Chapter 7 Currency Crises and Financial Volatility

1. The World Bank Chapter 7Currency Crises and Financial Volatility © Pierre-Richard Agénor

2. Sources of Exchange Rate Crises • Currency Crises: Recent Experiences • Currency and Banking Crises • Predicting Financial Crises • Sources and Effects of Financial Volatility • Coping with Financial Volatility

3. Sources of Exchange Rate Crises • Inconsistent Fundamentals • Rational Policymakers and Self-Fulfilling Factors

4. Inconsistent Fundamentals • Conventional or first-generation model of currency crises was formulated by Krugman (1979) and Flood and Garber (1984). • Single (tradable) good, full-employment, small open-economy model with exogenous output. Assumptions: • Foreign-currency price of the good is fixed and domestic price level is equal to the nominal exchange rate due to purchasing power parity. • Perfect foresight agents hold three categories of perfect substitutes assets: domestic money, and domestic and foreign bonds.

5. Demand for money depends positively on output and negatively on the domestic interest rate. • Uncovered interest parity equates the domestic interest rate to the foreign rate plus the expected rate of depreciation of the nominal exchange rate. • There are no private banks, so that the monetary base is equal to the sum of domestic credit issued by the central bank and the domestic-currency value of foreign reserves held by the central bank. The central bank pegs the exchange rate through unsterilized intervention. • Domestic credit expands at a constant growth rate to finance the government budget deficit.

6. . d =  > 0, . i = i* + e. md = p + y - i,  > 0, hs = d + (1 - )R, 0 <  < 1, p= e, md: nominal money demand; p: price level; y: real output; hs: nominal supply of base money; d: domestic credit; e: spot exchange rate; i*: constant foreign interest rate; i: domestic interest rate; R: domestic-currency value of the foreign reserves held by the central bank.

7. . m - e = y - e. • Assume  = 0 and ms = 2hs: ms = d + R. • Money market equilibrium: ms = md = m. • Assume i* = 0:

8. . . R = - . - m = e + y. - • When exchange rate is credibly fixed at e = e, e = 0: • Under a fixed-exchange-rate regime, the rate of depreciation is zero and real money balances are also constant because output is constant. • In this case official reserves and growth rate of it: - R = y + e - d,

9. For the nominal money supply to remain constant and ensure equilibrium of the money market, official reserves must fall at the same rate as the rate of credit expansion. • When  > 0, any finite stock of official reserves will be exhausted in a finite period of time. • Once foreign reserves reach a lower bound (Rmin) the central bank will be unable to defend the prevailing parity and will be forced to abandon the pegged-rate regime: natural collapse.

10. With  > 0, rational agents will anticipate that, without speculation, reserves will eventually fall to the lower bound, and will therefore foresee the ultimate collapse of the system. • At that point, the rate of depreciation will jump from zero to a positive value; i will jump upward, and md will fall. • To maintain money market equilibrium, the real money supply must also fall; and because the nominal money stock cannot change in a discrete manner, the nominal exchange rate must undergo a step depreciation. • Rise in prices imposes therefore a capital loss on agents holding domestic-currency assets.

11. Speculators endowed with perfect foresight will not wait passively to absorb the capital loss; they will attempt to reduce their holdings of domestic assets and in the process will force a crisis before the lower bound on reserves is reached. • Issue: determine the exact moment at which the fixed-exchange-rate regime is abandoned or, equivalently, the transition time to a floating-rate regime. Flood and Garber (1984): this transition time can be calculated through a backward-induction process:

12. In equilibrium, under perfect foresight, agents can never expect a discrete jump in the level of the exchange rate, because a jump would provide them with profitable arbitrage opportunities. • So arbitrage in the foreign exchange market requires the exchange rate prevailing immediately after the attack to be equal to the fixed rate prevailing at the time of the attack. • Time of collapse is found at the point where the shadow floating rate, the exchange rate that would prevail if reserves had fallen to the minimum level and the exchange rate were allowed to float freely, is equal to the prevailing fixed rate.

13. Time of collapse: tc = (R0 - Rmin)/  - , R0: initial stock of reserves. Implications: • The higher R0, the lower Rmin, or the lower , the longer it will take for the collapse to occur. • With no speculative demand for money ( = 0) the collapse occurs when reserves are run down to Rmin.

14. The interest rate (semi-) elasticity of money demand determines the size of the downward shift in money balances and reserves that takes place when the fixed exchange-rate regime collapses; • nominal interest rate jumps to reflect an expected depreciation of the domestic currency; • the larger  is, the earlier the crisis. • The speculative attack always occurs before the CB would have reached the minimum level of reserves in the absence of speculation.

15. Stock of reserves just before the attack: Rtc = Rmin+ . - • Figure 7.1: The path continuing through point A corresponds to the natural collapse ( = 0). • At that point the rate of depreciation of the exchange rate jumps from zero to  and the domestic interest jumps from i* to i* + . • Expected capital loss leads to a speculative attack. - • e remains constant at e until the collapse occurs and begins depreciating smoothly at point B.

