15 November 2007: Foreign Exchange Risk - A Historical Perspective

Although the future is not likely to repeat the past precisely, past events can provide valuble lessons that will improve our understanding of how Forex markets will function in the future.

Major Historical Events in the Forex Markets
Forex management is motivated by the need to conduct international trade and manage international capital investments. In the post-barter era, international trade and investing have been conducted under a variety of foreign exchange regimes. We will briefly describe these regimes, beginning with the gold standard in 1870.

The Gold Stadard. From 1870 through to the beginning of World War II, most of the world was on the gold standard. The US joined this arrangement in 1879. Under the gold standard, each country committed to exchange rates for extended periods of time. Commitment to the gold standard required countries to maintain gold reserves. It also meant that central banks had to deflate their currencies during periods of trade deficits and inflate their currencies during periods of trade deficits and inflate their currencies during periods of trade surpluses. These adjustments were required to discourage investors from exchanging their currency holdings for gold and thus depleting a country's gold reserve.

Between the Wars. World War I temporarily halted the use of the gold standard as international trade declined sharply and gold shipments were suspended. In the aftermath of the war, countries experienced vastly different rates of inflation; a return to the prewar fixed exchange rates was impossible because the nominal prices of goods between countries had been changed so much. Fluctuation in exchange rates contributed to a decline in international trade, which was exacerbated by the Great Depression.

In an attempt to promote international trade and economic growth, some of the major countries returned to the gold standard. They failed to achieve stable parity values, however, partly because of the variation in economic policies, which generated different inflation rates. The lack of economic coordination strained many countries' balance of payments and domestic economies and led most of them, once again, to abandon the gold standard.

Some countries, most notably France, remained on the gold standard and imposed import quotas to address balance of payments deficits. As a result, the French franc became significantly overvalued. France negotiated an arrangement with the US and England to devalue its currency without retaliatory devaluations, but this cooperation in exchange rate management ended with the outbreak of World War II.

The Bretton Woods Agreement. In July 1944, as World War II drew to a close, 44 countries met in Bretton Woods, New Hampshire, to discuss the future of the international monetary system. The two major participants were the UK, represented by John Maynard Keynes, and the US, represented by Harry Dexter White. The participants took the following actions:

• The International Monetary Fund (IMF) was established with the authority to lend foreign exchange to the member countries on the condition that they pursue sound economic policies. These funds were to be used to stabilize exchange rates.
  
• The US dollar and the pound sterling were established as reserve currencies.
  
• Exchange rates were fixed within a 1% band relative to the dollar, and the dollar was fixed relative to gold at a rate of $35 an ounce. The US committed to convert dollars into gold.
  
• After a transition period, currencies were to become convertible into gold.
  IMF member countries were required to make a payment of gold and currency to fund the IMF's lending activities, and their voting privileges were proportional to their financial contributions.
  

By the late 1950s, the West European countries were discussing banding together to promote trade and financial cooperation among the countries. On March 25, 1957, France, West Germany, Belgium, the Netherlands, Luxembourg, and Italy signed the Treaty of Rome, which created the European Economic Community (the Common Market). At the same time, the US was encouraging European countries to increase their exports to the US in order to build up their dollar reserves. The Europeans succeeded to the point that by 1960, their dollar claims on the US exceeded its gold supply.

The US balance of payments deficit motivated Presidents John F. Kennedy and Lyndon B. Johnson to impose credit and capital controls, which spurred the development of the Eurodollar market. Eurodollars are dollar-denominated deposits in banks outside the US that are not subject to US-imposed credit controls.

The UK also ran a deficit in the mid-1960s, which led to a 14% devaluation of the pound in 1967. This devaluation, in turn, heightened fears that the dollar would be devalued, especially in light of continuing US balance of payments deficits.

The fear of a dollar devaluation produced a run on gold that forced the creation in 1968 of a two-tiered system for trading gold. Under this system, central banks could trade gold at a fixed official price whereas private investors could trade gold only at fluctuating market prices. Also in December 1969, the IMF issued Special Drawing Rights to augment gold and the dollar as international reserves.

