Currency Crisis
Trade, investment, current account. How they lead
into disaster
Currency crisis
Today‘s topics
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Basics of exchange rates
Anatomy of a breakdown: Russian Crisis 1997/98 as a
typical example of a currency crisis
How do currency crisis appear
How to avoid crisis an step by step approach as proposal
Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Currency crisis
Balance of payments‘ influence
last two lectures: balance of payment as a RESULT of
economic action.  ceteris paribus view.
There are factors influencing the balance of payments AND
the balance of payments is influencing such factors itself
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inflation rates. Imported goods can be cheaper, to much capital = money is
available through inflow
saving rate. As of the inflow of cheap foreign capital there is not a high pressure
on domestic saving (investment)
exchange rate. Changes lead to distortions of real import/export demand
Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Currency crisis
Basics about exchange rates
if saying, the balance of payment influences and is influenced
by the exchange rate, we need some facts about exchange
rates.
In general there are two types of exchange rate regime. All thinkable
systems are a mixture of them:
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fixed exchange rate regimes
flexible (free floating) exchange rates
Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Currency crisis
System of fixed exchange rates
A Central Bank (or Central Banks) declare, that there is a
certain exchange rate between currencies
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However real economic development can show, there is
more demand for one currency than for another.  its price
(exchange rate) would rise.
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As this is not allowed by treaties, the Central Bank has to
act to keep the rate stable.
Advantage: Stability in planning. Disadvantage: real economic development
is braked out.
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Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Currency crisis
System of free exchange rates
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In such a system, currencies float freely against each other.
This does not mean, that there’s no influence on the
exchange rate by central banks. In opposite, there is
evidence, that western central banks were much more active
on international markets AFTER Bretton Woods break down
In such a system especially smaller states are in danger of
speculative attacks. Politics is exposed highly to the world
markets
Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Currency crisis
Current situation
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Major currencies as the US$, EURO, £, Japanese ¥, Swiss
Franc are free floating against each other.
Most of the other states bound their currency at least to
some extend to one of these currencies
Markets are highly speculative, even against big players like
EU(2010), Japan (2011)
Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Currency crisis
Case: Russia 1997/1998
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After the hard transformation shock in Russia, the
government managed to stabilize the Ruble by 1996.
After stabilizing the Ruble it was bound to the US Dollar to
create trust in the Russian currency. (domestic and abroad)
Government was running large deficits (Tax base broke
together, as about 50% of GDP was lost!)
Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Currency crisis
Case: Russia 1997/1998 (2)
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After stabilizing the ruble, the government tried to finance
itself by issuing ruble bonds, as well as bonds in Dollar.
(before they financed themselves by central bank!
Inflation)
The demand for Russian bonds in Russia (as trust came back
through stabilized Ruble) and abroad (as of the exchange
rate aim) rose strongly!
Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Currency crisis
Case: Russia 1997/1998 (3)
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Starting by almost zero the foreign debt of the Russian state
grew fast (in Rubles AND US Dollar), as government stayed
deep in deficits.
Given the bond situation Russia developed into a promising
Emerging market. A lot of foreign capital was invested in
Russia
Portfolio investment in Russia rose from practically zero in
1995 to almost $100 billion in 1997
Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Currency crisis
Case: Russia 1997/1998 (4)
Current Account
100000
80000
60000
Current
Account
40000
20000
0
-20000
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95 97 99 01 03 05 07
Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
As we can see in the
graph of yesterday:
The high foreign
investment rate
brought Russia’s
Current Account
(=Capital Account) into
deficit! (Although there
was high export of raw
materials!)
07.04.2011
Currency crisis
Case: Russia 1997/1998 (5)
As we saw yesterday: the absorption power of a young
transformation country is quite low.
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remember: danger in stage one: fixed exchange rate and high interest rate lead to a to
high inflow of foreign capital, that can not be invested properly (foil 14)
the strong capital inflow created a bubble at stock exchange
(from January 1996 to August 1997 the RTS raised by
326%!)
Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Currency crisis
Way into crisis
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We saw: the capital inflow to Russia was highly dependent
on the rate of the ruble. However through the bad situation
of the public households there was a latent pressure on
depreciation
in July 1997 the financial crisis of Asian “Tiger states “
(Thailand, Indonesia, South Korea, Singapore) started. (the
problems, that led into this crisis are very similar to the
Russian ones)
Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Currency crisis
Way into crisis (2)
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As of the Asian Crisis all other Emerging Markets were
checked upon risks
Investors started to mistrust the situation in Russia and
started to retract capital from Russia (from August 1997 till
July 1998 the RTS lost 80%!)
As consequence of the break down in Asia, the prices for raw
material were declining by more than 30% worsening the
Russian Current Account
Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Currency crisis
Anatomy of a brake down
As of the fleeing capital in 1998 Russian government came
into problems in refinancing.
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trust in the stability of the ruble rate was lost  currency risk growing, the
attractivity of Russian state bonds shrinking
to be able to refinance, the interest rates had to be risen. End of 1997 the interest
rate was already at 20% in May 1998 it reached 150%!!!
through this development the real interest rates at banks
rose up to more than 40%, destroying most credit financed
firms in need of re financing
Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Currency crisis
Anatomy of a brake down (2)
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The consolidation of state household was stopped through
this development, as the credit costs rose extremely and the
tax incomes broke away
To sum it up: international capital flew the country, interest rates for
the state and firms rose largely, the raw material prices broke down,
firms went bankrupt at large number, the state had to stop payments
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Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Currency crisis
Free floating as a way out?
Why not just to give the exchange rate into free floating to
ease the pressure?
protecting interests of stakeholders
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private investors. Last capital inflow would come to an end as of risk
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banking sector. Loss at share market! Financed at large scale in foreign credits!
AND invested largely in the insurances against exchange rate risks (forward
contracting). These amounted to a sum of 3 times (!!!) of the banks total assets!
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state. The states incomes are in rubles. However there is a large foreign debt in
Dollars. A sharp depreciation drives the costs up sharply thus
Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Currency crisis
August 17th 1998 and the consequences
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Finally Банка России could not stand the pressure and
to abandon the fixed rate of the ruble
within a short time the ruble lost about 75% of its value
30.00
$/RR rate
20.00
10.00
$/RR rate
0.00
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07.04.2011
Currency crisis
Consequences
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The Russian government declared the state as bankrupt and
set a moratorium of 3 months within which no payment
towards the debt would be done
The state declared short run ruble debt as long run and
refused to repay them in the short run
A hair cut (currently discussed in Greece) towards foreign
currency debt was inacted
Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Currency crisis
Consequences (2)
Foreigners being invested in Russian Dollar bonds directly
lost money through the hair cut
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Foreigners being invested in RR bonds lost through the
limitation in money disposability. Even worse was the loss
through exchange rate changes. Although they had done
forward contracts
 The trust in investments in Russia was largely destroyed
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Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Currency crisis
Consequences (3)
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As of high exchange rate risk deals (re financing in Dollar,
forward contracts in RR) and as of the brake down of the
RTS as well as the bankruptcy of the state the banks lost
almost all their assets
Russians started to retract all their assets from the banks, so
the banking system broke down completely
As of this no credits could be given to companies any they
went bankrupt
Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Currency crisis
Consequences (4)
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Taking data of the World Bank 15 of the biggest 18 Russian
banks went bankrupt and still were insolvent in 2002! Just
by Russian laws avoiding the break down of insolvent banks
(and firms) they could continue working
The central bank took its responsibility as a lender of last
resort and avoided the total break down by lending money
to the banking system
Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Currency crisis
Russian crisis – a very specific one?
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We took the example of the Russian crisis, however it is
typical for capital account / current account driven
currency crisis in Emerging Markets. (like in Asia (1997),
Argentina (2002), Mexico (1994) etc.)
