International Fixed Income
Topic 6A: Currency Crises
1
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)
2
I. Currency Crisis
a 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(?) )
time
» withdrawal from peg into float
» withdrawal from convertibility into exchange controls
3
Review of XR Regimes
Source: IMF publications, 1997
4
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
5
The Attack
for a speculative attack may vary
What is common?
Reasons/triggers
» 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”
6
Factors Affecting Speculative Attacks
Factors
»
»
»
»
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
»
»
»
»
»
which increase the sustainability of a pegged rate
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)
7
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
8
0
4/1/2000
1/1/2000
10/1/1999
7/1/1999
4/1/1999
1/1/1999
10/1/1998
7/1/1998
4/1/1998
1/1/1998
Example: Brazilian Real (1998-…)
2.5
2
1.5
1
Bz. Real
0.5
9
4/1/2000
1/1/2000
10/1/1999
7/1/1999
4/1/1999
1/1/1999
10/1/1998
7/1/1998
4/1/1998
1/1/1998
Example: Brazilian Real (1998-…)
2.5
30
2
25
1.5
20
15
1
0.5
5
0
0
Bz. Real
Brady Yield
10
10
Example: Brazilian Real (1998-…)
2.5
60
2
50
40
1.5
30
1
20
0.5
Bz. Real
Brady Yield
Bz. Int. Rte
10
4/1/2000
1/1/2000
10/1/1999
7/1/1999
4/1/1999
1/1/1999
10/1/1998
7/1/1998
4/1/1998
0
1/1/1998
0
11
Example: Brazil -- 9/13/1998
Reserves:
declined from $80Bil to $55Bil. $1Bil/day
outflow rate that week
Stockmarket: 75% lower y.t.d., 35% over the previous
month
Int Rate:
from 30%pa to 50%pa (approx. 5-7%
inflation). Currency overvalued (?).
Deficit:
8% of GDP
Political scene: election was in 3wks
Effect on the US: 15th largest trading partner, 1.7% of
trade
12
Contagion
do we mean by “CONTAGION EFFECT” ?
Study examines crisis index in the post MexPeso collapse
What
INDEX=a*(currency depr) +b*( loss in reserves)
Index
rises for countries w/ highly overvalued RXR, low
reserves, and a recent lending boom
==> The “Tequila Effect” is not random
Some debate still exists
Source: Sachs, Tornell & Valasco, “Financial Crises in EM: lessons from 1995”,
Brookings Papers on Economic Activity N0.1 1996, 147-215
13
Correlation breakdown
Event
Date
Variables
Prior to
During
ERM
Sep92
GBP/$ , GBP LIBOR
-0.10
0.75
Mexico
Dec94
Peso/$ , 1mo Cetes
0.30
0.80
87 crash
Oct87
Junk yield , 10yr Treasury
0.80
-0.70
Iraq
Aug90
10yr JGBs , 10yr Treasury
0.20
0.80
Asian
Crisis
1997/8
Brady debt of Bulgaria and
the Philippines
0.04
0.84
14
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!
15
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.
16
III. Examples
ERM
crisis
Peso crisis
Russian debt default (during Asian Contagion)
17
A. ERM crisis
1979
Exchange Rate Mechanism (ERM) led to stable and
narrow target zones among European countries
In 1992-93, however,
18
Implied vol: the GBP crash of 1992
DM/L
19
80
70
60
50
40
30
20
10
0
4/3/2000
10/3/1999
4/3/1999
10/3/1998
4/3/1998
10/3/1997
4/3/1997
10/3/1996
4/3/1996
Russia, $-denominated 3%, 2003
Russia Bond
20
Cetes & Currency
9
8
7
6
5
4
3
2
1
0
Cetes-91
Cetes-182
MP/$
N
ov
-9
4
Ja
n95
M
ar
-9
5
M
ay
-9
5
Ju
l -9
5
Se
p95
N
ov
-9
5
Ja
n96
90
80
70
60
50
40
30
20
10
0
21
0
