capital
have been substantial in Latin America and Asia,
reflecting renewed investm ent o p p o rtu n itie s and
increased solvency in these regions. The ability of the
developing world to attract large inflows of foreign cap
ital during 1991 and 1992 helps to explain why import
demand and economic activity more generally in the
developing world have remained resilient in the face of
weakening demand in the industrial world.13
"A ccording to estimates presented in the International Monetary
Fund’s World Economic Outlook. October 1992. investment spending
as a share of GDP rose roughly 3 percentage points in both Asia
and the Western Hemisphere from 1986 to 1992.
12For a detailed discussion of recent developments in developing
countries' access to international capital markets, see Charles
Collyns et a l., Private Market Financing For Developing Countries.
International Monetary Fund, December 1992.
13There is some evidence that external forces, specifically the
industrial world recession and falling U.S. interest rates, have
encouraged a portfolio shift towards developing world assets and
influenced the recent pattern of world capital flows. See Guilermo
A Calvo, Leonardo Leiderman, and Carmen Reinhart, "Capital
Inflows and Real Exchange Rate Appreciation in Latin America: The
Role of External Factors," International Monetary Fund, Working
Paper no. 92-62, August 1992
Table 3
Developing C ountry Im ports and Foreign Income Gains
Shares of GDP
1986
1991
Change from 1986 to 1991
(Percentage Points)
All developing countries
Imports from industrial countries
Exports to industrial countries
Debt service interest payments
12.1
13.5
2.9
13.9
15.0
2.1
+ 1.8
+ 1.5
- 0 .8
Asia
Imports from industrial countries
Exports to industrial countries
Debt service interest payments
12.7
14.7
1.7
16.8
18.7
1.5
+ 4.1
+ 4.0
- 0 .2
Latin America
Imports from industrial countries
Exports to industrial countries
Debt service interest payments
8.4
10.5
4.9
10.9
11.7
3.5
+ 2.5
+ 1.2
- 1 .4
Source: International Monetary Fund,
World Economic Outlook,
October 1992.
FRBNY Q uarterly R eview/W inter 1992-93
71
relationship is found for Latin American countries. Dur
ing 1987-91, increased Latin exports to the industrial
world were associated with a 0.89 percentage point
increase in their purchases from the United States. In
contrast, estimates for Asian countries are smaller and
not significant statistically.
These findings are consistent with the view that
developing country export performance has been a par
ticularly important determinant of demand in countries
facing high debt burdens. Indeed, when we isolate the
countries with the highest ratios of debt service to
exports during the mid-1980s, we find a significant rela
tionship between their export earnings and purchases
from the United States.
It is also useful to compare these results with esti
mates of a similar relationship between industrial coun
tries’ export performance (here measured as total
exports of a country) and their purchases of U.S.
goods. In contrast to the developing country results, a
negative relationship is found between an industrial
country’s exports and its purchases of U.S. goods. The
divergence in results between industrial and developing
economies most likely arises because industrial econo
mies are not credit constrained and employ their
resources relatively efficiently. The effect of increased
export earnings on demand should therefore be largely
captured in the income growth variable. The negative
coefficient estimates in the regression probably capture
the impact of macroeconomic developments not incor
The evidence presented here suggests that develop
ing countries’ ability to export to the industrial world
independent of income growth has been an important
determ inant of their purchases of U.S. goods. To
assess this linkage more directly, we present in Table 4
the results of regressions relating U.S. export growth to
developing countries (USXi) from 1987 to 1991 to devel
oping countries’ sales to the industrial world (DVXi) and
their GDP growth (DGDPj) over this period. In addition,
we have included a variable (TRD*) identifying countries
that have undertaken major trade liberalization pro
grams since the mid-1980s to determine whether U.S.
exports have grown more rapidly to those countries.
Examining a broad cross section of thirty-eight large
developing economies, we find a significant and strong
positive relationship between individual country sales to
the industrial world and their purchases of U.S. goods.
On average, an added 1 percentage point in a develop
ing coun try’s exports to the industrial world over
1987-91 was associated with 0.64 percentage point
higher U.S. sales to the country. Estimates of the
impact of trade liberalization indicate an additional
boost to our export growth from the opening of markets,
but the coefficient estimate fails to pass significance
tests at standard statistical levels.
