INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

1
INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

• Speculative Attacks on Currencies

2
Purpose of These Slides

• (1) 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 (a peg is where the government is managing
  its currency in a very tight range to another
  currency, or basket of currencies).
• (2) To give you examples of currency attacks and
  the consequences of those attacks.
• United Kingdom pound attack in 1992.
• Asian currency attack in 1997.

3
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 existing
  (i.e., 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.

4
Attacking a Overvalued Pegged Currency

• Attacks on an Overvalued Currency
• Currency is sold short on foreign exchange
  markets
• Short selling Speculators borrow overvalued
  currency, sell it on foreign exchange markets,
  and intend to buy it back later when currency
  weakens.
• Short selling puts downward pressure on the
  overvalued currency.

5
Attacking a Undervalued Pegged Currency

• Attacks on an Undervalued Currency
• Currency is bought on foreign exchange markets.
• Speculators buy undervalued currency, and
  intend to sell it later when currency
  strengthens.
• Buying the currency puts upward pressure on the
  undervalued currency.

6
Assumptions Before Attack will Proceed

• Before attacking a currency, speculators must
  also be confident that the government of the
  countrys whos currency is under attack
• (1) Lacks the will to defend its currency.
• Not willing to adjust interest rates (perhaps for
  political reasons)
• (2) Lacks the resources to defend its currency.
• Does not have sufficient foreign exchange to
  support its currency.
• Would need dollars or other hard currency if
  their currency is being sold.

7
Case Study 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.

8
Dominance of Germany in the ERM

• While the ERM included many European countries,
  Germany was the leading player.
• Therefore, the German mark was the dominant
  currency in this arrangement.
• In addition, 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.

9
Cartoon Representing German Dominance
10
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.

11
Response of British Government to Speculative
Attack September 1992

• Pound currency attack begin in September1992
• Led by hedge funds For example, George Soros.
• Wednesday, September 16 (Black Wednesday)
• Bank of England raised interest rates twice from
  10 to 12 and then later in the day to 15
• Move was an attempt to make U.K. investments more
  attractive to overseas and domestic investors.
• 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!
• Pound fell from 2.7780 to 2.413 or -13.1

12
British Pound Jan 1991 Dec 1992
13
15 Change in British Pound
14
Pound Against the U.S. Dollar 1992

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

15
Case Study Asian Currency Crisis of 1997

• 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.

16
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 foreign borrowing.
• Government borrowing for infrastructure
  investment
• Corporate borrowing for investment expansion.

17
The Thai Baht A Pegged Currency

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

18
Thailand Begins to Unravel

• The massive increase in foreign investment
  eventually resulted in
• Overcapacity in Thailand
• 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.

19
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.
• Question Where would the dollars come from the
  finance the external debt?
• Traders believed the baht was overvalued at 25
  to the dollar.

20
The Attack on the Thai Baht Peg

• Believing the baht was overvalued, speculators
• Start to sell the baht short in May1997
• 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.

21
Response of the Thai Government

• The Thai Government initially responded by
• Purchasing bahts 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 Continuing to defend the peg was
  quickly approaching an impossible situation.

22
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.

23
Bahts 55 Fall Against the Dollar
24
Contagion Effect in Asia (1997)

• The attack on the Thai baht, quickly spread to
  other Asian currencies
• Example of a 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

25
Indonesia Rupiah, Jan 1997 Dec 1997
26
Philippine Peso, Jan 1997 Dec 1997
27
Taiwan Dollar, Jan 1997 Dec 1997
28
Korean Won, Jan 1997 Dec 1997
29
Malaysian Ringgit, Jan 1997 Dec 1997
30
Malaysian Ringgit 1997 June 2005
31
July 21, 2005 Malaysia Moves To a Managed Float.
32
Exchange Rate Changes in Asia June 1997 to June
1998
33
One Government, However, Was Able to Successfully
Defend Its Currency

• 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.

34
Hong Kong Dollar in 1997