International Fixed Income

1
International Fixed Income

• Topic 6A Currency Crises

2
Outline

• Description
• Effect on international bond market
• local currency
• -denominated
• Examples
• ERM crisis (1992)
• peso crisis (12/94)
• russian default (8/98)
• Asian currency crisis (1997-98) (see
  http//www.stern.nyu.edu/nroubini/asia/AsiaHomepa
  ge.html)

3
I. Currency Crisis a First Look

• Central bank uses reserves to maintain XRs within
  a band
• For various reasons
• Domestic money demand falls
• Dom inflation, loss of competitiveness, economic
  slow-down, corporate failure, foreign withdrawals
  (political turmoil)
• AND/OR
• Domestic money supply rises
• Fiscal financing via printing, excess dom credit
• Central bank loses reserves
• Crisis ( when reserves are exhausted(?) )
• withdrawal from peg into float
• withdrawal from convertibility into exchange
  controls

time
4
Review of XR Regimes
Source IMF publications, 1997
5
Currency Crisis Uncertainty

• Non-zero minimal reserve threshold
• There may be an outside infusion (IMF aid, hence
  negative minimal level) to allow more time for
  correcting macroeconomic measures gt Peg may
  survive an attack

6
The Attack

• Reasons/triggers for a speculative attack may
  vary
• What is common?
• Investors are rational and forward looking
• When expected (risk adjusted?) return on DomXR
  lower than FX, investors/speculators sell DomXR
  and reserves decline
• As a defense, domestic interest rates often rise.
  Then it is the question of the probability, size
  and timing of the devaluation
• Investors see the end-game, and try to switch
  from high yield domestic into hard currency just
  at the right time
• w.r.t. timing, look for coordination signals

7
Factors Affecting Speculative Attacks

• Factors which increase the sustainability of a
  pegged rate
• Large stock of reserves
• Low domestic rate of credit creation
• High demand for domestic money (high income / low
  interest rates)
• Low expected inflation in the case of a collapse
• Factors contributing to a currency crisis
• Overvalued domestic currency
• ltgt Large and persistent current account
  deficit
• Excess credit creation (vulnerable banking system
  gt liquidity crunch)
• Low FX reserve relative to short term sovereign
  debt (liquidity)
• Conflict in the gvmt policy objectives
• (government needs to subject dom monetary policy
  resulting implications to pegging partners
  currency fluctuations. May result in loss of
  competitiveness, slowdown, unemployment gt
  politically unsustainable)

8
Predictive Currency Crisis Variables

• Rank leading indicators based on
• Probability of crisis given indicator signal
• Avg. number of month prior to signal that
  indicator signal is issued
• Persistence of signal ahead of crisis
• Most prominent signals
• Hard currency reserves
• Real exchange rates
• Domestic credit
• Credit to the public sector
• Domestic inflation
• Interest rate differential widens
• Equity crash

Source Kaminsky, Lizondo Reinhart, Leading
indicators of Currency Crisis, IMF WP 97/79,
July 1997
9
Example Brazilian Real (1998-)
10
Example Brazilian Real (1998-)
11
Example Brazilian Real (1998-)
12
Example Brazil -- 9/13/1998

• Reserves declined from 80Bil to 55Bil.
  1Bil/day outflow rate that week
• Stockmarket 75 lower y.t.d., 35 over the
  previous month
• Int Rate from 30pa to 50pa (approx. 5-7
  inflation). Currency overvalued (?).
• Deficit 8 of GDP
• Political scene election was in 3wks
• Effect on the US 15th largest trading partner,
  1.7 of trade

13
Contagion

• What do we mean by CONTAGION EFFECT ?
• Study examines crisis index in the post MexPeso
  collapse
• INDEXa(currency depr) b( loss in reserves)
• Index rises for countries w/ highly overvalued
  RXR, low reserves, and a recent lending boom
• gt The Tequila Effect is not random
• Some debate still exists

Source Sachs, Tornell Valasco, Financial
Crises in EM lessons from 1995, Brookings
Papers on Economic Activity N0.1 1996, 147-215
14
Correlation breakdown
15
Loose Ends

• Selection bias
• a currency crisis may or may not have developed
• (country may take pain now to avoid more pain in
  the future)
• How far is down?
• Currency likely to overshoot if/when devaluation
  occurs
• Exactly by how much is critical for speculators
  profitability calculations
• Speculators solve for
• Expected gain given a crisis VS expected loss w/o
  one
• Function of size, magnitude and timing of crisis
• Has a structural change in crises occurred (IMF
  role) ?
• gt PROFITABLE TRADING strategies may exist!

16
II. International Bond Pricing

• Two primary effects
• Default premia for emerging market countries goes
  up. (See next page graph from last class on Cetes
  and Tesebonos).
• Currency premia (from expected devaluation) goes
  up. (See next page graph from last class on Cetes
  and Tesebonos).
• Both of these lead to increases in the bonds
  yield, i.e, a severe drop in the bond price.
• Secondary effect (though potentially important)
• Impact on US market via financial crisis.
• Contagion effect across other markets facing
  similar issues.
• Liquidity effect.

17
III. Examples

• ERM crisis
• Peso crisis
• Russian debt default (during Asian Contagion)

18
A. ERM crisis

• 1979 Exchange Rate Mechanism (ERM) led to stable
  and narrow target zones among European countries
• In 1992-93, however,

19
Implied vol the GBP crash of 1992
DM/L
20
Russia, -denominated 3, 2003
21
Cetes Currency