Chapter 5 - Currency Crises

ECO 402AH - Spring 2023

LAU Byblos

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I- Introduction

Currency crisis represents a sudden drop in the confidence to a given currency

leading to a speculative attack against it and to its devaluation or depreciation.

Currency crises often result from inconsistent and non transparent economic
policies, which can increase market uncertainty and trigger a speculative attack
against the domestic currency.

Can also be due to institutional and structural variables and over-borrowing of the
public and private sectors.

Broadly speaking, domestic macroeconomic factors, external sector factors, public

finance, and global factors can all have a role in causing a currency crisis.
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I- Introduction

Economic costs of currency crises:

-Output decline and income contraction

-Higher inflation
-Higher unemployment
-Lower real wages
-Negative fiscal implications (of higher debt burden and financial sector
restructuring)

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II- Theoretical models of currency crises

• Three generations of theoretical models have attempted to explain the onset and
development of currency crises.

• The first-generation models were built after the balance-of-payment crises in

Mexico, Argentina, and Chile in the1970s and the early 1980s.

• The second-generation models were stimulated by the ERM crisis in 1992 and the
Mexican crisis of 1994–1995.

• The third-generation models emerged after the Asian crisis of 1997–1998.

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II- Theoretical models of currency crises
First-Generation Models:

• Mundell (1960) developed a balance of payments model: one of the first attempts to
explain the interdependence between the ability to maintain a currency peg and the
level of the international reserves of a central bank.

• Krugman (1979) elaborated the first version of the first generation models inspired
by Mundell’s model and the work of Salant and Henderson (1978).

• Krugman’s model has been refined later by Flood and Garber (1984) and others.

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II- Theoretical models of currency crises

• According to the first generation models, currency crises stem from fundamental
inconsistency between domestic economic policies.

• Meaning, the attempts to maintain a fixed exchange rate by the central bank by
controlling the supply of money are contradicted by the perseverance of money-
financed budget deficits by the government (expansionary policies).

• Such policy inconsistency can be for a while of no great concern if the monetary
authority/the central bank possesses sufficiently large reserves, but when these latter
are perceived inadequate by speculators then there will be a wave of currency selling.

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II- Theoretical models of currency crises
• So when reserves drop to some critical/dangerous level there would be a sudden
speculative attack on the currency that would rapidly push those reserves further to a
very low level and force the abandonment of the fixed exchange rate regime.

• This is because the ability to maintain the peg is tightly related to the availability and
size of official foreign exchange reserves.

• The speculative attack against the exchange rate leading to a currency crisis is
therefore provoked by the anticipation of depletion of central bank’s international
reserves resulting from an expansionary macroeconomic policy incompatible with a
peg exchange rate (i.e. excessive fiscal deficit, being monetized by monetary
authorities).

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II-Theoretical models of currency crises

• Thus, rational agents and speculators observing the pursuit of an expansionary

monetary policy can expect that there will be a decline in reserves and resulting
collapse of an exchange rate peg at some point in time.

• The Central bank is able to defend an exchange rate peg as long as it has reserves
and then has no choice but to allow an exchange rate to float freely.

• The lower or the smaller the stock of international reserves and/or the higher the rate
of domestic credit expansion, the shorter it takes before an exchange rate peg is
attacked and collapses and the opposite is true.

• In the absence of speculation, collapse of the peg exchange rates occurs after
depletion of reserves.
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II-Theoretical models of currency crises
Second-Generation Models:
Addressed serious drawbacks of the first generation models.

In the first generation models the governments and central banks were perceived as
defenseless, meaning once engaged in inconsistent macroeconomic policies (a policy
incompatible with maintaining the peg), they will face reserve depletion.

As a matter of facts, policymakers have more choices/decisions and can modify their
policies when balance of payments deteriorates or can devalue the domestic currency
without depleting the reserves.

