MSc Financial MarketsFinancial Markets and

RegulationMSc Finance

Financial Markets and CrisesProfessor Anne C. Sibert,

Birkbeck, University of LondonAutumn 2014

Speculative Attacks

Speculative attack on the Icelandic krona

Central Bank of Iceland

A fundamental theorem of international finance

• A country with a fixed exchange rate and mobile capital cannot follow an independent monetary policy.

• The only exception is if a country has an important reserve currency it might be able to follow an independent monetary policy in the short run. (US during the Bretton Woods system)

Simple central bank balance sheet

ASSETS• Government

securities• Foreign exchange

reserves

LIABILITIES• Commercial bank

reserves• Currency

The money supply comes into being in two ways:

•The government conducts an open-market operation, buying government securities and selling domestic currency. Money that comes into being this way is called domestic credit. In some cases private sector securities are also used.

•The government intervenes in the foreign exchange market, buying foreign exchange for home money.

The government tries to follow an independent monetary policy

ASSETS• Government

securities ↑• Foreign exchange

reserves

LIABILITIES• Commercial bank

reserves• Currency ↑

Suppose that the government tries to follow an independent monetary policy by increasing domestic credit. It conducts an open-market operation and buys government securities and sells domestic currency. Money that was in the hands of the central bank is now in the hands of the private sector.

If the government does not do something, its currency will

depreciateASSETS• Government

securities ↑• Foreign exchange

reserves ↓

LIABILITIES• Commercial bank

reserves• Currency ↑↓

To maintain its pegged exchange rate the government must intervene in the foreign exchange market, selling its foreign exchange for money. Money is thus taken out of the hands of the private sector and the money supply returns to its original level.

The only effect is to increase government securities and shrink foreign reserves.

If the foreign reserves become low enough, the government will have to devalue.

So, why would a country want a fixed exchange rate?

• Floating exchange rates are volatile and can be a source of shocks.

• Since you cannot follow an independent monetary policy, a fixed exchange rate is a way to commit to low inflation.

Why would a country fix its exchange rate and then increase its domestic

credit?• The usual reason is that the country has

to finance a fiscal deficit, which it does by issuing government bonds.

• If the central bank buys some of these bonds then the government does not have to pay them back.

• As we just saw, the central bank will have to intervene and sell foreign reserves.

• Thus, the country is financing its fiscal deficit by drawing down its reserves.

Black Wednesday

• On 16 September 1992, the government withdrew the pound from the Exchangre Rate Mechanism (ERM) of the European Monetary System (EMS) after being unable to keep sterling above its floor.

• The Treasury spent £27 billion in reserves in a vain attempt to prop up the pound.

• George Soros made over £1 billion short selling sterling.

Some other examples of recent collapses

• Mexico reportedly ran down $25 billion in reserves and borrowed $25 billion more but was unable to prevent the collapse of the peso in 1994.

• Iceland attempted to peg the krona at 131 kr. per euro on 7 October 2008. It abandoned the peg the next day and the euro depreciated to 340 kr. per euro.

It is almost always feasible to prevent a speculative attack

• If a country has or can borrow enough foreign reserves to buy back its monetary base, then it is always possible to maintain a fixed exchange rate.

• But buying back your monetary base is contractionary and most policy makers do not have the will to do this.

• Some countries try to prevent speculative attacks by instituting capital controls.

Explaining speculative attacks

• There are three generations of models. The first shows how speculative attacks can depend upon fundamentals and shows how reserves can vanish almost instantly. [But this is best shown on a white board.]

• The second demonstrates that the same set of fundamentals can lead to multiple outcomes.

• The third considers how a particular outcome in a multiple outcome scenario might arise.

A second generation model

• Consider a stylised economy with two investors. • The central bank has pegged the exchange rate at

one unit of home currency = one unit of foreign currency.

• Each investor has 10 units of domestic currency that he can trade for foreign currency.

• The central bank has R units of foreign currency (its reserves) that it can use to defend the fixed exchange rate.

• It costs an investor one unit of currency to attack the pegged exchange rate.

• If the pegged exchange rate collapses, then it is devalued by 50 percent.

Payoffs• An investor who does not attack gets a payoff of zero.• Any investor who attacks must pay one unit of home

currency. (Perhaps this because he gets a less favourable interest rate.)

• In a successful attack, investors convert R units of domestic currency into R units of foreign currency. The home currency depreciates by 50 percent and the foreign currency can be converted back to 3R/2 units of home currency. Thus, investors end up with 3R/2 – R = R/2 more units of foreign currency then they started with.

• In one investor participates in a successful attack then his payoff is R/2 - 1. If two investors participate, they split the foreign exchange gain and each has a payoff of R/4 - 1.

