HITESH PATEL asked:
UK’S GOVERNMENT’S ECONOMIC POLICY OF THE 1960s AND THE EURO-DOLLAR MARKET *
A. Introduction
On the 11th May 1965, the Chancellor of the Exchequer announced that local and central Government spending was to decrease in order to restore the balance of payments to equilibrium, and to enable the nation to live within its income.
Within five months from the statement of the Chancellor of the Exchequer, Mr. Berne of the British Embassy in Germany stated that, a German newspaper Neue Zurcher Zeitung (NZZ) on the 12th October 1965 produced a lengthy analysis of the sterling crisis, and clearly pointed to the reason why the UK turned to the Euro-dollar market to relieve the Chancellor of the Exchequer of his financing problem . The view held was that, that the source of the crisis of confidence lay primarily with the UK rather than with foreign companies, most of whom had kept their sterling holdings down to the minimum since 1961, and what happened in the autumn of 1964 was a panic flight from sterling by domestic holders of it. The newspaper assumed that the UK had about one thousand million pounds to re-pay as a result of the various arrangements made since December 1964, and that of this about 10% had to be repaid by May 1965, a third by December 1967, and the rest by May 1970. About five hundred million pounds would be regained though the reversal of “leads and lags” and other positions, and it would be possible, if the economy could be brought reasonably into balance, for the UK to recover the remaining five hundred million pounds by 1970. However, although it was possible for the UK to re-pay these amounts, the article quoted that the UK’s reserves were so low that the UK will remain under heavy strain. The article further discussed that there were talks of some transfer of UK sterling debts to the IMF, but this was not appropriate since the sterling debts were of a normal commercial nature. The conclusion was that the logical course was a long-term foreign loan and that the UK would probably, seeks such a loan. That, the main priority was first, to overcome the short-term disturbances, and secondly to have achieved some success in the introduction of long-term policies .
It soon became apparent that borrowing abroad by local authorities and the nationalised industries and the interest shown by the LCCÂ’s (London County Council) proposal to raise a loan in Euro-dollars, was a way to relieve the Chancellor of its financing problem. Various possibilities of Long-term borrowing, were examined as a means of assisting the UK balance of payments. However, the benefit to the reserves would only accrue if the proceeds of external borrowing was applied to financing expenditure which had to be made in any case, and not used as a basis for additional expenditure .
However, it was not until 1967 (the second half of the 1960s), that the UK government actually began to investigate the possibility of its nationalised industries and public authorities borrowing on the Euro-dollar market. This argument was further developed by the Treasury by 1969, which had for some time been arguing that it would be useful for the UK reserves, if the UK could, in some form, borrow abroad. However, the UK government itself could not borrow as, although the other governments have borrowed in the European capital market, these have tended to be the less developed countries, and thus a move by the UK would have been regarded with suspicion. It was suggested therefore, that the Government encourage local authorities and nationalised industries to borrow abroad (most obviously where interest rates are low) by operating through the Exchange equalisation Account, and giving the local authority an exchange rate guarantee, in return for which a small charge would be made. In view of this proposition, Mr. Macdonald (MP Labour – Chislehurst) asked the following question to the Chancellor of the Exchequer, on the 14th February 1969 in the House of Commons , with the proposed reply:
Question: Whether the Chancellor of the Exchequer is aware that borrowing in overseas capital markets by the nationalised industries would benefit the balance of payments, and what steps he proposes to take to encourage such borrowing?
Answer: The Chancellor agreed that there would be advantage to the balance of payments if those nationalised industries who have the power to do so were to borrow at medium and long-term in these markets. The Treasury is therefore prepared to give consent to such borrowings and, in addition, in appropriate cases, to make special arrangements to relieve the industries of the associated exchange uncertainties.
B. The Euro-dollar market
City corporations of both European and other countries had borrowed US dollars in the foreign currency market (e.g. Milan, Amsterdam, Oslo, Tokyo, Yokohama). Only UK local authorities had not borrowed externally except by taking sterling deposits directly or indirectly from non-residents. One of the most significant developments in the Euro-dollar market in 1963 has been the growth of long-term deposits. In 1963, for instance, deposits of up to three yearsÂ’ maturity were rare; in 1964 they were common. Paul Einzig (in the September issue of the Journal of Finance) in 1964, argued that Arab recipients of oil royalties owned most of the long-term deposits . This source of funds to the market had been growing greatly in 1963, and had compensated for withdrawals of officially owned funds. This development was welcomed in the market by the Euro-bankers, which meant that they were no longer at the mercy of changes in official policy. The ease with which the market had adjusted for withdrawals of official funds was witnessed by the stability of interest rates in 1963 and 1964. Apart from Arab investors, American corporations have been lending increased amounts in 1963 to the market. Not only had the amounts increased, but also the length of deposit. Einzig also attributed the increased volume of long-term lending by American corporations to fears of possible exchange controls in the US. Given the increased maturities of deposits, the Euro-bankers were enabled to lend for longer periods. Five-year loans were increasing, while three-year loans were commonplace. Also, Euro-funds were being used to subscribe to issues of foreign bonds in the London capital market.
