9 (20) Exchange Rate Crises: How Pegs Work and How They Break
1. Discovering Data From Figure 2-4(13-4) in Chapter 2(13), identify
three countries with fixed exchange rates. Now use the Internet to
search for and visit the websites of each of these countries’ central
banks and download the latest balance sheet information. For each
of the three central banks, answer the following questions.
Answer: Answers will depend on the countries chosen as well as the
years. Here we use Denmark, Venezuela, and Hong Kong to
illustrate a wide range of pegs in terms of stability. Unless
otherwise stated the following numbers are all in millions. All items
were retrieved in April 2017 and reflect data at the end of 2016.
a. What is the size of the central bank’s balance sheet in local
currency (i.e., total assets or total liabilities)?
Country
Size of Balance Sheet
Denmark
DKr 2,252,579
Venezuela
Hong Kong
VEF 15,169,233
HK$20,654,286
b. On the liability side, what is the base money supply in local
currency issued by the central bank (call it Mbase)?
Mbase
Country
Denmark
DKr 1,730,023
Venezuela
Hong Kong
VEF 12,316,553
HK$2,213,970
c. On the asset side, what is the quantity of foreign
exchange reserves in local currency held by the central
bank (call it R)?
Country
R
Denmark
DKr 454,565
Venezuela
VEF 106,336 ($1 = VEF 10.2)
Hong Kong
HK$2,908,876 ($1 = HK$7.69)
d. What is the central bank’s backing ratio (R/Mbase)?
Finally, given the balance sheet positions and backing ratios of these central
banks, discuss their ability to defend their pegs.
Answer: The backing ratios are listed below. It is clear that Hong Kong, which runs a
currency board, has sufficient foreign reserves to back its currency in nearly any
crisis, as it has more than 100% of the monetary base backed with foreign
currency. Denmark represents a relatively stable peg with a fairly large buffer of
foreign reserves (about a quarter of its monetary base) available. Venezuela has
the least of these three and unsurprisingly has had the least stable peg. At the time
of retrieving these data, Venezuela had recently devalued its peg and is still facing
an enormous amount of pressure to do so again as black market rates for U.S.
dollars per bolívar have crashed well below the official rate.
Country
R/Mbase
Denmark
26.28%
Venezuela
Hong Kong
8.63%
132%
2. The economic costs of currency crises appear to be larger in emerging markets and
developing countries, than they are in advanced countries. Discuss why this is the
case, making reference to the interaction between the currency crisis and the financial
sector. In what ways do currency crises lead to banking crises in these countries? In
what ways do banking crises spark currency crises?
Answer: Developing countries and emerging markets are less likely to have sound
institutions of macroeconomic policy and financial markets. Also, these countries are
more likely to adopt a fixed exchange rate regime because the benefits are relatively
greater than those in advanced economies. The situation is exacerbated by the fact
that private sector, particularly banks, as well as the governments in these countries,
borrow in the international markets in dollars, and thus accumulate dollardenominated liabilities. Because of all the aforementioned factors, these countries are
more likely to suffer from all three types of crises: exchange rate, banking, and
sovereign default. Therefore, there is potential for feedback between the three crises,
resulting in twin crises or triple crises. Currency crises can lead to financial crises
because changes in the value of the currency affect the local currency value of dollardenominated debt. Banks’ dollar-denominated liabilities relative to local currencydenominated assets suddenly blow up, leading to large-scale banking sector
insolvency. Financial crises in turn can lead to currency crises because during a
banking crisis (or default crisis), the central bank is pressured to expand the money
supply to bail out weak banks (or the government). This ultimately reduces the value
of the domestic currency. As the exchange rate is expected to depreciate, investors
dump domestic currency assets in exchange for foreign currency, which leads to loss
of foreign reserves and an eventual abandoning of the peg.
3. Using the central bank balance sheet diagrams, evaluate how each of the following
shocks affects a country’s ability to defend a fixed exchange rate.
In the following answers, we assume the central bank keeps domestic credit
unchanged whenever possible. See the following graphs.
a. The central bank sells government bonds.
Answer: The central bank must allow its reserves to increase by the amount of
domestic credit contraction. We see from the diagram that this moves the country
further from the floating line, improving its ability to defend the peg.
b. Currency traders expect a depreciation in the home currency in the future.
Answer: This is a sort of speculative attack, in this case, the country is hurt from
decreased demand for its assets. Traders will sell the home currency and buy foreign
currency, so the central bank’s reserves and money supply decrease. This hurts the
country’s ability to defend the exchange rate peg.
c. An economic contraction leads to a change in home money demand.
Answer: The decrease in money demand will lead to a decrease in interest rates
and depreciation of the currency unless the central bank intervenes in the forex
market. In this case, the central bank must sell foreign currency reserves and buy
domestic currency, reducing its reserves and contracting the money supply. This hurts
the country’s ability to defend the exchange rate peg.
d. The foreign interest rate falls.
