146. Memorandum From the Under Secretary of the Treasury for Monetary Affairs (Yeo) to President Ford 1
Under the general heading of monetary concerns there are four specific items that might be discussed and on which your views will be of great interest to other leaders.
Provision of financial assistance to countries such as Italy which are in structural balance of payments disequilibrium (countries which have a structural deficit in their current accounts): Countries in this category have been borrowing large amounts of money in an effort to finance the adverse gap between what they receive in earnings on exports of goods and services, and what they pay to other countries for imports of goods and services.
Large scale borrowings become necessary because the natural inflow of capital to finance the resultant current account deficits is insufficient. The borrowings have typically been in the form of long term bond issues denominated in dollars; but the British have traditionally used the London money market—to attract short term funds from private concerns—and central banks in order to finance their deficit.
In addition to the UK and Italy, France, Belgium, Denmark, and Sweden are using this technique and thereby are avoiding the depreciation in their exchange rate which would otherwise follow. They want to avoid a lower exchange rate because it would make imports more costly and add to inflationary pressures. Financing operations of this type if carried on for prolonged periods can produce two adverse results:
- A substantial disparity between the internal value of a country's currency, eroded by inflation, and the external value or exchange rate, propped up artificially by sustained heavy external borrowing.
- An exhaustion of a country's ability to borrow in the private market place as lenders become afraid to extend additional credit.
The second development acts as a trigger. In the case of Italy, reserves were exhausted, they realized they could borrow no more, and so let the exchange rate go. The drop in the rate, reflecting the pressures that had been concealed from 1969 to late last year by heavy external borrowing (approximately $12 billion), was 20% over a 2-month period. The sharp rate decline does not reflect an inadequacy in the international [Page 524]monetary system but rather inadequate Italian economic and financial policies.
In the case of the UK, the overall effect has been similar but the specific trigger different. The short term funds that the UK has attracted over the years have recently tended to move out of sterling because of a feeling that the UK has not embarked on a serious effort to deal with its inflation and thus sterling was destined to continue to decline in value. Funds leaving London resulted in sharp downward pressure on sterling (the rate has dropped from 2.02 to 1.77 in the past six months). This in turn has served to validate the very fears that prompted the initial moves out of sterling. In addition, British residents have attempted to protect themselves by the following phenomenon (leads and lags): UK importers rush to pay as quickly as possible before sterling goes down further and exporters defer payments as long as possible.
There are three policy options in the UK and Italian cases:
- Do nothing. In the case of Italy refuse to extend credit, in effect insisting on an exclusively internal solution. This would involve some further depreciation of the lira and draconian domestic economic and financial policies. An unwillingness on the part of the Italian people to support a total austerity effort could result in a series of controls on imports and foreign exchange transactions (a seige economy). This probably would not work and if not the result could be the financial collapse of Italy. This in turn could prompt counter measures from other countries.
- Provide official credit—country to country loans and/or multilateral credit—on a "no conditions" basis. This could involve a need of $3–4 billion every 18–24 months for Italy and a larger amount of $4–5 billion for the UK.
- Provide official credit but with meaningful conditions—an economic program that gears the extension of credit to the accomplishment on a step by step basis of a program of domestic economic and financial stabilization. This is what was done obliquely with the UK in the recent $5.3 billion support package.2 The one condition of that package was that if other sources are not available the UK will draw from the IMF (and thus meet the conditions that the Fund will require, including a tighter monetary policy and a material reduction in the budget deficit known as the "Public Sector Borrowing Requirement"). At the present rate the British, who have yet to make the substantive policy changes necessary, will have to borrow from the IMF.
This approach has the advantage of tying limited amounts of official financing to corrective policies; it does not run the risks inherent in the "do nothing" option and if successfully supplemented does not involve the almost unlimited amounts implicit in the "provision of official finance without conditionality" approach.
We have, under your direction, focussed our efforts on the last option. There are, however, two obstacles:
- The reluctance of countries like the UK and Italy to accept this approach, and the sensitivity on the part of others who fear that they could find themselves in similar circumstances. In general, the Germans, Japanese and French should support this approach; the Canadians' attitude is unknown.
- The availability of money of a conditional nature for Italy is quite limited.
The best institutional arrangement for producing conditional financing is the IMF. It does not involve Congress, does not impact our budget, and cloaks the conditionality in a multinational mantle that dilutes opposition within a borrowing country to conditions imposed by the US or other outsiders. (This last concern has watered down considerably the conditionality re E.C. credit extended to Italy and bilateral gold secured loans made by Germany to Italy.)