Hence, the Euro-dollar market (or dollars in London) had developed into not only a short-term borrowing market, but to dollars available in London for borrowing for longer periods. Nevertheless, deposits of dollars were occasionally offered in London for periods of two years or more, but enquiries by the Bank of England suggested that these had become very rare. Apart from this market, there had been the growth of the business of floating longer-term dollar loans in London at around 15-years or more . Mainly continental subscribers had taken these up.
C. Financing the balance of payments deficit (up to the end of 1966)
The deficit on the current and long-term capital account of the UK was in the order of £200m in the second half of 1965, and £350m in 1966. There were three elements which constituted a strain or relief for the reserves: first, the balancing item, secondly the balance of payments of the overseas sterling area, and short-term capital flows to and from the non-sterling area .
The balance of payments of the overseas sterling area was deteriorating and the reserves of these countries as a whole were being reduced. The countries with large expected deficits (e.g. Australia and Malaysia) had large reserves of sterling to draw upon, whilst the oil states, which were expected to be in surplus, were not likely to accumulate the proceeds in sterling as they used to do. Short-term capital flows to and from the non-sterling area were unpredictable . Interest differentials were not favourable to such inflows, and a large outflow was always possible if there was a further weakening of confidence and that no appreciable relapse was likely without favourable differentials and some restoration of confidence.
D. Proposal of Foreign Currency Borrowing from the Treasury
On the 10th February 1969, Ministers had decided that the nationalised industries should be encouraged to cover a proportion of their borrowing needs from international capital markets . The Treasury had been examining some of the implications of this decision.
It was not envisaged that anything but a small proportion of the borrowing needs of the nationalised industries could be met through borrowing abroad. Medium and long-term borrowing in the Euro-bond and other overseas capital markets would, however, provide a significant and useful benefit to the balance of payments. During 1969, such borrowing would offer an interest rate advantage to the nationalised industries compared with borrowing from the National Loans Fund, but the nationalised industries might be deterred from using the facilities offered by these markets because of the exchange uncertainties. In order to overcome this obstacle, the Chancellor of the Exchequer had approved a scheme whereby in appropriate cases the Government would be able to relieve a nationalised industry of the exchange uncertainties associated with borrowing in foreign currencies . The scheme was as follows:
The foreign currency proceeds of a foreign currency loan raised by a nationalised industry would all be converted into sterling through the Bank of England at the going rate in the ordinary way. The authorities would undertake that all the foreign exchange needed subsequently from time-to-time for the service of the loan would be sold to the industry against sterling at this rate , and in return the industry would undertake to acquire all its foreign exchange for servicing the loan from the Bank of England at this rate. In return for this exchange cover, the industry would be expected to pay a half-yearly charge, which it is intended should be calculated as the difference between the “all-in” cost of the foreign borrowing (including all initial as well as recurring management expenses) and what it would cost to borrow an equivalent sum from the National Loans Fund at the same date and according to the normal rules for Government lending to the industry concerned, less a margin normally of ¼% a year. Thus the industry would neither lose nor benefit from subsequent changes in exchange rates; and the interest rate margin of ¼% a year should encourage the industries to borrow in this way .
The Act, which gives an industry power to borrow abroad also, requires specific Treasury consent for each loan of this kind. Moreover, the industries would no doubt wish, and foreign lenders expect, a Treasury guarantee of the kind, which is normally provided in respect of market borrowing by these industries. This guarantee would protect the lender in case of default of payments of capital and interest. The Treasury would need to be satisfied that the terms and conditions, including the currency, size and timing of the borrowing are appropriate, both in relation to the UKÂ’s balance of payments and to the prevailing conditions in these international and foreign capital markets .
The scheme described applied only to borrowing in currency of a country outside the sterling area. It did not apply to borrowing in a country of the sterling area, or through a sterling area country. This borrowing would not be an additional source of finance, which would allow the industries to exceed the approved investment programme. Foreign borrowing was an alternative source of finance, not a way of increasing investment .
