INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

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INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

• Lecture 2 Read on Your Own
• The International Monetary System
• Attacking Currencies

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Purpose of These Slides

• To demonstrate how markets attack foreign
  currencies.
• Why an attack occurs and the conditions necessary
  for success.
• Success measured by the country abandoning its
  peg.
• To give you examples of currency attacks and the
  consequences of those attacks.
• United Kingdom pound attack in 1992.
• Asian currency attack in 1997.
• While these slides will deal with pegged
  currencies, attacks on poorly managed currencies
  can also occur and through the same process
  discussed in these slides.

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Why Do Countries Abandon a Peg Regime?

• Sometimes the market forces them to do so.
• If the market perceives that the countrys peg is
  unrealistic and unsupportable speculators may
  move against (i.e., attack) the currency.
• If the speculation becomes too great, governments
  may be forced to abandon peg.
• Sometimes the government may abandon a peg as
  part of its own orderly process to move its
  economy towards a more open, market driven
  system.
• Likely to be Chinas motivation

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Market Forcing Countries to Abandon Peg An
Attack on a Currency

• Attacks on currencies can occur for a variety of
  reasons, but essentially they all relate to
• Where the market believes that the established
  (pegged rate overstates (or understates) the
  currencys true (intrinsic) value.
• Why might a currency be perceived as overvalued?
• Inappropriate domestic monetary and fiscal
  policies.
• Weakness in the countrys external (trade)
  position.
• Weakness in the countrys key financial sector
  (banking).
• Why might a currency be perceived as undervalued?
• Underlying strength in the economy of the country
  which is not reflected in the pegged exchange
  rate.

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How Does the Market Attack a Currency Necessary
Conditions in Financial Markets

• The financial markets of a country must be fairly
  open for currency attacks to occur.
• Open capital and currency markets.
• Funds must be able to flow into or out of a
  country.
• Stock markets and currency markets.
• It would be somewhat difficult to attack the
  Chinese currency today.
• Financial markets are still tightly controlled
  and not very open.

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Attacking a Overvalued Pegged Currency

• Attacks on an Overvalued Currency
• Currency is sold short on foreign exchange
  markets.
• Speculators borrow currency, sell it now, and
  intend to buy it back later when currency
  weakens.
• Speculators selling stock short on country stock
  markets.
• Provides them with needed foreign exchange (in
  pegged currency) and potential profits if
  currency weakens.

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Attacking a Undervalued Pegged Currency

• Attacks on an Undervalued Currency
• Currency is bought (long) on foreign exchange
  markets.
• Speculators buy currency, and intend to sell it
  later when currency strengthens.
• Speculators buying stock (long) on country stock
  markets.
• Potential profits when currency strengthens.

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Essential Assumption Before Attack will Proceed

• In addition to the previously discussed
  conditions, the speculators must also be
  confident that the government of the countrys
  whos currency is under attack
• lacks the will to defend its currency.
• Not willing to adjust interest rates
• lacks the resources to defend its currency.
• Does not have sufficient foreign exchange to
  support its currency.
• Would need dollars if currency is being sold.

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British Pound Attack (1992)

• Britain joined the European Exchange Rate
  Mechanism (ERM) in October 1990.
• ERM was designed to promote exchange rate
  stability within Europe.
• Under the ERM, European currencies were pegged
  to one another at agreed upon rates.
• The British pound was locked into the German Mark
  at a central rate of about DM2.9/
• Generally feeling at the time was that this rate
  overvalued the pound against the mark.

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Dominance of Germany in the ERM

• While the ERM included many European countries,
  Germany was the leading player.
• Thus, the German mark was the dominant currency
  in this arrangement.
• Thus, German monetary policy had to be followed
  by the other members in order for the other
  member states to keep their currencies aligned
  with the German mark.
• This was especially true with regard to German
  interest rates.

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Cartoon Representing German Dominance
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Series of Events Leading Up to the Attack on the
Pound

• While the markets felt the pound was overvalued
  when it joined the ERM, a combination of events
  just before and after Britain joined convinced
  the market that the pound was ready for
  speculation.
• These events were
• The fall of the Berlin Wall in Nov 1989
• The economic recession in the U.K. in 1991-92.
• German decided to raise interest rates in order
  to attract needed capital for the reunification
  of Germany.
• The issue for the U.K. was having to raise
  interest rates during their recession.
• Political and economic component to this
  decision.