Important distinctions can be observed when the rela
tionship between developing countries’ sales to the
industrial world and their purchases of U.S. goods is
estimated across regions. A very strong and significant
Table 4
U.S. Export Perform ance and Developing C ountry Sales to the Industrial World
USX , = C + B,{D V X i) + B2(D V G D P j)+ B3(TRD,) + |x,
Number of
Observations
All developing countries
38
Asia
11
Latin America
14
High-debt-service countries*
13
Industrial economies*
21
C
B,
b2
b3
r2
16.3
(1.14)
17.7
(0.38)
23.4*
(176)
38.9”
(8.40)
113.5'*
(3.21)
0.64**
(4.24)
0.59
(1.59)
0.89**
(3.97)
0.51**
(4.09)
-1 .1 9 *
(-2 .6 0 )
0.32**
(3.29)
0.36*
(2.13)
0.14
(0.44)
0.53*
(1.89)
0.73
(1.36)
20.24
(1.64)
.44
—
.27
—
.41
—
.69
—
.16
Notes: The variables are defined as follows: USX, = cumulative U.S. export growth to country i, 1987-91; DVX, = cumulative export growth of
country i, to the industrial world, 1987-91; DVGD Pj = cumulative G D P growth of country i, 1987-91; TRD,-dum m y variable identifying
countries that undertook major trade liberalizations since the mid-1980s. Data for growth in exports and G D P are based on dollar values of
variables. Standard errors are adjusted to be consistent in the presence of heteroskedasticity.
^Defined as those countries whose ratio of debt service to exports exceeded one-third for the 1985-86 period.
*For industrial economies, export growth (DVXj) represents total export sales growth over 1987-91.
'Significant at 10 percent level
“ Significant at 1 percent level
72
FRBNY Q uarterly Review/W inter 1992-93
porated in the estimated relationship— most notably the
decline in the dollar’s real value relative to other indus
trial currencies— which weakened foreign exports and
stimulated U.S. exports during this period.
Export performance and the U.S. trade balance
The analysis presented here highlights the close link
ages between economic conditions in the industrial
world and U.S. export performance in developing coun
try markets. These linkages can help to explain
the evolution of our merchandise trade balance with
developing countries and can shed light on the pros
pects for the continuation of our strong export
performance.
Although U.S. exports grew rapidly to all regions of
the world in the second half of the 1980s, our overall
trade balance with developing countries followed a dif
ferent course than our trade balances with industrial
countries (Chart 6). Trade with the industrial world
accounted for all of the roughly $40 billion improvement
in our merchandise trade balance from 1986 through
1990. While U.S. import growth from industrial countries
slowed sharply from its pace during the first half of the
decade, purchases from developing countries acceler
ated, increasing nearly as rapidly as our exports. As a
result, our trade position with the developing world as a
whole, as well as with Asia and Latin America sepa
rately, deteriorated somewhat during this period.
The rapid rise in U.S. imports from the developing
world is readily explained by the changes in price com
petitiveness discussed earlier. By limiting the apprecia
tion of their currencies against the dollar after 1985,
developing countries realized large improvements in
their competitive position against Europe and Japan.
These gains enabled developing country exporters to
make significant inroads in U.S. markets, leading to a
rise of more than 6 percentage points in the developing
world’s share of total U.S. imports from 1986 to 1990.
Through these market share gains, developing coun
tries improved their trade position with the United
States during this period, despite the relatively moder
ate growth in U.S. domestic demand.14
Our earlier analysis linking the imports of developing
countries to their foreign exchange earnings would sug
gest that the developing world’s strong appetite for
industrial world goods was not accompanied by a dete
rioration in its balance of trade. In fact, developing
countries recorded an improvement of roughly $30 bil
lion in their trade balance with industrial countries from
1986 through 1990. This relationship between imports
and foreign exchange earnings did not, however, con
strain movements in the trade position of the developing
world with any individual industrial country. Nonethe
less, the United States is a particularly important desti
nation for developing country exports, accounting for
more than 40 percent of Asian sales and more than 50
percent of Latin American sales to the industrial world
during this period. As a result, our willingness to
expand purchases of developing country goods was
probably vital in fueling both developing country
demand and the strong performance of our exports to
these countries.
The onset of recession in the United States in 1990,
followed soon after by a downturn in activity in Europe
and Japan, slowed import demand across the industrial
world. This falloff in activity has had little impact on our
balance of trade with other industrial countries, which
Chart 6
U.S. Merchandise Trade Balances by Region
Billions of dollars
25-----------------------------------------------------------------------------Latin America
0-------------------------------------------------------------
-25
•| 7 5 1----------------- 1----------------- 1----------------- 1----------------- 1-----------------1-----------------1--------------
1986
14The performance of developing country exports was even more
impressive elsewhere in the industrial world during this period.
Spurred by competitiveness gains and the acceleration in foreign
industrial world growth, developing country exports grew more
rapidly to Europe and Japan than to the United States after 1986.
1987
1988
1989
1990
1991
1992
Note: Figures for 1992 are based on seasonally adjusted
annualized data through the third quarter.
FRBNY Quarterly R eview/W inter 1992-93
73
remains roughly unchanged from its 1990 level. Weaker
industrial country demand did, however, boost the trade
position of the United States and other industrial coun
tries relative to developing countries during 1991 and
1992.
Although weaker export earnings slowed spending in
many developing countries, developing world import
demand did not collapse as it had during the last
cyclical slowdown in the industrial world in 1982. A
sharp rise in private capital inflows during the past two
years enabled the developing world to dampen the
effects of this downturn. In particular, capital inflows to
Latin America exceeding $40 billion in both 1991 and
1992 (about four times their average during the second
half of the 1980s) spurred a boom in regional demand.
