Foreign Exchange Crises

Sara Silver

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Brief History

Until the 20th century, money consisted of gold and silver coins, which were broadly accepted across borders. Paper currency was first issued by banks and was only gradually accepted by governments seeking to manage their money supply. Nations sometimes tried to stabilize their currencies by fixing their exchange rates to an anchor, as in the gold standard that lasted from 1870 to 1914, or the Bretton Woods system in effect from World War II until 1973. In this context, a nation that could not sustain its fixed exchange rate or left the system altogether would face a currency crisis. Unless there was a simultaneous banking disaster, it generally did not see an economic collapse or financial crisis.

The liberalization of emerging financial markets and increasing global financial integration over the last two and a half decades set the stage for a new, frightening kind of implosion, where a nation's currency and banks both collapse, leading to capital flight, soaring interest rates and a haemorrhaging of the real economy. The economic disaster in Argentine at the turn of the century capped two decades of overall financial crises. South America hosted the first of what scholars call “modern” financial crises from 1981-1983, when Chile, Argentina and Uruguay all suffered. Since then, Russia, Mexico, Thailand, Indonesia, Malaysia, Turkey and other nations have faced economic disaster when a currency crisis combines with a banking collapse.

Besides a formal devaluation, factors such as actual or rumored political instability, interest rate hikes, a spectacular company failure or unexpected declines in the economy can all lead anxious investors to move their money elsewhere. As this happens, people sell more of the local currency, flooding the market and further reducing its value. To maintain the peg, the government needs to raise the value of the currency, usually by selling its reserves of foreign currency and buying its own. When it becomes obvious that the government has insufficient reserves–or willpower–to meet its obligations to finance imports, debt and still support its currency, that triggers a currency crisis. When this occurs, governments, banks and companies that have taken out debt denominated in dollars, marks or other strong currency, but whose income is in the local currency face danger as debt becomes increasingly unmanageable: it takes more and more local currency to meet payment schedules. At the same time, real interest rates (ie above the current inflation rate) tend to rise after a currency crisis to make up for risk of increases in future inflation to levels of 20% to 50%—levels that are generally considered unsustainable. Remember: a project financed by debt that requires a 50% real interest rate (ie above and beyond inflation) needs to make a 50% profit margin just to break even.

At the same time, the developed world tends to borrow at variable (as opposed to fixed) interest rates (i.e. those that move with the overall interest rate). Borrowers in this case face enormous problems—more so if the loan is also in a foreign currency. After Mexico’s 1994 devaluation, middle class families lost their homes, their cars and all of their savings trying to keep up with credit card debt when interest rates reached above 50%.

A separate problem concerns liquidity, or having enough access to cash when it is needed. Liquidity shortages typically occur as a result of one of two interrelated factors.

  • The first has to do with the sudden cessation of capital inflows, which means that companies so far reliant on foreign flows for their financial survival now find it difficult to refinance their debt. The second factor has to do with the central bank, which, while trying to defend a currency peg, drains liquidity from the local system. By doing so, it can cause real sectors of the economy to contract, and even induce banking failures. Ironically, it is the strongest and most promising countries – for example Mexico in 1994 and East Asian nations in 1997 – that are often subject to liquidity crises. As the ones that attract the strongest capital inflows, these countries are sometimes likely to over-borrow and are thus most affected by capital flight when things start to smell bad. Note, however, that not all sudden devaluations lead to broader financial crises.
  • Much depends, as noted above, on the currency in which revenues and debts are denominated and if there is currency mismatch, for example when revenues are in the local currency and debt is in hard currency. It also matters whether the private sector is exposed to risks from changing interest rates. Britain’s sudden exit from the European Monetary System in 1992, accompanied by a sudden devaluation of sterling against other countries, seemed like a national humiliation at the time. But, in retrospect, the domestic economy benefited from the sudden improvement in competitiveness and lower interest rates leading to an impressive economic recovery. While the devaluation of the Mexican peso in 1994 led to more than 50 per cent of the nation’s bank loans being written off, the healthier Brazilian banks survived with no greater write-offs than usual after the Brazilian real was devalued in 1999.