The case of good fundamentals

• Suppose that R > 20. Then the two investors cannot force an attack.

• The payoffs are then 0 for any player who does not attack and -1 for any player who does attack.

• We can represent this simple game using a device called a game table.

The game with good fundamentals.

• Player 1 chooses a row; player 2 chooses a column.

• The payoffs are in the matrix.For example, if player 1 chooses Don’t Attack and player 2 chooses Attack, they get the payoff in the lower left box. Player 1 gets 0 and player 2 gets -1.

• The solution is simple: each player has a dominant strategy. That is, one that is best no matter what the other player does. They both play Don’t Attack.

AttacAttackk

DonDon’’tt

AttacAttackk

AttacAttackk -1,-1-1,-1 -1,0-1,0

DonDon’’tt

AttacAttackk

0,-10,-1 0,00,0

The case of bad fundamentals

• Suppose that R < 10. Then either player can launch a successful attack. Suppose that R = 8.

• The payoff is 0 for any player who does not attack.

• The payoff is 8/2 – 1 = 3 to any player who attacks alone.

• The payoff is 8/4 – 1 = 1 to any player who attacks with the other player.

The game with bad fundamentals.

• The solution is simple here as well. Both players have a dominant strategy: Attack.

• The exchange rate collapses.

AttacAttackk

DonDon’’tt

AttacAttackk

AttacAttackk 1, 11, 1 3,03,0

DonDon’’tt

AttacAttackk

0,30,3 0,00,0

The case of intermediate fundamentals

• Suppose that R = 16. No investor acting on his own can force a devaluation, but both acting together can.

• The payoff is 0 for any player who does not attack.

• The payoff is -1 to any player who attacks alone.

• The payoff is 16/4 – 1 = 3 to any player who attacks with the other player.

The game with intermediate fundamentals.

• The solution here is not quite so straightforward.

• If player 2 attacks, player 1 is best off if he attacks. (I underline 1’s payoff to indicate this)

• If player 2 does not attack, player 1 is best off not attacking.

• Player 1, does not have a dominant strategy.

• As things are symmetric, player 2 is best off if he attacks when player 1 attacks and not attacking when player 1 does not attack.

AttacAttackk

DonDon’’tt

AttacAttackk

AttacAttackk 33, 3, 3 -1,0-1,0

DonDon’’tt

AttacAttackk

0,-10,-1 00,0,0

Nash equilibria

• The two outcomes (Attack,Attack) and (Don’t Attack,Don’t Attack) have the property that each player is responding optimally to the other’s choice.

• Or, to put it another way, in these two outcomes, neither player regrets his decision.

• A Nash equilibrium is a list of strategies such that no player can be made better off by switching to a different strategy so long as all other players adhere to their strategy specified in the list.

Some properties of Nash equilibria

• The Nash equilibrium concept is named after the mathematician John Nash of A Beautiful Mind, who developed it in his doctoral dissertation at Princeton in 1949. He later shared a Nobel prize in economics for his work in game theory.

• As you can see, Nash equilibria are not unique: this game has two (three if we let the players randomise over strategies).

• A Nash equilibrium is not necessarily efficient, in the following sense. At the Nash equilibrium (Don’t Attack, Don’t Attack) both players could be made better off by playing (Attack,Attack).

This is similar to a bank run

• If one investor thinks that the other investor will not attack, then he should not attack.

• If one investor thinks that the other investor should attack, then he should attack.

• Thus, there are multiple outcomes associated with the same fundamentals.

A problem with this

• Neither player knows what the other player is going to do when he chooses his strategy.

• How do you respond optimally, when you don’t know what the other player is going to do?

• We did not have that problem with the games with good fundamentals and bad fundamental because each player has a dominant strategy.

• Here, it is not obvious that you would get the Nash equilibrium.

This type of game is known as a coordination game.

• Ken Binmore’s game

• Consider another game. A boy and a girl have agreed to meet for coffee, but there are two coffee shops and they forgot to agree on which one. Neither has a cell phone

StarbucStarbucksks

CostaCosta

StarbucStarbucksks

20,2020,20

0,00,0

CostaCosta

0,00,0 10,1010,10

Wouldn’t they both go to Starbucks?

• For this to be the likely outcome we need strong assumptions about the payoffs.

• Both the boy and the girl need to believe that Starbucks is best.

• They each need to believe that the other believes that Starbucks is best.

• They each need to believe that the other believes that the other believes Starbucks is best and so on. This is called common knowledge that Starbucks is best.

The game with intermediate fundamentals.

• One difference between this and the bank run game is that (Attack,Attack) is best for both, whereas, in the bank run the outcome where no one runs is probably better than the one where everyone runs.

