Treasury and Federal Reserve
Foreign Exchange Operations October-December 1995

During the fourth quarter of 1995, the dollar appreciated modestly, strengthening 3.7 percent against the Japanese yen and 0.5 percent against the German mark. The dollar also rose 0.6 percent on a trade-weighted basis against other G-10 currencies. 1.
Toward the end of the quarter, the dollar consolidated in increasingly narrow ranges, and trading activity declined as market participants reduced their risk appetite ahead of year-end. The U.S. monetary authorities did not undertake any intervention operations during the quarter. In other operations, the U.S. Treasury's Exchange Stabilization Fund (ESF) and the federal Reserve System each received repayments from Mexico in the amount of $350 million on their respective short-term swap arrangements and renewed the same arrangements in the amount of$650 million each for an additional ninety days.

SUBDUED YEAR-END MARKET ACTIVITY
The dollar opened the quarter at DM 1.4273 and Y99.55 and proceeded to fluctuate between DM 1.3808 and DM 1.4550 and Y99.28 and Y104.12 during the period. In the environment of limited risk-taking witnessed during the quarter, countervailing political and economic developments in the United States and overseas helped to keep the dollar in these relatively narrow ranges. The dollar closed the quarter at DM 1.4339 and Y103.20.

THE DOLLAR GRADUALLY APPRECIATES AGAINST THE YEN
The dollar modestly extended its gains against the yen from the previous quarter as the wide interest rate differential and signs of reduced trade imbalances between the United States and Japan continued to favor the dollar. In addition, the prospects for fiscal consolidation in the United States combined with a better U.S. economic outlook relative to other major economies also helped to support market sentiment for the dollar.
As in the prior quarter, market participants continued to anticipate increased private capital outflows from Japan as a result of low domestic interest rates and sizable domestic debt maturing in the fourth quarter. The substantial decrease in japan's current account surplus also contributed to the negative sentiment for the yen. Furthermore, most Japanese exporters were perceived to be absent from the marketplace, having already filled their hedging requirements. On the other hand, Japanese institutional investors reportedly purchased dollars in conjunction with acquisitions of U.S. government securities. Amidst these factors, the dollar rose to the quarter's high of Y104.12 on November 2.
The dollar also benefited in part from market perceptions of a weak Japanese banking system and of a lack of transparency in Japanese banks accounting practices and nonperforming loan disclosures. After several Japanese banks were downgraded by a credit rating agency, short-term funding costs for nearly all Japanese banks increased sharply, exacerbated by year-end funding pressures. Stress on the Japanese banking system was highlighted by problems related to Daiwa Bank's operations in the United States and the lack of a resolution to the troubled housing loan corporations (jusen). These concerns were manifested in additional premia on yen- and dollar-denominated LIBOR deposits that Japanese banks had to pay to borrow money. Although the Japan premium receded subsequently, concerns about the health of the Japanese banking system continued to linger through the remainder of the quarter.

TENSIONS AMONG CURRENCIES IN THE EUROPEAN UNION
As the quarter began, the dollar eased against the mark. Among the factors adversely affecting the dollar, tensions among currencies in the European Union (EU) remained most discernible. These strains sporadically escalated as public-sector strikes against social security reform measures intensified in France and uncertainty regarding the future of Prime Minister Dini's government in Italy threatened to jeopardize the 1996 budget process. In late October, as these events increasingly drew the attention of market participants, the German mark generally strengthened against other EU currencies. Subsequently, the dollar sustained losses against the mark to reach the quarter's low of DM 1.3808. Later, however, the French government demonstrated its commitment to preserve the core social security reform measures, and Italy's 1996 budget process advanced. As a result, the mark reversed its earlier trend and weakened against other European currencies. In turn, this weakening trend helped the dollar to recover against the mark.

EXPECTATIONS OF LOWER INTEREST RATES IN EUROPE
As the quarter progressed, expectations that European interest rates would decline, bolstered by evidence of slowing economic growth and subsiding inflationary pressures in major European countries, boosted the dollar to the quarter's high of DM 1.4550 against the mark on December 8. Subsequently, central banks in Germany, the United Kingdom, France, and several other European countries lowered their official interest rates by 25 to 50 basis points in December, leading market participants to expect further easing.
The positive effect on the dollar stemming from expectations of lower European interest rates was partly offset by increasing expectations of monetary easing in the United States, where signs of somewhat slower economic growth and subdued inflationary pressures persisted. On December 19, the Federal Reserve reduced the federal funds rate by 25 basis points. Subsequently, expectations of monetary easing in Europe outpaced expectations in the United States and remained a dollar-supportive factor.