Reporters trying to discern when currency devaluation might lead to a full-fledged financial crisis should ask questions about the health of the banking and corporate sectors. Telltale signs that an economy is ripe for disaster are increasing corporate indebtedness or leverage (compare the amount of debt to total capital, which is debt plus equity, listed on the balance sheet of public companies), and the growth of nonperforming, or uncollectable, loans on bank's balance sheets. Poor supervision of banks and companies, particularly when banks are allowed to develop links the companies they fund, let these problems fester and deepen.

From the book "Emerging Financial Markets" by David Beim and Charles Calomiris (McGraw Hill, 2000), p. 294.
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Columbia Business School Professors David Beim and Charles Calomiris cite four prerequisites for financial collapse:

  1. Financial liberalization
  2. A fixed currency value
  3. Large, optimistic capital inflows
  4. Underlying weakness in banks and firms

Any one of these factors can start the vicious cycle, but all must be present for a currency crisis to cause an economic disaster.

Why Currencies Lose Value

  • Inflation means the currency buys less real goods and services within a nation. Measures the rate that prices increase.
  • Exchange Rate Depreciation measures the price of local currency against dollars, euros or other strong currency. A depreciated–ie weaker–currency, buys fewer imports than before. An exchange rate depreciates when it steadily loses value on the open market. A devaluation occurs when a government suddenly reduces the currency’s value – either by taking steps to reduce its value, or, equivalently, by discontinuing measures to prop it up.

Inflation and exchange rate depreciation are closely related over the long term, but can vary widely over the short term. For example, if a country expands the money supply – ie prints money – faster than the economy itself is growing, the currency would be worth less both inside and outside the nation, causing both inflation and a devaluation. Exchange rates take into account not only current inflation, but anticipated increases. Devaluation can also lead to inflation by forcing up the price locals must pay for imported goods.

While a small amount of inflation is not necessarily bad, uncertainty about inflation is extremely damaging, since it makes it very hard for banks, businesses and consumers to plan for the long term. The higher the inflation rate is, the more variable it becomes.

While it is difficult for many nations to collect taxes or reduce spending, printing money has seemed a relatively painless way for many governments to finance their budget deficit. Printing money without appropriate backing increases the money supply. (This is usually defined as the amount of currency in circulation plus deposits, but some measures include money market accounts and other liquid assets.) Unless backed by increased reserves, productivity increases or an increase in the size of the economy, higher money supply can cause inflation. A nation needs enough currency to keep the economy going, but there can be too much of a good thing.

Currency boards and other restrictions on the money supply are often implemented to prevent the excessive printing of money to finance government operations.

Fixed Exchange Rates — Countries trying to control inflation can anchor the value of their currency to another stronger currency. A less strict form than currency boards, governments use these measures to announce their intention to buy and sell their local currency to maintain its price close to a stated value. The European Community tried to stabilize their currencies against each other from 1975-1995 through the Exchange Rate Mechanism. Because the bands needed to be frequently widened, they signed on to create European Monetary Union through the Maastricht Treaty of 1991, which requires all signers to control deficits, government debt and inflation.

If the exchange rate is fixed, then inflation can actually cause the real value of the currency to rise, known as a real exchange rate appreciation. For example, if local wages rise but the exchange rate does not, then wages can buy more goods from abroad. This means as well that it is more expensive for other nations to import its goods. This is what is called a loss of competitiveness.