17. The domestic interest rate, as a result of the interest parity condition jumps by  at the moment the attack takes place (from F to F`). • Prior to the collapse, the money stock is constant. • In the postcollapse regime, the money stock is equal to Rmin plus domestic credit, and grows also at the rate  . • After speculative attack both reserves and the supply of money fall by  . • The size of the attack,  , corresponds exactly to the reduction in money demand induced by the upward jump in the domestic interest rate.

18. Extension (Agénor and Flood, 1994): • nature of the fiscal constraint that underlies the assumption of an exogenous rate of credit growth and the factors that may prevent policymakers from adjusting their fiscal and credit policies to prevent a crisis; • nature of the postcollapse exchange-rate regime; • output, real exchange rate, and current account implications of an anticipated exchange-rate crisis; • role of external borrowing and capital controls; • uncertainty over the critical threshold of reserves and the credit policy rule.

19. Ozkan and Sutherland (1995): fixed exchange rate system can survive longer with capital controls. But anticipation of controls may have exactly the opposite effects. • Dellas and Stockman (1993): possibility of introducing capital controls may generate self-fulfilling crises. Introduce uncertainty on domestic credit growth: • sharp increases in domestic nominal interest rates that often precede an exchange-rate crisis can be explained.

20. Other implications: • The transition to a floating-rate regime becomes stochastic and collapse time becomes a random variable that cannot be determined explicitly. • There will be a nonzero probability of a speculative attack in the next period, a possibility that in turn produces a forward discount on the domestic currency (peso problem). • Reserve losses tend to exceed increases in domestic credit because of a rising probability of regime collapse. • Reserve depletion tends therefore to accelerate prior to the regime change (as observed in actual crises).

21. Key assumption of the conventional model: money supply falls, in line with money demand, at the moment the currency attack takes place. • But if reserve losses are completely sterilized, there will be no discrete jump in the money supply. Flood, Garber, and Kramer (1996): • In such conditions a fixed exchange rate regime cannot be viable; as long as agents understand that the central bank plans to sterilize an eventual speculative attack, they will attack immediately. • By adding a risk premium, fixed exchange rate can remain viable under sterilized intervention.

22. Risk premium adjusts to keep the mdconstant when the attack occurs, just as sterilization maintains ms constant. • Problem: since ms does not change and e cannot jump, the domestic interest rate cannot jump either (in contrast to empirical evidence). • Evidence: currency crises tend to be preceded by a real exchange rate appreciation and growing current account deficits.

23. Extension of the model to explain these facts (Willman, 1988): • Assume: two goods, one tradable the other nontradable; nontradable sector prices are set as a markup over wage costs; and nominal wages are forward looking. • Anticipated future depreciation of the nominal exchange rate will translate into higher nominal wages and higher prices of nontradables today. • Because prices of tradables remain fixed until the actual regime change, the real exchange rate appreciates.

24. This reduces the relative price of importables and thus leads to increased imports and a growing current account deficit prior to the collapse.

25. Rational Policymakers and Self-Fulfilling Factors • Problem with the conventional model: exact timing of an exchange rate crisis may be difficult to pin down if the inconsistency between fiscal and exchange rate policies is conditional or contingent on the occurrence of a speculative attack. • Key feature of the second-generation literature on currency crises: explicit modeling of policymakers' preferences and policy rules.

26. Policymakers: deriving benefits from pegging the currency and also facing other policy targets (accumulation of foreign reserves, a high level of output, low unemployment, and low domestic interest rates). • Depending on the circumstances, they may find it optimal to abandon the official parity. • Abandonment of the peg is the result of the implementation of a contingent rulefor setting the exchange rate. • Each period, the policymaker considers the costs and benefits associated with maintaining the peg for another period, and must decide whether or not to abandon it.

27. This decision depends on the realization of a particular set of domestic or external shock. • Obstfeld (1995): illustrates self-fulfilling crises and multiple equilibria. • Log of output: y = - (w - e) - u,  > 0. (w - e): real wage; e: log of nominal exchange rate. It is equal to log of domestic price level due to PPP assumption. u: serially independent shocks.

28. Nominal wages are set before the demand shock is observed. Constant expected real wage: w = E-1e, E-1: expectations operator conditional on information available at period t-1. • Policymaker’s loss function: L = (1/2)(y - y)2 + 2/2,  > 0, y: desired level of output; : inflation. ~ ~

29. First term: cost of deviations from the desired level of output; • Second term: cost of deviating from zero inflation. Implications: • Under a discretionary policy regime, a fixed exchange rate prevails in equilibrium only if inflation is infinitely costly. • Economy is characterized by a systematic devaluation bias.