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Response of British Government to Speculative
Attack September 1992

• Pound currency attack begin in September 1992
• Led by hedge funds George Soros.
• Wednesday, September 16 (Black Wednesday)
• Raised interest rates twice from 10 to 12 and
  then to 15
• Attempt to make U.K. investments more attractive.
• During the attack the Bank of England spent 4
  billion pounds (7 billion) in defense of its
  currency.
• Buying pounds (selling U.S. dollars and German
  marks).
• Estimates 1/3 of its hard currency was spent.
• Thursday, September 17, U.K. left the exchange
  rate mechanism and let the pound float!
• From 2.7780 (ERM floor) to 2.413 or -13.1

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British Pound Jan 1991 Dec 1992
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Change in British Pound
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Pound Against the U.S. Dollar 1992

• Down by 25 What did this mean for U.S.
  Companies operating in the U.K.?

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Asian Currency Crisis of 1997 Background

• During the 1980s, a group of countries in
  Southeast Asia known as the Asian Tigers
  experienced exceptionally high economic growth
  rates.
• The economic miracle was accompanied by these
  countries opening up their financial markets to
  foreign capital inflows
• Also, during this time, the currencies of these
  countries were pegged to the U.S. dollar.

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Thailand Background

• Thailand was part of the southeast Asian region
  which experienced double digit real growth up to
  the mid-1990s.
• Exports were critical to the regions exceptional
  growth.
• Thailands exports had increased 16 per year
  from 1990 to 1996.
• Economic growth in the region was fueled by
  massive increases in borrowing.
• Government borrowing for infrastructure
  investment
• Corporate borrowing for investment expansion.

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The Thai Baht

• The Thai baht had been pegged to the U.S. dollar
  at 25 to the dollar for 13 years.

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Thailand Begins to Unravel

• The massive increase in investment eventually
  resulted in
• Overcapacity
• Poor lending/investment decisions
• Investment in speculative activities (especially
  the property markets)
• On February 5, 1997, the Thai property developer,
  Somprasong Land, announced it could not make a
  3.1 million interest payment on an outstanding
  80 billion loan.
• Other Thai development companies followed and the
  Thai property market began to unravel.

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Currency Traders Assess the Situation

• Currency traders were aware of the following
• Thailands enormous external debt which was
  denominated in U.S. dollars would require a large
  demand for dollars.
• Coupled with the debt burden, Thailands export
  growth began to slow and moved into deficit.
• Where would the dollars come from the finance the
  external debt?
• Traders believed the baht was overvalued at 25
  to the dollar.

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The Attack on the Thai Baht Peg

• Believing the Baht was overvalued, speculators
• Start to sell the Baht short in May 1997
• Traders borrowed Bahts from local banks and
  immediately resold them in the foreign exchange
  markets for dollars.
• If the Baht did weaken, traders could buy the
  Bahts back and pay off the loan and make a profit
  on the dollar appreciation.

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Response of the Thai Government

• The Thai Government initially responded by
• Purchasing the Baht on foreign exchange markets
• Used 5 billion in this effort
• Raising interest rates from 10 to 12.5
• Thailand was quickly running short of U.S.
  dollars
• They had just over 1 billion left to support the
  Baht.
• The higher interest rates raised the cost of
  borrowing and adversely affected floating rate
  loan liabilities.
• Bottom line Defending the peg was nearing
  impossible.

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Releasing the Peg

• On July 2, 1997, the Thai government announced
  they were abandoning the peg and would let the
  currency float.
• The Baht immediately lost 18 of its value
• By January 1998, it was trading at 55 to the
  dollar.

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Bahts Fall Against the Dollar
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Contagion Effect in Asia (1997)

• The attack on the Thai Baht, quickly spread to
  other Asian currencies
• Regional contagion effect
• Concern mounted regarding the economic and
  financial soundness of these countries as well.
• As a direct result, many of these Asian countries
  were forced to abandon their pegged regimes.
• For a complete discussion of the crisis see
• http//www.wright.edu/tran.dung/asiancrisis-hill.
  htm

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Indonesia Rupiah, Jan 1997 Dec 1997
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Philippine Peso, Jan 1997 Dec 1997
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Taiwan Dollar, Jan 1997 Dec 1997
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Korean Won, Jan 1997 Dec 1997
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Malaysian Ringgit, Jan 1997 Dec 1997
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Malaysian Ringgit 1997 June 2005
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July 21, 2005 Malaysia Moves To a Managed Float.
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Exchange Rate Changes in Asia June 1997 to June
1998
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Some Governments, However, Were Able to
Successfully Defend Their Currencies

• Hong Kong Dollar
• China purchase massive amounts of stock being
  sold on the Hong Kong stock exchange.
• Offset the short selling of hedge funds.
• China sold massive amounts of U.S. dollars in
  defense of the HK
• Offset the selling of the Hong Kong dollar on
  foreign exchange markets.
• The HK peg was successfully defended and remains
  so today.

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Hong Kong Dollar in 1997