By the late 1960s, the Japanese yen and the German mark had become significantly undervalued relative to the dollar, partly because of rising US inflation induced by the Vietnam War and President Johnson’s Great Society social welfare programs. In 1971, in an attempt to support the dollar’s exchange rate, West Germany bought a massive amount of dollars, which caused Germany’s money supply to expand by more than 20%. This strategy for supporting the dollar was not sustainable.

To remedy the US balance of payments problem, the US wanted West Germany and Japan to revalue their currencies upward. For their part, Germany and Japan wanted the US to curb the growth in money supply, tighten its credit, and cut its spending. Finally, in May 1971, Germany halted its intervention in the foreign exchange markets, effectively ending the Bretton Woods Agreement.

The Smithsonian Agreements and the Aftermath. In 1971, the US suspended the dollar's convertibility into gold and allowed the dollar to float freely. This decision was motivated by a large trade deficit that almost depleted the United States' gold supply. The dollar was devalued, and in an arrangement known as the Smithsonian Agreement, exchange rates were allowed to fluctuate within a 4.5% band. The official gold price was raised to $38/ounce, but convertibility was not resumed. By 1973, most currencies were floating against the dollar, which casued a fall in the dollar's value.

The Jamaica Accord. In 1976, at a meeting in Jamaica, the IMF officially agreed to floating exchange rates. Also, the countries forming the European Monetary Union established parties with narrow margins for their mutual exchange rates and agreed to let their currencies continue to float in a wide band with respect to the dollar. This arrangement was known as "the snake in the tunnel."

In 1979, the European Monetary System was created and the Exchange Rate Mechanism (ERM) was put in place. Under the ERM, the member countries, with the exception of Italy and the UK, pledged to maintain their exchange rates within a band of -/+2.5% around parity, which was referenced to the European Currency Unit. Italy and the UNK observed a band of -/+6%. During the next 10 years, numerous realignments of the parity relationship took place.

The Plaza and Louvre Accords. In 1985, the dollar reached an all-time high relative to the major currencies and the US experienced a high deficit. In September of that year, in an agreement known as the Plaza Accord, the Group of 5 (France, West Germany, Japan, the UK, and the US) coordinated their economic policies to drive down the price of the dollar. The Place Accord inaugurated a plan for the "orderly appreciation" of other currencies against the US dollar. These efforts resulted in a 30% decline in the dollar's value during the next 2 years.

To cope with the possibility that the dollar might overshoot its "natural level", the major industrial nations met again in February 1987 and reached a new agreement known as the Louvre Accord. Declaring that the US dollar had fallen far enough, the singers pledged to cooperate in stabilizing it and agreed to try as far as possible to maintain the then-current exchange rate levels.

The Maastricht Accord. In 1991, the European countries met in Maastricht and set a timetable and rules to establish a single European currency. The conditioned membership in this currency union on the maintainance of narrow bands around parity exchange rates.

When the reunification of Germany motivated Bundesbank in 1992 to pursue a tight monetary policy to forestall the onset of inflation, the narrow exchange rate bands forced other European countries to raise their interest rates at a time when their economies were mired in recession. This circumstance led speculators to sell the weak European currencies in anticipation of devaluation. Sweden, in an ill-fated attempt to defend the parity relationship of the krona, raised interest rates to 500%. The Bank of England unsuccessfully spent billions of pounds defending its exchange rate. The UK and Italy withdrew from the Maastricht Accord in September 1992, and several other European currencies were devalued shortly thereafter. A general realignment occurred in August 1993; bands were -/+15% around the new parity exchange rates. The Maastricht Accord was ratified in September 1993, but with considerably less enthusiasm for a unified European currency in the foreseeable future.

Over the years, exchange rate policies amoung nations have varied according to two major dimensions - cooperation versus noncooperation and rules-based intervention versus discretionary intervention. The current environment for most major currencies is characterized by government cooperation but with intervention at the discretion of the major central banks.