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Explore the effects of currency crises on the international bond market, analyzing examples like the ERM crisis, peso crisis, Russian default, and the Asian currency crisis. Understand the factors contributing to speculative attacks and predictive variables for currency crises. Learn how contagion effects and correlation breakdowns impact international bond pricing.
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International Fixed Income Topic 6A: Currency Crises
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)
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
Review of XR Regimes Source: IMF publications, 1997
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
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”
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)
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
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
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
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!
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.
III. Examples • ERM crisis • Peso crisis • Russian debt default (during Asian Contagion)
A. ERM crisis • 1979 Exchange Rate Mechanism (ERM) led to stable and narrow target zones among European countries • In 1992-93, however,
