Published in Euromoney November 1969
By F. E. Aschinger, Swiss Bank Corporation
It must be stressed at the outset that the international financial market itself is not the origin of crises. The speculative funds which are latent in the market only become active, the monetary ammunition is only fired off, so to speak, when the elements of crisis are already present. Speculation follows these elements like a shadow. It would be wrong to try to prevent crises and improve the monetary system by cutting back or eliminating the Eurodollar market. Anti-crisis measures must attack the evil at the roots. Measures against speculation are always of a mere accessory character.
Moreover, a great part of the factors causing extraordinary changes in the international flow of funds in times of a monetary crisis cannot be attributed to pure speculation. In many cases there exists a legitimate motive of protection against currency risk. This applies in particular to a large part of the leads and lags. A separation of purely speculative movements is difficult to make.
In spite of what has just been said, however, it must be realised that the Eurodollar market does create additional problems and difficulties in times of crisis. The big potential of liquid funds of that market can in such periods cause an avalanche effect, by increasing and accelerating the flow of hot money. Massive streams of Eurodollars into other currencies can flood one country and dry up another. The situation can often be made more difficult because capital movements emanating from the Eurodollar market are not so easy to control or influence as direct movements from country to country. The immense potential of speculation compared with 10 years ago calls for more vigilance on the part of monetary authorities and for further national and international defence measures.
Mutual swap facilities
The most important instrument for counteracting such disturbances is the system of mutual swap facilities set up by the Federal Reserve Bank of New York with the major central banks. This swap network now amounts altogether to more than $10,000 million, the most important swap agreements being with the Bank of England, the Swiss National Bank (directly and indirectly via the BIS), the BIS itself, and the central banks of Canada, France, the German Federal Republic, Italy and Japan. By using these swap lines when a critical situation arises, a country which suffers a large loss of currency can rapidly receive compensation, while another, into which there is a flood of capital, can re-channel the dollar stream via a swap transaction. For instance, the Swiss National Bank has, on occasion, when there has been an influx of hot money, used the swap agreements to place large amounts of Swiss francs at the disposal of the Federal Reserve Bank against dollars. The latter bank has then used these Swiss francs to buy back from the Swiss National Bank the dollars which flowed into it, thus avoiding the necessity of converting dollars into gold.
The precautionary swap network of the Federal Reserve Bank has been given ad hoc supplements in times of crisis by various multilateral swap agreements of the major central banks with any countries under currency pressure. The agreements made with Britain and France are two particular cases in point.
So far the aim of international monetary co-operation in crises has been mainly to providing combined support credits for any currency under pressure, the measure of such credits being determined by the economic and monetary strength of the country concerned. However, the idea is now gaining ground that support credits should be provided only or principally by those countries to which hot money has flowed during an eruption of speculation. Thus, to use the vogue word, there would be a 'recycling' of speculative funds.
This idea was first broached officially when there was a flight last November of some $2,500 million into the German Federal Republic in anticipation of a Deutschemark revaluation. The Bonn Conference of the Group of Ten, which was convened to subdue the November crisis, announced that new ways of counteracting the effects of speculative capital movements should be studied. The discussions of the central bank governors of the Group of Ten and the BIS on this subject led on February 10 of this year to a joint declaration, which can be summarised as follows:
1. International credit support should continue to be in accordance with the nature, scale and duration of the emergency. The project of a schematic credit system is thereby rejected.
2. Support procedure should be speeded up, however, inasmuch as the governors of the central banks in the BIS should meet as soon as a crisis occurs so that a decision about ad hoc aid could be taken without delay.
3. Support action should be channelled in the opposite direction to the flow of speculative capital, so that the central banks of recipient countries should come into play more rapidly and effectively than would otherwise be the case. Refinancing actions should be taken to lighten the debtor risks of creditor countries. The Bank for International Settlements should increase its role as an intermediary in the recycling of hot money by procuring funds either from national financial markets or from the Eurocurrency market.
The idea of harnessing the financial markets for recycling purposes has been taken further by the West German Economics Minister, Professor Karl Schiller. According to his proposal, a deficit country which is exposed to a massive exodus of capital should itself replenish its reserves by borrowing on the financial markets of the surplus countries or on the Eurodollar market.
Many people seem to think that 'recycling' is some kind of a patent solution. The redirecting of flight capital should make it unnecessary for a country under severe speculative pressure to suspend convertibility or to introduce import restrictions. At the same time, the beneficiary countries should be spared the consequences of an inflationary flood. Thus, it is thought, the recycling of speculative funds would be the answer to the problem. However, whatever temporary relief might be given by recycling, it has its weaknesses and limits. Above all, we must be clear that such an operation can only have a short-term character, that it can only return flight capital to a country on a credit basis and that it can do nothing to remove the causes of the trouble.
