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Explore how markets attack currencies, reasons for currency attacks, conditions necessary for success, examples of past attacks, importance of peg regime, and the impact of abandoning a peg. Learn about attacking overvalued and undervalued pegged currencies.
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INBU 4200INTERNATIONAL FINANCIAL MANAGEMENT Lecture 2: Read on Your Own The International Monetary System: Attacking Currencies
Purpose of These Slides • To demonstrate how markets 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 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. • 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. • Likely to be 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 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 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. • Open capital and currency markets. • Funds must be able to flow into or out of a country. • Stock markets and currency markets. • It would be somewhat difficult to attack the Chinese currency today. • Financial markets are still tightly controlled and not very open.
Attacking a Overvalued Pegged Currency • Attacks on an Overvalued Currency: • 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 selling stock short on country stock markets. • Provides them with needed foreign exchange (in pegged currency) and potential profits if currency weakens.
Attacking a Undervalued Pegged Currency • Attacks on an Undervalued Currency: • Currency is bought (long) on foreign exchange markets. • Speculators buy currency, and intend to sell it later when currency strengthens. • Speculators buying stock (long) on country stock markets. • Potential profits when currency strengthens.
Essential Assumption Before Attack will Proceed • In addition to the previously discussed conditions, the speculators must also be confident that the government of the country’s who’s currency is under attack: • lacks the will to defend its currency. • Not willing to adjust interest rates • lacks the resources to defend its currency. • Does not have sufficient foreign exchange to support its currency. • Would need dollars if currency is being sold.
British PoundAttack(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. • The British pound was locked into the German Mark at a central rate of about DM2.9/£ • Generally 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. • Thus, the German mark was the dominant currency in this arrangement. • 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 German interest rates.
Series of Events Leading Up to the Attack on the Pound • While the markets felt the pound was “overvalued” when it joined the ERM, a combination of events just before and after Britain joined convinced the market that the pound was 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. • German decided to raise interest rates in order to attract needed capital for the reunification of Germany. • The issue for the U.K. was having to raise interest rates during their recession. • Political and economic component to this decision.
Response of British Government to Speculative Attack: September 1992 • Pound currency attack begin in September 1992 • Led by hedge funds: George Soros. • Wednesday, September 16 (“Black Wednesday”) • Raised interest rates twice from 10% to 12 and then to 15% • Attempt to make U.K. investments more attractive. • During the attack the Bank of England spent 4 billion pounds ($7 billion) in defense of its currency. • Buying pounds (selling U.S. dollars and German marks). • Estimates: 1/3 of its hard currency was spent. • Thursday, September 17, U.K. left the exchange rate mechanism and let the pound float! • From 2.7780 (ERM floor) to 2.413; or -13.1%
Pound Against the U.S. Dollar: 1992 • Down by 25%: What did this mean for U.S. Companies operating in the U.K.?
Asian Currency Crisis of 1997: Background • During the 1980s, a group of countries in Southeast Asia – known as the “Asian Tigers” – experienced exceptionally high economic growth rates. • The economic miracle was accompanied by these countries opening up their financial markets to foreign capital inflows • Also, during this time, the currencies of these countries were pegged to the U.S. dollar.
Thailand: Background • Thailand was part of the southeast Asian region which experienced double digit real growth up to the mid-1990s. • Exports were critical to the regions exceptional growth. • Thailand’s exports had increased 16% per year from 1990 to 1996. • Economic growth in the region was fueled by massive increases in borrowing. • Government borrowing for infrastructure investment • Corporate borrowing for investment expansion.
The Thai Baht The Thai baht had been pegged to the U.S. dollar at 25 to the dollar for 13 years.
Thailand Begins to Unravel • The massive increase in investment eventually resulted in: • Overcapacity • Poor lending/investment decisions • Investment in speculative activities (especially the 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 • Currency traders were aware of the following: • Thailand’s enormous external debt which was denominated in U.S. dollars would require a large demand for dollars. • Coupled with the debt burden, Thailand’s export growth began to slow and moved into deficit. • Where would the dollars come from the finance the external debt? • Traders believed the baht was “overvalued at 25 to the dollar.
The Attack on the Thai Baht Peg • Believing the Baht was overvalued, speculators: • Start to sell the Baht short in May 1997 • Traders borrowed Bahts from local banks and immediately resold them in the foreign exchange markets for dollars. • 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 the Baht on foreign exchange markets • Used $5 billion in this effort • Raising interest rates from 10 to 12.5% • Thailand was quickly running short of U.S. dollars • They had just over $1 billion left to support the Baht. • The higher interest rates raised the cost of borrowing and adversely affected floating rate loan liabilities. • Bottom line: Defending the peg was nearing impossible.
Releasing the Peg • On July 2, 1997, the Thai government announced they were abandoning the peg and would let the currency float. • The Baht immediately lost 18% of its value • By January 1998, it was trading at 55 to the dollar.
Contagion Effect in Asia (1997) • The attack on the Thai Baht, quickly spread to other Asian currencies • Regional contagion effect • Concern mounted regarding the economic and financial “soundness” of these countries as well. • As a direct result, many of these Asian countries were forced to abandon their pegged regimes. • For a complete discussion of the crisis see: • http://www.wright.edu/~tran.dung/asiancrisis-hill.htm
Some Governments, However, Were Able to Successfully Defend Their Currencies • Hong Kong Dollar • China purchase massive amounts of stock being sold on the Hong Kong stock exchange. • Offset the short selling of hedge funds. • China sold massive amounts of U.S. dollars in defense of the HK$ • Offset the selling of the Hong Kong dollar on foreign exchange markets. • The HK$ peg was successfully defended and remains so today.