All of the roughly $13 billion improvement in the U.S.
trade balance from 1990 through 1992 can be traced to
our trade with Latin America.
The recent rise in capital inflows to the developing
world may, however, have negative consequences for
U.S. export performance. The history of developing
country financing is marked by episodes in which large
inflows of capital to the developing world are followed by
market corrections and debt-servicing problems. The
persistence of high debt levels and the recent deteriora
tion in the current account positions of several large
developing countries have raised concerns that a shift
in external financing availability could occur, prompting
a significant weakening in developing world demand as
it did in 1982-83.
It is also true, however, that a country’s vulnerability
to shifts in external financing depends c ritic a lly on the
resiliency of its economic system and the soundness of
policies pursued.15 Evidence suggests that the recent
inflows of capital to the developing world may be, at
least in part, the fruits of the fundamental economic and
political reforms taking place. These developments,
together with other im portant differences between
recent experience and the events of the early 1980s,
point to greater sustainab ility of current financial
15ln comparing the response of Latin America and developing Asia to
the external shocks of the early 1980s, Jeffrey Sachs emphasizes
the importance of sound macroeconomic policies ("External Debt
and Macroeconomic Performance in Latin America and East Asia,”
Brookings Papers on Economic Activity, 2:1985, pp. 523-64).
74
FRBNY Quarterly Review/Winter 1992-93
flows.16
Certainly, important risks remain for U.S. export perform
ance in the developing world, particularly if recovery in
industrial world activity is delayed or if protectionist
pressures lead industrial countries to raise barriers
against developing country exports. Nevertheless, the
ability of many developing countries to limit their vulner
ability to the current economic downturn in the indus
trial world must be viewed with cautious optimism.
Conclusion
In our highly integrated world economy, major develop
ments in one part of the world have repercussions for
nations everywhere. Developing countries have been par
ticularly sensitive to changes in world economic conditions
because of their limited access to international credit
markets throughout most of the past decade.
Our analysis highligh ts how the m ajor macroeconomic developments in the industrial world during
the second half of the 1980s— specifically, the rapid
pace of demand growth and the declines in the dollar’s
value and U.S. interest rates— improved conditions for
a developing world beset by foreign debt problems. One
important consequence of this improvement has been a
sharp increase in developing country import demand.
This increase in turn largely explains the surge in U.S.
exports to these countries since 1986.
Our export performance in the developing world has
remained strong despite a deterioration in industrial
world growth during 1991 and 1992. The revival of cap
ital inflows, particularly to Latin America, has enabled
developing countries to weather declines in industrial
world demand for their goods and to continue their
imports of industrial country goods. Although these
developments are supported in part by the ongoing
reforms in the developing world, both the linkages
described in this article and past experience suggest
that the resiliency of developing world demand is lim
ited. As a result, strong U.S. export growth to this
region can probably only be sustained if developing
countries can also increase the sales of their goods to
the industrial world.
16For a detailed assessment of the sustainability of the recent inflow
of capital to developing countries, see Collyns et al., Private Market
Financing.
Treasury and Federal Reserve
Foreign Exchange Operations
November 1992-January 1993
During the November-January period, the dollar con
tinued to appreciate against the German mark and
Japanese yen from the low levels established in the
prior period. The U.S. authorities did not intervene in
the foreign exchange markets.
Developments in dollar exchange markets
Over the period, the dollar gained 1 percent in value
against the yen, 4.5 percent against the mark, and 5.5
percent on a trade-weighted basis.1 The dollar’s upward
movement was supported, first, by the perception that
the incoming Clinton Administration would pursue a
policy of fiscal stimulus and, subsequently, by stronger
than expected U.S. economic growth and persistent
expectations of official rate reductions in Germany and
Japan. The dollar’s trend was interrupted by changing
estimates of the amount of any U.S. fiscal stimulus, by
perceived postponements of German rate reductions,
and by widespread market reports, of European central
bank sales of dollars.
The dollar trends higher. Following the U.S. election in
November, analysts were predicting that the U.S. econ
omy would begin to outperform those of other indusThis report, presented by William J. McDonough, Executive Vice
President and Manager of the System Open Market Account,
describes the foreign exchange operations of the United States
Department of Treasury and the Federal Reserve System for the
period from November 1992 through January 1993. John W. Dickey
was primarily responsible for preparation of the report.
1The dollar’s movements on a trade-weighted basis in terms of the
other Group of Ten currencies are measured using an index
developed by the staff of the Board of Governors of the Federal
Reserve System.
trialized countries and that a narrowing of interest rate
differentials would favor the dollar in the coming year.
The prospect of a strengthening dollar was given con
tinued support by indications that President-elect Clin
ton would apply fiscal stimulus early in 1993 should
there be any signs of economic weakness. Although
hopes for a reduction in official rates by the Bun
desbank were disappointed in both November and
December, expectations for such a move early in the
new year persisted. Anticipating a stronger dollar in the
new year, market participants in late December and
early January bid up the dollar to its period highs of
DM 1.6490 on January 8 and ¥126.21 on January 13.
