Foreign Exchange: The Complete Deal. James McDowell. Sharpe
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application to the IMF for a standby facility). Despite winning a confidence vote on 11 March 1976 the Prime Minister decided to resign a few days later on 16 March. Sterling was now on the run despite intervention, and interest rates reached 15% on 6 October. The scale of the sterling collapse was immense. GBP/USD fell from above 2.40 in April 1975 to just below 1.60 in November 1976 and GBP/DEM (Deutschmark) from 6.10 to around 3.90 over the same period.
On 7 June the UK announced a $5.3bn six-month credit facility from other central banks, $2bn of which came from the US central bank. However, the US imposed a payment deadline of 9 December 1976. The UK was unable to meet this condition, which prompted the application to the IMF for a standby loan of $3.9bn on 29 September 1976. The US position was hardly supportive but has echoes of Germany today – they were unwilling to bail out a country with flawed economic policies. Cuts in UK public spending inevitably followed.
The notion that Ireland or Greece would have been saved by devaluation is an illusion. Their debt levels were extremely high and their ability to borrow extremely low. As was graphically seen in 1976, a falling currency severely impacts on inflation and any flexibility on domestic monetary policy.
1980s
The impact of the current account and interest rates on the exchange rate was never so clearly demonstrated as from 1978 to 1981. During this period sterling rose by over 20% against a basket of currencies. The arrival of North Sea oil in 1976, coupled with the second oil crisis of 1978-79, had turned a traditional deficit on the oil account into a substantial surplus; sterling was now viewed as a petro-currency. At the same time the UK was experiencing a boom, which, despite the oil surplus, contributed to a deficit in the current account that was countered by a sharp rise in interest rates attracting speculative flows.
From 1978 to 1980 the bank interest rate rose from 6.5% to 17%. This inevitably led to a sharp fall in manufacturing production and imports, which led to record surplus in 1981. Two factors mitigated against even greater sterling gains: the abolition of exchange controls in November 1979, which prompted large investment outflows, and Bank of England intervention. By 1981 sterling started to ease back but the damage had been done and British manufacturing had been dealt a blow it would never recover from.
The European Union at this time was looking for greater political and monetary union and in 1979 the European Monetary System (EMS) was established. The most important component of this system was the Exchange Rate Mechanism (ERM). Member countries agreed to peg currencies within a 2.25% band of a weighted average of European currencies; this weighted average was called the European Currency Unit (ECU). The early period was characterised by regular re-alignments – from 1979 to 1987 there were 11. The usual pattern was for low inflation, low surplus countries such as Germany and Holland to revalue and for high inflation, high deficit countries such as France and Italy to devalue. This arrangement is known as a ‘currency bloc’: a group of currencies fixed in value against one another but floating against all others.
During the 1980s the primary UK policy objective was the control of inflation through essentially the targeting of money supply growth. This met with mixed results and it was felt by Chancellor Lawson by the mid-1980s that joining the ERM would impose a low inflation discipline. Prime Minister Thatcher refused but nonetheless the Chancellor pursued a policy of shadowing the Deutschmark, a beacon of post-war low inflationary growth. However, this coincided with strong economic growth, popularly known as the Lawson boom. In 1986 the current account deficit was £2.3bn, by 1988 this had risen to £17.5bn and inflation was on the rise despite tagging the Deutschmark (DM).The exchange rate policy was abandoned and interest rates were raised from 7.5% in May 1988 to 15% in October 1989, providing support to the pound.
While the deficit started to contract inflation was stubborn and in September 1990, with a view to further deflating the economy, the UK joined the ERM at DM 3 to the pound. Even at the time this was considered too high an exchange rate. By 1991 inflation started to fall and the UK economy was in recession. UK inflation was still high relative to its main trading partners and sterling was unable to devalue sufficiently to restore competitiveness because of ERM membership. By 1992 the current account deficit had increased to £10.1bn, a remarkable level given the scale of the recession. The government wanted to cut rates but sterling was trading close to the lower end of its trading band within the ERM. An exit from the ERM and an ensuing devaluation was discounted on fears of reviving inflation. There was also a considerable amount of political capital invested in staying within the system.
1990s
In July and August 1992 sterling came under intense selling pressure, which prompted the Bank of England to intervene to keep sterling above the lower band. The most famous seller was George Soros. On 15 September, Black Wednesday, interest rates were raised to 15% but the selling continued and Chancellor Norman Lamont was forced to announce that the UK was leaving the ERM the next day. The pound fell 10% immediately. The scale of intervention is not known but it ran into billions. It is believed that no losses were incurred. These transactions were turned for a profit in later years.
The importance of these events cannot be overstated. If sterling had weathered this attack it probably would have entered the euro in 1999. Instead, it reinforced the euro sceptic camp and floating rate advocates. The UK would not again attempt to control the value of sterling. For the Conservative government it was a total disaster and arguably resulted in the party losing its reputation for financial soundness on the dealing room floor.
What the devaluation did achieve was to ignite a strong recovery in the economy and an improvement in the current account. From 1993 to 1997 a deficit of £10.6bn was transformed to a surplus of £6.6bn. More importantly, inflation did not erupt as the world economy was experiencing deflationary pressures. In 1996 sterling was again on the rise backed by high interest rates, relatively strong economic growth and subdued inflation.
2000s
The early years of 2000 were similarly characterised, although sterling found additional support from the rapid growth in financial services, which the UK dominated with the US, and the diversification of foreign exchange reserves by the world’s central bank from dollars.
During this period the UK ran deficits on the current account but these were no longer an explicit policy constraint as they were viewed as self-correcting in the long run and in a period of global monetary expansion foreign investors were prepared to finance it. This all came to a sorry end in 2008 when the global financial system, in particular in the UK, imploded. The markets reverted to risk aversion with massive flows into safe-haven assets such as US Treasuries and out of deficit currencies and emerging market equities (risk assets). Sterling capitulated as huge borrowings in low interest currencies, notably the yen and Swiss franc (CHF) (carry trades), were unwound and investors sold sterling as more bank losses and failures were revealed.
Endnotes
1 C. Fred Bergsten, Director of the P G Peterson Institute for International Economics. [return to text]
2 fraser.stlouisfed.org/publications/ERP/issue/1227 [return to text]
2. Central Banks and Foreign Exchange Intervention
What is foreign exchange intervention?
Foreign exchange intervention is often quoted in the news but rarely will you see any working definition. I shall view it as any transaction or announcement by an official agent of a government that is intended to influence an exchange rate. Typically intervention operations are implemented by the monetary authority. Central banks tend to use a narrower definition, which is the sale or purchase of foreign currency against domestic currency in the foreign exchange market.
Intervention is normally transacted directly through the large commercial banks (normally of the country in question) and can be public or secret. It can be enacted through one bank or a number of banks to achieve maximum impact or visibility. Secret interventions are difficult to hide and sometimes may be carried out by the Bank for International Settlements.