Waiting for Godot

Solution suggestions

Written/compiled by Ian H. Giddy

Two questions:

(1) Based on the economic, financial market and political conditions prevailing at the time of the case, what is the probability of an Irish punt (IP) devaluation in the next 3 months? And how much?

(2) How would this possibility affect a company like Waterford Foods, and what should they do about it?

1. Will the Punt Devalue?

1.1. The Fixed-Rate System of the ERM

(a) Goal is monetary unification of Europe

(b) Main tool is monetary coordination - adopt policies and inflation rate more like Germany's

1.2. The Economic Pressures that Arise in such a Fixed-Rate System

When economic conditions diverge, especially when there is a general recessionary tendency, one country may need to stimulate while another needs to fight inflation.

Germany - inflation threatened so Bundesbank insisted on tight money.

Britain - recession threatened so tight money, and high interest rates hurt.

Ireland - doubly hurt - high unemployment, high interest rates, and since Britain had dropped out of ERM, exports were hurt by the strong punt vs. the pound sterling.

1.3. The Alternatives facing the Government

In the long run, the pressures stemmed from different economic conditions and economic policies in the European community. After all, the Dutch guilder were coined under such pressure, because the Dutch government totally subordinates its monetary and exchange rate policies to Germany's.

So in the long run, economic and policy convergence is the only solution.

In the short run, the government has a limited range of choices:

(a) Initiate a radical and permanent change in monetary and fiscal policy, designed to change expectations. Could have very high cost over an extended period.

(b) Intervene in the FX market, using reserves and borrowing foreign currencies

(c) Tighten monetary policy, raise interest rates, temporarily, to attract funds and make shorting the currency very expensive

(d) Impose exchange controls such as deposit requirements on commercial banks

(e) Exert informal influence, "moral suasion" over domestic financial institutions

(f) Devalue and re-fix

(g) Devalue and float

The task is to analyze the extent to which the government is willing and able to adopt one or more of the first 5 choices, and how effective they are.

A crucial point is reached when reserves are severely depleted. Often there is a "clincher" event that causes more speculation and forces the government to give in. In the Irish case, this occurred when the UK dropped its interest rate by a full 1%, lowering sterling vs. the DM and making Irish exports even less competitive in Britain. (On Jan. 26, 1993)

2. How would Waterford be affected, and what should the company do?

It will cost the company more to repay the German debt if the Punt devalues against the DM. But:

2.1. A punt devaluation would help Waterford Foods' exports to the UK, but hurt the translated value of UK operations.

2.2. Shorting the punt consistently would prove extremely expensive, given the high short term rates imposed by the Central Bank of Ireland, and the forward discount on the Irish Punt.

2.3. Hedging selectively is also risky - WF could spend a lot to borrow Punts or sell Punts forward, and be caught unhedged on the one day that the government happens to choose to devalue.

2.4. In the end, unless WF has special information, best is to accept market rates and hedge/match according to the dictates of the company's economic exposure.

Waiting for Godot: Computations

(1) What is the probability of a devaluation?

- Fundamental (interest rates, inflation, etc.)

- Pressures on the government

- What alternatives government has?

- How much

(2) What should the company do?

(a) Forward hedge - sell I, buy DM 3 mo forward (cost?)

(b) Money market hedge - borrow I, buy DM spot, invest in Germany (cost?)

Calculations for the hedge decision

One way to look at is simply:

Hedge if Probability of devaluation times Size of devaluation, in percent is greater than cost of hedge, as measured by the forward discount.

Cost of forward hedge: Interest differential, on 3-mo basis

Example:

Prob. = 75% Amount = 8%

Prob *Amt = 6%

Forward hedge: SPOT DM/IP 1.663*1.590 = 2.6442

3 MO. FORWARD DM/IP 1.608*1.61 = 2.5889

3 MO. Discount, % = 2% (3 month basis)

Interest differential (20% - 8.5%)/4 = 2.875% (3 month basis)

RESULT: COST OF HEDGING < EXPECTED GAIN FROM DEVAL. OF IEP

So Waterford Foods should hedge by borrowing Irish punts and investing in German marks, or by buying German marks forward, whichever is cheapest (or whichever is most politically acceptable).

