THE BANK FOR INTERNATIONAL DEVELOPMENT BACKGROUND [Neat the end of October 1985, Maria Mendez, assistant treasurer for the Bank for International Development (BID), was analyzing historical data on borrowing costs in yen and dollars. A proposed new issue of dollar-denominated debt had renewed an internal debate about the bank's financing polices. The debate centered on polices for selecting currencies in which to raise funds for the bank's lending activites. The treasurer's practice of issuing indifferent currencies, depending on market conditions, had been criticized lately both internally and by a few of the bank's directors. To help prepare a response to this criticism, the treasurer asked Ms. Mendez to analyze borrowing costs in different currencies ‘The BID was a supranational financial institution with the mission of promoting worldwide economic development. It was organized and owned by many governments around the world that subscribed and paid into its capital base. As such, BID had no natural “home” currency and, in fact, reported its operating results and financial condition in several currencies. Most of the bank’s funds were raised by substantial borrowings on the open market. The bank made loans for many types of projects, especially infrastructure projects designed to promote economic growth in the borrowing nation. All of its loans carried a sovereign guarantee. ‘The bank had steadfastly resisted. pressure to make loans for purely politcal purposes and ‘This case was prepared by Professors W, Carl Kester and Timothy A. Luchmman. Copyright © 1989 by he ‘resident and Fellow of Harvard College. Harvard Business Schol cate 249-034.‘32 _ FOREIGN EXCHANGE MARKETS AND EXCHANGE-RATE DETERMINATION consistently refused to consider rescheduling any of its debt. To date, no borrower had ever defaulted on one ofits loans. ‘The bank was careful to maintain its own status as a high-quality credit, as ‘evidenced by its AAA rating. Further reflecting its conservatism, the bank hedged its ‘positions in all currencies; all borrowing in a given currency was matched by loans and low-risk investments (e.g, government bonds) in that same currency. Because of its strict eredit guidelines, conservative financial policies, and the support of member governments, BID was able to borrow in capital markets around the world at rates ony slightly above the U.S. government's, CONTROVERSY ABOUT CURRENCIES AND BORROWING COSTS ‘The primary objective of BID's treasurer was quite clear: to minimize the bank's cffective borrowing costs. Because exchange risk was effectively transferred to borrowers, minimizing borrowing costs was not a controversial objective, and the treasurer focused intently on the bank’s cost of debt, At first the only funds available at low cost in large volume were U.S. dollars. However, as surpluses developed in Japan, Germany, and OPEC nations, nondollar borrowings began to expand. Exhibit 1 provides a breakdown of BID's debt by currency and maturity as of September 1985. ‘As the menu of currency choices expanded, BID’s treasurer increasingly sought to borrow in whatever currencies appeared to offer the best terms at any given time. His opinions about the future course of interest rates and exchange rates had resulted in noticeable shifts inthe composition of new issues by the bank. For example, the bank had borrowed heavily in dollars during the period 1975-1978, in 1980, and again in 19821983, while turning to other currencies inthe remaining intervals of the decade. This on-again, off-again policy with respect to the dollar had prompted two types of criticisms. First, some critics thought it ill-advised to borrow U.S. dollars when interest rates were significantly lower in other currencies such as Japanese yen, deutsche marks, and Swiss francs. They argued that BID should take advantage ofits ability to tap capital markets around the world to select the market offering the lowest iterest rate ata given time. However, the treasurer thought it likely that the dollar would depreciate sufficiently over the life of the borrowings to more than offset the higher dollar interest rate. Tt was this response that rankled a second group of critics. They argued that if market interest rates reflected expected changes in currency values, then there was no point in trying to time” the market. The treasurer's switching from one currency to another was sheer speculation that could not be expected to pay off in the long run. ‘This group of crties argued that currency choices should be guided by internal targets for different currencies, rather than by market timing considerations. ‘THE SITUATION IN OCTOBER 1985 In October 1985, the treasurer was considering a $500 million issue of 7-year Eurodollar floating-rate notes. The issue would float with 3-month US$ LIBOR (the London interbank offered rate), which had fallen by more than 100 basis points since‘THE BANK FOR INTERNATIONAL DEVELOPMENT 33 the beginning of 1985. By the end of October, BID could expect to pay 7.95 percent initially on such a dollar issue. However, the rate on a comparable issue of Euroyen ‘notes would be still lower, at 7.75 percent. The bank had successfully issued Euroyen notes since 1983, and some of the bank's officers argued for a similar issue at the present time, despite the fact that yen (¥) rates had risen more than 100 basis points since the beginning ofthe year. Inflation had been fairly low in both countries. Japan ‘experienced consumer price inflation of 1.9 percent