How did the Credit Crisis of 2008 Impact European Exchange Rates? Mark David Witte

European Currencies & TED Spread

The BIG Questions What drove exchange rate innovations during the credit crisis? What’s the impact of credit risk aversion (or awareness) as measured by the TED spread? What role for Macroeconomic Imbalances? Or more Meese-Rogoff puzzle (fundamentals don’t impact ex. rates) ? Carry trade and interest differentials? –Carry trade = borrow in low int. rate countries to invest in high interest rate countries

Interest Rates during Crisis

Methodology Change in Exchange Rate k Change in interest rate differential Various Macro imbalances that literature says are important & TED spread for each country pair DATA 36 country pairs Sept through January 2009 OLS with robust standard errors Regression follows microstructure approach from Evans and Lyons (2002)

Results – Table 1 Reg. 1Reg. 2 Lagged Exchange Rate Change 0.28** (0.03) Interest Rate Differential **-0.219** (0.089)(0.088) Change in Interest Rate Differential (0.93)(0.92) Lagged Change in Interest Rate Differential (1.05)(1.03) Constant-0.19 (0.27) Country Pair TED Spread?NoYes R-squared % annual ex. rate change for 1% difference in interest rates

Insignificant Macroeconomic Imbalances – Table 1 Current Account/GDP Differential Current Account/GDP Differential X TED Spread Growth of M/GDP Differential Growth of M/Foreign Currency Assets Diff. Real Effective Exchange Rate Diff. External Debt Measures GDP growth rate Diff. (-)* -- faster growing countries depreciated = opposite of literature on currency crises

What about TED Spread? Hungarian Forint falls against 7 of 8 currencies as TED spread widens Hungarians borrowed EUR and CHF pre-crisis

Determinants of Int. Rate Diff. All Country Pairs (36 Total) Reg. 1Reg. 2Reg. 3 Current Account/GDP Differential **-0.088**-0.068** (0.003) Past Inflation Differential 1.274**0.995**1.021** (0.019)(0.022)(0.023) Gross External Debt (% of GDP) Differential - Government 4.653**4.110** (0.215)(0.201) Gross External Debt (% of GDP) Differential – Banks 0.201** (0.016) R-squared If the interest rate differential is so important than what are it’s determinants?

Causation & Amplification by TED Spread Reg. 1Reg. 2 Lagged Exchange Rate Change 0.28** (0.03) Predicted Interest Rate Differential (Table 2, Reg. 3) 0.175* (0.094) Interest Rate Differential x TED Spread 0.144** (0.041) Change in Interest Rate Differential (1.02) Country Pair TED Spread?YesNo R-squared More significant estimate than previous coefficients

Foreign Currency Assets Reg. 1Reg. 2 Lagged Exchange Rate Change 0.28** (0.03) Interest Rate Differential 0.184** (0.090) Foreign Currency Assets Differential (In Trillions) * (0.094) Country Pair TED Spread?NoYes R-squared Expensive: Additional $1 Billion = 1.6% Appreciation Mean = $0.65 BillionStd.Dev. = $1.7 Billion

Conclusion Interest Rate Differential significantly impacted Exchange Rates = unwinding of carry trade –1% higher int. rate = 5.3% - 4.2% annual depreciation –Magnified by TED Spread Foreign Currency Assets hedge depreciation but are very expensive Hungary especially hard hit by TED Spread Macroeconomic Imbalances (current account deficits, high inflation, high external debt) only indirectly are associated with exchange rate swings