Developing countries and smaller developed country governments often issue bonds in other currencies than their own. This allows investors to separate out the credit risk from the currency, inflation, and interest-rate risk of a particular country. An investor in developing country ‘hard-currency’ bonds, for example, can buy such bonds to take a view of the country’s fiscal health without the issue of dealing with the local currency and its fluctuation. As such, investors may be more willing to invest in a government’s foreign-currency bonds than those in local currency.
Of course, such bonds are less than ideal for the issuer because it has to take the risk that currencies may move in an unfavorable direction when it comes time to repay. Large developed governments largely eschew such issues for this very reason. Many may think a country like the United States has never had a need for issuing foreign-currency government bonds, at least in the last century, but they would be wrong. The country did feel compelled, or at least pressed, to issue foreign-currency bonds twice, but for monetary rather than fiscal reasons.
Exchange Stabilization Fund
Central to the story of America’s foreign-currency bonds is the objective of foreign exchange intervention, regulating the value of the dollar relative to other major currencies. For decades, this was done through the Exchange Stabilization Fund (ESF), created in 1934. The ESF is a Treasury controlled fund used to intervene in currency markets. In other countries, foreign-currency reserves and foreign exchange policy are often under the jurisdiction of the central bank. In the U.S., responsibility for these has usually been centered in the Treasury, with the central bank, the Federal Reserve, often playing second fiddle.
The ESF was an American response to Britain’s own Exchange Equalisation Account formed in 1932 to maintain the value of the pound after Britain abandoned the gold standard. The ESF was funded with $2 billion from the increase in value of U.S. gold reserves following the devaluation of the US dollar in 1934 from $20.67 per ounce of gold to $35.00. However, $1.8 billion of these funds were later used to fund the American subscription to the International Monetary Fund upon its founding. Since then, the ESF has been called on to intervene in markets with minimal resources at its disposal.
Under the Bretton Woods System, the monetary order established in 1944, the U.S. facilitated foreign currencies’ pegs to the dollar by taking the other side of the trade on foreign sales of dollars for gold or gold for dollars. The ESF was authorized to intervene in markets under the Gold Reserve Act of 1934, which had established the fund. Nonetheless, large ESF interventions were uncommon prior to 1960, thanks to a benign and disciplined foreign exchange environment.
This was fortuitous because the reserves in the ESF amounted to little at the time; in 1961, the fund held just $336 million. When conditions began to change in the 1960s and the ESF was called upon to ensure the value of the dollar held firm in the face of mounting pressure, the fund needed to augment these reserves greatly. From 1963 on, this was done with the assistance of the Federal Reserve, which provided a financing facility to the ESF, allowing it to obtain fresh funds. The ESF further augmented its reserves by operating in the forward market, where reserves only had to be used if a position was being closed out at a loss, rather than the ‘spot’ market.
Foreign Hedging of Dollar Risk
As the 1960s drew on, the dollar came under pressure due to outflows of capital from the U.S. to Europe and Japan. Those economies were growing faster and had higher interest rates, attracting investor capital. This effect would have lifted the value of foreign currencies above the levels established under the Bretton Woods System had other central banks not bought dollars to keep the currencies stable. However, there was some skepticism that these countries would continue to willingly hold so many dollars. Indeed, some opted for redeeming their dollars for gold, which was their right, causing some depletion of American gold reserves.
Even those holding dollars did not want to rely on the Bretton Woods arrangement holding much longer and controlled risk by hedging their exposure. This simply put pressure on the dollar by other means since hedging a currency usually involves selling the currency, or a derivative of it, in another market. Foreign central banks chose to hedge by selling currency forward contracts, essentially locking in a future price for their dollars. As such, the dollar went on to trade at large discounts in the forward market.
It wasn’t just governments, private firms with dollar exposure, like German exporters, hedged their dollar risk as well. They often did this by borrowing in dollars and buying marks. This way, if the value of the dollar fell, the reduction in the value of their dollar borrowings would make up for reduced export revenues. This arrangement also allowed German firms to benefit from lower financing costs in America.
This hedging by public and private entities had the potential to put downward pressure on the dollar, even if the peg to gold held for the moment, inducing further hedging. To counter this pressure, the American Treasury and Federal Reserve began to escalate their intervention in foreign exchange markets in 1962. They obtained foreign currency through swaps set up with other central banks. The currency obtained in these swaps was then used to purchase dollars in the forward market, lifting its value.
The swaps with foreign central banks, under which the Federal Reserve traded dollars for foreign currency, were meant to be temporary. To reverse the swap, the Federal Reserve would have had to sell dollars and purchase foreign currencies, like the West German mark, to repay its counterparties. This would have reversed the support for the dollar the operation had provided. To extend the duration of this support, the Treasury issued foreign-currency government bonds. These bonds became known as ‘Roosa bonds’ after the Treasury Undersecretary for Monetary Affairs under Presidents Kennedy and Johnson, Robert Roosa.
