CURRENCY DEVALUATIONS IN EMERGING MARKETS

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CURRENCY DEVALUATIONS IN EMERGING MARKETS
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This class explores

• Why do currency crises occur?
• What factors would be useful to know?
• Why are currency crises so difficult to predict?

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Q. Why do currency crises occur?

• Currency crises occur when a fixed (or managed )
  exchange rate mechanism is abandoned under
  duress. Under a floating FX rate system, the
  exchange rate decline is expected a necessary
  component of the adjustment mechanism.
• A myriad of factors can cause currency crises to
  occur, i.e. economic, political, corruption,
  etc., however some data requires greater
  attention and is more objectively analyzed than
  other information.
• Let us focus on the four major economic
  variables monitored closely by the IMF
• 1) Current Account deficits
• 2) Foreign Currency Reserves
• 3) The Real Exchange Rate
• 4) The Fiscal Deficit

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1) Current Account deficits

• Reported as a of GDP. Why not list it as an
  absolute number?
• A large current account means that a country
  must either
• a) Attract capital from abroad to gain access to
  the foreign currency it needs to cover the
  Current Account deficit
• or
• b) Draw down its stock of FX Reserves

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1) Current Account deficits

• Q. What level of Current Account deficit can be
  sustained?
• A. Typically, 1-3 of GDP can easily be financed
  by attracting FDI ( Foreign Direct Investment is
  considered a less risky source of capital ) or
  incoming portfolio flows ( more risky as is
  easily reversible )
• Current Account deficits gt 5 of GDP are in
  the danger zone

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1) Current Account deficits

• Whether a Current Account deficit can be
  sustained is also dependent upon
• a) Whether a country is using imports to build
  productive capacity that will permit it to earn
  foreign currency in the future
• OR
• b) Whether a country is merely importing
  consumption goods
• The combination of a fixed/pegged exchange rate
  and sustained Current Account deficits is a
  highly watched indicator, though some countries
  in those situations have managed to avert a
  currency crisis

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2) Foreign Currency Reserves

• Two Foreign Currency Reserve measurements are
  commonly used
• a) of GDP (focus is on a countrys buffer
  against capital shifts)
• b) Months of imports covered ( focus is on the
  size of Foreign Currency Reserves required for
  net import flows)
• A high level of Foreign Currency Reserves
  provides a buffer against devaluation
• This buffer should be greater if
• a) The country has a significantly large short
  term foreign currency debt level
• and/or
• b) The country has experienced volatile capital
  flows

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2) Foreign Currency Reserves

• When faced with a persistent Current Account
  deficit, the Central Bank can either
• a) Draw down its Foreign Currency Reserves
• This process causes no domestic economic
  dislocation, however this course of action is
  limited by the extent of the countrys Foreign
  Currency Reserves
• OR
• b) Attract foreign investment (FDI or Portfolio
  capital inflows)
• This course of action, ie. raising domestic
  interest rates, tax breaks for subsidiaries of
  MNCs, etc. often encounters domestic opposition

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3) The Real Exchange Rate

• Q. What is the difference between a Nominal
  exchange rate a Real exchange rate?
• Nominal FX rate The relative price of two
  currencies
• (this is visible to market participants daily)
• Real FX rate The relative price of two
  identical baskets
• of goods in the two countries
• Q. What do real exchange rates tell us?
• It is the nominal FX rate adjusted for the
  relative inflation rates between the two
  countries
• Measures international competitiveness
• Sees the relative movements in prices after
  adjusting for exchange rate movements

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3) The Real Exchange Rate

• Two Examples
• 1) Lets assume inflation in the US rises by 6,
  while in Mexico it increases by only 4 (a 2
  differential)
• However simultaneously, the US depreciates
  3 versus the MXP.
• Thus US competitiveness has improved by 1
• This is a real depreciation of the US against
  the MXP
• 2) Lets assume inflation in Mexico rises by
  10, while in the US it increases by only 3 (a
  7 differential) However simultaneously, the
  Mexican Peso depreciates 5 versus the US. Thus
  Mexican competitiveness has decreased by 2
• This is a real appreciation of the Mexican
  Peso against the US

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3) The Real Exchange Rate

• Conclusion
• a) If a countrys inflation rate differential
  vis-a-vis another currency gt its nominal
  depreciation against that currency then that
  currency is experiencing a real appreciation
  vis-a-vis the other currency
• b) If a countrys inflation rate differential
  vis-a-vis another currency lt its nominal
  depreciation against that currency then that
  currency is experiencing a real depreciation
  vis-a-vis the other currency

