The most interesting figures, however, are those relating to marks, which illustrate vividly what I have mentioned on page 23 above concerning the enormous money rates of interest current in Germany subsequent to the collapse of October 1922, as a result of the effort of the real rate of interest to remain positive in face of a general anticipation of a catastrophic collapse of the monetary unit. It will be noticed that the effective short money rate of interest in terms of marks ranged from 50 per cent per annum upwards, until finally the quotations were merely nominal.
2. If questions of credit did not enter in, the factor of the rate of interest on short loans would be the dominating one. Indeed, as between London and New York, it probably is so under existing conditions. Between London and Paris it is still important. But elsewhere the various uncertainties of financial and political risk, which the war has left behind, introduce a further element which sometimes quite transcends the factor of relative interest. The possibility of financial trouble or political disturbance, and the quite appreciable probability of a moratorium in the event of any difficulties arising, or of the sudden introduction of exchange regulations which would interfere with the movement of balances out of the country, and even sometimes the contingency of a drastic demonetisation,—all these factors deter bankers, even when the exchange risk proper is eliminated, from maintaining large floating balances at certain foreign centres. Such risks prevent the business from being based, as it should be, on a mathematical calculation of interest rates; they obliterate by their possible magnitude the small “turns” which can be earned out of differences between interest rates plus a normal banker’s commission; and, being incalculable, they may even deter conservative bankers from doing the business on a substantial scale at any reasonable rate at all. In the case of Roumania or Poland, for example, this factor is, at times, the dominating one.
3. There is a third factor of some significance. We have assumed so far that the forward rate is fixed at such a level that the dealer or banker can cover himself by a simultaneous spot transaction and be left with a reasonable profit for his trouble. But it is not necessary to cover every forward transaction by a corresponding spot transaction; it may be possible to “marry” a forward sale with a forward purchase of the same currency. For example, whilst some of the market’s clients may wish to sell forward dollars, other clients will wish to buy forward dollars. In this case the market can set off these, one against the other, in its books, and there will be no need of any movement of cash funds in either direction. The third factor depends, therefore, on whether it is the sellers or the buyers of forward dollars who predominate. To fix our minds, let us suppose that money-market conditions exist in which a sale of forward dollars against the purchase of spot dollars, at a discount of 1½ per cent per annum for the former, yields neither profit nor loss. Now if in these conditions the purchasers of forward dollars, other than arbitragers, exceed sellers of forward dollars, then this excess of demand for forward dollars can be met by arbitragers, who have cash resources in London, at a discount which falls short of 1½ per cent per annum by such amount (say ½ per cent) as will yield the arbitragers sufficient profit for their trouble. If, however, sellers of forward dollars exceed the purchasers, then a sufficient discount has to be accepted by the former to induce arbitrage the other way round—that is to say, by arbitragers who have cash resources in New York—namely, a discount which exceeds 1½ per cent per annum by, say, ½ per cent. Thus the discount on forward dollars will fluctuate between 1 and 2 per cent per annum according as buyers or sellers predominate.
4. Lastly, we have to provide for the case, quite frequent in practice, where our assumption of a large and free market breaks down. A business in forward exchange can only be transacted by banks or similar institutions. If the bulk of the business in a particular exchange is in a few hands, or if there is a tacit agreement between the principal institutions concerned to maintain differences which will allow more than a competitive profit, then the surcharge representing the profit of a bank for arbitraging between spot and forward transactions may much exceed the moderate figure indicated above. The quotations of the rates charged in Milan for forward dealings in lire, when compared with the rates current in London at the same date, indicate that a bank which is free to operate in both markets can frequently make an abnormal profit.
But there is a further contingency of considerable importance which occurs when speculation is exceptionally active and is all one way. It must be remembered that the floating capital normally available, and ready to move from centre to centre for the purpose of taking advantage of moderate arbitrage profits between spot and forward exchange, is by no means unlimited in amount, and is not always adequate to the market’s requirements. When, for example, the market is feeling unusually bullish of the European exchanges as against sterling, or of sterling as against dollars, the pressure to sell forward sterling or dollars, as the case may be, may drive the forward price of these currencies to a discount on their spot price which represents an altogether abnormal profit to any one who is in a position to buy these currencies forward and sell them spot. This abnormal discount can only disappear when the high profit of arbitrage between spot and forward has drawn fresh capital into the arbitrage business. So few persons understand even the elements of the theory of the forward exchanges that there was an occasion in 1920, even between London and New York, when a seller of spot dollars could earn at the rate of 6 per cent per annum above the London rate for short money by converting his dollars into sterling and providing at the same time by a forward sale of the sterling for reconversion into dollars in a month’s time; whilst, according to figures supplied me, it was possible, at the end of February 1921, by selling spot sterling in Milan and buying it back a month forward, to earn at the rate of more than 25 per cent per annum over and above any interest obtainable on a month’s deposit of cash lire in Milan.
It is interesting to notice that when the differences between forward and spot rates have become temporarily abnormal, thus indicating an exceptional pressure of speculative activity, the speculators have often turned out to be right. For example, the abnormal discount on forward dollars, which persisted more or less from November 1920 to February 1921, thus indicating that the market was a bull of sterling, coincided with the sensational rise of sterling from 3.45 to 3.90. This discount was at its maximum when sterling touched its lowest point and at its minimum (in the middle of May 1921) when sterling reached its highest point on that swing, which showed a remarkably accurate anticipation of events by the balance of professional opinion. The comparatively high discount on forward dollars current at the end of 1922 may, in the same way, have been partly due to an excess of bull speculation in favour of sterling based on an expectation of its recovery towards par, and not merely to the cheapness of money in London as compared with New York.
The same thing seems to have been true for the franc. In January and February 1921, the abnormal premium on the forward franc indicated that, in the view of the market, the franc had fallen too low, which turned out to be the case. They turned round at the precise moment when the franc reached its highest value (end of July 1921), and were right again. During the first five months of 1922, when the franc was almost stable, spot and forward quotations were practically at par with one another, whilst the progressive fall of the franc since June 1922 has been accompanied by a steady and sometimes substantial discount on forward francs; indicating, on this test, that the professional market was bearish of francs and therefore right once more. The lira tells somewhat the same tale. Thus, whilst the reader can see for himself by a study of the tables that no precise generalisation would be accurate, nevertheless the market has been broadly right when it has taken a very decided view, as measured by forward rates.
This result may seem surprising in view of the huge amounts which exchange speculators in European currencies, more particularly on the bull side, are reputed to have lost. But the mass of amateur speculators throughout the world operate by cash purchases of the currency of which they are bulls, forward transactions being neither known nor available to them. Such speculation may afford temporary support to the spot exchange, but it has no influence on the difference between spot and forward, the subject now under discussion. The above conclusion is limited to the fact that when the type of professional speculation which makes use of the forward market is exceptionally active and united in its opinion, it has proved roughly correct, and has, therefore, been a useful factor in moderating the extreme fluctuations which would have occurred otherwise.
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Out of the various practical conclusions which might be drawn from this discussion and the figures which accompany it, I will pick out three.