Download An Attack on a Currency

INBU 4200
INTERNATIONAL
FINANCIAL
MANAGEMENT
Lecture 2, Appendix 1:
Speculative Attacks on Currencies
Purpose of These Slides

To demonstrate how markets (i.e., speculators and
hedge funds) attack foreign currencies.

Why an attack occurs and the conditions necessary for
success.


To give you examples of currency attacks and the
consequences of those attacks.
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

Success measured by the country abandoning its peg.
United Kingdom pound attack in 1992.
Asian currency attack in 1997.
While these slides will deal with pegged currencies,
attacks on poorly managed currencies can also
occur and do so through the same process
discussed in these slides.
Why Do Countries Abandon a Peg
Regime?

Sometimes the market forces them to do so.


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
If the market perceives that the country’s peg is
“unrealistic” and “unsupportable,” speculators may move
against (i.e., attack) the currency.
If the speculation becomes too great, governments may be
forced to abandon peg.
This was Argentina’s reason.
Sometimes the government may abandon a peg as
part of its own orderly process to move its economy
towards a more open, market driven system.

This was China’s motivation.
Market Forcing Countries to Abandon
Peg: An Attack on a Currency


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Attacks on currencies can occur for a variety of reasons, but
essentially they all relate to:
 Where the market believes that the established (pegged rate
either overstates or understates the currency’s “true” (intrinsic)
value.
Why might a currency be perceived as overvalued?
 Inappropriate domestic monetary and fiscal policies.
 Weakness in the country’s external (trade) position.
 Weakness in the country’s key financial sector (banking).
Why might a currency be perceived as undervalued?
 Underlying strength in the economy of the country (especially its
trade position) which is not reflected in the pegged exchange
rate.
How Does the Market Attack a
Currency: Necessary Conditions in
Financial Markets

The financial markets of a country must be fairly
“open” for currency attacks to occur.


Country must have open capital and currency markets.
Funds must be able to flow into or out of a country.

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In and out of both the country’s stock market and currency
market.
As a result, it would be somewhat difficult to attack the
Chinese currency today.

Why? Financial markets are still tightly controlled and not very
open.
Attacking a Overvalued Pegged
Currency

Attacks on an Overvalued Currency (where
the markets feel a downward correction is
appropriate)

Overvalued currency is sold short on foreign
exchange markets.


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Speculators borrow currency, sell it now, and intend to
buy it back later when currency weakens.
Speculators may borrow currency through taking out
bank loans, or by
Selling stock short on the country’s stock exchange.

Selling stock short provides speculators with needed
foreign exchange (in pegged currency).
Attacking a Undervalued Pegged
Currency

Attacks on an Undervalued Currency (where the
markets feel a upward correction is appropriate)

Undervalued currency is bought (held long) on foreign
exchange markets.



Speculators buy currency, and intend to sell it later when
currency strengthens.
Speculators simply buy the currency on foreign exchange
markets and, in addition, speculators may
Buy stock (held long) on the country’s stock markets.

Potential “foreign exchange related” profits if the currency
strengthens.
Essential Assumption Before Attack
will Proceed

In addition to the previously discussed conditions,
speculators must also be confident that the
government of the country’s who’s currency is under
attack:

Lacks the will (generally political) to defend its currency.


Not willing to adjust interest rates because of the impact on
the domestic economy.
OR lacks the resources to defend its currency.

Does not have sufficient hard currency (necessary foreign
exchange) to use in foreign exchange markets to support its
currency.

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For example, the country would need hard currency (e.g., dollars)
if currency is being sold.
The dollars would be used to buy up its currency and hold its price
on foreign exchange markets.
Attack on the British Pound (1992)

Britain joined the European Exchange Rate
Mechanism (ERM) in October 1990.


ERM was designed to promote exchange rate stability
within Europe.
Under the ERM, European currencies were
“pegged” to one another at agreed upon rates.
 In October 1990, the British pound was
“locked” into the German Mark at a central
rate of about DM2.9/£
 General feeling at the time was that this rate
overvalued the pound against the mark.
Dominance of Germany in the ERM

While the ERM included many European countries,
Germany was the leading player because of its
economic dominance.


Thus, the German mark was also the dominant currency in
this arrangement and German monetary policy set the tone
for the rest of the ERM members.
Thus, German monetary policy had to be followed
by the other members in order for the other member
states to keep their currencies aligned with the
German mark.

This was especially true with regard to Germany’s interest
rate.
1992 Cartoon Representing German Dominance in
the ERM: Germany the Big Fish
Series of Events Leading Up to the
Speculative Attack on the Pound


While the markets felt the pound was “overvalued” when it joined the
ERM, a combination of two critical events, one just before and a second
just after Britain joined the ERM convinced some in the market that the
pound was now ready for speculation.
These events were:
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Fall of the Berlin Wall: As a result, German decided to raise interest
rates in order to attract needed capital for the reunification of East and
West Germany.

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The fall of the Berlin Wall in Nov 1989
The economic “recession” in the U.K. in 1991-92.
Other ERM countries need to follow with higher interest rates.
UK Recession: However, the issue for the U.K. was having to raise
interest rates during their recession.