Different methods of Currency Controls

  • Free Float – Governments simply let the market determine the currency’s value, expending no resources to prop up its value. This is mainly meant to allow the local currency—rather than the real economy—to absorb economic shocks. While this staves off sudden collapses – a broken peg – the nation’s imports and exports become subject to the often volatile swings of the currency markets.
  • Dirty Float– Government intervention is decided on a case-by-case basis often as a way of smoothing out otherwise desirable movements in the currency. While many developed nations profess to be free marketers, they will sometimes intervene to change their exchange rate. For example, the US and Japanese central banks have coordinated actions to change the dollar-yen exchange rate, while the UK “shadowed” the Deutschmark for several years in the 1980s.
  • Crawling Pegs and Trading Bands – The pegged exchange rate moves slowly but in line with inflation. This can work well if inflation is mild and the exchange rate is relatively constant. Chile, Colombia, Ecuador and Israel have all maintained crawling bands.
  • Currency Board – Legal framework ensuring that local currency is always backed by reserves of dollars or another strong currency, in effect, making the two currencies substitutes. This prevents the government from printing money to finance government operations. The scheme is used by countries that want to maintain their own currency out of pride but actually subject themselves to the monetary policies of another nation. In Argentina, a currency board was credited with reining in the hyperinflation of the late 1980s. The system collapsed in 2001, when the federal government could neither control nor cover spending by provincial governments. Ecuador, Panama and El Salvador all use the U.S. dollar as their currency (see backgrounder on Dollarization on this site).

Although capital controls only indirectly influence exchange rates, some nations limit the flow of capital in and out of a nation to help prevent a sudden influx of currency that can overheat an economy (as in Chile between 1991 and 1998) or to stop a sudden, and damaging, outflow of capital (as in Malaysia in 1998 as a result of the Asian financial crisis that began a year earlier).

Market Valuations

On the world markets, banks and traders evaluate the relative worth of currencies. Strong currencies generally have low and stable inflation, an open monetary policy that leads to a stable money supply that grows in pace with the rest of the economy, adequate international reserves, a nearly balanced budget and trade that shows no great imbalance.

Since few countries meet this ideal, psychology plays an enormous role in the valuing of currencies. For example, the market can – and has – long ignored yawing trade deficits and budget deficits in the US and had great confidence in the dollar, preferring to believe that capital inflows will continue. When Asian currencies were attacked in the autumn of 1997, many of their reserves were strong and their trade balances were either in surplus or with small deficits. But analysts knew their banks were weak and thus thought their currencies vulnerable in the future.

Government Intervention

When a domestic currency is overvalued, it renders domestic production too costly for exporters to compete internationally. Exports shrink and imports rise while demand for the foreign currency, as a means of holding value, rises. In this case, the central bank must make up for the excess demand for the foreign currency by buying its own currency on the open market to maintain the fixed exchange rate. To do so, it must use up its international reserves, held in US dollars or other hard currency.

Although it is less common, if the currency is undervalued (ie selling for less than it should), few people willingly put the currency on the market, so the central bank needs to make up for the lack of supply by selling its currency for hard currency. This will result in a gain in international reserves.

Tip #1: Many central banks refuse to say whether they are intervening in the market, but a reporter can get a good clue by checking for changes in the level of international reserves. In 1994, Mexico’s reserves dropped from $17.2 billion at the end of October, to $12.5 billion at the end of November, to $6.1 billion at the end of December. The government widened the peso’s trading band on Dec. 20, allowing a de facto devaluation of 15 percent, but as they drained their reserves, were forced to let the peso float on Dec. 22.

Financial analysts also look at the current account, part of what is called the balance of payments, to predict future exchange rates. The current account measures the amount of money flowing in and out of a country through trade in goods and services as well as income from investments and interest on loans.

Tip #2: A Current account surplus indicates that a nation is increasing its claims on foreign wealth – and would suggest a future strengthening of the domestic currency – while a deficit means that country has a decreased claim on foreign assets – and a weakening of the domestic currency.

