3 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 Asia’sThailand “Tom Yum Kung Effect”The Brazilian real crisisArgentina’s currency board crisisSolutions proposed.
4 Currency CrisisMany 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.
5 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.
6 Relevant TheoriesModel of Balance of Payment crises (Paul Krugman)Contagion effect- Weak Fundamentals of neighbors leading to contagion- “Pure” contagion (Speculative attack: Self-fulfilling effect)
7 Model of BOP Crises (Krugman’1979) Different role of international reserves under fixed and flexible regimesBOP = Current account + Capital account + Reserves
8 ContagionDefinition- 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 , the Latin American crises of , and the Asian crises of
9 Contagion “true” contagion/ “pure” contagion - Arises when common shocks and all channels of potential interconnection are either not present or have been controlled for.Fundamentals-based contagion- Arises when the infected country is linked to others via trade or finance.
10 “true” contagion/ “pure” contagion a. Multiple equilibrium and self-fulfilling shifts in expectationse.g. currency crisis: Loss of confidence in central bank’s commitment to a pegged exchange rate regime can cause speculators to attack currency.
11 “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.
12 “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.
13 Market manipulationScenarios 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. Soros’s attack on the British pound in1992.
14 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.
15 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.
16 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.
17 Empirical implications Wolf (1997)- explain the pairwise correlations in stock returns by bilateral trade and other common macroeconomic fundamentals.
18 The Latin American Crises Currency Crises in 1990sThe ERM Crises in 1992The Latin American CrisesInThe Asian CrisesIn 1997
19 The ERM crises ofThe Foreign Exchange Crisis of September 1992Exchange Rate, Et(DM/pounds)RETD1RETF1RETF3RETF2E par1231’Expected Return(in pounds terms)iD1iD2iD3Foreign Exchange Market for British Pounds in 1992
20 The ERM crises ofThe 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 wasn’t 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.
21 The ERM crises ofBecause 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.
22 Case Study: Mexico’s “Tequila Effect” and East Asia’s Crises Story of Mexico’s crisisStory of East Asia’s crisisComparisons
23 1994 Mexico’s Crisis: “Tequila Effect” Lax monetary policyExcessive fiscal deficit-financingDivergent inflation rates with trade partners, fundamentally the USEvident overvaluation of the peso requiring continuous backing with reserves.
24 1994 Mexico’s Crisis: “Tequila Effect” Divergence from purchasing power parity rapidly led to current account deficitsGradually changed exchange rate system1989 crawling peg1991 oscillation band with ceiling and floor levelsFinally in late 1994, the peso was allowed to float
25 1997 East Asia’s Turmoil East Asia’s rapid growth questioned Input-based versus healthy productivity-basedDiminishing returns confirmed by the relapse between GDP and Investment growthHigh dependency on short term foreign capital inflowsDomestic saving not commensurate with investmentPositive I-S gap implied the need of foreign funds
26 1997 East Asia’s Turmoil Weak financial supervision Rapid credit expansion amid higher degree of liberalization (details in Thailand’s case)Foreign-denominated loans popular among financials and corporations.International Loans to finance unproductive activities such as consumption and spendingEast Asian experiences of high current account deficits
27 Current account balances in 1996 Source: An Introduction to open Macroeconomics, currency crises and the Asian crises
28 Comparison of Exchange Rate Source: Financial Times
29 Comparison : Tequila & Tom Yum Kung SimilaritiesDeterioration in current accountSimilarities but with different degreeShort term capital inflowsInternational bank lending
30 Comparison : Tequila & Tom Yum Kung DifferencesGovernment action. More Moral Hazard in Asia given high expectation of government guaranteeThe level of regional integration. NAFTA was signed immediately preceding Mexican crisis. So members stood ready for the turmoil.
43 The Brazilian EconomyThe 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.
44 Causes of the crisis Inflation Poor fiscal policy Poor currency exchange policiesCorruptionContagion from Russia to Brazil
45 How did the crisis begin? Rising instability in Russia created difficulties for Brazil’s 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.
46 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.
47 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.
48 What actions were taken by the government? tightened monetary policycentral bank raised nominal interest ratescompulsory reserves on time depositsoffers of securities tied to the exchange rateexchange market deregulationadjust public sector accounts
49 Economic indicators Change in real gross domestic product The inflation rate (CPI) increasedThe real interest rate decreasedThe trade deficit as % of GDP decreasedInternational reserves (billion US$) decreasedThe exchange rate R$/$ (end of period) depreciated
50 ContagionBrazil’s 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.
51 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
52 What lessons from this crisis can others learn so the same problem does not occur? Overvaluation of the nation’s 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.
54 Argentina’s 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.
55 Causes of the crisis (As we know) Argentina’s monetary system, locally known as “convertibility,” was a currency board.The peso’s exchange rate of 1 per US dollar made persistently overvalued.As a result, Argentina's exports suffered, triggering recession and default.
56 True causes of the crisis Increasing tax rates.Freezing bank deposits.Devaluing the peso.Forcibly converting dollar bank deposits and contracts into pesos (“pesofication”).
57 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 Argentina’s new peso was fixed at 1 US dollar per peso. A currency board achieved its goal of price stability,
58 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.
59 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, And by February 1, the peso had lost fully half of its value.
60 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.
61 The 4 stepsDetermine 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.
62 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.
63 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.
64 The solutions for currency crises Extensive capital controlsThe agreement of the policiesAdaptation of the policiesCredibility of the policiesMonetary unionDeregulation of goods and factor markets with strict prudential supervisionUsing discretionary policy
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