Currency Crises: Sources

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Currency Crises
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Currency Crises Sources Solutions

• Miss Nawaporn Rujirawanich 434 55404 29
• Miss Benjaporn Apisaksirikul 434 55485 29
• Miss Sirintra Arkkaleephan 434 56165 29
• Miss Janjuda Warunyanon 434 56383 29

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Currency Crises Agenda

• Assessing the sources of crises and relevant
  theories.
• Reviewing currency crises experienced by selected
  countries.
• England The ERM Crises and speculative attack
• Mexico Tequila Effect with comparison to East
  Asias
• Thailand Tom Yum Kung Effect
• The Brazilian real crisis
• Argentinas currency board crisis
• Solutions proposed.

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Currency Crisis

• Many countries have at one time or another dealt
  with a currency crisis. A crisis only seems to
  occur for fixed rate or pegged currencies, since
  floating currencies are able to adjust on a
  relatively gradual, daily, basis to forces
  affecting them. A currency crisis is identified
  as an official devaluation or revaluation, or
  instances in which the currency is floated. It
  is also sometimes known as a balance of payments
  crisis.

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Underlying Sources of Crises

• Divergent in Monetary Policy between currency
  partners.
• Overvalued currency with unsound fundamentals.
• Malpractice of pegging currency to stronger trade
  partners.
• Chronic current account deficit.
• Too high short term foreign capital inflows.
• Excessive level of financial liberalization.
• Lack of credibility due to inconsistent policies.

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Relevant Theories

• Model of Balance of Payment crises (Paul Krugman)
• Contagion effect
• - Weak Fundamentals of neighbors leading to
  contagion
• - Pure contagion (Speculative attack
  Self-fulfilling effect)

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Model of BOP Crises (Krugman1979)

• Different role of international reserves under
  fixed and flexible regimes

BOP Current account Capital account
Reserves
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Contagion

• Definition
• - Contagion is a case where knowing that there
  is a crisis elsewhere increases the probability
  of a crisis at home.
• - The currency crises of the 1990s have
  consisted of three regional waves the ERM
  crises in Europe from 1992-3, the Latin American
  crises of 1994-5, and the Asian crises of 1997-8.

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Contagion

• Fundamentals-based contagion
• - Arises when the infected country is linked to
  others via trade or finance.

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true contagion/ pure contagion

• a. Multiple equilibrium and self-fulfilling
  shifts in expectations
• e.g. currency crisis Loss of confidence in
  central banks commitment to a pegged exchange
  rate regime can cause speculators to attack
  currency.

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true contagion/ pure contagion

• b. Wake-up call
• - A crisis in one country can create a wake-up
  call for investors by causing them to reevaluate
  their view of (take another look at) economic
  fundamentals of other countries, even if the
  fundamentals of other countries are unchanged.
• crisis may spread from initial target to other
  countries exhibiting similarly weak economic
  fundamentals.

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true contagion/ pure contagion

• c. Herding behavior
• - If investors have imperfect information about
  conditions in foreign countries because of high
  costs of collecting and analyzing information,
• investors may follow actions of other investors
  rather than make own assessments,
• - If some investors are perceived to know more
  about foreign conditions than others,
• uninformed investors may overreact to actions
  of informed investors if latter have to sell off
  assets.

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Market manipulation

• Scenarios in which crises are generated either by
  self-fulfilling rational expectations or by
  irrational herding behavior imply at least the
  possibility or profitable market manipulation by
  large speculators.
• e.g. Soross attack on the British pound in
• 1992.

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Theories of contagion

• 1. Nurkse competitive devaluations
• Once one country has devalued, it makes it
  costly (in terms of a loss of competitiveness and
  output) for other countries to maintain their
  parity.

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Theories of contagion

• 2. Calvo and Mendoza (1998)
• - present a model where the fixed costs of
  gathering and processing country-specific
  information give rise to herding behavior, even
  when investors are rational.
• 3. Kodres and Pritsker (1998)
• - focus on the role played by investors who
  engage in cross-market hedging of macroeconomic
  risks.

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Empirical implications

• Eichengreen,et.al.(1996)
• - attempted to discriminate among bilateral
  trade link channel and a wake-up call
  hypothesis, where similarities to the crisis
  country in fundamentals lead investors to
  reassess the risk of the other countries.

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Empirical implications

• Wolf (1997)
• - explain the pairwise correlations in stock
  returns by bilateral trade and other common
  macroeconomic fundamentals.