After mid-January, however, there was an unwinding
of long-dollar positions as it became apparent that a
reduction in official rates by the Bundesbank was not
imminent and that the Clinton Administration’s overall
fiscal policy might put greater weight on reducing the
budget deficit. Many market participants then assumed
that if U.S. economic conditions were to worsen,
responsibility for ensuring adequate economic growth
would fall on the Federal Reserve. Although a reduction
in official U.S. rates was still not seen as likely, an
easing was perceived to be in the range of possible
monetary policies, and that perception contributed to
the dollar’s brief reversal. But at the end of January, the
release of stronger than expected U.S. economic data,
pa rticu la rly the strong fo u rth -q u a rte r 1992 gross
domestic product and December 1992 durable goods
orders, seemed to erase the prospects for interest rate
reductions by the Federal Reserve and refresh the
expectation that the U.S. economy would be outper
forming others over the year. Thus, in the closing days
FRBNY Quarterly Review/Winter 1992-93
75
of the period, the dollar moved up from January lows of
DM 1.5660 and ¥122.85 to close the period at DM
1.6102 and ¥124.60.
designed to avoid end-of-year upward pressure on inter
est rates. Moreover, in statements that appeared to
acknowledge a weakening in the German economy
while expressing optimism about the central bank’s abil
ity to control inflation, senior Bundesbank officials pre
dicted sharp reductions in German interest rates during
the course of 1993. In the final week of December,
Bundesbank officials added that an easing could occur
earlier in 1993 than was previously expected. It was
during this period that the dollar posted most of its
gains toward its January 8 high against the mark.
In early January the Bundesbank did engineer a
small reduction in market interest rates through its mar
ket repurchase operations. However, by mid-January,
when the decline in market rates had not been followed
by a reduction in the Bundesbank’s official Discount and
The market awaits interest rate reductions in Germany
and Japan. Throughout the period, on-again off-again
expectations for reductions in official interest rates by
the Bundesbank and the Bank of Japan punctuated the
dollar’s movements.
In response to continued pressures within the Euro
pean Exchange Rate Mechanism (ERM), many market
participants expected the Bundesbank to ease interest
rates in early November and, when this did not occur,
attention focused on the prospects for an easing in
December. Although no official rate reduction came in
December, the Bundesbank’s market operations were
Chart 1
The Dollar against the German Mark and the Japanese Yen
German marks per U.S. dollar
A
l
I
I
!
German mark
l
I .....
I
/•
I
I
Japanese yen per U.S. dollar
/ y
a
k
/ v
.
r
fS
W
m
i
J
\
v
a a
,
V *y\
i I
-^
-r
v ";
V-
v A -V
Japanese yen
*
,
„
v.
! \ "
Vv
V
1
1
Feb
1
Mar
1
Apr
1
May
1
Jun
1
Jul
1992
76
FRBNY Q uarterly Review/W inter 1992-93
1
Aug
1
Sep
1
Oct
1
Nov
............
Dec
Jan
1993
Chart 2
The Dollar against Selected Foreign Currencies
Percentage change
1992
1993
Notes: The chart shows the percentage change in daily rates for
the dollar from November 1992 through January 1993. All figures
are calculated from New York closing rates.
Table 1
Federal Reserve
Reciprocal Currency Arrangem ents
Millions of Dollars
Institution
Austrian National Bank
National Bank of Belgium
Bank of Canada
National Bank of Denmark
Bank of England
Bank of France
Deutsche Bundesbank
Bank of Italy
Bank of Japan
Bank of Mexico
Netherlands Bank
Bank of Norway
Bank of Sweden
Swiss National Bank
Bank for International Settlements:
Dollars against Swiss francs
Dollars against other
authorized European currencies
Total
January 31, 1993
250
1,000
2,000
250
3,000
2,000
6,000
3,000
5,000
700
500
250
300
4,000
600
Lombard rates, expectations for an easing in German
monetary policy were postponed to early March and the
dollar began its brief reversal against the mark.
Expectations for a reduction in the Official Discount
Rate (ODR) by the Bank of Japan persisted during the
period, gaining in strength as the period closed, though
with less direct effect on exchange rates than in the
German case. In December, comments by Japanese
officials focused on the need to stimulate demand
through fiscal policy and, as a result, prospects for a cut
in the ODR receded. But in January, the release of weak
Japanese retail sales, production, and employment data
and a declining stock market heightened concerns
about weakness in the Japanese economy and returned
attention to the prospects for an immediate reduction in
the ODR. Despite widespread expectations for an ODR
cut at the end of January, the dollar was not able to
sustain its m id-January high against the yen as
exchange market attention focused on the January 22
report of a record Japanese trade surplus for the calen
dar year 1992 and on the risk that policy makers might
respond to the trade imbalance by seeking an apprecia
tion of the yen.