Answer: This increases domestic money demand, so the central bank must
intervene in the forex market, buying foreign reserves and selling domestic currency,
expanding the money supply. This increases reserves, therefore improving the
country’s ability to defend the peg.
4. What is a currency board? Describe the strict rules about the composition of reserves
and domestic credit that apply to this type of monetary arrangement.
Answer: A currency board forces the central bank to maintain a backing ratio of
100%. The country’s money supply is entirely backed by foreign currency reserves,
so it has no domestic credit (M = R). This means that the central bank cannot buy or
sell domestic credit. All money demand shocks are fully absorbed in reserves. In the
simple model of the central bank balance sheet, this is the furthest a central bank can
be from the floating line, making it impossible for the currency to float unless the
country decides to do away with the board itself.
5. What is a lender of last resort and what does it do? If a central bank acts as a lender of
last resort under a fixed exchange rate regime, why are reserves at risk?
Answer: A lender of last resort provides credit to banks that are either insolvent or
suffering from illiquidity. When a central bank serves as a lender of last resort to
private banks, it will expand domestic credit when the banking system is struggling.
To defend the exchange rate peg, this expansion of domestic credit implies that
reserves are reduced. Therefore, each time the central bank extends credit, this
reduces its ability to defend the peg.
6. Suppose that a country has a local currency known as the dollar, its money supply is
$1,500 million, and its domestic credit is equal to $1,000 million in the year 2015.
The country maintains a fixed exchange rate, the central bank monetizes any
government budget deficit, and prices are sticky.
a. Compute total reserves for the year 2015 in dollars. Illustrate this situation on a
central bank balance sheet diagram.
Answer: M = 1,500 and B = 1,000. Therefore, R = 500 (point A on the following
diagram).
b. Now, suppose the government unexpectedly runs a $200 million deficit in the
year 2016 and the money supply is unchanged. Illustrate this change on your diagram.
What is the new level of reserves?
Answer: The deficit is financed through the central bank buying government
bonds. B = 1,200 and R = 300.
c. If the deficit is unexpected, will the central bank be able to defend the fixed
exchange rate?
Answer: Yes. The central bank has sufficient reserves to defend the exchange
rate peg.
d. Suppose the government runs a deficit of $200 million each year from this point
forward. What will eventually happen to the central bank’s reserves?
Answer: Each year, reserves will decline by $200 million and domestic credit
expands by the same amount. This process continues until reserves diminish to 0
(point E on the following diagram). This will happen in the third year.
e. In what year will the central bank be forced to abandon its exchange rate peg and
why?
Answer: After 3 years, the country would be forced to float.
f. What if the future deficits are anticipated? How does your answer to part (e)
change? Explain briefly.
Answer: If the future deficits are anticipated, then investors know that the
currency will remain fixed 4 years from now, and from then on will keep
depreciating. This will raise domestic interest rates when currency floats
accompanied with a fall in money demand. There will be a sudden loss of reserves
and a rise in exchange rate. To avoid the loss of currency’s value, therefore, investors
will liquidate their domestic currency holdings in advance and therefore the central
bank will run out of the reserves in advance of 3 years. The economy will move to
point E in fewer than 3 years.
7. Consider two countries with fixed exchange rate regimes. In one country, government
authorities exert fiscal dominance. In the other, they do not. Describe how this affects
the central bank’s ability to defend the exchange rate peg. How might this difference
in fiscal dominance affect the central bank’s credibility?
Answer: If a country has fiscal dominance, the central bank is forced to finance
budget deficits through buying government bonds. This expands domestic credit,
depleting reserves. Once reserves reach 0, the country is forced to float. If the country
does not exhibit fiscal dominance, then when the government runs deficits, the central
bank need not finance these deficits, so the composition of the money supply is left
unaffected. Also, if investors know that one country has fiscal dominance and another
does not, they are more likely to anticipate depreciation in the country with fiscal
dominance, knowing that deficits will deplete reserves. This could lead to a positive
currency premium and a higher interest rate for this country and hurt its economy.
The government may be forced to float its currency merely because of the investors’
depreciation expectations. On the other hand, if investors believe the central bank is
independent of the government, they are less likely to anticipate depreciation, making
it easier to defend the peg.
8. A peg is not credible when investors fear depreciation in the future, despite official
announcements. Why is the home interest rate always higher under a noncredible peg
than under a credible peg? Why does that make it more costly to maintain a
noncredible peg than a credible peg? Explain why nothing more than a shift in
investor beliefs can cause a peg to break.
Answer: The home interest rate is always higher under a noncredible peg because
there is a positive probability that the currency may depreciate, giving rise to an
expected depreciation. In addition, the uncertainty of the exchange rate also makes
currency holding risky. Therefore, due to the above two factors, investors require a
currency premium to hold domestic assets (i.e., to prevent them from buying foreign
currency and selling domestic currency). If the peg is credible, investors do not
require this premium, so i = i*. This means that is it more costly to defend a
noncredible peg. The required contraction in output is higher because the central bank
will have to contract the money supply by more to drive up interest rates. From
Figure 9-17 (20-17) in the textbook, we can see that there are two possible equilibria
(in Zone II). The actual outcome for the economy depends on investors’ beliefs about
the peg.