Waiting for Godot: Supplement

If fact, the Irish punt did devalue within the EMS. The article that follows sums up the devaluation event and the economic and political issues surrounding it:

European Report

February 3, 1993

EMS: IRISH POUND DEVALUED BY 10%

Following in the footsteps of the Pound Sterling, the Lira, the Peseta and the Escudo, the Irish Punt has given in to money market pressures. At an emergency meeting in Brussels on January 30 convened at Ireland's request, the Monetary Committee, made of up EC Finance Ministers and Central Bank Governors, decided to devalue the Punt by 10% against the other currencies in the exchange rate mechanism of the European Monetary System (EMS). This devaluation is a bitter pill for the Irish Government to swallow, as it had struggled against the effects of speculation for several months at a heavy cost in terms of foreign currency reserves and traders' competitiveness. The French Franc, another regularly besieged currency, could be the speculators' next target. In light of these events, the Monetary Committee postponed a regular meeting originally scheduled for January 31.

Franc/D-Mark parity intact.

The Irish Punt has been devalued by 10% against the other currencies participating in the EMS exchange rate mechanism (the Belgian/Luxembourg and French Francs, the Deutschemark, the Danish Krone, the Dutch Guilder, the Spanish Peseta and the Portuguese Escudo). The Greek Drachma, which does not belong to the exchange rate mechanism, and the Pound Sterling and the Italian Lira, which left the system in September, are not directly affected by this realignment. Bilateral exchange rates between the other currencies in the exchange rate mechanism, and thus the parity between the French Franc and the Mark, have not changed. The Irish Punt will remain in the narrow band of the EMS, where the range of fluctuation against other European currencies is + or - 2.25% either side of the central rate. The Irish authorities confirmed, in the Monetary Committee communique, that they are determined to "continue to pursue the budgetary and other economic policies which have strengthened the Irish economy in recent years".

The fight against speculation.

The market's January 29 attack struck the final blow to the Punt, weakened since the Autumn. Since the Pound Sterling left the EMS on September 16 and lost 15% of its value, the Punt had been hanging by a thread, as the Irish authorities admitted. Finance Minister Bertie Ahern admitted that the Irish Government asked for the realignment unwillingly, because of the weakened condition of the Pound Sterling and devaluation of several currencies in the system over the past few months. Developments in Irish politics could only postpone the Punt's devaluation; the general election of November 25 ushered in a long period of uncertainty, with Prime Minister Albert Reynolds managing to hold on to his job only by forging an alliance with the Labour Party on January 12.

The Anglo-Irish link.

The devaluation of the Punt can only be explained by the close relationship

between Ireland and the UK. The Irish are proud of their economic progress, which puts them among the leaders of the countries participating in the future single European currency. Ireland's inflation rate, at 2.9% last year, is one of the lowest in the EC, its balance of payments surplus on current account is equivalent to more than 6% of its GDP, and its public deficit is under the 3%-of-GDP standard established by the Maastricht Treaty. The only blot on this otherwise excellent record is a catastrophic unemployment rate of 18%. More than 30% of Ireland's trade is with the UK, compared to 75% in the 1950s, and 66% when Ireland joined the EC in 1973. With the 15% devaluation of the Pound Sterling which followed its withdrawal from the EMS, the value of the Punt exceeds that of the British currency for the first time since Ireland gained its independence in 1922. However, this development spells disaster for Irish exports to the UK, which have cost 17% more on the British market since September.

On the strength of its economic performance, Ireland has spared no effort to avoid devaluing its currency. To help companies suffering from the over-valued Punt, the Irish Government created a special 50 million Punt (82 million Dollar) fund to provide 50 Punts per week per employee to companies in difficulty.