Tip #3: Look at the trade balance, a component of the current account. If imports are rising while exports are shrinking, this suggests that the currency may be overvalued since imports are cheap and exports are too expensive for other nations to buy. In 1979, Chile had opened much of its economy, but was plagued by inflation. It fixed the exchange rate at 39 pesos per dollar and succeeded in nearly eliminating inflation over the next two years. A trade deficit of more than 10 percent of GDP suggested that the currency was overvalued. The peg broke in 1982, causing a massive contraction in the real economy. A similar dynamic was at work in the collapse of Argentina’s currency board in 2001, as its companies became hopelessly uncompetitive with neighboring countries.

When Governments Can't Sustain their Exchange Rate

The above Tips give a sense of pressures on governments trying to maintain their currency at a fixed value. When there is a hint that a country will devalue, many holders of the currency want to get rid of it, causing a crush of sales that some economists have compared to a bank run.

Once a government exhausts its reserves – and its capacity to borrow to increase them – it can no longer prop up demand for its currency. Any hint that a government lacks commitment or credibility alerts a group of currency traders, known as speculators, who try to make money by betting that the currency will decline or by hastening its fall. Unregulated hedge funds, which borrow heavily so that bets on small moves in exchange rates can be magnified many times over, are often the vehicles for such speculation.

Understanding Speculation

Speculators can be the large banks’ own trading departments, hedge funds or other institutional investors.

Spot Rates – The amount a currency sells for now.

Forward Contracts – An agreement to sell one currency for a given amount of another sometime in the future. For example, if the Mexican peso is now trading at 9 per dollar and people believe it to be overvalued, a firm may only commit itself to paying 10 pesos per dollar a year from now.

How It Works – If speculators believe a currency to be overvalued, they sell the currency both spot and forward, which can precipitate a crisis. Selling spot can create an excess of supply now – they hope more than the government can buy back. By selling the currency forward (if a forward market exists) at the fixed price, they stand to gain an enormous profit if the peg breaks and its value drops. With little chance of a currency gaining strength, there is very little risk, unless the central bank dramatically raises rates.

Amid a crisis, governments and the media often blame foreign speculators for bringing down a currency. Indeed, the Hungarian-born philanthropist George Soros made more than $1 billion of his fortune by attacking the pound sterling and the Italian lira in 1992, just before they dropped out of the European Monetary System.

But more often, local banks, companies and government officials are among the first to see a crisis brewing. This rush to sell local currency holdings is called “capital flight,” and was why some observers described Indonesia’s proposal to establish a currency board during the Asian crisis of 1997 as an “exit strategy for wealthy Indonesians.”

Derivatives – A new generation of derivative instruments (so called because their price is derived from the value of another instrument) have helped to increase volatility. These make it much easier for speculators to swap risks with others, and to make heavy bets.

US banks bought high-interest rate government securities, like Tesobonos, which paid out in pesos at a rate linked to the dollar, but then hedged their risk through derivative contracts with Mexican banks. Although there were laws preventing Mexican banks from speculating against the peso, they signed derivative contracts to accept the proceeds of the Tesobonos, in exchange for an upfront dollar deposit and regular dollar payments. This effectively reduced the return of the US banks to a normal dollar loan yield, and gave the higher returns to Mexican banks in exchange for accepting the risk. Thus, when the peso lost strength, it was the Mexican banks that had to sell ever more pesos to meet their obligations under the Tesobono currency swaps.

What reporters need to look for:

  • Who is doing the selling? Are they selling the currency or the country in general?
  • If the pressure is foreign, is it really speculators, such as hedge funds? Or is it, more dangerously, an exit by large long-term institutions like pension funds?
  • If the pressure is domestic, is it wealthy people moving their money out of the country? Or is it local banks meeting derivatives contracts?
  • Who holds dollar debt? Who holds debt in local currencies?
  • Is the crisis happening to both the currency and the financial system?
  • Which foreign banks did the lending and how much exposure do they have?
  • Besides exporters, who will benefit from a devaluation? Besides importers, who will suffer?
  • What happens to domestic credit? Which people and businesses hold loans denominated in the foreign currency?
  • What is the role of the International Monetary Fund, World Bank and US Treasury? Is the country considered “too big to fail?”

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