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Currency Crises in 1990s
The ERM Crises in 1992
The Latin American Crises In 1994-5
The Asian Crises In 1997
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The ERM crises of 1992-1993

• The Foreign Exchange Crisis of September 1992

Exchange Rate, Et (DM/pounds)
RETD1
RETF1
RETF3
RETF2
E par
1
2
3
1
Expected Return (in pounds terms)
iD1
iD2
iD3
Foreign Exchange Market for British Pounds in 1992
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The ERM crises of 1992-1993

• The huge potential losses on pound deposits and
  potential gains on mark deposits caused a massive
  sell-off of pounds (and purchases of marks) by
  speculators. The need for the British central
  bank to intervene to raise in British interest
  rates, all the way to iD3. After a major
  intervention effort on the part of the Bank of
  England, which included a rise in its lending
  rate from 10 to 15, which still wasnt enough,
  the British were finally forced to give up on
  September 16 They pulled out of the ERM
  indefinitely, allowing the pound to depreciate by
  10 against the mark.

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The ERM crises of 1992-1993

• Because foreign exchange crises lead to large
  changes in central banks holdings of
  international reserves and thus affect the
  official reserve asset items in the balance of
  payments, these crises are also referred to as
  balance-of-payments crises.
• It is estimated that central banks in the
  European Monetary System lost 4 to 6 billion as
  a result of exchange rate intervention during the
  crisis.
• A speculative fund run by George Soros ran up to
  1 billion of profits during the crisis, and
  Citibank traders are reported to have made 200
  million.

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Case Study Mexicos Tequila Effect and East
Asias Crises

• Story of Mexicos crisis
• Story of East Asias crisis
• Comparisons

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1994 Mexicos Crisis Tequila Effect

• Lax monetary policy
• Excessive fiscal deficit-financing
• Divergent inflation rates with trade partners,
  fundamentally the US
• Evident overvaluation of the peso requiring
  continuous backing with reserves.

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1994 Mexicos Crisis Tequila Effect

• Divergence from purchasing power parity rapidly
  led to current account deficits
• Gradually changed exchange rate system
• 1989 crawling peg
• 1991 oscillation band with ceiling and floor
  levels
• Finally in late 1994, the peso was allowed to
  float

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1997 East Asias Turmoil

• East Asias rapid growth questioned
• Input-based versus healthy productivity-based
• Diminishing returns confirmed by the relapse
  between GDP and Investment growth
• High dependency on short term foreign capital
  inflows
• Domestic saving not commensurate with investment
• Positive I-S gap implied the need of foreign
  funds

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1997 East Asias Turmoil

• Weak financial supervision
• Rapid credit expansion amid higher degree of
  liberalization (details in Thailands case)
• Foreign-denominated loans popular among
  financials and corporations.
• International Loans to finance unproductive
  activities such as consumption and spending
• East Asian experiences of high current account
  deficits

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Current account balances in 1996
Source An Introduction to open Macroeconomics,
currency crises and the Asian crises
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Comparison of Exchange Rate
Source Financial Times
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Comparison Tequila Tom Yum Kung

• Similarities
• Deterioration in current account
• Similarities but with different degree
• Short term capital inflows
• International bank lending

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Comparison Tequila Tom Yum Kung

• Differences
• Government action. More Moral Hazard in Asia
  given high expectation of government guarantee
• The level of regional integration. NAFTA was
  signed immediately preceding Mexican crisis. So
  members stood ready for the turmoil.

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The Brazilian Currency Crisis (1999)
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The Brazilian Economy

• The Brazilian economy is the largest in Latin
  America and one of the 10 largest in the world.
  The Brazilian currency is the real. From October
  1994 through January 14, 1999, the official rate
  was determined by a managed float. Since January
  15, 1999, the official rate floats independently
  with respect to the US dollar.

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Causes of the crisis

• Inflation
• Poor fiscal policy
• Poor currency exchange policies
• Corruption
• Contagion from Russia to Brazil

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How did the crisis begin?

• Rising instability in Russia created
  difficulties for Brazils economy and negative
  perceptions of the credibility of the emerging
  economies. These negative expectations of the
  Brazilian economy led the government to adopt
  severe fiscal measures with a conservative
  approach to monetary policy. The restrictive
  economic policy produced a decrease in the level
  of activity and investment indicators mainly in
  the second half of the year.

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How did the crisis go?

• In January of 1999, Brazil redefined its exchange
  system and adopted a free floating rate. The
  events of the crisis that led to changing its
  exchange system occurred during the week of
  January 11, 1999, the week of the real crisis.
• The real was hovering around the bottom of its
  allowed trading band, billions of dollars in
  capital flowed out of the country, and the
  Brazilian equities fell in value.

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How did the crisis go?

• The 1999 balance of payments had a differentiated
  pattern of transactions with the rest of the
  world, when compared to previous years.
• Several measures were adopted in the first
  quarter of 1999 to preserve the stabilization
  process.

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What actions were taken by the government?

