International Fixed Income

1. International Fixed Income Topic 6A: Currency Crises

2. Outline • Description • Effect on international bond market • local currency • $-denominated • Examples • ERM crisis (1992) • peso crisis (12/94) • russian default (8/98) • Asian currency crisis (1997-98) (see http://www.stern.nyu.edu/~nroubini/asia/AsiaHomepage.html)

3. I. Currency Crisisa First Look • Central bank uses reserves to maintain XRs within a band • For various reasons • Domestic money demand falls Dom inflation, loss of competitiveness, economic slow-down, corporate failure, foreign withdrawals (political turmoil) AND/OR • Domestic money supply rises Fiscal financing via printing, excess dom credit • Central bank loses reserves • Crisis ( when reserves are exhausted(?) ) • withdrawal from peg into float • withdrawal from convertibility into exchange controls time

4. Review of XR Regimes Source: IMF publications, 1997

5. Currency Crisis: Uncertainty • Non-zero minimal reserve threshold • There may be an outside infusion (IMF aid, hence negative minimal level) to allow more time for correcting macroeconomic measures ==> Peg may survive an attack

6. The Attack • Reasons/triggers for a speculative attack may vary • What is common? • Investors are rational and forward looking • When expected (risk adjusted?) return on DomXR lower than FX, investors/speculators sell DomXR and reserves decline • As a defense, domestic interest rates often rise. Then it is the question of the probability, size and timing of the devaluation • Investors see the end-game, and try to switch from high yield domestic into hard currency just at the right time • w.r.t. timing, look for “coordination signals”

7. Factors Affecting Speculative Attacks • Factors which increase the sustainability of a pegged rate • Large stock of reserves • Low domestic rate of credit creation • High demand for domestic money (high income / low interest rates) • Low expected inflation in the case of a collapse • Factors contributing to a currency crisis • Overvalued domestic currency • <==> Large and persistent current account deficit • Excess credit creation (vulnerable banking system => liquidity crunch) • Low FX reserve relative to short term sovereign debt (liquidity) • Conflict in the gvm’t policy objectives (government needs to subject dom monetary policy & resulting implications to pegging partner’s currency fluctuations. May result in loss of competitiveness, slowdown, unemployment ==> politically unsustainable)

8. Predictive Currency Crisis Variables • Rank leading indicators based on • Probability of crisis given indicator signal • Avg. number of month prior to signal that indicator signal is issued • Persistence of signal ahead of crisis • Most prominent signals • Hard currency reserves • Real exchange rates • Domestic credit • Credit to the public sector • Domestic inflation • Interest rate differential widens • Equity crash Source: Kaminsky, Lizondo & Reinhart, “Leading indicators of Currency Crisis,” IMF WP 97/79, July 1997

9. Example: Brazilian Real (1998-…)

10. Example: Brazilian Real (1998-…)

11. Example: Brazilian Real (1998-…)

12. Example: Brazil -- 9/13/1998 • Reserves: declined from $80Bil to $55Bil. $1Bil/day outflow rate that week • Stockmarket: 75% lower y.t.d., 35% over the previous month • Int Rate: from 30%pa to 50%pa (approx. 5-7% inflation). Currency overvalued (?). • Deficit: 8% of GDP • Political scene: election was in 3wks • Effect on the US: 15th largest trading partner, 1.7% of trade

13. Contagion • What do we mean by “CONTAGION EFFECT” ? • Study examines crisis index in the post MexPeso collapse INDEX=a*(currency depr) +b*( loss in reserves) • Index rises for countries w/ highly overvalued RXR, low reserves, and a recent lending boom • ==> The “Tequila Effect” is not random • Some debate still exists Source: Sachs, Tornell & Valasco, “Financial Crises in EM: lessons from 1995”, Brookings Papers on Economic Activity N0.1 1996, 147-215

14. Correlation breakdown

15. Loose Ends • Selection bias: a currency crisis may or may not have developed (country may take pain now to avoid more pain in the future) • How far is down? • Currency likely to overshoot if/when devaluation occurs • Exactly by how much is critical for speculator’s profitability calculations • Speculators solve for: • Expected gain given a crisis VS expected loss w/o one • Function of size, magnitude and timing of crisis • Has a structural change in crises occurred (IMF role) ? ===> PROFITABLE TRADING strategies may exist!

16. II. International Bond Pricing • Two primary effects • Default premia for emerging market countries goes up. (See next page graph from last class on Cetes and Tesebonos). • Currency premia (from expected devaluation) goes up. (See next page graph from last class on Cetes and Tesebonos). • Both of these lead to increases in the bond’s “yield”, i.e, a severe drop in the bond price. • Secondary effect (though potentially important) • Impact on US market via “financial crisis”. • Contagion effect across other markets facing similar issues. • Liquidity effect.

17. III. Examples • ERM crisis • Peso crisis • Russian debt default (during Asian Contagion)

18. A. ERM crisis • 1979 Exchange Rate Mechanism (ERM) led to stable and narrow target zones among European countries • In 1992-93, however,

19. Implied vol: the GBP crash of 1992 • DM/L

20. Russia, $-denominated 3%, 2003

21. Cetes & Currency