We could show clearly how important it is to observe the
rational development as we modeled it yesterday and act as
stabilizing politics.
Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Currency crisis
Anatomy of Currency Crisis
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Emerging markets are opening to world financial markets
High growth rates with high potential of profits
FIXED EXCHANGE RATES eliminating risks of losses
World financial markets insert huge amounts of capital
Banking system in Emerging Markets are usually inefficient
Ability to absorb capital to low (not enough projects)
Capital flows into consummation
Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Currency crisis
Anatomy of Currency Crisis (2)
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As of consummative credits and usually high deficits of the
state the productivity of the capital shrinks. The economy is
vulnerable.
If an asymmetric shock appears, investors get into panic, as
they notice the risk at once. They retract their capital at once to
keep their values.
A herd effect appears leading to a break down of share markets,
credit markets, banking system and the ability of the government
to re finance itself
Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Currency crisis
Emerging Markets – helpless to the markets?
For emerging markets it‘s without alternative to open themselves to
the world markets to develop. (need for capital, need for export
markets) However opening should be done carefully
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As capital inflows are important, they should be allowed,
however we have seen: speculation causes huge damage!
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example Chile: to avoid speculative capital each foreign capital importer had to
pay 30% of the investment amount to a non interest account at central bank.
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restriction to invest in share markets, but free access to FDI (China)
Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Currency crisis
Domestic capital market.
However regulation ALWAYS causes distortions and there
are always detours to avoid them.
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Chile/ China: taking a domestic investor „on the paper“
Main problem: greed. Wanting to much to fast (+easy for
government).
As we saw, the key problem is the inefficient domestic
capital market, not being able to absorb the foreign capital
Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Currency crisis
Ways to avoid a currency crisis – step by step
The way to avoid a crisis is preparing a country for the entry on
world markets. Let‘s develop some proposed steps:
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Consolidate state finances, build up reliable state institutions
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Subsidize industries which are able to sell their products on
world markets. They should develop technically as well as
economically
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Open the good‘s markets
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Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Currency crisis
Ways to avoid a currency crisis – step by step (2)
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Adopt the fixed exchange rate in regular distances. Most
likely it will rise.
Open the country to investments in production (however
NOT in the industries you subsidized before)
Develop a banking system with strong rules concerning risk
control of credits given.
After stabilizing state finances and building up a risk adverse
banking system and stabilizing currency by fixed exchange rate,
ease the monetary policy  lower interest rates
Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Currency crisis
Ways to avoid a currency crisis – step by step (3)
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( the last point is only possible if there is a appreciating
pressure on the local currency, which should appear through
successful exports)
Observe the situation in the banking system after expansive
monetary policy. (IMPORTANT STEP!) Goes the money
available into desirable projects or mainly into
consummation?
If it goes into consummation: Adjust the system above and
improve the banking system
Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Currency crisis
Ways to avoid a currency crisis – step by step (4)
if it goes to profitable projects and is not given away at large
scale for consummation: open the country for portfolio
investments
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As the profits realizable in the country will be high, there could be a tax on
buying portfolio investments implemented to avoid short run speculation
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Minimal holding times could be implemented
Check the behavior of the banking sector again.
if it works properly: open to international credit markets
Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Currency crisis
Switch to free floating
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By following the steps, which can take 10 years or even
more, the country should be able to go on a sustainable path
into world markets
As the country now gained enough trust through its rational
behavior, the fixed exchange rate should be abandoned in
steps, taking away the risk of distortions in the exchange rate
A currency crisis is avoided
Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Currency crisis
Conclusion
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Free market powers can sharply damage emerging markets
through imbalances in Capital and Current Account
Currency crisis can lead to a total break down of economic
activity
A way out is, to develop sustainable structures and prepare a
country carefully before opening to the world markets
Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011
Thank you very much for your
attention!
Email: thomasstiegler@gmx.de
Tel: 898 3443 6308
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Dipl.- Kfm. Thomas Stiegler, University of Göttingen.
07.04.2011