Another emergency aid plan, a guarantee fund for loans to cover exchange-rate fluctuations totalling 1.1 billion Punts (1.8 billion US Dollars), is under consideration . The plan, expected to be adopted in the second week of February, will provide loans to companies in the industrial and tourism sectors at better terms than on the market.

On January 18, the authorities in Dublin had received the support of their European partners for their economic and monetary policy. In a statement issued at the time, EC Finance Ministers stressed that they supported the Government policy aimed at maintaining the Irish Punt's parity and deemed this policy to be perfectly justified. However, the UK decision on January 29 to cut interest rates again, this time from 7 to 6%, badly dented the strategy being followed by the Government in Dublin. Shortly after Norman Lamont, the UK Chancellor of the Exchequer, announced the cut, Ireland asked for an emergency meeting of the Monetary Committee to be convened.

Bitter decision.

In these circumstances, the Irish Government is somewhat annoyed by the "defeat". During a debate held in Brussels on February 1 concerning the EC's 1993 work programme, the Irish Foreign Minister, Dick Spring, rose to accuse the Member Sates of failing to cooperate on monetary affairs. The Irish Finance Minister, Mr Bertie Ahern, was even more blunt, when he said back in Dublin that "after months of hard struggling, calls to the EC and reluctance to devalue, the Government has been compelled to observe that the Community spirit has been replaced by bilateral agreements between Germany and France, which have been advantageous to Paris but detrimental to the Irish Punt" . The Finance Minister had complained on January 31 that the smaller countries were not getting the same treatment as the bigger ones, and his remarks reflected the bitterness felt by his Government, especially when France was able to get "a separate deal" to support its currency. "We held out for five months but I don't think we could justify inflicting that kind of pain on the Irish people to fight a European battle. We had got to the stage where the rich were getting richer and the poor were getting poorer and there was no help on the way." The Irish Finance Minister is calling for an urgent reform of the European Monetary System, as agreed by the Member States in October, during their Summit meeting in Birmingham. "It is vital for this EMS revision to be made at an early date, otherwise joint interests, the bond of solidarity and the capacity to act together will be called into question by many of our citizens", stated the Irish Foreign Minister in Brussels on February 1.

Question mark over French Franc's future.

With the devaluation of the Irish Punt, speculators have managed to break

the final weak link in the EMS and thus put even more pressure on the French Franc. As a result of close consultations between the Bank of France and the Bundesbank, the French Government has so far managed to rescue the Franc/D-Mark parity. The question now is how much longer the French authorities can withstand the pressure. The Bundesbank is already showing signs of exhaustion and the Bank of France's foreign currency reserves are showing signs of strain. The French Government is just as determined as ever not to devalue the Franc. Prime Minister Pierre Beregovoy repeated his resolve on February 1. The situation remains shaky, for the Franc has become an issue in the election campaign and could help some political tendencies to weaken the Government's position ahead of the general election in March.

For many analysts, including the former Governor of the Bundesbank, Karl-Otto Puehl, the parity between the French Franc and the German Mark assumes a symbolic value. If the French Government were compelled to allow the Franc to float, that would mean the end of the European Monetary System. And this would be sure to deal a serious blow to the Economic and Monetary Union programme.

German Government vs Bundesbank.

Given the present situation, the attention has switched to Frankfurt to see if there is any hope there of a cut in interest rates. For the first time since the monetary crisis erupted last September, a member of the German Government, the Secretary of State for Finance, Hans Kuehler, has openly criticised the attitude of the Bundesbank. "We are in the midst of a recession in Germany and I do not see any convincing sign that the situation is about to change. Lower rates would take the strain off the economy and benefit the construction industry", asserted the German official in an interview with a weekly German magazine. According to German law, the Bundesbank is completely independent of political power. "The law does not prescribe that price stability has to be maintained at the cost of a huge recession", stressed Mr Kuehler, stressing that in Europe lower rates would certainly help to bring about an economic recovery. This opinion is shared by the French authorities.

