European Economic Perspectives 1
October 1993

Taming Speculation

To make the ERM work, capital controls in the form of margin requirements are necessary.

It is hard to imagine a more absurd way of conducting monetary policy than that of the ERM in the early 1990s. Speculators would borrow a currency from commercial banks in order to sell it on the foreign exchange market; central banks would buy the currency to keep it within its ERM band; commercial banks would reacquire the currency, by borrowing it from their central bank, and re-lend it to speculators. At each turn, official reserves declined, falling ultimately to unsustainable levels and provoking a crisis.

This vast recycling pump clearly revealed the incompatibility of independence in monetary policy, fixed exchange rates and perfect mobility of capital. The pump could be set in a motion by evidence of currency overvaluation. It could also be activated by government lacked resolve, they were offered an irresistible one-way bet: by selling the currency they could oblige the authorities to raise interest rates to intolerable heights, thus forcing the authorities to surrender. This fundamental flaw caused the instability of the narrow-band ERM. Because of it, any attempt to re-establish the ERM on similar lines will fail.

What is to be done? Jumping immediately to a monetary union would solve the problem of instability. In economic logic, this course is impeccable. Politically, however, it is naive. Germany has long favoured a gradual approach. Recent turmoil has only hardened its unwillingness to accelerate the timetable.

So why not simply learn to live with the wide bands of the new ERM? The answer is exchange-rate instability. Wide bands eliminate the one-way-bet problem by relieving central banks of the obligation to intervene, but even countries with no intention of exercising their monetary independence cannot guarantee that future economic or political changes will not trigger changes in policy. Faced with this possibility, markets will protect themselves by trading the currency and exchange rate will shift. If expectations of a change in policy are disappointed, the currency may recover. In the interim, however, the result is volatility. If we have learnt one thing about freely floating exchange rates, it is that they are volatile. Without intervention in the foreign-exchange market, even the 15% bands of the new ERM may soon be under pressure.

Instability will lead Germany to conclude that the EC is not ready for EMU. As Alan Winters argues above, it will encourage protectionism and endanger the foreign market. And it will make life difficult for countries seeking to exploit their new independence in monetary policy. Such countries can succeed in lowering interest rates only if investors expect their currency to recover after its initial depreciation. Otherwise the markets will demand higher (not lower) interest rates to compensate them for the risk of further depreciation. Without the nominal anchor of a narrow-band ERM, nothing rules out possibility that one depreciation will cause the markets to expect another. In that case rates would rise rather than fall, and economic recovery would be further postponed.

The only solution to the ERM dilemma is to slow down speculative attacks - though not by the sort of capital controls that were common until the 1980s. The answer is temporary margin requirements on financial institutions with open positions in foreign exchange. Banks and other institutions dealing on their own account would deposit with the central bank at zero interest a proportion of any short positions in the domestic currency. This would impose a cost on foreign-exchange speculation - a cost that would rise with the interest rate. During speculative crises, an increase in the interest rate would therefore discourage speculation twice; first by increasing the normal cost of borrowing and second by raising the cost of meeting the margin requirement.

This proposal commonly faces several misconceived objections. Margin requirements are said to be impracticable. Actually, the concept of the open position is easily applied in in a world of mobile capital; it is precisely what currency traders and financial institutions calculate at the close of business each day. Reporting, monitoring and complying are therefore relatively straightforward.

It is sometimes said that banks typically close their open position at the end of each day. perhaps they do in placid times, but not during speculative crises. If the banks had closed their open positions during the crisis of 1992, they could hardly have made such big trading profits! By definition, in fact, someone's position must be open whenever a speculative attack is under way. If deposit requirements caused financial institutions to close their positions daily, then so much the better: the measure would thereby succeed in reducing speculative pressure.

It is also argued that, to be effective, such measures need to be implemented by all countries, otherwise financial trading will simply move to less-regulated markets. International co-operation of this sort is unlikely to happen, the argument continues so the proposal can be dismissed. This is to misunderstand how the foreign-exchange market works. Suppose the franc is under pressure. Speculators may sell franc deposits that are held outside the French banking system. Margin requirements would not affect such sales, but the quantity of these deposits is finite. Once they have been sold (ultimately to the Banque de France), this source of speculation is gone. Further sales require the speculator, wherever he may be, to borrow francs in order to sell them. These additional francs are available only in France. Hence, by imposing margin requirements on borrowing in Paris, the Banque de France can unilaterally increase the cost of specualting against the franc. To stabalize an ERM currency, it is enough for the issuing country to impose margin requirements.

Would a country that unilaterally imposed margin requirements see some financial business migrate to other centres? Most likely, yes. For a country like the UK, which has invested heavily in London's status as a financial centre, this cost may be prohibitive. Its best answer to the ERM dilemma may therefore be to let sterling float, as it has done. For other countries, however, the balance of costs and benefits is different: they have less to lose if financial business migrates and more to gain if the ERM can once more be made to work well.

Another objection is that margin requirements, if effective, would distort the allocation of international capital. In a way, this is true: the whole idea is to "distort" the flow of capital. But margin requirements would not disrupt international flows of capital for investment - and that is a crucial distinction. The cost of margin requirements may be prohibitive for a 48-hour speculative round trip, but it is negligible when discountd over the 10- or 20-year horizon relevant for fixed investment.

The last popular objection is that this measure would be contrary to the spirit if not the letter of the Single European Act. This is wrong. Since margin requirements are not an administrative prohibition, they violate neither the letter or the spirit of the Act. They would impede financial integration - and financial integration is undeniably an important part of the broader economic integration that the EC seeks. But September 1992 has made it clear that full capital mobility and fixed exchange rates are incompatible. If governments choose to pursue financial integration and let currencies float, the resulting protectionist pressure could severely impair the integration of good markets. To pursue exchange-rate fixity without margin requirements requires nothing less that EMU.

Barry Eichengreen and Charles Wyplosz

Eichengreen is a Professor of Economics at University of California, Berkeley and Wyplosz is a Professor of Economics at INSEAD and joint managing Editor of Economic Policy.
Both are Research Fellows in CEPR's International Macroeconomics programme