30. But although a precommitment to a fixed exchange rate would eliminate the devaluation bias, it would also prevent the policymaker from responding to unpredictable shocks to output. There is therefore a trade-off between credibility and flexibility. • In choosing whether or not to maintain a fixed exchange rate or to devalue, the policymaker will select the alternative that minimizes its loss. • Decision to devalue takes place whenever the policy loss associated with maintaining the exchange rate fixed exceeds the total loss associated with a realignment. • Potential for self-fulfilling speculative attacks arises from a circularity problem.

31. Threshold point U that determines whether the policymaker devalues, depend on prior expectations of depreciation; in turn, these expectations depend on market perceptions of where U lies. • Shift in market expectations, or in the cost of devaluing, c, can lead to a change in the position of U and to a currency crisis. Figure 7.2: • Possibility of multiple devaluation trigger points. • If the private sector adopts the high value u* as the value that will trigger the abandonment of the fixed-exchange rate rule, then high u* will also solve the policymaker's optimization problem.

33. Similarly, if the private sector adopts the low value u* as the value that it believes will induce an exchange rate regime switch, then it will also be optimal for the policymaker to adopt it as well. • Thus, the economy can jump from one equilibrium to another; the shift in perceptions that triggers the jump can be completely unrelated to the behavior of macroeconomic fundamentals. • Increase in the cost of abandoning the peg may increase the likelihood of a crisis. Other sources of policy trade-offs on self-fulfilling crises: • Agénor and Masson (1999): adverse effects of high interest rates.

34. Example: banks may come under pressure if market interest rates rise unexpectedly. • To avoid a costly bailout, policymakers may want to implement a quick devaluation. • Calvo (1998) and Sachs, Tornell, and Velasco (1996a): it is a large volume of short-term debt (in domestic or foreign currency) that puts a country's exchange rate peg in a vulnerable position. • Large stock of domestic-currency short-term debt: • generate doubts about public-sector solvency; • raise fears that the authorities may inflate to reduce the real value of public debt;

35. impose constraints on the ability of policymakers to use high interest rates to fend off speculative attacks. • These factors may lead creditors to refuse to rollover the existing stock of debt and may increase the currency's vulnerability. • Large stock of foreign-currency short-term debt: • raise concerns about external solvency. • When short-term foreign debt to official reserves ratio is high, the risk of short-term liquidity problems may increase the vulnerability of the exchange rate to a sudden shift in expectations or perceptions.

36. Implications: • Flow measures of the adequacy of reserves and vulnerability and long-term solvency indicators have limited usefulness as indicators of exchange rate vulnerability relative to stock measures. • Alternative indicator of short-term vulnerability (Calvo, 1998) is the ratio of broad money to official reserves. • But, this indicator may also understate potential exchange market pressures if, for instance, holders of short-term domestic public debt become concerned about the sustainability of the exchange rate or about the government's ability to service its debt.

37. Generally: possibility of self-fulfilling crises makes any pegged rate regime precarious. • Fundamentals affect the multiplicity of equilibria. • But the policymaker is incapable of enforcing its preferred equilibrium should market expectations focus on an inferior one. • Sunspots could shift the exchange rate from a position where it is vulnerable to only very bad realizations of domestic and external shocks to one where output is so low absent a devaluation and a fall in real wages that even relatively small shocks will induce policymakers to devalue.

38. Two important issues remain: • Obstfeld (1995): if currency crises are viewed as a manifestation of possible multiple equilibria, there are no convincing explanations of the mechanisms through which market expectations coordinate on a particular self-fulfilling set of expectations. • Second, the evidence on the role of self-fulfilling factors in exchange rate crises remains limited.

39. Currency Crises: Recent Experiences • The 1994 Crisis of the Mexican Peso • The Thai Baht Crisis

40. The 1994 Crisis of the Mexican Peso • Between 1988 and 1993, macroeconomic stabilization and economic reform in Mexico led to a sharp reduction in inflation and an improvement in the operational balance of the public sector (Figure 7.3). • Key factor in bringing down inflation: exchange rate policy, which involved the fixing of the Mexican peso-U.S. dollar exchange rate in December 1987, followed by a preannounced narrow margin crawling peg and the adoption in November 1991 of a crawling peg with adjustable bands. • Figure 7.4.

45. Nominal depreciation over the period was not sufficiently large to prevent a growing appreciation of the real exchange rate. • Figure 7.5. • Surge in capital inflows led to a significant increase in gross international reserves. • In order to sterilize capital inflows, the authorities issued large amounts of short-term treasury bills Certificados de Tesoreria or Cetes bonds) denominated in pesos.

48. Large capital inflows continued, after the approval of NAFTA. As a result, the interest rate differential between Cetes bonds and interest rates in the United States declined significantly (Figure 7.6): • Currency risk indicator: interest rate differential between Cetes and Tesobonos (short-term dollar liabilities repayable in pesos); • Default risk indicator: Tesobono-U.S. certificate of deposit rate differential. • Expansion in domestic credit and relaxation of the fiscal stance and a series of adverse political events brought the Mexican peso under severe pressure in the second quarter of 1994.