For his part, the head of the Bundesbank, Helmut Schlesinger, stressed in London on February 1 that realignments within the EMS were indeed necessary from time to time. "There was once a widely-held illusion that the EMS was already a de facto monetary union, a currency area in which exchange rate adjustments were no longer possible. They have been necessary and they cannot simply be banned until monetary union is established, even though they will become less compulsory as convergence increases."

Four realignments in five months.

The decision to devalue the Irish Punt brings the number of realignments in the EMS since last September to a total of four. Never in its entire 14-year history has the EMS known a crisis of such magnitude. Below is a review in chronological order of monetary developments since last Summer.

Chronology of recent events in the Exchange Rate Mechanism

June 2, 1922: Danish voters narrowly reject the Maastricht Treaty by referendum leading to the emergence of exchange rate tensions with the ERM and rises in short term interest rates in several Member States.

July 2, 1992: The U.S. Federal reserve announces the seventh consecutive reduction in its discount rate to only 3%, accelerating the recent rapid depreciation of the Dollar relative to Community currencies.

July 16, 1992: The Bundesbank raises its discount rate by O.75 of a percentage point, adding further to the monetary squeeze in the Community and the downward pressure on the Dollar.

August 25, 1992: Publication of the first polls suggesting a negative vote in the French referendum.

August 28, 1992: Fuelled by growing fears over the unsustainability of the Italian budget deficit, Lira falls below its floor in the ERM.

September 3, 1992: The U.K., under growing pressure to increase interest rates in defence of Sterling's weakness, chooses instead to arrange lending facilities for an amount equal to seven and a quarter billion Pounds to bolster its external reserves.

September 4, 1992: The US further reduces the federal funds rate by 1/4 of a percentage point to 3% and the Dollar falls to a record low relative to the Deutschmark. Italy raises interest levels sharply in an attempt to raise the Lira above its ERM floor, and announces that it will be making use of the Very Short Term Financing facility.

September 6, 1992: The EcoFin Council in Bath reaffirms its commitment to existing exchange rate parities in the ERM. A succession of opinion polls point to the possibility of a rejection of the Maastricht Treaty in the French referendum.

September 8, 1992: Finland floats the Markka and Sweden increases its short-term rates.

September 14, 1992: In an effort to relieve ever mounting tensions within the ERM and to reduce massive speculative attacks on the Lira, a 7% devaluation of the Lira and a reduction in the German discount and Lombard interest rates of 1/2 and a 1/4 of a percentage are implemented.

September 16, 1992: Notwithstanding massive central bank intervention and a cumulative 5 point increase in the discount rate, Sterling falls substantially below its ERM floor and the Chancellor announces its withdrawal from the mechanism. The Lira also suffers further massive speculative attacks and also falls below its new ERM floor. The Swedish Central Bank increases its marginal lending rate to 500%.

September 17, 1992: Italy abandons attempts to maintain the Lira within the ERM and temporarily suspends its participation in the mechanism. The Spanish Peseta is devalued by 5%. The Danish Krone, French Franc and Irish Punt are all subject of speculative attacks requiring central bank intervention and rises in interest rates. Pressure on the Franc eases following declarations of support from the Bundesbank and the German government the following day.

September 20, 1992: The narrow acceptance of the Maastricht Treaty in the French referendum fails to dissipate doubts on the prospects for its eventual ratification and tensions intensify within the ERM over the following days. These tensions lead to a combination of interest rate rises, joint communique of France and Germany and the application of existing or new capital controls in some Member States.

November 19, 1992: Following several weeks of relative calm and a gradual return to pre-September interest rate levels within the ERM, tensions are revived following Sweden's decision to abandon its peg to the Ecu.

November 22, 1992: The Spanish Peseta and the Portuguese Escudo are both devalued by 6%, while pressure continues to mount against the French Franc, the Danish Krone and in particular the Irish Punt. Conversely short-term money market rates continue to fall in Germany, Belgium and the Netherlands.

