Currency Crises

Reading Extra reading: Olivier Blanchard, “Macroeconomics” Chap. 17-20.

UIRP & Exchange Rate Volatility Using UIRP we can write the exchange rate as a function of the future series of exchange rate differentials. Since forecasts of future variables may be volatile and subject to optimism and pessimism, this may explain a large degree of exchange rate volatility.

Costs of Exchange Rate Volatility Volatile exchange rates generate income risk for firms that export goods. This may eliminate some benefits of international trade. Volatile exchange rates generate liability risk for firms that borrow foreign currency to finance investment projects. This is especially significant for firms in emerging markets.

Advantages of Fixed Exchange Rate Regimes Large economies that operate true floating exchange rates experience large fluctuations in relative value of currencies. Small economies with large exposure to international trade may want to reduce risks faced by their export industries by stabilizing the exchange rate. Exchange rate stability may also reduce the risks of borrowing abroad. Small emerging markets may want to finance capital accumulation by borrowing abroad.

Crises For various reasons, international financial markets may lose confidence in fixed exchange rate regimes. If intl. fin. markets believe that a currency depreciation has some possibility of occurring they will increase expectations of future exchange rate or risk premium.

Loss of Credibility Define a credible fixed exchange rate regime as eFIX = et+1E = eLR. If the forex market loses confidence that eFIX = et+1E and expects a depreciation, this will reduce their willingness to buy domestic currency bonds. Holding today’s spot exchange rate constant this will increase the interest rate and result in a decline in demand. Under flexible exchange rates, an increase in rp or eLR will increase output because it depreciates current exchange rate. Under fixed exchange rates, an increase in rp or eLR will reduce output, because it will raise interest rates.

Equilibrium i$ +(eLR’/e)-1 i i i** i* IS i$ +(eLR/e)-1 e Y** Y* Y eFIX

Consequences of a Loss of Currency Credibility: HK 1998

Reasons for Loss of Credibility Public Finance Many governments borrow to finance spending beyond tax collection. When debts reach a point, difficult to find lenders willing to provide fresh funds. Lenders will fear default. Fears of default will lead to a direct increase in the risk premium if debt is denominated in foreign currrency. Central bank can print money and buy government debt (Open Market Operations) if it is denominated in domestic currency. When a central bank does open market purchase under fixed exchange rates, forex markets will sell the excess money back to central bank or the exchange rate will depreciate. Eventually, the central bank will run out of foreign reserves. This may force them to abandon the exchange rate peg, causing an increase in eLR

During the 1990’s, Brazil faced growing domestic debt. (Source: CEIC)

By 1997, increasing share was being purchased by Banco Central By 1997, increasing share was being purchased by Banco Central. (Source: CEIC)

In 1998, foreign reserves begin to decline. (Source: IMF IFS)

In late 1998, fixed exchange rate lost credibility and interest rates rose. Ultimately, in early 1999, real devalued.

Crises and Business Cycles Public finance related crises are common in emerging markets and developing countries. But in 1998, HK government had no deficit and substantial foreign currency reserves. Why would markets lose faith in HK dollar fixed exchange rate which had remained pegged for 15 years. Likely answer: many of HK’s trading partners were in a recession. This would mean a recession for HK which the government could ameliorate by devaluing the currency. Forex markets may have been uncertain about the willingness of new government to undergo recession to avoid devaluing the currency.

European Exchange Rate Mechanism During the early 1990’s, many European currencies including the UK pound and the Swedish krona were linked (within some range) to the European Currency Unit (which was in turn linked to the German mark). Increasing value of DM, made forex markets believe that this linkage might break down.

Bank of England very quickly abandoned the ERM when forex speculators began betting against the pound. (Source: CEIC)

UK devalued against the ECU (Source: IMF IFS)

ERM Crisis seemed to have very little negative effect on British business cycle. (Source: IMF IFS)

Multiple Equilibrium in Beliefs Game if Central Bank values stability. Believe in Devaluation Believe No Devaluation Devalue No Recession Boom Don’t Recession Forex Markets believe Policy Choice

East Asian Boom During the early-mid 1990’s, there were large flows of capital from North America, Japan and Western Europe to emerging East Asia. Most capital flows were US$ syndicated loans and bonds with low risk premium. Exchange rates with the US dollar remained very smooth during this process.

Asian Crisis In Mid-1997, lenders began to doubt the credit of Asian borrowers. They withdrew loans or raised interest rates (rp↑) To maintain fixed exchange rates, East Asian central banks raised local interest rates. Even at high interest rates, capital flowed out of the country. Eventually central banks ran out of foreign reserves and they were forced to devalue the currencies.

Aftermath Unlike the ERM crisis, the decision to devalue the currency did not mean regional troubles were over. In East Asian economies, there was a persistent decline in output, consumption and investment following devaluation. Why?

Dollarization: Liability Local firms had borrowed in dollars but earn profits in local currency. When currency devalued, cost of repaying foreign currency debt raises sharply. Many firms were driven into bankruptcy. Remaining firms were such bad risk no one would lend them money to finance investment. Investment falls.

Dollarization: Trade East Asian trade is denominated in US$. When domestic currency devalues, it does not make exports more competitive. Expenditure switching occurs only through imports. Moreover, inter-regional trade is also denominated in dollars. Korean Imports from Thailand become more expensive, Thai imports from Korea become more expensive. Overall imports decline. Exchange rate has less effect on the trade bala Net effect is that a devaluation may not have positive effects on IS curve.

Currency Controls Some East Asian economies, such as China and Malaysia, have implemented currency controls. The central bank posts a fixed exchange rate but also regulates, administratively, the purchase and sale of foreign currency. Forex traders can trade domestic currency to import and export. Forex traders are not allowed to trade for international investment. Interest Parity Does not Hold Central Bank Can Have Interest Schedule and fixed exchange rate.

Exchange Rate Systems Impossible Trinity: There are a menu of three policy goals, among which a government can choose at most two. Free International Capital Flows Fixed Exchange Rates Free Interest Rate/Monetary Policy If a country, like HK, chooses 1) and 2) then domestic interest rates must equal foreign interest rates.

Fixed Exchange Rates/Free Capital Movements If there are free capital flows, then UIRP holds. A permanent fixed exchange rate St = St+1 implies i = iF. If currencies have constant relative value over time, then investing in bonds denominated in either one should be equivalent so interest rates should be equivalent.

Currency Controls Under flexible exchange rates with free capital flows, rises in eLR, i$, rp will increase output. Under fixed exchange rates with free capital flows, rises in eLR, i$, rp will reduce output. Under fixed exchange rates with currency controls, rises in eLR, i$, rp will have no effect on output.

Y is less sensitive to a change in monetary policy with fixed exchange rates & capital controls than flexible exchange rates because the exchange rate does not respond to interest rate changes. LMP ISFIX i LMP’ ISFLEX Y