68Th Annual Report Chapter VI. Exchange Rates and Capital Flows
Total Page：16
File Type：pdf, Size：1020Kb
VI. Exchange rates and capital flows Highlights In 1997 and early 1998 current and prospective business cycle developments in the three largest economies continued to dominate interest rate expectations as well as the movements of the dollar against the yen and the Deutsche mark. The yen showed more variability than the mark as market participants revised their views regarding the momentum of the Japanese economy. As in 1996, the dollar’s strength served to redistribute world demand in a stabilising manner, away from the full employment economy of the United States to economies that were still operating below potential. A question remains as to whether the US current account deficit, which is expected to widen substantially as a result of exchange rate changes and the Asian crisis, will prove sustainable given the continuing build- up of US external liabilities. Under the influence of several forces, large currency depreciations spread across East Asia and beyond in 1997. Apart from similarities in domestic conditions, common factors were the strength of the dollar, competition in international trade, widespread shifts in speculative positions and foreign investors’ withdrawal of funds from markets considered similar. The fall in output growth and wealth in Asia depressed commodity and gold prices, thereby putting downward pressure on the Canadian and Australian dollars. Against the background of a strong US dollar, most European currencies proved stable or strengthened against the mark. As fiscal policies and inflation converged, forward exchange rates and currency option prices anticipated the euro over a year before the scheduled introduction of monetary union. Already in 1997, trading of marks against the other currencies of prospective monetary union members had slowed. The US dollar, the Deutsche mark and the Japanese yen The dollar and business cycle developments The dollar started 1997 on an appreciating trend against both the yen and the The dollar responds mark (Graph VI.1) as a result of market expectations of monetary tightening in to changing views about growth the United States and no change in monetary policy in Germany and Japan (Graph VI.2). These expectations were founded on signs of accelerating US growth, coupled with rising unemployment in Germany and continuing weakness of the financial sector in Japan. Particularly large capital flows from Japan to the United States in April, which contributed to the substantial increase in cross-border transactions in bonds and equities (Table VI.1), accentuated the yen’s depreciation (Graph VI.3). Bank for International Settlements -- 68th Annual Report 98 The yen and the mark against the dollar Weekly averages * 80 1.07 90 1.21 100 1.35 110 1.49 120 1.63 130 Yen/US$ (left-hand scale) 1.77 Mark/US$ (right-hand scale) 140 1.91 1995 1996 1997 1998 * Inverted scales. A decline indicates a dollar appreciation. Graph VI.1 From May to July the dollar moved in scissor-like fashion against the yen and the mark. Against the mark, it appreciated towards DM 1.90, a level never before reached in the 1990s, in the context of an increasing consensus that the euro would arrive on schedule with a broad membership. At the same time it depreciated substantially against the yen in response to perceptions (in the event erroneous) of improving economic prospects in Japan. The yen also rose when market participants interpreted statements by Japanese and US policy-makers as suggesting the possibility of official purchases of yen against dollars. Japanese investors exploited the yen’s strength during this period by continuing to purchase US bonds in large amounts. Six-month forward interest rates * Weekly averages, in percentages and percentage points United States Germany Switzerland Japan United Kingdom Levels Differentials vis-à-vis the US rate 8 2 6 0 4 -- 2 2 -- 4 0 -- 6 1995 1996 1997 1998 1995 1996 1997 1998 * Derived from 6 and 12-month LIBID. Graph VI.2 Bank for International Settlements -- 68th Annual Report 99 Cross-border transactions in bonds and equities* 1975 1980 1985 1989 1990 1991 1992 1993 1994 1995 1996 1997 as a percentage of GDP United States 4 9 35 101 89 96 107 129 131 135 160 213 Japan 2 8 62 156 119 92 72 78 60 65 79 96 Germany 5 7 33 66 57 55 85 170 158 172 199 253 France 5 21 52 54 79 122 187 197 187 258 313 Italy 1 1 4 18 27 60 92 192 207 253 470 672 Canada 3 9 27 55 65 83 114 153 208 189 251 358 * Gross purchases and sales of securities between residents and non-residents. Source: National balance-of-payments data. Table VI.1 The scissor blades closed during the summer as the release of weak Japanese economic data dampened earlier optimism about an acceleration of growth. This reduced the likelihood