Currency tensions in Europe continue.
Pressures on a
number of European exchange rates, particularly the
German mark/French franc rate, persisted during the
November-January period. In response to these pres
sures, German and French authorities repeatedly stated
their commitment to the existing parity between their
currencies and confirmed their participation in market
intervention in support of the franc. The Spanish peseta
and the Portuguese escudo were each devalued within
the ERM by 6 percent on November 22, and the Irish
punt was devalued by 10 percent on January 30. In
addition, the Swedish and Norwegian monetary authori
ties abandoned their currencies’ links to the European
Currency Unit on November 19 and December 10,
respectively.
While these exchange rate pressures within Europe
had little direct impact on dollar exchange rates, partic
ularly in comparison with the previous period, transac
tions related to the financing of official European inter
vention were perceived as a ffe ctin g the dollar.
Throughout the period, market participants reported
that both in the course of rebuilding official reserves and
in transactions related to financing official borrowings, a
number of European central banks were heavy sellers
of dollars and that, at times, this selling pressure
restrained the dollar’s upward trend against the mark.
1,250
30,100
★
*
*
*
FRBNY Quarterly R eview/W inter 1992-93
77
Chart 3
The Dollar against the German Mark and the Japanese Yen
Japanese yen per U.S. dollar
German marks per U.S. dollar
128'
Japanese yen
November
December
January
1993
Chart 4
Table 2
Net Profits ( + ) or Losses ( - ) on
United States Treasury and Federal Reserve
Foreign Exchange Operations
Millions of Dollars
Federal
Reserve
A
9.0
\
^
8.5
a
Valuation profits and losses
on outstanding assets
and liabilities as of
October 31, 1992
+ 3,746.3
Germany
Realized
October 31, 1992January 31, 1993
8.0
S
*H
w -v -*'
rv V
♦♦♦
i
♦
*
Japan
------ •*-
•
n
VI
........ ............
3.0
U.S. Treasury Exchange
Stabilization Fund
+ 2,293.8
+ 109.5
+ 25.1
Valuation profits and losses
on outstanding assets
and liabilities as of
January 31, 1993
+ 2,868.4
+ 1,749.9
Note: Data are on a value-date basis.
unitea otstss
tl 1111111111111111111 i i m m m i m m i i i i
November
December
1992
iiiiiiiiiiiiiim ijil
January
1993
While the U.S. authorities did not execute any foreign
exchange transactions during the period, settlements
were completed on a total of $1,455.8 million in forward
sales of German marks. As previously reported, these
78
December
1992
Short-Term Interest Rates for Selected Countries
Percent
9.5
Three-Month Euro Rates
4.0
November
January
1993
1992
FRBNY Q uarterly Review/W inter 1992-93
settlements were executed in May 1992 with the
Deutsche Bundesbank in an effort by both the U.S. and
German monetary authorities to adjust the level of their
respective foreign currency holdings. During the period,
$729.4 million and $726.5 million against marks settled
on November 23 and December 21, respectively, com
pleting the total of $6,176.6 million of spot and forward
dollar purchases from the Bundesbank. For each trans
action, 60 percent was executed for the account of the
Federal Reserve and 40 percent for the account of the
Treasury’s Exchange Stabilization Fund (ESF). The Fed
eral Reserve and the ESF realized profits of $109.5
million and $25.1 million, respectively, from these settle
ments. As of the end of January, cumulative valuation
gains on outstanding foreign currency balances were
$2,868.4 million for the Federal Reserve and $1,749.9
million for the ESF.
The Federal Reserve and the ESF invest their foreign
currency holdings in a variety of instruments that yield
market-related rates of return and have a high degree of
liquidity and credit quality. A portion of the balances is
invested in securities issued by foreign governments.
As of the end of January, the Federal Reserve and the
ESF held either directly or under repurchase agree
ments $7,834.0 million and $8,356.0 million equivalent,
respectively, in foreign government securities valued at
end-of-period exchange rates.
FRBNY Quarterly Review/Winter 1992-93
79
Treasury and Federal Reserve
Foreign Exchange Operations
August-October 1992
The August-October period was marked by serious
strains in European exchange rate relationships and
shifting market views about the outlook for interest
rates in the major countries. Although the dollar briefly
reached all-time lows against the mark and yen in
September, it closed the period up on balance 4.5
percent against the German mark, down about 3.0
percent against the Japanese yen, and up 6.8 percent
on a trade-weighted basis.1
The U.S. monetary authorities intervened in the
exchange markets in two episodes during August in
their only operations during the period. Entering the
market on a total of four days that month, they sought to
counter persistent downward pressure on the dollar by
buying $1.1 billio n against the German mark, in
amounts shared equally by the U.S. Treasury and the
Federal Reserve.
