INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

Lecture 2, Appendix 1:

Speculative Attacks on Currencies

Purpose of These Slides To demonstrate how markets (i.e., speculators and

hedge funds) attack foreign currencies. Why an attack occurs and the conditions necessary for

success. Success measured by the country abandoning its peg.

To give you examples of currency attacks and the consequences of those attacks. United Kingdom pound attack in 1992. Asian currency attack in 1997.

While these slides will deal with pegged currencies, attacks on poorly managed currencies can also occur and do so through the same process discussed in these slides.

Why Do Countries Abandon a Peg Regime? Sometimes the market forces them to do so.

If the market perceives that the country’s peg is “unrealistic” and “unsupportable,” speculators may move against (i.e., attack) the currency.

If the speculation becomes too great, governments may be forced to abandon peg.

This was Argentina’s reason. Sometimes the government may abandon a peg as

part of its own orderly process to move its economy towards a more open, market driven system. This was China’s motivation.

Market Forcing Countries to Abandon Peg: An Attack on a Currency Attacks on currencies can occur for a variety of reasons, but

essentially they all relate to: Where the market believes that the established (pegged rate

either overstates or understates the currency’s “true” (intrinsic) value.

Why might a currency be perceived as overvalued? Inappropriate domestic monetary and fiscal policies. Weakness in the country’s external (trade) position. Weakness in the country’s key financial sector (banking).

Why might a currency be perceived as undervalued? Underlying strength in the economy of the country (especially its

trade position) which is not reflected in the pegged exchange rate.

How Does the Market Attack a Currency: Necessary Conditions in Financial Markets The financial markets of a country must be fairly

“open” for currency attacks to occur. Country must have open capital and currency markets. Funds must be able to flow into or out of a country.

In and out of both the country’s stock market and currency market.

As a result, it would be somewhat difficult to attack the Chinese currency today. Why? Financial markets are still tightly controlled and not very

open.

Attacking a Overvalued Pegged Currency Attacks on an Overvalued Currency (where

the markets feel a downward correction is appropriate) Overvalued currency is sold short on foreign

exchange markets. Speculators borrow currency, sell it now, and intend to

buy it back later when currency weakens. Speculators may borrow currency through taking out

bank loans, or by Selling stock short on the country’s stock exchange.

Selling stock short provides speculators with needed foreign exchange (in pegged currency).

Attacking a Undervalued Pegged Currency Attacks on an Undervalued Currency (where the

markets feel a upward correction is appropriate) Undervalued currency is bought (held long) on foreign

exchange markets. Speculators buy currency, and intend to sell it later when

currency strengthens. Speculators simply buy the currency on foreign exchange

markets and, in addition, speculators may Buy stock (held long) on the country’s stock markets.

Potential “foreign exchange related” profits if the currency strengthens.

Essential Assumption Before Attack will Proceed In addition to the previously discussed conditions,

speculators must also be confident that the government of the country’s who’s currency is under attack: Lacks the will (generally political) to defend its currency.

Not willing to adjust interest rates because of the impact on the domestic economy.

OR lacks the resources to defend its currency. Does not have sufficient hard currency (necessary foreign

exchange) to use in foreign exchange markets to support its currency. For example, the country would need hard currency (e.g., dollars)

if currency is being sold. The dollars would be used to buy up its currency and hold its price

on foreign exchange markets.

Attack on the British Pound (1992) Britain joined the European Exchange Rate

Mechanism (ERM) in October 1990. ERM was designed to promote exchange rate stability

within Europe. Under the ERM, European currencies were

“pegged” to one another at agreed upon rates. In October 1990, the British pound was

“locked” into the German Mark at a central rate of about DM2.9/£

General feeling at the time was that this rate overvalued the pound against the mark.

Dominance of Germany in the ERM While the ERM included many European countries,

Germany was the leading player because of its economic dominance. Thus, the German mark was also the dominant currency in

this arrangement and German monetary policy set the tone for the rest of the ERM members.

Thus, German monetary policy had to be followed by the other members in order for the other member states to keep their currencies aligned with the German mark. This was especially true with regard to Germany’s interest

rate.

1992 Cartoon Representing German Dominance in the ERM: Germany the Big Fish

Series of Events Leading Up to the Speculative Attack on the Pound While the markets felt the pound was “overvalued” when it joined the

ERM, a combination of two critical events, one just before and a second just after Britain joined the ERM convinced some in the market that the pound was now ready for speculation.

These events were: The fall of the Berlin Wall in Nov 1989 The economic “recession” in the U.K. in 1991-92.

Fall of the Berlin Wall: As a result, German decided to raise interest rates in order to attract needed capital for the reunification of East and West Germany. Other ERM countries need to follow with higher interest rates.

UK Recession: However, the issue for the U.K. was having to raise interest rates during their recession. A recession would be properly addressed by lower interest rates. Thus there was both a political and economic component to the potential

decision to raise rates. Markets thought the UK would not be willing to raise rates to defend the

pound.

Response of British Government to Speculative Attack: September 1992 Pound currency attack begin in September 1992

Short selling of the pound was led by hedge funds: particularly George Soros.

The British Government’s initial response to the attack occurred on Wednesday, September 16 Raised interest rates twice from 10% to 12 and then to 15%

Attempt to make U.K. investments more attractive. Also, during the attack the Bank of England gave up $7 billion in hard

currency in defense of the pound. Central bank bought $4 billion worth of pounds which were being sold

short (it did this by selling U.S. dollars and German marks to speculators).