of a rise in Japanese interest rates, while US interest rates were expected to remain unchanged. Concerns about the US trade deficit with Japan, however, may have moderated the dollar’s appreciation against the yen. The mark’s recovery against the dollar during this period reflected expectations of some monetary tightening in Germany, expectations which were fulfilled in early October. From the end of October to year-end, the spreading of the crisis in Asia Large Japanese sales influenced exchange rate movements between the three major currencies. The of foreign bonds … market view that the impact would be greatest on the Japanese economy tended to amplify the weakening of the yen in response to growing pessimism about the outlook in Japan and concern about financial strains. Japanese investors sold unprecedentedly large amounts of foreign bonds during this period, reversing the Portfolio flows from Japan to the United States 1 In billions of US dollars Japanese net purchases of: US equities 15 US bonds 2, 3 US net sales of: Japanese equities 10 Japanese bonds 2 5 0 -- 5 -- 10 -- 15 1994 1995 1996 1997 1998 1 A positive (negative) sign indicates a net flow from (to) Japan. 2 Data may include official transac- tions. 3 1994 data include US equities. Sources: Japanese Ministry of Finance and US Treasury. Graph VI.3 Bank for International Settlements -- 68th Annual Report 100 large outflows from Japan during the phase of relative yen strength (Graph VI.3). Banks reducing dollar assets in order to pay off dollar liabilities accounted for some of the flows. Some of these bond sales, however, led to purchases of yen against dollars, so the yen’s weakness suggests other forces were at work. One … outweighed such factor may have been the sizable short positions taken against the currency by speculative in both the spot and the option market by speculative operators outside Japan. positioning Hedge funds and proprietary trading desks were seen buying long-dated dollar calls at the current exchange rate, consistent with the view that economic weakness and financial fragility would lead to further appreciation of the dollar against the yen. Given the large interest rate differential, these options were out of the money (and therefore cheap) and would yield a positive return if the dollar strengthened even marginally. One indication of this speculative positioning was the persistent premium on one-year dollar calls over equally out-of-the-money yen calls in late 1997 and early 1998 (a positive risk reversal in Graph VI.4). The dollar falls In contrast to its strength against the yen, the dollar weakened against the with US equities in mark from the end of October to mid-November, reflecting the market view October … that the Asian crisis would have a greater economic impact in the United States than in Europe. As in 1996, the dollar’s steepest fall occurred on the day of the biggest decline in the US equity market (27th October). This decline, triggered by a plunge in the Hong Kong stock market, was accompanied by a rise in market uncertainty (an increase in the variance of the probability density function implied by option prices). Market participants also became willing to pay more for options that would pay off in the event of a much weaker dollar over the following months (a fattening of the left-hand tail of the distribution in Graph VI.5). Other than on days of very sharp drops in the US equity market, the relationship between currency values and equity markets varies. With a large but The exchange rate, implied volatility and risk reversals of the yen Left-hand scale (inverted, in ¥/US$): Right-hand scale (in percentages): Exchange rate Implied volatility (one-month) Risk reversal (one-month) Risk reversal (one-year) 110 15 115 12 120 9 125 6 130 3 135 0 140 -- 3 1997 1998 Sources: National Westminster Bank, Swiss Bank Corporation and BIS. Graph VI.4 Bank for International Settlements -- 68th Annual Report 101 Probability distributions of the mark against the dollar 24th October 1997 0.30 28th October 1997 0.25 0.20 0.15 0.10 0.05 0 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2.0 2.1 2.2 Note: The Dow Jones index fell by 554 points or 7.2% on 27th October 1997. The calculation assumes risk neutrality. The vertical lines indicate the forward rate from futures contracts (i.e. the mean of the distribution) for each date. Source: W. Melick (Federal Reserve Board) using Chicago Mercantile Exchange data. Graph VI.5 stable short-term interest rate differential between the dollar and yen over the … highlighting past two years, the alternation of pessimism and optimism about the prospects the relationship between exchange for sustained growth in Japan has expressed itself in similar movements in both rates and equity the yen’s exchange rate and the Japanese equity market.