UNCERTAINTIES SURROUNDING THE U.S. BUDGET NEGOTIATIONS
Throughout the quarter, the apparent consensus on achieving a balanced budget in the United States was viewed by market participants as a positive development for the U.S. asset markets. At times, however, particularly toward the end of the quarter, concerns about the ceiling on the U.S. Treasury's borrowing authority somewhat impeded the dollar's gains. In the U.S. government securities market, the protracted impasse in budget negotiations raised concerns about possible disruptions in the regular Treasury auction schedule and contractions in the supply of Treasury securities. Because foreign exchange market participants generally did not take significant dollar positions based on the potential outcome of the budget negotiations, however, the net effect of these concerns on the dollar was muted.

NORTH AMERICAN DEVELOPMENTS
In Canada, financial markets were volatile preceding the referendum on Quebec independence. In the third week of October, the Canadian dollar fell to a four-month low of CAD 1.3790 against the U.S. dollar as opinion polls indicated an even split between "yes" and "no" votes. After the secessionist referendum was defeated the Canadian dollar recovered, but given the narrow margin of defeat focus turned immediately to the possibility of another referendum in the near future.
Following the referendum, market participants increasingly anticipated monetary easing by the Bank of Canada, and the Canadian dollar resumed its weakening trend against the U.S. dollar. On December 20, the Bank of Canada lowered its overnight call rate by 25 basis points following the Federal Reserve's policy easing. The Canadian dollar traded calmly for the remainder of the month.
In Mexico, financial markets encountered abrupt selling pressures in the first half of the quarter as political concerns and worse than expected economic data rekindled doubts about the timing of and prospects for economic recovery. The ensuing sell-off was exacerbated by the reluctance among many investors to hold Mexican assets toward year-end. Near the end of the quarter, the Mexican monetary authorities tightened liquidity conditions and purchased pesos in the foreign exchange market to dampen volatility. The Mexican financial markets stabilized, and the peso, at NP 7.70, closed the quarter 17.2 percent weaker against the dollar.

MEXICAN SWAP ACTIVITY
On October 11, Mexico made partial repayment on its short-term swap arrangements with the U.S. monetary authorities. A total of $700 million was repaid, divided evenly between the Federal Reserve System and the ESF. Subsequently, the respective short-term arrangements, with principal amounts totaling $1.3 billion, were renewed on October 30 for ninety days.

TREASURY AND FEDERAL RESERVE FOREIGN EXCHANGE RESERVES
The U.S. monetary authorities did not undertake any intervention operations this quarter. At the end of the quarter, the current values of the German mark and Japanese yen reserve holdings of the Federal Reserve System and the ESF were $20.5 billion and $17.0 billion, respectively. The U.S. monetary authorities invest all of their foreign currency balances in a variety of official instruments that yield market-related rates of return and have a high degree of liquidity and credit quality. A significant portion of these holdings are invested in German and Japanese government-issued securities. As of December 31, the Federal Reserve and the ESF held, $7.3 billion and $10.9 billion, respectively, in German and Japanese government securities, either directly or under repurchase agreement. 2.
In addition, the ESF held $10.5 billion equivalent in nonmarketable Mexican government securities in connection with the medium-term swap arrangement.

ENDNOTES
1. The dollar's movements on a trade-weighted basis against ten major currencies are measured using an index developed by staff at the Board of Governors of the Federal Reserve System.

2. This sentence is corrected and revised from the original text of the "Treasury and Federal Reserve Foreign Exchange Operations" report released February 7, 1996.

* * * *

This report, presented by Peter R. Fisher, Executive Vice President, Federal Reserve Bank of New York, and Manager, System Open Market Account, describes the foreign exchange operations of the U.S. Department of the Treasury and the Federal Reserve System for the period from October 1995 through December 1995. Soo J. Shin was primarily responsible for preparation of the report.