SPECULATIVE ATTACKS AND CURRENCY CRISES

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SPECULATIVE ATTACKS AND CURRENCY CRISES

• RECENT EXPERIENCE AND LESSONS FOR POLICYMAKERS

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LECTURE OUTLINE

• Motivation -- The Crises in the European Monetary
  System (EMS) and the Mexican Peso.
• Economics of Speculative Attacks --Macroeconomic
  Factors vs. Self-fulfilling Attacks
• Empirical Evidence -- Cross-Country Studies, Case
  of Mexico, Tequila Effects
• Lessons for Policy -- What can be done

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Recent Experience

• The Crisis in the EMS (1992-93)
• February 7, 1992 - Maastricht Treaty was signed.
  Move towards EMU by the end of the decade.
• June 2 - Danish referendum with a no vote.
• Early September - Polls reporting increased
  support for a no in the French referendum on
  September 20.
• September 8 - Finnish markka forced to be
  floated, Italian lira devalued by 7.
• September 16 (Black Wednesday) - British pound
  forced to float, Sweden raised overnight marginal
  lending rate to 500 per year, lira fell through
  ERM floor.

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• September 17 - Lira was floated, Spanish peseta
  devalued by 5.
• September 20 - France votes yes. Pressure
  continues throughout September.
• November 19 - Sweden lets the krona float after
  loosing 25b in reserves in 6 days. Three days
  later the spanish peseta and the portuguese
  escudo were devalued by 6.
• December 10 - Norwegian krone was floated.
• February 1, 1993 - Irish punt was floated.
• Throughout March pressure continues on peseta and
  escudo and for the first time on Belgian franc.

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• May 13 - Escudo and peseta were devalued by 6.5
  and 8 percent, respectively.
• July - Enormous pressure on Belgian franc, Danish
  krone, French franc, escudo and peseta.
• August 2 - European finance ministers agreed to
  increase the bands of the ERM to 15, except for
  the deutsche mark dutch guilder exchange rate.

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• The Mexican Peso Crisis (1994)
• December 1994 - Mexico had lost more than half of
  its international reserves since March of 1994,
  which were down to 10.5b, devalued its currency
  by 15 on December 20 and was forced to let it
  float on December 22 after loosing another 4b in
  two days.
• A number of other emerging markets were adversely
  affected in early 1995, especially Argentina,
  Brazil and the Philippines. This phenomenon has
  been dubbed the Tequila Effect.

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Economics of Speculative Attacks

• Two approaches
• A. Speculative Attacks are the rational reaction
  of investors to bad economic policies.
• B. Speculative Attacks are self-fulfilling, i.e.,
  are forced by the markets on countries that
  otherwise follow prudent policies, simply because
  the markets believe that those policies will not
  be sustainable after the attack.

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Emphasis on Macroeconomic and Financial Variables
Before the Crisis

• First explanation by Krugman (1979) - Govt keeps
  the exchange rate pegged as long as the
  international reserves exceed a minimum
  tolerable level (for example zero). It runs a
  deficit which is financed by domestic credit.
  With a fixed exchange rate, investors want to
  hold domestic and foreign assets in fixed
  proportions. Therefore, investors exchange a
  portion of the increased supply of domestic
  credit for reserves, the shadow exchange rate
  (which would prevail if the pegging is abandoned)
  depreciates gradually over time. When the shadow
  rate equals the current rate, investors attack
  the currency, depleting the authorities
  remaining reserves.

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• Basic idea Policies that weaken the shadow
  value of the currency weaken the viability of the
  exchange rate peg and bring an attack forward in
  time. For example expansionary fiscal and
  monetary policies.
• The various extensions of that story suggest that
  we should be looking for the following signs
  before the attack overvalued real exchange
  rates, higher real wages, rising relative unit
  labor costs, significant policy uncertainty,
  current account deficits and accelerating reserve
  losses.

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Self-fulfilling Speculative Attacks

• Flood and Garber (1984) and Obstfeld (1986) -
  Possibility of multiple scenaria.
• A. If there is no attack, then monetary and
  fiscal policies are in balance and there is no
  reason to assume that the pegged exchange rate
  will not be maintained indefinitely.
• B. If and only if the currency is attacked, the
  authorities switch to more accommodating monetary
  and fiscal policies consistent with the lower
  level of the exchange rate.
• So speculative attacks can be self-fulfilling.

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• Conclusion No reason to anticipate negative
  trends in monetary and fiscal policies, wages,
  prices, reserves or the current account before
  the attack.
• Why can the attack occur? For example, an
  increase in unemployment. This causes investors
  to revise upward their probability that the govt
  will abandon the current policies. The markets
  will react and attack the currency.
• However, if speculators, for whatever reason,
  lose confidence in the authorities commitment to
  defend the currency, the authorities will be
  forced to raise interest rates. This increases
  expected unemployment and there is a vicious
  circle of higher interest rates and expected
  unemployment until the currency collapses.

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Empirical Evidence

• Dornbusch et. al. (1995) - They identify the
  following as the common elements of some recent
  experiences real exchange rate appreciation,
  deterioration in the current account, heavy
  external borrowing, distress of the financial
  system, poor growth, inflation stabilization
  programs and high real interest rates.
• Sachs et. al. (1996) - They examine the impact of
  the Mexican Peso crisis on emerging markets
  (Tequila effects). They find that overvalued
  real exchange rates and recent lending booms,
  coupled with low reserves, relative to the
  short-term commitments of the central bank was a
  necessary condition for crisis.

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• Eichengreen et. al. (1994) - They examine
  industrial countries
• Frankel and Rose (1996) - They examine currency
  crashes in over 100 developing countries from
  1971 through 1992. They find that crises tend to
  occur when FDI inflows dry up, domestic credit
  growth is high, northern interest rates rise,
  real exchange rate shows overvaluation. They are
  also associated with sharp recessions. No link
  with current account or budget deficits.

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The Mexican Peso Crisis

• See chronology of main events on handout.
• What happened in Mexico was not unprecedented nor
  unusual compared to the experiences of other
  countries. Why was the reaction so sudden and
  the penalty so high?
• Besides the fiscal and current account problems,
  financial variables played a role. Financial
  vulnerability at the end of 1994 made possible a
  run on Tesobonos to bring Mexico to the brink of
  default.
• New Tesobonos holders were not found because
  there must have been a change in expectations as
  to the countrys solvency.

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• The probable reason as to why the markets reacted
  in such a way is related to the fact that in a
  global financial world investors may be very
  sensitive to the perception of small negative
  shocks (eg. unscheduled peso devaluation coupled
  with policy announcements that were not
  compatible with lower govt spending).
• The Tequila Effect is explained by the fact that
  investors were taken by surprise by the extent of
  the crisis. The effect is explained by their
  reaction.

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Lessons for Policymakers

• Simple interpretation Governments bring currency
  crises on themselves through the pursuit of
  excessively expansionary policies.
• Without the right macroeconomic conditions in
  place, a govt should be prepared to take serious
  and often painful policy steps with uncomfortable
  macroeconomic implications, in order to defend
  its exchange rate.
• However, good economic policies are no guarantee
  of no exchange market pressures.

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• Self-fulfilling attacks rest on a bet by market
  participants that governments will not respond
  through tough policy action. Conditions that
  would make this action more costly are
  recession, high unemployment, past or impeding
  elections and finance ministers on thin ice.

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What can be done?

• Monetary Union a la Maastricht.
• Tobin tax (tax on foreign exchange transactions).
• Learn to live with dirty float (misalignments,
  volatility, etc).