In 1979 the new Conservative government abolished UK exchange control. There has been very little analysis of the consequences of abolition for the exchange rate, interest rates, equity prices or balance of payments flows. In Discussion Paper No. 294, Research Fellows Michael Artis and Mark Taylor investigate the effects of the abolition of dir-ect investment controls, portfolio investment controls and monetary controls in the United Kingdom.
The pre-1979 controls on direct investment restricted sterling-financed foreign investment except where it had a positive effect on the balance of payments. A comparison of data in the six quarters before abolition in June 1979 with those for the subsequent two quarters reveals a total effect of £638m a quarter on foreign currency borrowing to finance direct investment. With respect to portfolio investment, the controls stipulated that purchase by UK residents of foreign exchange to invest overseas could be made only from the sale of existing foreign securities or from foreign currency borrowing. Artis and Taylor present data showing that foreign currency traded at an implied premium over the official exchange rate which generally exceeded 30% in the period 1974-9. A net outward flow of portfolio investment after 1980 of around £30bn can be attributed to abolition of the control.
A third element of the controls restricted the holding by UK residents of foreign currency deposits as well as sterling lending to overseas residents. The ratio of £M3 (the broad monetary indicator which excludes foreign currency bank deposits) to M3 (which includes them) fell from around 91% in the late 1970s to 85-7% in the mid-1980s. In the presence of the monetary controls, full arbitrage is inhibited, so that the differential between on-shore and off-shore interest rates can exhibit significant departures from zero and significant variability. Artis and Taylor use non-parametric techniques to test for a downward shift in the differential between the three-month Euro-sterling and local authority interest rates after October 1979. The results show an unequivocal volatility reduction in the differential. Abolition of monetary exchange controls should have significant implications for monetary regulation and control, the authors note. Abolition must reduce the scope for sterilized intervention and manoeuvres in the forward markets. Liberalization also rendered pointless credit-rationing controls, such as the `corset', and those of the classical balance-sheet ratio type. Thus while the subsequent reform of UK banking regulations on very liberal lines may have occurred in any case, Artis and Taylor argue that the abolition of exchange controls made it inevitable.

The strong effect of liberalization on portfolio investment flows suggests that UK and overseas stock markets may have become more closely integrated after 1979. Using monthly data from 1973 to 1986 for the stock market indices of West Germany, Japan, the Netherlands, the United States and the United Kingdom, Artis and Taylor test for a significant shift in the correlation of monthly stock market returns, and for long-run cointegration of stock market indices before and after October 1979. The results show no marked increase in the correlation of short-run UK stock market returns with those of any of the other four countries. But they do reveal that the UK and foreign (non-US) stock market indices were cointegrated after 1979 but not before, suggesting that the abolition of exchange control has very probably contributed to the internationalization of the UK stock market. While these effects seem clear and robust, Artis and Taylor find the immediate impacts of abolition on asset prices, interest and exchange rates and balance of payments flows difficult to isolate from the contemporaneous impacts of North Sea Oil, the second oil price shock and the `reputation' of the new government.

Abolishing Exchange Control: The UK Experience
M J Artis and Mark P Taylor

Discussion Paper No. 294, February 1989 (IM)