1. Exchange Rate Policies

2. Why Study Exchange Rates?
To understand the economic environment
Forecasting for planning purposes
To understand exposure to currency risk
Financial impact of exchange rate move varies
With the nature of the asset/liability
With the cause of the move

3. Outline: Exchange Rate Determination
Role of Government
Market Forces
Real economic effects
Monetary effects

4. Exchange Rate Policy
The role of government

5. Exchange rates are determined by supply and demand for the currencies

6. How governments affect exchange rates
Currency market intervention
(intentional)
Central Bank buys/sells home currency in exchange for its foreign currency reserves.
Monetary policy
(unintentional through impact of inflation)
Central Bank buys/sells home currency in exchange for bonds

7. Types of Exchange Rate Policies
free float (no intervention)
“dirty”or managed float(some intervention)
fixed exchange rate or “peg” (unlimited intervention at a fixed rate)
through central bank policy
currency board
dollarization

8. Asian Financial Crisis of 1997 and its aftermath
Some Policy Examples
Asian Financial Crisis of 1997
and its aftermath

9. Thailand - background
“Young Asian tiger” - attracted heavy foreign investment;
low cost of labor
open financial markets
Prosperous and growing export sector
Once growth began, country grew even more attractive to investment.

10. Exchange rate policy: baht pegged to US $
Problems:
U.S. dollar appreciated throughout the 90s
Therefore baht appreciated as well
Consequence 1:
Declining export competitiveness
Normal exchange rate response precluded by peg
Reduced fundamental strength of economy

11. baht pegged to appreciating US $
Consequence 2: apparent financial arbitrage
Thai interest rates higher than those of US
Normal exchange rate response precluded by peg
Thai firms (and others) borrowed dollars to invest in short-term Thai financial assets. (“carry trade”)

12. Currency market implications
Market response
Falling demand for baht to pay for Thai exports
Increasing supply of baht to buy dollars to service loans
Thai central bank found itself constantly buying baht and selling dollars to maintain the peg

13. Collapse of the peg
Eventually, some came to believe the central bank would run out of dollar reserves and be forced to abandon the fixed exchange rate.
Speculative response
As a result, peg was “broken”, exchange rate was allowed to float and immediately lost value.
Capital flight, heavy currency losses to Thai businsses and financial crisis

14. Discussion
In such cases, central banks often blame speculators for the collapse of the exchange rate.
To what extent is this justified?
What ethical considerations should govern speculation on currency or financial markets?

15. Weak regulation of the banking sector
Some structural features of the Thai financial sector made the crash worse
Weak regulation of the banking sector
During the boom, many banks made a lot of weak loans, often as a result of political influence
Asset price “bubbles” resulting from heavy inflow of financial capital from the “carry trade”

16. Spread of the crisis
Currencies perceived to be in circumstances similar to the Thai baht also came under selling pressure
Indonesia
Korea
Less affected by currency crisis directly
Japan (imposing foreign currency reserves)
China (financial still highly insulated from the world)
Philippines (no previous boom to crash from)

17. Hong Kong Hong Kong dollar also subject to heavy selling pressure.
Pegged exchange rate supported by a currency board
Hong Kong dollar also subject to heavy selling pressure.
Because the currency board had sufficient reserves, the fixed exchange rate survived.
Consider resulting impact on
Money supply
Interest rate
Economic activity

18. Spread of Crisis beyond Asia
Further currencies subject to speculative attack
Russia 1998
Brazil 1999
Brazil very promptly abandoned its peg to the dollar.
The currency dropped greatly in value,
Economy recovered in subsequent years

19. Argentina: Collapse of a currency board
Like Brazil, currency was pegged to U.S. dollar
Like Brazil, came under attack in 1999
However, because the peg was supported by a currency board, Argentina attempted to maintain the fixed exchanger rate. (Like Hong Kong)

20. Consequences for Argentina
Terms of trade with Brazil, major trading partner, became very unfavorable.
Exports collapsed,
Imports increased,
Deep economic recession

21. Consequences for Argentina
Although the currency peg controlled inflation of the currency, Argentina maintained a large fiscal deficit.
Funded by borrowing on international markets
Eventually limit of borrowing capacity was reached.
Policy options then were:
Reduce expenditures = political consequences
Abandon currency board and create money to cover obligations (inflation) – occurred in 2002.
Accompanied by a default on past foreign debt

22. Lessons about Exchange Rate Policy
Policy matters (especially in the short run).
In the long run no policy can overcome market forces.