The bonds gave the U.S. government foreign currency that it could exchange into dollars to support the latter currency on a longer-term basis. This scheme’s objective was to hold the Bretton Woods System together, preventing a devaluation of the dollar and a run by foreign central banks to convert their dollars into gold. Issuance of Roosa bonds and the financing facility with the Federal Reserve helped increase the ESF’s assets to $2.6 billion by 1968. Of course, given the means of this increase, the fund’s liabilities rose accordingly, to $2.1 billion.
Given how unique among American government bonds they were, it’s worth examining the Roosa bonds closer. The notes were medium term bonds issued from 1962 to 1971. Indeed, for almost a decade, the U.S. government had a foreign-currency debt, with bonds issued in West German marks, Swiss francs, Italian lira, Belgian francs, and Austrian schillings.
Despite the project’s intent, pressure on the dollar continued, so the Treasury opted to refinance the bonds when they came due rather than repaying them by selling dollars for marks, lira, francs, and schillings. Because the U.S. dollar fell in value in the following years, repaying the bonds proved expensive; as a result, the capital position of the ESF even became negative by 1978. The issuance may have helped but it did not prevent a devaluation of the dollar or a diminution in the country’s gold reserves which fell over 40% through this period.
The dollar began a steady devaluation in 1971; that was the year the Bretton Woods System was abandoned when Germany allowed the mark to float and the U.S. suspended the dollar’s convertibility into gold. With the system thus gone, American intervention in the foreign exchange markets diminished for much of the subsequent decade and the dollar sank in value. The dollar/mark exchange rate fell from over 3.5 marks to the dollar in 1971 to well under 2.0 to the dollar by the end of the decade. However, this soon became a political problem when some recognition began to be given to the weak dollar as a source of the country’s inflation problem.
By the end of the decade, American state interference in the foreign exchange market began in earnest once more. There was a return to the solution of swaps and bonds. First, the Federal Reserve entered into a new swap facility with the German Bundesbank in 1978 and used the marks it obtained to purchase dollars on the international markets. Further, just as with the prior use of a transatlantic swap facility, the U.S. government issued foreign-currency bonds, this time known as ‘Carter bonds’, for then-President Jimmy Carter. The bonds’ proceeds would be used to purchase dollars or eventually repay the swap.
Up to $10 billion in Carter bond issuance was approved. The notes had maturities of two to four years and were issued in Germany and Switzerland from 1978 to 1980. They carried coupons of 5.95% to 6.70% in German marks or 2.35% to 2.65% in Swiss francs. Whether because of the Carter bonds or not, the dollar actually began to strengthen meaningfully in 1980 and 1981, rising from about 1.75 marks to the dollar at the beginning of 1980 to around 2.5 marks in the summer of 1981. Fortunes had turned so much that rather than being a seller of foreign currency, the U.S. was becoming a net buyer, purchasing foreign currency to repay the bonds and the swap facility. Some $7 billion in foreign currency was purchased in this period.
Currency Management Since 1980
This was not the end of government intervention in the foreign exchange markets. The dollar continued to strengthen into the mid-1980s, too much in the eyes of many in Washington. The trend culminated in the Plaza Accord, a deal to let the dollar depreciate against foreign currencies, agreed to in September 1985. The following years saw the German mark double in value against the dollar, strengthening from its 1985 low of 3.2 to the dollar to 1.6 by 1988. However, the dollar strengthened once more into the late 1990s. By 2000, the Federal Reserve had been intervening in currency markets again, purchasing Japanese yen in 1998 and euros in 2000. This was done to support those weakening currencies, a finalé to the seesawing position of the dollar in the late 20th century.
During the last two decades, American intervention in foreign exchange markets has been largely absent. That other countries, whose currencies are pegged to the dollar, intervene frequently is no surprise but for much of the 20th century the American government itself went to great lengths to maintain the value of the dollar against other currencies. Occasionally it was too strong, but often too weak, and these interventions nonetheless occurred both before and after the end of the Bretton Woods System. One of the most curious products of this era in currency management were American foreign-currency denominated government bonds.
More from the Tontine Coffee-House
Foreign currency sovereign bonds were issued by various Latin American countries soon after they obtained independence, sparking a speculative sovereign bond boom and bust in the 1820s. During the American Civil War, the Confederacy also turned to foreign-currency borrowing, albeit with a unique twist.
1. Exchange Stabilization Fund » History. U.S. Department of the Treasury, 12 Jan. 2010.
2. Henning, C. Randall. “The Exchange Stabilization Fund: Slush Money or War Chest?” Peterson Institute for International Economics, 1999.
3. Hetzel, Robert L. “Sterilized Foreign Exchange Intervention: The Fed Debate in the 1960s.” Federal Reserve Bank of Richmond Economic Quarterly, vol. 82, no. 2, 1996, pp. 21–46.
4. Pauls, B. Dianne. “U.S. Exchange Rate Policy: Bretton Woods to Present.” Federal Reserve Board of Governors, Nov. 1990.
5. United States, Congress, House of Representatives. Testimony of Anthony M. Solomon, Under Secretary of the Treasury for Monetary Affairs, U.S. Government Printing Office, 1979.