The second-generation models allow therefore the governments to optimize their

decisions. (Not stick to pursued policy but get involved in market responses). 9
II-Theoretical models of currency crises

In reality, the government is not going to thoughtlessly keep on printing money to

cover a budget deficit, irrespective of the repercussions or external situation.

Nor the central bank is going to persistently sell foreign exchange to peg the exchange
rate until the last dollar of reserves is vanished.

Both the government and the central bank have a range of possible choices, policies,
and measures.

Governments can and do try to condition/adapt fiscal policies on the balance of

payments.

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II-Theoretical models of currency crises
Also central banks have a diversity of tools available to defend the exchange rate other
than intervening in the foreign exchange market, including the ability to tighten
domestic monetary policies and raise interest rates.

Undoubtedly there are costs to such policies and measures in face of the potential
benefits and therefore the defense of an exchange rate is a matter of trade-offs rather
than strictly and blindly selling foreign exchange until the reserve is depleted.

So the “second-generation” crisis models take these points into consideration and try to
correct the mentioned defects.

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II- Theoretical models of currency crises

The second-generation models were first proposed by Obstfeld (1994) and further
developed by Obstfeld (1997), Velasco (1996), Drazen (1999) and many others.

Unlike the initial models were fundamentals (of which fiscal and monetary policies) are
either consistent with a currency regime (peg) or not, fundamentals can be so strong and
still cannot prevent a successful attack on the currency, or can be so weak yet the attack
can be avoided.

This is to say speculators may or may not coordinate their actions in order to attack the
peg. Speculative attack on currency can develop either as a result of a predicted future
deterioration in fundamentals, or purely through self-fulfilling prophecy/prediction
( something that would justify investors’ pessimism).
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II- Theoretical models of currency crises

The crisis then has to do with the trade-off between the costs of maintaining the fixed
rate and the cost of abandoning it.

Deteriorating trade off (when costs exceed benefits) could mean that at some future date
the country is inclined to devalue irrespective of any possible speculative attack.

Realizing this, speculators would try to get out of the currency ahead of that devaluation
and by this would worsen further the government’s trade off, leading to an earlier
devaluation.

The government could therefore be forced to abandon its fixed exchange rate due to a
speculative attack that made defending the rate too expensive.
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II- Theoretical models of currency crises

The government could have a motive to allow its currency to depreciate

-to reduce its large debt burden denominated in the domestic currency and
-reduce unemployment by adopting a more expansionary monetary policy that
could not do as long as committed to a fixed exchange rate.

The government could choose instead to defend a fixed rate

-on the belief it facilitates international trade and investment and ensures price
stability

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II- Theoretical models of currency crises
Third-Generation Models:

Krugman (1999), Aghion et al (2001), Chang and Velasco (1999) and others

Focus on microeconomic weaknesses like moral hazard-driven lending by weakly

regulated banks and the resulting over-borrowing which can trigger in an environment
of high capital mobility speculative attacks against the existing exchange rate regime.

Expected failure of banks and expected government rescue operations would mean
anticipated fiscal costs of financial restructuring and its partial monetization. Thus,
microeconomic weaknesses and banking problems plus monetary and fiscal factors
lead to speculative attacks.
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II- Theoretical models of currency crises
Highlight private-sector balance sheets, especially financial and non financial firms
with foreign-currency debt.

A currency depreciation set off by speculative attack would sharply worsen balance
sheets, as the domestic currency value of foreign-currency debt rose.

This in turn would damage the real economy, through the deleveraging process
depressing investment, which would feed back into further currency depreciation, and
so on.