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3) The Real Exchange Rate
Q. Why does an increase in the real exchange rate
create currency devaluation pressures? A. It
hurts all firms that are exposed to foreign
competition. Exporters suffer, because their
costs are higher when measured in terms of
foreign currency Firms facing import competition
are hurt, because foreign producers are under no
pressure to increase prices with domestic
inflation
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3) The Real Exchange Rate

• The impact of an increase in the Real Exchange
  Rate depends to a great degree on the Trade to
  GDP ratio
• An appreciation of the Real Exchange Rate of a
  country with a high Trade to GDP ratio is
  particularly worrisome
• Why?
• Because exports are not competitive in world
  markets, and imports capture a greater market
  share in the domestic market

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4) The Fiscal Deficit

• This links (though impacting the firms Current
  Account) connection with currency crises is not
  clear cut
• If a country has a high domestic savings rate,
  then the fiscal deficit can be financed with
  local savings, ie. there is no need to borrow
  foreign currency funds from overseas, and thus
  there is no pressure on the FX rate.
• If a country has a low domestic savings rate,
  then typically Governments finance the budget
  deficit by easing monetary policy (ie. printing
  money), and that puts pressure on the FX rate.

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Q. Why are currency crises so difficult to
predict?

• Unfortunately, no single indicator or combination
  of indicators, works accurately on every occasion
  or situation
• Global market watchers (IMF, World Bank, Private
  investors, etc.) understand the significance of
  the variables and their interplay that puts
  pressure on the exchange rate.
• However, the timing of market forces that force a
  country towards a currency crisis is not easily
  predicted.
• In many cases, the decision and timing to abandon
  a fixed exchange rate is a political one

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Q. What other factors would be useful to know?

• This list is formidable!
• 1) Timing of parliamentary elections/majority of
  Ruling party, opposition strength
• 2) Impact of current economic conditions on
  various segments of society
• 3) Level of corruption
• 4) Extent of capital flight
• 5) The black market FX rate vs. Central Bank FX
  rate

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DIFFERENT TYPES OF FLOATING FIXED FX RATE
SYSTEMS

• a) FLOATING FX RATES
• - CLEAN (PURE) FLOAT
• Market demand supply solely determine the
  equilibrium FX
• rate, namely zero government intervention
• - MANAGED (DIRTY) FLOAT
• Though the FX rate is floating, Government
  authorities
• occasionally intervene to
• Influence the direction
• Alter the rate of change in the currency value

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b) FIXED FX RATES

• FACE THREE ON-GOING DILEMMAS
• Q1. TO WHAT DOES THE GOVERNMENT FIX THE VALUE OF
  ITS CURRENCY?
• A1. A variety of possibilities exist
• - Gold
• - Some other currency ( e.g. US, Euro, FF )
• - Some composite basket ( e.g. SDR )

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Q2. WHEN, HOW OFTEN, BY HOW MUCH, SHOULD THE
COUNTRY CHANGE THE VALUE OF ITS FIXED RATE?

• A2. THE ABILITY TO MOVE / ALTER A FIXED FX RATE
  HAS INTRODUCED THE WORD PEG
• - ADJUSTABLE PEG The FX rate is adjusted when
  the
• country is faced with a fundamental
  disequilibrium in its international position
• - CRAWLING PEG An anticipatory solution via a
  continual scheduled change in the pegged rate
  usually tracks some internal indicator such as
• - Domestic inflation versus pegged currency
  inflation rate
• - Domestic money supply versus pegged country
  money supply
• - Level of international reserve holdings

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Q3. SHOULD THE GOVERNMENT DEFEND ITS FIXED RATE
AGAINST MARKET PRESSURES TUGGING TOWARDS AN
APPRECIATION / DEPRECIATION OF ITS CURRENCY?

• A3. The Government can defend its FX rate in the
  
• following ways
• 1. FX intervention
• 2. FX controls
• 3. Monetary policy
• 4. Undertake macro-economic policy reforms ( e.g.
  expand export programs, reduce government
  spending )
• OR
• The Government can succumb to market forces!

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Q. WHERE DOES A CENTRAL BANK OBTAIN US TO
UNDERTAKE FX INTERVENTION?
A. It cannot just create US! It can however -
Use its own international reserve holdings -
Obtain US from the Federal Reserve, i.e. Aid
package - Access global capital markets do a
sovereign bond offering - Borrow US via
pre-established swap lines
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Q. WHAT DOMESTIC MONETARY ACTIONS DO CENTRAL
BANKS ENGAGE IN? CAN THESE ACTIONS IMPACT FX
MARKETS?

