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