These arrangements were brought to the attention of the industries concerned, and had encouraged them to take advantage where appropriate. The process of obtaining powers to borrow in foreign currencies was not complete, as these powers were being acquired by those industries that asked for them, as the opportunity arised – generally when borrowing powers were increased . The industries that already possessed powers were:
• The Electricity Council
• The Gas Council
• The North of Scotland Hydro Electricity Board
• The South of Scotland Electricity Board
The Air Corporations also had power to borrow in foreign currencies. Under exchange control arrangements, they had been expected to borrow abroad to finance expenditure overseas and for the purpose of foreign aircraft. It was agreed that powers would be taken for the British Steel Corporation, and the National Coal Board had shown considerable interest in acquiring them. It was important to choose suitable opportunities for nationalised industry borrowing in international capital markets, and the issues by British public corporations would had to be properly “marshalled” and managed. It was for this reason that the timing as well as the terms of issue would be subject to control. If a corporation was contemplating proposals to borrow abroad, they would make contact with the UK Treasury at a very early stage. The UK Treasury at the same, would immediately bring the Bank of England into the discussions. It would also be essential for any industry contemplating this kind of borrowing to use the services of a City house or houses of first class standing and experience in this field .
E. The philosophy behind the UKÂ’s GovernmentÂ’s Economic Policy
In the case of the public bodies, it was one thing to have the necessary powers to borrow abroad, and another to persuade the industries to use them. The main obstacle was the absence of an exchange guarantee. Hence, the margin between the cost of borrowing overseas, and the cost of borrowing from the National Loans Fund, was not sufficient to safeguard the industries against the exchange risk for which, they would otherwise have had to carry. In general, it was clear that the UK government agreed that foreign currency borrowing was desirable and “had” to be encouraged. The following two frameworks of argument were put forward by the Treasury which underpin this very policy:
Framework One:
In formulating the foreign currency borrowing philosophy the natural starting point is the shadow foreign rate and the rate of return on marginal domestic investment. The former shows the extent to which the UK is willing to lower the present trading ratio between domestic and foreign resources to obtain scarce foreign exchange. For the sole purpose of this analysis, the rate is taken to be 20%, and the marginal return on UK domestic investment to be 8%. Now that we have the preference rate implied by the shadow foreign exchange rate and the marginal return on domestic investment, we have an implicit time preference rate for foreign exchange. For the basis of this conceptual approach the implicit rate of discount is 10%.
Having obtained this figure, we need to consider now the implication for foreign currency borrowing policy. In simple terms, it seems to be this. Foreign currency borrowing will benefit the nation as a whole provided that the effective borrowing rate (i.e. the actual market rate plus any allowance we want to make for possible exchange rate changes) is less than 10%, and that the domestic investment project which the switched funds will finance promises a marginal return of not less than 8%. So taking this into account, it seems difficult to consider the question whether exchange guarantees should be given to encourage this borrowing until there is fairly general agreement that this or some other similar criterion is the right one. Assuming that this criterion is substantially “correct”, we start with the obvious argument that it will be worthwhile to give an exchange guarantee if, without such a guarantee, the public bodies concerned are unwilling to borrow, even though the relative rates fall within the criterion specified above. There are, of course, then to be considered the contrary arguments, in particular the view that much damage could be done by what will be taken as a vote of little confidence in the stability of present exchange rates by the UK public sector. The argument may of course be exaggerated, and may carry much less weight after the Basle arrangements. But it seems to be that this question of exchange guarantees is logically secondary, and that we must first decide what is at stake (i.e. how much we want this foreign currency borrowing).
To conclude this framework, it is in the national interest that foreign borrowing take place when the implicit discount rate on foreign exchange exceeds that on domestic resources and when the interest rate differential between abroad and at home is less than the differential between the implicit discount rates. If the implicit discount rate for foreign exchange is 10% and that for domestic resources is 8% while the domestic interest rate is 7½%, foreign borrowing would be preferable from the national point of view so long as the foreign interest rate is less than 9½%. (the foreign interest rate should be calculated to include an allowance for any danger of foreign revaluation). So long as foreign borrowing is likely to be by foreign-currency borrowing. The fact that domestic borrowers will borrow where the interest rate (including allowances for brokerage charges and exchange rate fears) is lowest means that they will borrow sub-optimal sums in foreign currency issues when-ever the discount rate for foreign exchange exceeds that for domestic resources. There is therefore a case for giving a subsidy of up to the amount of this differential. The case for an exchange guarantee is that it is the best, or the only feasible, method of giving such a subsidy, and that the benefit of giving this subsidy will outweigh the possible dangers to confidence in the stability of the monetary unit.
Framework Two:
The second framework possesses a completely different argument than of framework one. The Public Records contains proof that the existence of a premium on foreign exchange (a shadow exchange rate) does not in itself imply that the discount rate on foreign exchange exceeds that on domestic resources (as stated in framework one). That, as long as the reference rate is constant over time, the two discount rates are identical. The implicit discount rate on foreign exchange exceeds that on domestic resources when, but only when, the preference rate for foreign exchange is falling over time.