Dollar declines against the mark in response to
interest rate pressures
Interest rate considerations were the dominant factor in
exchange rate movements during the period. Interest
rate differentials provided a strong incentive for capital
flows into the higher yielding securities denominated in
German marks and in other currencies thought to be
This report, presented by William J. McDonough, Executive Vice
President of the Federal Reserve Bank of New York and Manager of
the System Open Market Account for the Federal Open Market
Committee, describes the foreign exchange operations of the United
States Department of Treasury and the Federal Reserve System for
the period from August to October 1992.
1The dollar’s movements on a trade-weighted basis are measured
using an index developed by the staff of the Board of Governors of
the Federal Reserve System.
80
FRBNY Quarterly Review/Winter 1992-93
closely linked to the mark. They also made it attractive
for U.S.-based entities that were building up foreign
currency receivables to postpone the repatriation of
these funds so as to benefit from higher interest rates
overseas and, perhaps, from a continued depreciation
of dollar exchange rates.
For many market participants, however, the dollar’s
position in the exchange market carried a two-sided
risk. On the one hand, the fact that the dollar was
already trading relatively close to the historical low
reached in 1991 against the German currency gave rise
to fears that if selling pressures against the dollar
became intense enough to break through this level, the
dollar’s decline might gain significant momentum. On
the other hand, market participants were still mindful of
the experience the previous month, when the authori
ties of the United States and other industrialized coun
tries intervened to buy dollars, triggering a sharp shortcovering rally.
Under these circumstances, market participants were
particularly sensitive to indications either that the inter
est differentials might widen further— thereby putting
renewed selling pressure on dollar rates— or that the
authorities might again intervene. The economic data
for the United States released early in August gave no
clear indication of serious further deterioration, but nei
ther did they offer assurance of a sustained upswing.
The Federal Reserve had eased monetary policy in
early July, and markets expected further ease in the
absence of a stronger recovery. Meanwhile, in the face
of rapid monetary growth in Germany, the Bundesbank
had tightened monetary policy in mid-July. But above
target money growth continued, and it was thought
that the Bundesbank would keep monetary policy firm—
perhaps even tighten policy once more— despite data
suggesting that the German economy might be begin
ning to slow.
Market participants looked to the release of monthly
U.S. labor force data early in August to give direction to
dollar rates. They expected that if the data proved to be
weaker than expected, the Federal Reserve would soon
ease pressures on bank reserves. When the data,
released on Friday, August 7, appeared to confirm eco
nomic weakness, the dollar showed some initial resis
tance but then came on offer later that same day, and
the U.S. authorities intervened to stabilize the dollar.
When pressures reemerged the following Tuesday, the
U.S. authorities again intervened in an operation joined
by other central banks. Over the two days, the U.S.
authorities bought a total of $600 million against the
German mark. Selling pressures were somewhat
blunted by the interventions, but the operations did not
interrupt the tendency of the dollar to decline.
By late August, the German mark was strengthening
not only against the dollar but also against other Euro
pean currencies in response to strains that were to
become far more intense later in the period. With the
Chart 1
The Dollar against Selected Foreign Currencies
Percentage change
/
Ita ian lira
J
*
~ fC j
r'
<!i
V
British pound
Canadian dollar
a
I■
if
^ 8 - %
d te n "'
7 * rY
Germ an mark
August
r
\
1
\
\
L
i
's '
Japanese yen
11M1111111111M1M11 l l l l l l l l l l l l l l l l l l l l l l
September
October
1992
Notes: The chart shows the percentage change in daily rates for
the dollar from July 31, 1992. All figures are calculated from
New York closing rates.
dollar again approaching its 1991 low, the U.S. authori
ties intervened on August 21 and 24, in cooperation
with other monetary authorities, buying a total of
$500 million. But when these operations did not appear
to discourage the bidding for marks, the U.S. authorities
refrained from further intervention.
The dollar continued to ease, establishing a new
historical low against the mark of DM 1.3862 on Sep
tember 2. But trading conditions for the dollar were
relatively orderly, even in the face of the disappointing
labor market statistics released in early September and
the continuing market expectations of declining U.S.
interest rates, which appeared to be confirmed by Fed
eral Reserve operations on September 4 that eased
conditions in the federal funds market.
European currencies face severe pressures
By late August and during most of September, market
attention focused on pressures within the Exchange
Rate Mechanism (ERM) of the European Monetary Sys
tem (EMS) and between the EMS and those currencies
linked to it through the European Currency Unit
(ECU)— for example, the Finnish markka and Swedish
krone. During the lengthy negotiations among European
Community countries on European Monetary Union that
had led up to the December 1991 Maastricht Treaty,
market participants had become impressed by the par
tic ip a tin g g o ve rn m e n ts’ e vid e n t co m m itm e n t to
exchange rate stability. Though the treaty did not pro
vide for fixed exchange rates within the system for
several more years, market participants came to
assume that few of these governments would counte
nance devaluation in the interim. As a result, investors
felt increasingly secure holding securities denominated
in ERM currencies other than the mark. Investors pur
chasing assets that carried even higher yields than DMdenominated assets appeared to give little weight to
exchange rate risk in ex ante calculations of riskadjusted returns. During the long interval since the last
general ERM realignment in 1987, the total amount of
assets allocated on the basis of this view reached
substantial sums.