December 10, 1992: The Bundesbank increases its M3 monetary target for 1993 by one percentage point at both extremes to a range of 4 1/2 per cent to 6 1/2 per cent. Norway suspends its Ecu peg putting pressure on the DKR and the FF.

December 13, 1992: The European Council in Edinburgh announces a Community growth initiative in an effort to aid recovery through the restoration of business and consumer confidence. A formula to accomodate the Danish rejection of the Maastricht Treaty and a new Cohesion Fund to promote growth in the less developed Member States are also agreed.

Early January 1993: Tensions are again revived in the ERM after the Christmas lull on financial markets and interest rates are raised in France and Ireland. The German authorities again re-affirm their commitment to the existing DM/Franc parity. France announces accelerated plans for granting full independence to its central bank. The Bundesbank reduces its repurchase rate by 15 basis points, a move followed by corresponding reductions in Belgium and the Netherlands.

The following report indicates that Ireland was able to ease monetary policy after the exchange rate crisis and devaluation of the punt:

February 5, 1993, Friday, BC cycle

IRELAND SETS SHORT TERM FACILITY RATE AT 13.75 PCT

DATELINE: DUBLIN, FEB 5, REUTER

The Central Bank of Ireland said it has restored the provision of overnight accommodation to the money market through the short term facility rate which it has set at 13.75 pct.

The facility was suspended on November 23 when the rate was 13.75 pct, the central bank said.

Germany was under great pressure to ease to keep the ERM together:

February 4, 1993, Thursday, BC cycle

ECU BONDS BACK ON TRACK AS GERMANY CUTS KEY RATES

BYLINE: By Paul Keller

DATELINE: LONDON, FEB 4, REUTER

Ecu bond and futures markets are set to reap the benefits of lower interest rates in Germany and a soothing of tensions within the ERM, analysts said.

"(German rate cuts) are positive for Ecu markets, and to the extent the Bundesbank is acting to keep the ERM together, it keeps the Economic and monetary union roadshow on the road," said Robin Hubbard, chief economist at Paribas Capital Markets.

The Bundesbank trimmed its Lombard rate to 9.0 pct from 9.50 and its discount rate to 8.0 pct from 8.25 pct.Ecu bond futures dropped some 10 basis points as traders creamed off profits.

German Finance Minister Theo Waigel said the Bundesbank's decision to lower its key interest rates would help the European economy -- "There will be positive impulses from this, particularly for the economic development in Europe," he said.

Ecu market players seemed to agree with him.

"Europe needs the ERM and the Germans have acted to try and save it," said Hubbard at Paribas.

He added, "The formula laid down in the Maastricht accord invoves using the ERM to move towards EMU (European economic and monetary union). And you ain't going to get the Ecu as the single currency of Europe without Maastricht."

Analysts said the Bundesbank had been expected to cut its rates in the next few weeks because of unmistakeable evidence that the West German economy was heading deeper into recession, but strains in the ERM brought the move forward.

Hans Knol, head of fixed income at Kredietbank said Danish crown weakness and the devaluation of the Irish punt at the weekend had brought the ERM to the brink of disaster.

"If the Danish crown had devalued or pulled out of the ERM, the French franc looked set to be the next in the firing line," said Knol. "Now, Ecu bonds are back on track but probably without the same conviction that we'll get EMU by 1999."

Knol noted that the Ecu market had traded higher this morning in anticipation of the Bundesbank council meeting and hopes for a non-inflationary German public sector wage deal.

"Ecu bonds look generally steady now and we expect them to remain well underpinned for the time being," Knol noted.

He also anticipated the Ecu would consolidate its stronger position which has seen the difference between benchmark Ecu issues and bunds narrow to around 100 basis points from 200 b.p.

"Ecu bonds are trading close to their theoretical levels (the calculated yield of the Ecu's composite markets) and it's on the cards for them to start trading below the theoretical."