9. You are the economic advisor to Sir Bufton Tufton, the prime minister of Perfidia.
The Bank of Perfidia is pegging the exchange rate of the local currency, the Perfidian
albion. The albion is pegged to the wotan, which is the currency of the neighboring
country of Wagneria. Until this week both countries have been at full employment.
This morning, new data showed that Perfidia was in a mild recession, 1% below
desired output. Tufton believes a downturn of 1% or less is economically and
politically acceptable but a larger downturn is not. He must face the press in 15
minutes and is considering making one of three statements:
a. “We will abandon the peg to the wotan immediately.”
b. “Our policies will not change unless economic conditions deteriorate further.”
c. “We shall never surrender our peg to the wotan.”
What would you say to Tufton concerning the merits of each statement?
Answer: Each statement is designed to either affect or address investors’
expectations.
a. By abandoning the peg, the central bank is free to conduct monetary policy to
push the economy closer to full employment, through the expansion of domestic
credit and the money supply. The prime minister might do this for one of two reasons.
First, the 1% output gap is in fact too large for his taste. The data may be revised to
indicate it is actually larger. Second, the prime minister anticipates that investors will
view the peg as not credible, realizing there is no purpose in defending it. Recall that
defending a noncredible peg is more costly than defending a credible one. However,
if the prime minister believes the costs of the peg are smaller than the benefits, he
should not make this statement.
b. This statement is designed to reassure investors that the peg is credible because
the cost of the output gap is smaller than the benefit of pegging. The benefit of this
statement is that it conveys to investors that they should view the peg as credible. If
the prime minister wants to maintain the peg, then this statement will help to reassure
investors. The drawback of this statement is that it reminds investors of the contingent
commitment and clearly defines the terms. If further data are released in the coming
days to indicate the situation is worse than expected, a speculative attack will surely
follow.
c. This statement has a similar effect to the previous one, but it too has pros and
cons. First, this statement is a stronger commitment to the peg, possibly staving off a
speculative attack if bad economic news arrives in the coming days. If the benefits
from the peg are substantially higher than even further output gaps, this statement is
likely to help by stabilizing exchange rate expectations. The investors will believe
that the government will fight with all its might to defend the currency. If the benefits
are not substantially larger, investors are not likely to believe this statement. They
know that there are conditions under which the prime minister will abandon the peg.
Therefore, this statement may not help if investors do not take the prime minister’s
statements as rational or believable.
10. What steps have been proposed to prevent exchange rate crises? Discuss their pros
and cons.
Answer: The propositions are as follows:
• Impose capital controls to stop the outflow (or restrict the inflow) of foreign
capital to prevent speculative attack. However, capital flows are hard to control, and
by controlling capital flows the country may lose its reputation of open capital
markets, which can hurt future capital inflows
• Commit to either a floating or a fixed exchange rate, but do not attempt to
maintain an intermediate regime because this creates added uncertainty, potentially
driving up the currency premium. However, this also implies that the country loses
the flexibility that comes with dirty float, that is, the ability to fix exchange rates as
well as manage its money supply from time to time.
• Abandon the fixed exchange rate and switch to float. Floating exchange rates are
not subject to speculative attacks, so the central bank need not have monetary policy
dictated by the maintenance of foreign reserves. Floating exchange rates can,
however, hurt trade in goods and services from its trading partners in particular if the
country’s trade is large relative to its GDP—this is one reason for the euro’s
existence.
• If a fixed exchange rate is preferred, then a hard peg (currency board) is the best
way to defend the peg because the money supply is composed entirely of foreign
reserves. This means that neither fiscal nor monetary policy makers can damage the
peg’s credibility through poor policy decisions. But this does not allow any monetary
policy flexibility, and sometimes the cost of currency board in terms of domestic
economic contraction may get too high. Example: Argentina in the late 1990s—it
eventually dissolved its currency board, in 2002.
• Work toward improving the institutions of macroeconomic policy and financial
markets to reduce the risks associated with exchange rate pegs/crises. This is a longterm policy and cannot be utilized in the short run.
• Establish a lender of last resort to loan foreign currency reserves during a crisis.
This will help to defend the peg in case of a temporary crisis, mitigating its negative
economic effects. The International Monetary Fund (IMF) can lend foreign currency
to countries to help defend the peg during a crisis. However, having a safety umbrella
with an expected bailout in case of crises can lead to countries engaging in excessive
external borrowings and the private sector getting into risky investments.
• Accumulate reserves as insurance against a crisis. With large volumes of reserves,
in some cases exceeding the money supply, the country is in a better position to
defend the peg. However, only countries that have current account surpluses can
successfully accumulate reserves. If the country as a whole is a borrower, it is hard
for its central bank to be a lender.