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III-Relationship between Banking and Currency Crises
Banking -----Currency
• Expectations that concerned authorities will prevent the
financial system from collapse following a banking crisis,
and bail it out by expansionary policies, putting therefore
pressure on the exchange rate and leading to a
depression or devaluation.
• Bank panics and runs on domestic banks means deposit
withdrawals and conversion of money into hard currency,
again putting therefore pressure on the exchange rate
and leading to a depression or devaluation.
• A banking crisis harms credit relations, deteriorates the
financial position of domestic firms and generates
economic slowdown and a sharp drop in available
profitable investment opportunities. This drive foreign
investors to withdraw their assets resulting in massive
capital outflow and currency collapse
Currency -----Banking
• Sharp depreciation or devaluation of the currency
deteriorates the financial situation of firms with large
unhedged foreign exchange liabilities (with large currency
mismatch in their balance sheets), thus affecting
negatively the liquidity and solvency of banks.
• Currency devaluation increases expected inflation and
thus ultimately interest rates that would increase the
debt burden on firms. The banking system will be affected
through an increase in non performing loans.
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IV-The Exchange Rate Mechanism (ERM) Crisis of 1992-93
-In 1992 and 1993, many European countries adopting the Exchange Rate Mechanism
were attacked.

-In the fall of 1992, massive capital flows led to the exit of Britain, Italy, and Spain
from the Exchange Rate Mechanism of the European Monetary System.

-The exit from the ERM contributed to a boom in the UK economy (drop in
unemployment and low inflation) and pushed the British Pound above the rate at which
it originally exited.

-In the summer of 1993, a second wave of attacks led to a decision to widen the
exchange rate bands of that system, essentially to allow the French franc to depreciate
without any formal exit.
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IV- The Exchange Rate Mechanism (ERM) Crisis of 1992-93
-Then France, having been given this flexibility and margin for a somewhat weaker
franc, chose not to use it, returning to the original narrow band against the mark.

-The targeted and attacked European economies had:

- low and stable inflation before and after the currency crisis
- Full access to domestic and foreign capital markets: no problem with foreign
exchange reserves
- No rapid growth of domestic credit
- No need to monetize budget deficits

-Attacks have been related therefore to growing belief among speculators that the
targeted economies had motivation for devaluation and thus established large short
positions to profit from a potential collapse of the exchange regime.
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IV-The Exchange Rate Mechanism (ERM) Crisis of 1992-93
-The motivation for devaluation was unemployment given inadequate demand, and the
resulting pressure on monetary authorities to engage in expansionary policies (that could
not be pursued as long as the European countries remained committed to a fixed
exchange rate).

-The unemployment problem relates largely to Germany reunification after the fall of
the Berlin Wall and the pursue of an expansionary fiscal policy which was faced with a
tight monetary policy by the German central bank (The Bundesbank).

-Other European countries in the ERM, pegging to the mark given that it was a key
currency of system, found themselves forced to coordinate the tight monetary policy
short of the fiscal expansion; thus they were pushed into recession and unemployment.

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IV-The Exchange Rate Mechanism (ERM) Crisis of 1992-93
-Attacked countries like Britain and Italy had considerable foreign exchange reserves
and were also entitled under ERM rules to credit lines from Germany.

-Such countries were therefore able to engage in direct foreign exchange intervention on
a very large scale to defend the currency and to use the tool of higher interest rates to
that purpose.

-However the motivation for abandoning the fixed parity ultimately dominated the
decision to maintain the peg.

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V-The Latin Crisis of 1994-95
The Latin crisis of 1994-95 had similarities and dissimilarities to the ERM crisis.

Many Latin America countries like Mexico and Argentina had overvalued currencies
before the crisis, associated with low growth and high unemployment, large current
account deficits, and costs and prices out of line with those of trading partners.

This would mean there has been a room for monetary expansion but this was
constrained by the desire to maintain the peg.

Still government officials were repeatedly claiming that devaluation was not an option
nor under consideration, and the financial markets trusted them.

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V-The Latin Crisis of 1994-95
Mexico had before its currency crisis:

-Political uncertainty (the peasant rebellion in Chiapas and the assassination of the
ruling party’s presidential candidate)

-Relaxed monetary and fiscal policy or discipline in the run-up to the presidential
election in 1994.

-Drying up foreign capital inflows and rapid decline in foreign exchange reserves.

-Inability to roll over the Tesobonos, dollar-denominated short-term debt.