• Wouldn’t both players here Attack? Again, we need common knowledge about the payoffs and if you think that there is a possibility that the other investor might mess up and play Don’t Attack, it is less risky to play Don’t Attack: your minimum loss is zero.

AttacAttackk

DonDon’’tt

AttacAttackk

AttacAttackk 3, 33, 3 -1,0-1,0

DonDon’’tt

AttacAttackk

0,-10,-1 0,00,0

Fundamentals

• In this little example I used reserves as the fundamentals because it made for nice algebra.

• Other fundamentals are macroeconomic variables and the government’s perceived will to support the currency.

Empirical Research

• Economists have not been successful at predicting currency crises.

• Berg and Pattillo (2000) reviewed the research and found that statistical models were able to predict about half the crises that occurred in sample, but only about one third that occurred post sample. In half the cases that a crisis was predicted, it did not occur.

• This is consistent with our story that the same set of fundamentals can be associated with or not associated with a crisis.

The third generation: focal points

• Two people have agreed to meet on Monday in New York City, but they have not specified where or when and cannot reach each other by phone or email.

• Any Nash equilibrium has the two people showing up at the same place at the same time. But, how can this happen.

• A New Yorker might feel that the natural place and time is under the clock in Grand Central Station at noon.

Convergence of beliefs

• It is not enough that each person knows that under the clock at noon it the right time and place. They must know that the other person knows this. And, know that the other person knows that they know this, and so on.

• “Under the clock at noon” is a focal point and their beliefs must converge on it.

Some focal points are natural

• Two players are shown a panel of four squares.

• Each independently selects one of the squares.

• If they both select the same square, then they both get a prize. If they select different squares, they do not get a prize.

• Three squares are blue; one square is red.

Some depend on culture or tradition

• A man and a woman play a game. Each is to name a number between zero and 100. If the numbers they choose sum to no more than 100, than each gets an amount of pounds equal to the number they named. Otherwise, they get nothing.

• Any outcome where the man chooses x and the woman chooses 100 – x, where 0 ≤ x ≤ 100, is a Nash equilibrium.

Fairness

• In most experiments with this game fairness is a focal point and the two players each ask for £50.

• But, imagine a patriarchical society where it is believed that men should get three times as much as women. If it were common knowledge that both players were from this society, the outcome might have women asking for £25 and men asking for £75.

Focal points and contagion

Often a currency crisis in one country is followed by a currency crisis in a similar country. This is called contagion.

Likewise, the failure of one bank could lead to a run on a similar bank.

Iceland

• Even if the Icelandic banks had been sound and there had not been a credit crisis, the Icelandic banks might not have survived.

• That Iceland did not have the foreign currency reserves to attack as lender of last resort might have coordinated investors on the run outcome.

The Asian Currency Crisis• On 14 and 15 May 1997, the Thai baht was the

subject of a speculative attack; the peg was abandoned on 2 July.

• In October 1997, the Hong Kong dollar was attacked. The government managed to defend the currency by raising overnight interest rates to 23 percent.

• After Thailand floated the baht, Indonesia's monetary authorities widened the rupiah’s band from 8 percent to 12 percent. A speculative attack occurred in August and the band was abandoned on 14 August.

• Did the abandoment of the Thai peg cause speculators to coordinate? Did the change in the rupiah’s band cause speculators to coordinate?

The ERM Crisis of 1992

• Fundamental cause: The reunification of Germany lead to higher interest rates in Germany and this led to pressure on the mark to appreciate against the other currencies.

• Focal points: A referendum in Denmark rejected the Maastricht Treaty and preliminary polls in France suggested that the vote there would be close.

Can central bank announcements coordinate expectations?

• “One peso, one dollar, full stop.” (Argentinian President Carlos Menem)

• Not a “scintilla of doubt about the pound”. Chancellor of the Exchequer Norman Lamont

Northern Rock

• On 12 September, the UK’s fifth largest mortgage lender, Northern Rock, was unable to refinance its maturing loans.

• If Northern Rock had been located in the euro area, it could have borrowed from the ECB using its good quality mortgages as collateral. But, as it was located in the United Kingdom it was forced to ask for a government bailout.

Did the government coordinate depositors?

• On 14 September, insisting that Northern Rock was solvent, the Chancellor authorised the Bank of England (as its agent) to make a loan to Northern Rock against appropriate collateral and at a penalty rate; the Bank of England announced that similar emergency funding would also be available to other institutions in similar circumstances.

• Their attention clearly focused by this usual action, Northern Rock depositors fled en masse on 17 September.

• Aside: Some might think the Finanical Services Authority indolent or ingenuous for standing by while Northern Rock introduced its “Together” mortgage range, which let first-time buyers borrow nearly six times their income and 125 percent of a property's value.