Estimates: 1/3 of its hard currency was spent. Thursday, September 17, U.K., the U.K Government decided that the

speculators had won and removed the pound from the exchange rate mechanism and let the pound float! The pound fell from 2.7780DM (the ERM floor) to 2.413DM by late October;

or -13.1% (see next slide). Against the dollar the pound fell by about 25%

British Pound: Jan 1991 – Dec 1992

Pound Against the U.S. Dollar: 1992 Down by 25%: What do you think this meant

for U.S. Companies operating in the U.K.?

Run Up to the Asian Currency Crisis of 1997 During the 1980s, a group of countries in Southeast

Asia – known as the “Asian Tigers” – experienced exceptionally high economic growth rates. Real (after adjusting for inflation) GDP for many grew in

excess of 10% annually. This so called economic miracle was accompanied

by these countries opening up their financial markets to foreign capital inflows. Foreign direct investment and portfolio investment.

Also, during this time, the currencies of these countries were pegged to the U.S. dollar.

Thailand: The Seeds of the Crisis Thailand was part of the southeast Asian

region which experienced double digit real growth up to the mid-1990s. Exports were especially critical to the regions’

exceptional growth. Thailand’s exports had increased 16% per year from

1990 to 1996. Economic growth in the region was also fueled by

massive increases in borrowing. Government borrowing for infrastructure investment and Corporate borrowing for investment expansion.

The Thai Baht: A Pegged Currency Regime

The Thai baht had been pegged to the U.S. dollar at 25 bahts to the dollar for 13 years.

Thailand Begins to Unravel The massive increase in Thailand’s investment

eventually resulted in: Overcapacity in the Thai economy Poor lending/investment decisions by Thai institutions. Investment in speculative activities (especially in the Thai

property markets) On February 5, 1997, the Thai property developer,

Somprasong Land, announced it could not make a $3.1 million interest payment on an outstanding $80 billion loan. Other Thai development companies followed and the Thai

property market began to unravel.

Currency Traders Assess the Situation At this time, currency traders and speculators were

aware of the following: Thailand’s enormous external debt, which was

denominated in U.S. dollars, would require a large need for dollars.

In addition to this U.S. dollar debt burden, Thailand’s export growth began to slow and eventually moved into deficit. Thus, Thailand was no longer receiving U.S. dollars from its

external trade position. Issue for Thailand: where would the dollars come from to

finance the external debt? Traders concluded that due to Thailand’s weakened

economic position, the baht was “overvalued” at 25 to the dollar.

The Attack on the Thai Baht Peg Believing the Baht was overvalued, traders

and speculators: Started to sell the Thai Baht short in May 1997

In doing so, traders and speculators borrowed Thai Bahts from local banks and immediately resold them in the foreign exchange markets for dollars. With this strategy, if the Baht did weaken, traders could buy

the Bahts back and pay off the loan and make a profit on the dollar appreciation.

Response of the Thai Government The Thai Government initially responded by:

Purchasing Thai Bahts on foreign exchange markets Used $5 billion in hard currency in this effort

And raising domestic interest rates from 10 to 12.5% However, Thailand was quickly running short of U.S.

dollars As the speculation continued, Thailand had just over $1

billion left to support the Baht. And, the higher interest rate raised the cost of

borrowing and adversely affected Thailand’s floating rate U.S. dollar loan liabilities.

Bottom line: Defending the peg was nearing impossible.

Releasing the Peg On July 2, 1997, the Thai government announced

they were abandoning the peg and would let the currency float. The Baht immediately lost 18% of its value against the dollar By January 1998, it was trading at 55 to the dollar.

Contagion Effect in Asia The attack on the Thai Baht, quickly spread to other

Asian currencies. This is an example of a regional contagion effect

Concern mounted regarding the economic and financial “soundness” of other Asia Pacific countries as well.

As a direct result, many of these Asian countries were forced to abandon their pegged regimes for floating or managed regimes. Malaysia is an exception as it restores a peg but eventually it

moves to a managed float. See the following slides for these exchange rate changes.

For a complete discussion of the crisis see: http://www.wright.edu/~tran.dung/asiancrisis-hill.htm

Indonesia Rupiah, Jan 1997 – Dec 1997

Philippine Peso, Jan 1997 – Dec 1997

Taiwan Dollar, Jan 1997 – Dec 1997

Korean Won, Jan 1997 – Dec 1997

Malaysian Ringgit, Jan 1997 – Dec 1997

Malaysian Restores its Peg: 1997 – June 2005

Malaysia Moves From a Peg to a Managed Float: July 21, 2005

Exchange Rate Changes in Asia: June 1997 to June 1998

Some Asian Governments, However, Were Able to Successfully Defend Their Currencies Hong Kong Dollar is successfully defended:

China’s monetary authorities purchase massive amounts of common stock being sold on the Hong Kong stock exchange. They do this to offset the selling of hedge funds and thus

stabilize common stock prices. China also sold U.S. dollars into the foreign exchange

markets in defense of the Hong Kong dollar. They do this to offset speculator short selling of the Hong

Kong dollar on foreign exchange markets. Throughout the crisis, the Hong Kong dollar peg was

successfully defended and the peg remains today.

Hong Kong Dollar During the Asian Currency Crisis (1997): Hardly a Ripple