This means that the case for subsidizing foreign currency borrowing is critically dependent upon the expected future values of the preference rate. For example, assuming that the policy of the late 1960s were to work with a 20% current preference rate and a 10% rate in the more distant future, this would justify a subsidy of up to about 1% per annum on a 15-year bond. The Government Economic Advisors would reconsider these preference rates, and it would entirely be possible that this would lead to modifications of the recommended values. As, it was difficult to envisage a situation in which the UK would be planning to be short of foreign exchange in 15 yearsÂ’ time than the UK were in the late 1960s. However, taking this scenario into account, this would mean that the UK could expect to have a fall in the preference rate over this period. This in turn meant that some subsidy would be justified.
This example was for a 15 year bond with a 7% British interest rate, and the preference rate falling from 20% to 10% between which the time the loan is contracted and the time the first interest payment falls due. The foreign currency borrowing would be socially preferable if the foreign interest rate is less than 7.97%, including exchange risks. Also, the difference in argument between the first framework and the second framework is the fact that the critical foreign effective borrowing rate should be the domestic interest rate plus the differential between the discount rates for domestic resources and foreign exchange, rather than the discount rate for foreign exchange.
Result
The UK Government completely agreed that the argument in favour of borrowing overseas depends on the interest rate differential between foreign funds and home funds being less than the differential between the discount rate on foreign exchange and the discount rate on domestic resources. That one only gets a difference between the discount rate on foreign exchange and the discount rate on domestic resources if the premium on foreign exchange is expected to change over the period of life of the proposed foreign borrowing. Also, the fact that there was not point in borrowing abroad just to pay it back tomorrow unless either:
(i.) The UK could put the real resource counterpart to use at home, to the UKÂ’s profit; or
(ii.) The UK expected foreign exchange to be cheaper, or in some sense less valuable, tomorrow than it is today.
Taking this into account, with the first point was being ruled out, the second point was the only alternative left. Nevertheless, if the notion that UK preference for foreign exchange need not decline through time was assumed, the result would be that foreign borrowing is undesirable. However, due to the UKÂ’s reserve situation in the 1960s in principle, foreign currency borrowing remained an alternative to other forms of borrowing, ways of liquidating existing assets, and reducing the UKÂ’s overseas investment flows.
F. Conclusion
Ministers had for some time thought that medium and long-term borrowing abroad by public corporations and local authorities would make a significant contribution to the UKÂ’s debt refinancing problems, even though the amount of borrowing that these bodies could do in overseas markets would in marginal be in relation to their total requirements. The chancellor shared this view, as did the Governor of the Bank of England, who reported that some of his central banking colleagues had expressed surprise that the UK Treasury had not so far taken advantage of the opportunities open to the UK in this direction. Some of the nationalised industries were keen to undertake such borrowing, and the UK had been equipping them with the appropriate powers when legislative opportunities had arisen. The Electricity Council and Gas Council already have powers, and the British Steel Corporation were to follow. In the local authority field, relatively few authorities had powers to borrow abroad; and there was a tax impediment in that the provision in the 1968 Finance Act enabling domestic concerns borrowing abroad to pay interest gross did not in its present form apply to local authorities. To get over this difficulty meant that legislation was required in the 1969 Finance bill, as the GLC were known to be interested in borrowing abroad, and other authorities would follow the GLCÂ’s lead.
However, it became clear that neither the nationalised industries nor local authorities were likely to take advantage of the opportunities to borrow abroad, despite the lower levels of interest rates in some of the international capital markets, if they themselves had to shoulder the exchange risk. The Chancellor therefore approved a scheme which in suitable cases, the Exchange Equalisation account would in effect take the exchange risk, in return for a charge to the borrower which will be calculated as to leave the borrower with an interest rate advantage of ¼% a year as compared with borrowing from the National Loans Fund.
The Chancellor also considered whether this arrangement would prompt pressure for similar treatment for the private sector. As most private overseas borrowing by UK concerns at the first quarter of 1969 was to finance overseas investment in accordance, with the UK’s Exchange Control rules. The Chancellor decided that the government would not encourage borrowing by British companies for domestic expenditure, which would be in some respects at odds with current policies designed to squeeze liquidity. The defence to this decision was that the British Government were favouring the nationalised industries and the public authorities when pursuing its policies. These “business interests” was part of a controlled programme of overseas borrowing which would advantage the UK’s balance of payments, and the UK Government was not proposing to operate this programme through the private sector.
ENDNOTE
This paper is based on the following PRO Files:
PRO PREM 13/2593: Prime Minister Files, “1969 UK Economic Policy”, (January 1969 – April 1969)
PRO T 312/1772: Foreign currency borrowing in overseas markets by (1) the UK Government (2) public corporations and local authorities. File Number: 2F 403/229/02 “PART A”.
PRO T 326 “series”: This involves a review of a range of PRO files involving: T 326 816, T 326 817, T 326 455, T 326 678, T 326 819, T 326 822, all involving, Borrowing abroad by local authorities and nationalised industries, (January 1964 – December 1969). File Number: 2-FH 3/116/03 “Part A-N”