Doubts had begun to develop as to the durability of
existing exchange rate relationships and the effective
ness of efforts to achieve greater economic con
vergence within Europe after Danish voters rejected a
referendum on the Maastricht Treaty in June. In midAugust, reports began to spread that voters in France
might also vote “ no” on a referendum on the Maastricht
treaty, and pressures on exchange rates within Europe
intensified. In the ensuing weeks an exchange crisis
swept through the EMS and related currencies that
entailed interventions of unprecedented size, large
changes in interest rate differentials within Europe, a
FRBNY Quarterly Review/W inter 1992-93
81
Outside of the EMS, severe pressures had developed
on the Nordic currencies, resulting in sizable interven
tions and considerable increases in short-term interest
rates, particularly in Sweden. The Finnish markka’s peg
to the ECU was also suspended.
small cut in German official interest rates, two realign
ments, and the suspension of the pound sterling and
the Italian lira from the ERM. The French franc came
under selling pressure but stabilized amid intervention
purchases of francs and a rise in French interest rates.
Chart 2
The Dollar against the German Mark and the Japanese Yen
Japanese yen per U.S. dollar
135
*s!
v
r/\
\
•*
/
*v
*
t
German marks per U.S. dollar
1.60
\
*
__ v
V -»
\
AV '
Japanese yen
'I
r
1
/
' / s .-
'V
\ f
V
/
*
llllllllllllllllllllll llllllllLUJII.lil.lil llllllllllllllllillll llllllllllllllllllllll
1.35
July
August
September
July
October
August
September
October
1992
1992
Chart 3
Short-Term Interest Rates for Selected Countries
Percent
Three-Month Euro Rates
i
A
?•*
— ^ —s i
V v-
/*.
;
V \V*
♦
♦*♦♦
Germany
United Kingdom
LLI.I.J !..! 1] I I 1.LI ! i I..11L.LLL 111.1,1111111,11 L H Ilil 111II 11II 11111111II 11 II IJIIJ.llJJLI.il II H ill
July
August
September
1992
82
FRBNY Q uarterly Review/W inter 1992-93
October
While dollar exchange rates responded at times to
pressures among European currencies in September,
the dollar was not the focal point of market attention at
that time. It initially encountered selling pressure
against the mark as investors sought to cover their
intra-European exposures by buying marks. Then, in
mid-September, the dollar snapped up rather quickly
against the mark when dollar-based investors and U.S.
entities sought refuge from the European tensions by
converting foreign currency investments or balances
into dollars. With the European intervention being con
ducted in European currencies— mostly in German
marks— the financial intermediaries effecting these
transactions sold marks in the market to get dollars
demanded by their customers. Once the pressures
began to subside late in September, the dollar began to
drift down toward the levels of late August.
Developments in the dollar/yen exchange rate
The movements of the dollar against the yen during
August and September were, in contrast to those
against the European currencies, relatively muted. The
interest differentials between the United States and
Japan were narrower, and market participants believed
that the authorities in Japan, like their counterparts in
the United States, would be tending to ease monetary
conditions. The dollar reached its high for the period of
¥128.19 on August 10 as evidence mounted that the
Table 1
Federal Reserve
Reciprocal C urrency Arrangem ents
slowdown in the Japanese economy was intensifying
and as the Japanese equity market showed persistent
weakness. But the yen then appreciated during Septem
ber. This move reflected some repatriation of capital by
Japanese companies with the approach of the fiscal
half-year end on September 30, a reaction to a rebound
in the Japanese equity market, and some flows into
yen-denominated assets in response to the develop
ments taking place in the EMS. The dollar gradually
declined against the yen through September, setting a
new historical low against that currency of ¥118.60 on
September 30.
Market tensions subside during October
Early in October, the pressures in the EMS started to
wane. After the British and Italian governments had
chosen to suspend their currencies’ participation in the
ERM, the pound and the lira depreciated to trade well
below their previous ERM floors. These and other
changes in exchange rates in Europe led to an effective
appreciation of the German mark. The Bundesbank
lowered both of its official interest rates in mid-Septem
ber, and money market rates also subsequently eased.
Although market participants remained uncertain about
the outlook for monetary union and the eventual config
uration of the EMS, funds started to flow back to France
and short-term interest rates in most of the EMS coun
tries were lowered from the crisis levels reached the
previous month. As market participants noted that the
slowdown in European economic activity was increas
ingly evident, they came to believe that the trend of
interest rates abroad might turn supportive of the dollar.