• Central banks control the money supply of the
  domestic economy
• They engage in Open Market operations which
  involve an exchange of currency for monetary
  assets
• Example A sale of US Treasury Bills in the NY
  Money markets, results in a reduction of US in
  circulation, thus leads to a reduction in the
  US money supply ( vice versa )

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Q. WHAT ARE THE COMPONENTS OF A CURRENCYS
OFFICIAL RESERVE ASSETS?

• A. Typical components include
• 1. Its own holdings of FX assets (in credible
  assets, i.e.
• currencies other than its own)
• 2. The countrys Reserve position with the IMF
• 3. The countrys holdings of Special Drawing
  Rights (SDRs)
• 4. Gold holdings
• 5. Proceeds from the sale of state assets

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Q. WHAT IS STERILIZED FX INTERVENTION?
A. When the reduction in the monetary base is
offset by the Central banks action in the Money
Market, namely via Open market operations This
forestalls any adjustment that would have
occurred through the monetary mechanism, i.e.
the effect of the loss of FX reserves on the
money stock
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Q. WHAT IS UNSTERILIZED FX INTERVENTION?

• The support of the domestic currency by the
  Central
• Bank in the Foreign Exchange Market leads to a
  macro
• adjustment via a contraction of the countrys
  domestic
• money supply
• This enables the country to support its exchange
  rate at
• the Fixed target level via the rising interest
  rate
• This rising domestic interest rate functions to
• strengthen the currency however it also leads to
  a
• domestic economic slowdown
• Result The Central bank can choose to target the
  level
• of its exchange rate, or the level of its
  interest rate, but
• cannot do both independently. Thus frequently the
• defense of a Fixed exchange rate system results
  in a
• loss of an independent monetary policy

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Q. WHY DO GOVERNMENTS STERILIZE?

• A. They sterilize when they want to Hold the FX
  rate away from its true market equilibrium value
  and
• SIMULTANEOUSLY
• .want to prevent the automatic adjustment
  mechanism from impacting the domestic money
  supply
• Q. WHAT ARE THE LONG RUN EFFECTS OF
  STERILIZATION?
• A. It is unlikely to be effective, as it implies
  a chronic
• disequilibrium in the countrys Balance of
  Payments ( BOP )

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STERILIZED FX INTERVENTION (CONTD.)

• ASSETS HELD BY A CENTRAL BANK ARE
• MB INT. RES. DC ..(1)
• AND
• BOP CHANGE IN INT.RES(2)
• GLOSSARY
• MB MONETARY BASE
• INT. RES. INTERNATIONAL RESERVES (CENTRAL
• BANKS HOLDINGS OF CLAIMS AGAINST THE REST OF
• THE WORLD)
• DC DOMESTIC CREDIT (CENTRAL BANKS HOLDINGS
• OF CLAIMS AGAINST ITS OWN GOVERNMENT)

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STERILIZED FX INTERVENTION (CONTD.)
When a country runs a BOP deficit, then the
countrys Central Bank is essentially buying its
own currency selling International
Reserves See Equations (1) (2) together In a
BOP deficit situation, the country experiences a
fall in International Reserves, if the DC is
unchanged, then the MB falls by an identical
amount Key Point THE BOP DEFICIT AFFECTS INT.
RES. WHICH AFFECTS THE MB Q. WHAT IS THE CENTRAL
BANK DOING VIA STERILIZATION? A. It is expanding
DC at the same rate as the International Reserves
outflow, thus preventing a contraction of the
MB i.e. If the change in DC change in
International Reserves, then the change in MB 0

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Q. A COUNTRY WITH A BOP DEFICIT DECIDES TO DEFEND
ITS FIXED FX RATE BY UNDERTAKING UNSTERILIZED FX
INTERVENTION. WHAT IMMEDIATE IMPACT WILL THIS
HAVE ON THE DOMESTIC ECONOMY?

• A. As the Central Bank buys the domestic currency
  (versus the foreign currency), it reduces the
  countrys monetary base thus its money supply.
  
• This results in higher interest rates.
• Rising interest rates lead to
• - Reduced interest sensitive spending
• - Lower aggregate demand
• - Falling real GDP/National Income
• - Rising unemployment

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Q. A LATIN AMERICAN COUNTRY HAS THE COMBINATION
OF HIGH INFLATION A FLOATING FX RATE. WHAT
OPTIONS DOES IT HAVE, DOES THAT INCLUDE MOVING
TO A FIXED FX RATE?