• tightened monetary policy
• central bank raised nominal interest rates
• compulsory reserves on time deposits
• offers of securities tied to the exchange rate
• exchange market deregulation
• adjust public sector accounts

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Economic indicators

• Change in real gross domestic product
• The inflation rate (CPI) increased
• The real interest rate decreased
• The trade deficit as of GDP decreased
• International reserves (billion US) decreased
• The exchange rate R/ (end of period)
  depreciated

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Contagion

• Brazils currency crisis spread to Argentina and
  was a major cause of the current Argentinean
  crisis and has impacted Paraguay and Uruguay in
  an adverse way.
• Brazilian products more competitive among these
  countries.
• Argentinean exports became more expensive and
  were demanded less by Brazilians.
• Only two years after the Brazilian crisis,
  Argentina ran into a crisis of its own.

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Post-Crisis Economy 2000 and beyond

• The increased pace of economic activity was
  generated to a great extent by growth in credit
  to the private sector.
• The ratio of gross fixed capital formation to GDP
  remained stable in 2000.
• The consistency of the Brazilian economic policy
  has reinforced confidence in the fundamentals of
  the Brazilian economy among both internal market
  agents and external investors.
• The current account deficit remained stable

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What lessons from this crisis can others learn so
the same problem does not occur?

• Overvaluation of the nations exchange rate is
  detrimental to the country.
• An overvalued exchange rate is often associated
  with a boom in consumption involving a large
  increase in imports.
• Overvaluation of the exchange rate encourages a
  decline in private savings as residents
  substitute present for future consumption.

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Argentinas Currency crisis (2001)
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Argentinas Currency History

• The Argentine story has been one of the
  intermittent economic progress interrupted by
  periodic crises. Argentina twice changed its
  currency in unsuccessful attempts to halt its
  spectacularly high inflation.
• In December 1983, Argentina created a new peso
  Argentino equal to 10,000 old pesos.
• In June 1985, Argentina introduced yet a new
  currency, the austral, declaring each austral
  equal 1,000 pesos Argentino.
• In April 1991, Argentina created another new
  currency, called the new peso, worth 10,000
  australs.

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Causes of the crisis(As we know)

• Argentinas monetary system, locally known as
  convertibility, was a currency board.
• The pesos exchange rate of 1 per US dollar made
  persistently overvalued.
• As a result, Argentina's exports suffered,
  triggering recession and default.

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True causes of the crisis

• Increasing tax rates.
• Freezing bank deposits.
• Devaluing the peso.
• Forcibly converting dollar bank deposits and
  contracts into pesos (pesofication).

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How did the crisis begin?

• In 1991, Argentina introduces the so-called
  Convertibility Law, which is a currency board in
  Argentina. The exchange rate for Argentinas new
  peso was fixed at 1 US dollar per peso. A
  currency board achieved its goal of price
  stability,

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How did the crisis begin?

• In 1999, Argentina slipped into recession, GDP
  falling, unemployment rate rising.
• Throughout the most of 1990s, Argentina ran large
  current account deficits.
• Deepening the recession, the heavy interest
  payments on foreign debt, and the riots in the
  street took their toll. Argentina announced that
  it would cease payment on its foreign debt.

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How did the crisis go?

• In January 2002, Argentina abandoned the currency
  board and let the nominal value of the peso float
  relative to the dollar.
• The peso lost 29 of its value on January 10,
  2002. And by February 1, the peso had lost fully
  half of its value.

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Ending the crisis Dollarization

• The most pressing problems are its currency, its
  financial system, and its tax system.
• How many dollars does Argentina have?
• How many dollars does Argentina need?
• Determining the exchange rate for dollarization
  involves 4 steps.

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The 4 steps

• Determine what liabilities need to be redeemed
  with dollar reserves.
• Assess the financial position of the central bank
  and the government.
• Announce that dollarization will occur and allow
  the peso to float cleanly for no more than one
  week.
• At the end of the period of floating, declare a
  fixed exchange rate with the dollar and announce
  that effective immediately.

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The Lessons for Crisis Prevention and Resolution

• First, we should have focused more closely on the
  debt dynamics.
• Second, currency boards are not necessarily as
  durable as some people liked to imagine in the
  wake of the Asian crisis, especially if they lack
  support from accompanying fiscal and structural
  policies.

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The Lessons for Crisis Prevention and Resolution

• Third, emerging market countries may need to be
  even more conservative with public external debt
  than we had thought.
• Fourth, we need to make it easier for countries
  to exit in a timely fashion from unsustainable
  debt dynamics.
• Fifth, we need to make our policy advice more
  persuasive when times are good and members do not
  require our financial help.

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The solutions for currency crises

• Extensive capital controls
• The agreement of the policies
• Adaptation of the policies
• Credibility of the policies
• Monetary union
• Deregulation of goods and factor markets with
  strict prudential supervision
• Using discretionary policy

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The End
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