Moreover, there is a danger that if recycling were to become a permanent and automatic institution, countries which were vulnerable to speculation would become apathetic about mastering the real causes of monetary crises. If every country had the certainty that lost capital would immediately be returned to it – even if only on a credit basis – the incentive to maintain balance of payments discipline would be considerably reduced. Moreover, an automatic and systematic recycling would hardly be feasible, since, as already mentioned, it is impossible to distinguish between speculative movements and those occasioned by balance of payments considerations which should not be recycled. The circumstances vary from case to case.
For all these reasons, the central bank governors were right when they refused to set up a system of recycling as an automatic institution. In their opinion and that of the BIS, the recycling of hot money can only take place on an ad hoc basis, firstly by making a decision in principle about support action and then by fixing conditions which are appropriate to the circumstances. Even this procedure might tend to weaken a country's will to make economic adjustments.
There are also practical limits to the recycling method. Speculative capital movements today mostly proceed by two routes: direct from country to country, at the expense of the monetary reserves of one and in favour of those of another, and indirectly via the Eurodollar market, the hot money either coming from or going into this market. The importance which the latter route has attained is revealed by the fact that of the $4,000 million which streamed into the Federal German Republic last May an estimated $2,000 million came from the Eurodollar market.
A direct recycling of the capital flow by the central bank of the recipient country back to the country of origin can only be effected in respect of the direct loss inflicted on the reserves of a deficit country. However, since recycling involves a credit risk, a country which has been the target of flight capital and has to recycle these funds must set limits to the extent of recycling. These limits are very clearly defined where large credit facilities in favour of a deficit country already exist. Whether the proposed refinancing via a third country suggested by the central banks can help in such cases remains to be seen.
If, on the other hand, speculative capital has flowed in via the Eurodollar market and is then recycled to that market, its recycling in critical times often has a boomerang effect. For example, during the Deutschemark revaluation crisis of 1961, and again in the November crisis of 1968 and the May crisis of this year, the German Federal Bank sought in vain to divert the tide of dollars to the Eurodollar market by means of cheap swaps. But so long as a wave of speculation is at its height the artificial rechannelling of inflowing funds to the Eurodollar market only leads to an accumulation of new hot money and feeds speculation afresh. A recycling to the Eurodollar market is only effective when a crisis is on the wane.
The difficulties encountered by a surplus country in recycling funds to the Eurodollar market would not be overcome by transferring the task of recycling to the deficit country. The suggestion of Professor Schiller that a deficit country should recoup lost capital on the financial markets of the surplus countries or on the Eurodollar market presumes that the country concerned has sufficient credit with the market. However, this is often not the case. Even the Bank for International Settlements could only act as an intermediary if it had received a guarantee from its member central banks to cover the credit risk vis-a-vis a deficit country, which would create rather a problem in concrete cases.
There is also a difference between the economic effects of a recycling of speculative capital from central bank to central bank and a recycling by commercial banks to the Eurodollar market, in that the former merely serves as a short-term compensation for currency losses without creaming off the excess liquidity in the surplus country, whereas the latter does draw off this excess. To this extent, a recycling to the international financial market has its advantages. A rechannelling of hot money from central bank to central bank cannot dispense a surplus country to take measures to control the increase in liquidity which the capital influx brings to its banking system.
The recycling method might help to improve central bank defences in a time of monetary crisis, but its possibilities are limited. It cannot be emphasised too often that the causes of monetary crises will not be eliminated in this way. To repeat a monetary ceterum censeo, these crises can only be prevented if the deficit and surplus countries adhere to suitable policies of adjustment and maintain their balance of payments discipline. The Eurodollar market, with its vast pool of floating short-term funds, is a challenge to the major currency countries to create better conditions for the smooth functioning of the international monetary system by improving the co-ordination of their economic policies and by laying more emphasis on balance of payments equilibrium. With the rapid growth of the Eurodollar market the stability of the dollar, in particular, has become more important than ever.
The Eurodollar market fulfils such important functions in the world's economy that it would be a mistake to curtail its working by restrictive measures just because it contains some dangers which become acute in international monetary crises. We have got to live with the Eurodollar market, and must therefore make every effort to pursue sound economic and monetary policies which will minimise its dangers and maximise its positive effects.
Part of an address by Dr Aschinger to the Federal Trust for Education and Research, London.