• A. IN THE SHORT RUN The Government must tighten
  monetary policy, i.e. raise interest rates
• Aggregate demand shall be reduced
• Weaker demand will put downward pressure on the
  inflation rate
• IN THE LONG RUN The solution is to reduce
  the growth in the Money Supply, i.e. The
  underlying cause of inflation

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Q. A LATIN AMERICAN COUNTRY HAS THE COMBINATION
OF HIGH INFLATION A FLOATING FX RATE. WHAT
OPTIONS DOES IT HAVE, DOES THAT INCLUDE MOVING
TO A FIXED FX RATE?

• Adoption of a fixed FX rate may help because
• 1. It is evidence of the Governments willingness
  to accept the discipline required for the
  efficient functioning of a Fixed FX rate system
• 2. Unsterilized FX intervention to combat a
  weakening currency (due to high inflation) will
  force a tighter monetary policy

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Q. A LATIN AMERICAN COUNTRY HAS THE COMBINATION
OF HIGH INFLATION A FLOATING FX RATE. WHAT
OPTIONS DOES IT HAVE, DOES THAT INCLUDE MOVING
TO A FIXED FX RATE?

• 3. The expectation of market participants that
  inflation fighting is a Central Bank priority,
  contributes to actual inflation declining.
• Why?
• Expectations hypothesis
• 4. The stability given to the local currency
  prices of imported goods by the fixed FX rate
• Steady import prices contribute to reducing
  the countrys inflation rate as well as putting
  competitive pricing pressure on competing
  domestic products

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PROS CONS OF ADOPTING A1) FLOATING FX RATE
SYSTEM2) FIXED FX RATE SYSTEM

• 1a) PROS OF A FLOATING FX RATE SYSTEM
• 1. Crisis avoidance
• How?
• As FX rates undertake necessary adjustments and
  large
• BOP deficits surpluses can be avoided
• Only the FX rate needs to adjust to correct this
• imbalance, i.e. no loss in FX Reserves or
  Government
• intervention is required
• Policy adjustment delays by decision makers can
  be
• avoided

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1a) PROS OF A FLOATING FX RATE SYSTEM
2. Monetary independence Each country can pursue
an independent monetary policy thus determine
its own inflation rate A countrys response to
domestic unemployment Increase the money
supply Results in declining interest
rates Domestic currency is less attractive
depreciates This leads to an export boom lower
domestic unemployment A countrys response to
domestic overheating Decrease the money
supply Results in rising interest rates Domestic
currency is more attractive appreciates This
leads to an import boom higher domestic
unemployment
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1a) PROS OF A FLOATING FX RATE SYSTEM

• 3. Consistency with capital mobility
• 4. Clearly identifies the comparative advantage /
  disadvantage of a country in various commodities
  when the equilibrium FX rate is translated into
  domestic prices
• Namely, a Floating FX rate is more likely to give
  accurate
• price signals for the allocation of resources
• Example An overvalued FX rate may result in
  Exports /
• Imports in which the country in reality has a
• comparative disadvantage
• Governments are prevented from setting Fixed FX
  rates
• that may benefit particular sectors of the
  domestic
• economy

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1b) CONS OF A FLOATING EXCHANGE RATE SYSTEM

• 1. Discipline imposed by fixed FX rate systems on
  monetary policy is missing
• 2. Disturbing speculative volatility
• 3. Damage to international trade investment
• 4. Lack of coordination in economic policy, e.g.
  countries may engage in competitive devaluations
• 5. Myth of greater autonomy

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2a) PROS OF A FIXED FX RATE SYSTEM

• 1. Price discipline
• Fixed FX rates impose price discipline by
  preventing
• Central Banks from engaging in an expansionary /
• inflationary monetary policies
• Empirical evidence shows that Central Banks
  circumvent
• this discipline, though the initial purpose was
  to gain
• credibility
• 2. Reduced volatility uncertainty
• Lessens impacts on pricing decisions, facilitates
  trade
• and investment flows, reduces hedging costs
• 3. Prevention of exchange crises This reason is
  suspect
• when we see recent experience!

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2b) CONS OF A FIXED FX RATE SYSTEM

• 1. Incompatible with open, integrated,
  international capital markets, eg. A rising real
  exchange rate hurts domestic producers as rising
  local costs makes exports less competitive in
  world markets
• 2. Offers a target to speculators, even if
  prudent economic policies are followed, ie.
  provides speculators with a one-way bet.