Unfortunately, under the rules limiting the amount individual countries can borrow from the IMF, Italy only has $520 million in additional credit available to it. We have developed a way around this constraint which involves activating the General Arrangements to Borrow and taking advantage of the agreement in Jamaica which stipulated that under "special circumstances" the limits that apply to individual country borrowings from the IMF could be exceeded. The GAB would provide the money (we have a continuing appropriation).
Germany, Japan, UK, and France are aware that we have developed this technique, but we have not discussed it with other participants. In general, the ones we have spoken to are receptive although they are concerned, as are we, about the possibility that LDCs would view this as preferential treatment for a developed country and thus escalate their demands for more financing from the IMF (even though the LDCs have received highly preferential treatment themselves, e.g., the Trust Fund and expanded Compensatory Financing Facility, and though the GAB can only be used for the developed countries who are members).
An alternative institution would be the Financial Support Fund but this facility will not come into existence until Congress passes the enabling legislation. The prospects for enactment by the current Congress are not high.
It is possible that the French might raise the matter of exchange rate volatility. They could point to the performance of sterling and the [Page 526]lira, and describe how the sharp depreciation in both currencies has adversely impacted French industry's competitive position both at home and in world markets. They might call for "heavy and concerted intervention", a euphemism for involving the US in large purchases of currencies like the lira and sterling. That is tantamount to the US extending large unsecured loans to Italy and the UK. The French could even threaten to retaliate by imposing trade and foreign exchange controls if we refused to participate in such operations.
The understanding at Rambouillet established that the US and others would intervene to counter disorderly market conditions, not to support currencies at artificial levels. The system has worked well, and the sterling and lira crises do not have their origins in the operation of the system but in the legacy of economic management errors that ultimately grew to the point where they could no longer be financed. French participation in an effort to provide conditional official financing to the UK and Italy would strengthen the developed world's capacity to deal with these problems.
The British might raise the subject of a "substitution account" for official sterling balances or the funds on deposit in London from foreign central banks. In its approximate form this idea dates back to when Prime Minister Callaghan was Chancellor of the Exchequer.3 In principle it involves an arrangement whereby other countries or their proxy, the IMF, would in some form guarantee (from an exchange risk standpoint) or take over responsibility for these balances—$12.8 billion in dollar terms.
From a technical standpoint we have examined the various ways this could be done. But from a policy standpoint a substitution account means additional credit, probably of an unconditional nature, for the UK. A proposal or feeler on a substitution account would support the view that the UK still does not appreciate the gravity of its situation and/or lacks the will to deal with it in terms of substantive policies.
- The Japanese will be concerned regarding the substantial criticism they have come under in the US press regarding their exchange rate policies. The charge is that they have prevented the yen from rising in price thereby gaining an artificial competitive advantage for Japanese products in world markets. This facilitates the development of an "export led recovery", the principal architect of which is Vice Prime Minister Fukuda. While it was just six months ago that the yen was the subject of downward pressure recently the facts tend to support the overall charge. We have raised this issue with the Japanese in private meetings several times. The most recent was in Anchorage on [Page 527]March 27, at which I discussed the situation with Finance Vice Minister Yoshida.4 While they disavowed manipulative practices, no tangible evidence of a change in policy was forthcoming. In recent weeks various private observers have called attention to their behavior. We have confined ourselves to pointing out that we have permitted our currency to float and that our current account has shifted from a $12 billion surplus in 1975 to a roughly $2 billion deficit in 1976. We have argued that this is necessary if countries like Italy and the UK are going to have the opportunity to move from their structural current account deficits to the surplus which is required if they are to stabilize their situation.
- Source: Ford Library, President's Handwriting File, Subject File, Box 49, Trips—Foreign—Economic Summit—1976 (4). No classification marking. A stamped notation on the memorandum indicates the President saw it.↩
- In a June 7 memorandum to President Ford, Simon, asserting that the recent fall in sterling's value "threatened the international monetary system and our open cooperative trading policy," reported that the United States had joined with several other countries to extend $5.3 billion in aid to the United Kingdom. (Ibid., L. William Seidman Papers, Box 319, Foreign Trips File, International Economic Summit, June 27–28, 1976, Memoranda and Statements (3))↩
- Callaghan served as British Chancellor of the Exchequer from 1964 until 1967.↩
- Apparently a reference to Taroichi Yoshida, Vice Minister at the Japanese Ministry of Finance.↩
- Yeo signed "Ed Yeo" above his typed signature.↩