during 1984; U.S. consumer prices inflated at 3.0 percent in 1984. In the first three quarters of 1985, Japanese inflation was running somewhat lower, at an annual rae of 1.5 percent. U.S. inflation was also lower, at an annual rate of 2.8 percent. The spot exchange rate was ¥211.50/$ and the 3-month forward rate was ¥211.61/S, COMPARING CAPITAL COSTS 1. was in these circumstances that Maria Mendez. was asked to address the question of whether real capital costs had been lower in some currencies than others during the previous decade. Of particular interest was the question of whether there appeared to ‘have been timing opportunites such asthe treasurer had recently tried to exploit. While all concemed realized that her study was being done with hindsight, everyone felt that the debate within the bank would benefit from some data Before examining all the major currencies in which the bank transacted, Ms. Mendez decided first to undertake a pilot study ofthe yen and the dollar. Accordingly, 1 research analyst had assembled a data base consisting of monthly observations of 90-day interest rates and inflation rates. in the United States and Japan, and end-of.month spot exchange rates and 90-day forward rates between the yen and the dollar.' The data covered the period from January 1976 to the present. They were arrayed in columns on an electronic spreadsheet as shown in the sample in Exhibit 2 (the complete spreadsheet is contained ina file onthe diskette accompanying this case). For convenience, interest rates and inflation rates, which are normally quoted on an annual basis, were converted to actual 90-day rates on a continuously compounded basis.? The observations were arrayed so that the consumer price inflation (CPI) actually experienced during a given 90-day period lined up with the nominal return promised to the holder of a Eurodeposit at the beginning of the same 90 days. ‘The data were ready for analysis. Before examining them, Ms. Mendez resolved to sive careful thought to the question of what she should expect to find. She wondered under what circumstances she should expect the bank to prefer to borrow in one currency rather than another. Moreover, if a particular currency did appear to be cheaper ata given time, could the opportunity have been exploited without hindsight? 'Ninety-day Ewodepont rates were chosen fr the plot study Decause ofthe ready avalablity of data in both cumencies, and beease of the else relatonship between BID's borrowing cot ad short tem Eurgmarket ates. ‘hates expressed ona continuously compounded bass are eatily manipulated for the purposes of sich «study. For example, the real (natin adjusted) rerun on 4 90a} Euroolar depot found ty simply Sulractng the continuously compound ifation rate fom he continously compounded tere rate- 134 FOREIGN EXCHANGE MARKETS AND EXCHANGE RATE DETERMINATION If s0, how? Finally, how long might such an opportunity persist? The results of the ‘analysis would affect not only the choice of currency for the bank’s next issue, but also EXHIBIT 1 BANK BORROWINGS BY CURRENCY, SEPTEMBER 1985 * Boigian wanes oni Bion pounds tering 033 Canaan dotars 024 Deutsche marke 28 Fronen rancs one alan ew 320 Japanese yen 1396 Kwai ars 098 Notheriane guiers 18 Sav Arabian rye oss Swen tro ore ‘Ss anes 1851 US donee an Venazuetan bobrares a0 +0000 ! | Basununs 5 i182{THE BANK FOR INTERNATIONAL DEVELOPMENT 35 EXHIBIT 2 SELECTED HISTORICAL INTEREST RATES, INFLATION RATES, AND EXCHANGE “These data are conte in the wotahee on he dskat accompanying is case RATES" Date ‘0-day _ 80-day any. Quy. Fd. ex Spot ex. Ftd, ox lend of | EuroyenEurodollar Japan us. 90-day, rate, ty. month) rate rate Print, PL int, vs YS promidisct. dn 7600123 0.0128 cou = 001s ogo ©0870 0.0008 Fee 78 00129 0.0135, oar oie = 3028080225 ‘.0002 Mar 78 00150 0.0134 0023 © 001s = 30280 299.70 0108 Ae 7% = 00123013 oor0r 00160 sas 20940 0.0001 Noy 7 00168 «=—«1S7-— 0.0013 01sa 3006029885 .00e2 dn 78 00147 0.0146, 0.0236 olds 298.89, 297.40 0.0031 78 0o1s2 (0.0137 0247 = 0012920400 298.40, ‘0.0020 ig 78 001s 0.0198 oss © 001008045. 288.75 ‘.oaee Sep. 78 00159 © 0.0140 poise = 0.0100 mais 28745 o.0024 Oa 7 ©0017 = 129 dors = 001ts ads 288.70 .0042 Now. 78 oo1e2 0.0125, 00263 oorg7 20895, 295.75. ‘0.0040 Dec 7% © oo1s0— 0.0122 0021s ©0024 28360 292.80 0.0027 vin 77 oot = 00128 0263 0025028880, 28030 0.0017 Fe. 7 001g7 (0.0125, cose «©0013, 284z0 282.70 0.0053 Mar 7 00156001268 dor 0.0206 «27885277 0 0.0088 Ae 7700131 cores core ones. «27785 277.70 0.0005 May 77 = 0013700? 00081 N49 277.21 27730 0.0008 an 7 001s = 00140 core: 0.0121 26677 287.70 0.0085, M77 (oot = OnNS2 0020 © 0010828620 «266.00 2.0006 fg 7 ores (tse os 00107 286.85 267.20 0.0017 Se. 77 00088 «=«0t6S. 000g ©0107 8335 285.45 0.0079 Oc 7 © 0.0008 «=m = 00108» Ms «e860 250.60 0.0080 Now. 77 00020 .0166 00057 = oiss 2423424570 =0.0198 Dec 77 0004s 0174 corr! oois7 268924000 0.0128 dn 78000720175, oe = 0022 23080210 0.0087 Feb. 78 0006200174 ooze = 002592595, 238.70 00118 Man 78 00030018 gio; ooze «= a090ae.d0 0.0095 Ae 78 0052.14 cots §=— 00267 2085 22.00 0.0106 May 78 0.0066 .0192 0000022722025, 223.40 “oor dn 78 © 00072 0.0208 oor7s = oats. 20168 204.70 0.0150 ‘au 78 © 00099-0204 oor o0att 48775 190.70, 0.0156 fg 73 00062022 00033 Oaet0 tara 190.20, 0.0162 Sop. 78 00069 «08 -001T1O0i72 1 10915, -0.0168 Oa 7 © 0006) «00289-00110 aes 172.40 47600" © =0.0207 Nov. 78 0.0008» .0273. 00048 © 00253 192.75 19750 -0.0289 Dec 78 00015 0.0278 ‘00s 0.0300 =189.80, 194.60 =0.0250 ee