Meanwhile, in the United States expectations dimin
ished that monetary policy in the United States would
In Millions of Dollars
Institution
Austrian National Bank
National Bank of Belgium
Bank of Canada
National Bank of Denmark
Bank of England
Bank of France
Deutsche Bundesbank
Bank of Italy
Bank of Japan
Bank of Mexico
Netherlands Bank
Bank of Norway
Bank of Sweden
Swiss National Bank
Bank for International Settlements:
Dollars against Swiss francs
Dollars against other
authorized European currencies
Total
Amount of Facility
.Vtl"-'::-'.:,
October 31, 1992
Table 2
250
1,000
2,000
250
3,000
2,000
6,000
3,000
5,000
700
500
250
300
4,000
600
1,250
Net Profits ( + ) or Losses ( - ) on
United States Treasury and Federal Reserve
Foreign Exchange O perations
In Millions of Dollars
Valuation profits and losses on
outstanding assets and
liabilities as of July 31, 1992
Realized
July 31-O ctober 31, 1992
Valuation profits and losses on
outstanding assets and
liabilities as of October 31, 1992
Federal
Reserve
U.S. Treasury
Exchange
Stabilization
Fund
+ 4,536.7
+ 2,503.9
+ 358.1
+ 119.9
+ 3,746.3
+ 2,293.8
30,100
Note: Data are on a value-date basis.
FRBNY Q uarterly Review/W inter 1992-93
83
continue to be eased. The labor market data for Sep
tember, released in early October, were seen as insuffi
ciently weak to trigger a policy reaction. As the month
progressed, talk spread that a fiscal stimulus package
would be introduced early in the next year. Under these
circumstances, the outlook for interest differentials
became more favorable to the dollar. With some of the
leads and lags that had built up against the dollar
earlier in the year now being reversed, the dollar
recovered substantially against the mark and to a lesser
extent against the yen in fairly active trading through
the rest of October.
Other operations
In other activity, a total of $1,873.1 million in off-market
spot and forward foreign currency sales, executed by
the U.S. monetary authorities, settled during the period.
• Forward purchases of $740.1 million and $733.0
million against German marks from the Deutsche
Bundesbank settled on August 21 and October 21,
respectively. These mark sales constituted a por
tion of the original $6,176.6 million of spot and
forward transactions initiated in May. As previously
reported, 60 percent of each transaction was exe
cuted for the Federal Reserve and 40 percent
was for the Exchange Stabilization Fund (ESF)
account.
84
FRBNY Quarterly Review/Winter 1992-93
• On September 8, the Federal Reserve agreed to
purchase $400 million against German marks in an
off-market transaction at the request of a foreign
monetary authority.
The Federal Reserve realized profits of $358.1 mil
lion, including $230.3 million from off-market transac
tions that settled during the August-October period. The
Treasury realized profits of $119.9 m illion, which
included $33.5 million from off-market transactions that
settled during the same three-month period. Cumulative
bookkeeping or valuation gains on outstanding foreign
currency balances were $3,746.3 million for the Federal
Reserve and $2,293.8 million for the Treasury’s ESF.
These valuation gains represent the increase in dollar
value of outstanding currency assets valued at end-ofperiod exchange rates, compared with rates prevailing
at the time the foreign currencies were acquired.
The Federal Reserve and the ESF regularly invest
their foreign currency balances in a variety of instru
ments that yield market-related rates of return and that
have a high degree of quality and liquidity. A portion of
the balances is invested in securities issued by foreign
governments. As of the end of October, holdings of such
securities by the Federal Reserve amounted to the
equivalent of $8,146.1 million, and holdings by the Trea
sury amounted to the equivalent of $8,666.9 million
valued at end-of-period exchange rates.
RECENT FRBNY UNPUBLISHED RESEARCH PAPERS*
9219.
McCarthy, Jonathan. “An Empirical Investigation of
Imperfect Insurance and Precautionary Savings
against Idiosyncratic Shocks.” December 1992.
9221.
Osier, Carol. “ Short-Term Speculators and the Ori
gins of Near-Random Walk Exchange Rate Behavior.”
December 1992.
9222.
Osier, Carol. “ Exchange Rate Dynamics and Spec
ulator Behavior.” December 1992.
9223.
Wenninger, John, and William Lee. “ Federal Reserve
Operating Procedures and Institutional Change.”
December 1992.
9224.
Steindel, Charles. “ Changes in the U.S. Cycle: Shifts
in Capital Spending and Balance Sheet Changes.”
December 1992.
9225.
Seth, Rama. “ Profitability of Foreign Banks in the
United States.” December 1992.
9301.
Mizrach, Bruce. “ Mean Reversion in EMS Exchange
Rates.” January 1993.
9302.
Mizrach, Bruce. “ Target Zone Models with Stochastic
Realignments: An Econometric Evaluation.” January
1993.
9303.
Boldin, Michael. “An Evaluation of Methods for Deter
mining Turning Points in the Business Cycle.” Janu
ary 1993.
+Single copies of these papers are available upon request.
Write Research Papers, Room 901, Research Function, Fed
eral Reserve Bank of New York, 33 Liberty Street, New York,
N.Y., 10045.
FRBNY Quarterly R eview/W inter 1992-93
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