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V-The Latin Crisis of 1994-95
-External pressure on the currency driving the government to devalue the Peso by 15
percent.

Such devaluation was widely perceived by investors as inadequate and the initial little
devaluation was followed by an almost complete loss of confidence in the Mexican
currency and policies. The peso quickly fell to half its pre-crisis value.

This led to rise in import prices and in the rate of inflation, which had previously
fallen to low single-digit levels.

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V-The Latin Crisis of 1994-95
In an attempt to stabilize the currency and the inflation rate, the government raised
domestic interest rates to very high levels (above 80 percent).

High interest rates resulted in sharp contraction in domestic demand, and thus real GDP
dropped by 7 percent in the year following the crisis.

Fears that the crisis would undermine Mexico’s economic and political stability and
affect adversely the US, led the United States to engineer a massive international loan to
the Mexican government to restore confidence and stimulate growth.

The financial support has been effective: by 1996 economic growth was resumed, and
the country regained normal access to international capital markets. This allowed
Mexico to repay the emergency loan ahead of schedule.
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V-The Latin Crisis of 1994-95
Argentina:
Had a currency board system/regime, with the peso tightly linked to the dollar at a
one-for-one parity, and with every peso in the monetary base backed by a dollar of
reserves.
Speculators attacked the currency and aroused capital outflows believing that
Argentina might soon abandon the currency board in order to lower the unemployment
rate.
The capital outflows under the currency board system led to a quick fall in the
monetary base. This, in turn, created a crisis in the banking system, which contributed
to a severe economic downturn.
International official loans were required to support and stabilize the banking system.
In 1996 Argentina also resumed economic growth.

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VI-The Asian Currency Crisis of 1997
Pre- crisis observations:

-Very large current account deficits.

-High growth record.

-Financial weaknesses: heavy investment in highly speculative real estate ventures,

financed by borrowing either from foreign sources or by credit from under-regulated
domestic financial institutions.

- Warnings from the IMF and the World Bank to the governments of Thailand, Malaysia,
and other countries of the risks posed by their financial situation and urged corrective
policies.
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VI-The Asian Currency Crisis of 1997

Near –crisis observations:

-Export slowdown in the region, due to the appreciation of the dollar (to which the target
currencies were pegged) and to unfavorable developments in key industries, due to,
among other things, growing competition from China.

-Lower exports and more apparent real estate build up preceded the bursting of the
bubble . Dropping real estate prices pulled down stock prices and adversely impacted
the solvency of financial institutions and created a financial distress.

-Few month before the currency crash, speculators began to wonder whether the
financial crisis of Southeast Asian countries, especially Thailand, might incite these
countries to devalue in the hope of stimulating the economy. 28
VI-The Asian Currency Crisis of 1997

-Growing belief that such a move to stimulate the economy is a high probability, even
with government insistence that it was not, led to widening interest premiums.

-Larger premiums increased the pressure, by adding deflationary momentum and

creating cash flow problems for financially stressed firms.

The crisis:

On July 2 1997, the government of Thailand surrendered to the pressure and ended its
determination to maintain the fixed exchange rate for the baht after months of
declaring that it would not abandon the peg.

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VI-The Asian Currency Crisis of 1997
The Thai currency rapidly depreciated by more than 20 percent and within a few days
most neighboring Asian countries (Malaysia, Indonesia and Philippines) had been
forced in face of speculative attacks to follow the Thai move and devalue their
currencies.

What compelled Thailand to devalue its domestic currency was huge speculation
against the baht, that over a few months only exhausted most of what originally
seemed to be a large accumulation of foreign exchange reserves.

Lack of confidence and expectation that the baht will be devalued drove speculators to
bet against the currency of Thailand and to flee it.

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VI-The Asian Currency Crisis of 1997
-In an effort to regain the lost confidence, involved countries imposed new fiscal
austerity measures.

-Thailand received an emergency loan from the IMF conditional upon cleaning up of
its financial system.

-South Korea had severe internal financial problems and a massive current account
deficit…

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