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A recession would be properly addressed by lower interest rates.
Thus there was both a political and economic component to the potential
decision to raise rates.
Markets thought the UK would not be willing to raise rates to defend the
pound.
Response of British Government to
Speculative Attack: September 1992

Pound currency attack begin in September 1992


Short selling of the pound was led by hedge funds: particularly George
Soros.
The British Government’s initial response to the attack occurred on
Wednesday, September 16

Raised interest rates twice from 10% to 12 and then to 15%

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Also, during the attack the Bank of England gave up $7 billion in hard
currency in defense of the pound.
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Attempt to make U.K. investments more attractive.
Central bank bought $4 billion worth of pounds which were being sold
short (it did this by selling U.S. dollars and German marks to
speculators).
Estimates: 1/3 of its hard currency was spent.
Thursday, September 17, U.K., the U.K Government decided that the
speculators had won and removed the pound from the exchange rate
mechanism and let the pound float!


The pound fell from 2.7780DM (the ERM floor) to 2.413DM by late October;
or -13.1% (see next slide).
Against the dollar the pound fell by about 25%
British Pound: Jan 1991 – Dec 1992
Pound Against the U.S. Dollar: 1992

Down by 25%: What do you think this meant
for U.S. Companies operating in the U.K.?
Run Up to the Asian Currency Crisis
of 1997

During the 1980s, a group of countries in Southeast
Asia – known as the “Asian Tigers” – experienced
exceptionally high economic growth rates.

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This so called economic miracle was accompanied
by these countries opening up their financial
markets to foreign capital inflows.
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Real (after adjusting for inflation) GDP for many grew in
excess of 10% annually.
Foreign direct investment and portfolio investment.
Also, during this time, the currencies of these
countries were pegged to the U.S. dollar.
Thailand: The Seeds of the Crisis

Thailand was part of the southeast Asian
region which experienced double digit real
growth up to the mid-1990s.

Exports were especially critical to the regions’
exceptional growth.
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Thailand’s exports had increased 16% per year from
1990 to 1996.
Economic growth in the region was also fueled by
massive increases in borrowing.
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Government borrowing for infrastructure investment and
Corporate borrowing for investment expansion.
The Thai Baht: A Pegged Currency
Regime
The Thai baht had been pegged to the U.S. dollar at 25
bahts to the dollar for 13 years.
Thailand Begins to Unravel
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The massive increase in Thailand’s investment
eventually resulted in:
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Overcapacity in the Thai economy
Poor lending/investment decisions by Thai institutions.
Investment in speculative activities (especially in the Thai
property markets)
On February 5, 1997, the Thai property developer,
Somprasong Land, announced it could not make a
$3.1 million interest payment on an outstanding $80
billion loan.

Other Thai development companies followed and the Thai
property market began to unravel.
Currency Traders Assess the Situation

At this time, currency traders and speculators were
aware of the following:
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Thailand’s enormous external debt, which was
denominated in U.S. dollars, would require a large need for
dollars.
In addition to this U.S. dollar debt burden, Thailand’s export
growth began to slow and eventually moved into deficit.


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Thus, Thailand was no longer receiving U.S. dollars from its
external trade position.
Issue for Thailand: where would the dollars come from to
finance the external debt?
Traders concluded that due to Thailand’s weakened
economic position, the baht was “overvalued” at 25 to the
dollar.
The Attack on the Thai Baht Peg

Believing the Baht was overvalued, traders
and speculators:

Started to sell the Thai Baht short in May 1997

In doing so, traders and speculators borrowed Thai
Bahts from local banks and immediately resold them in
the foreign exchange markets for dollars.

With this strategy, if the Baht did weaken, traders could buy
the Bahts back and pay off the loan and make a profit on
the dollar appreciation.
Response of the Thai Government
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The Thai Government initially responded by:
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However, Thailand was quickly running short of U.S.
dollars
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Purchasing Thai Bahts on foreign exchange markets
 Used $5 billion in hard currency in this effort
And raising domestic interest rates from 10 to 12.5%
As the speculation continued, Thailand had just over $1
billion left to support the Baht.
And, the higher interest rate raised the cost of
borrowing and adversely affected Thailand’s floating
rate U.S. dollar loan liabilities.
Bottom line: Defending the peg was nearing
impossible.
Releasing the Peg

On July 2, 1997, the Thai government announced
they were abandoning the peg and would let the
currency float.
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The Baht immediately lost 18% of its value against the dollar
By January 1998, it was trading at 55 to the dollar.
Contagion Effect in Asia

The attack on the Thai Baht, quickly spread to other
Asian currencies.
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Concern mounted regarding the economic and financial
“soundness” of other Asia Pacific countries as well.
As a direct result, many of these Asian countries were
forced to abandon their pegged regimes for floating or
managed regimes.
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This is an example of a regional contagion effect
Malaysia is an exception as it restores a peg but eventually it
moves to a managed float.
See the following slides for these exchange rate changes.
For a complete discussion of the crisis see:

http://www.wright.edu/~tran.dung/asiancrisis-hill.htm
Indonesia Rupiah, Jan 1997 – Dec 1997
Philippine Peso, Jan 1997 – Dec 1997
Taiwan Dollar, Jan 1997 – Dec 1997
Korean Won, Jan 1997 – Dec 1997
Malaysian Ringgit, Jan 1997 – Dec 1997
Malaysian Restores its Peg: 1997 – June
2005
Malaysia Moves From a Peg to a
Managed Float: July 21, 2005
Exchange Rate Changes in Asia: June
1997 to June 1998
Some Asian Governments, However,
Were Able to Successfully Defend
Their Currencies

Hong Kong Dollar is successfully defended:

China’s monetary authorities purchase massive amounts of
common stock being sold on the Hong Kong stock
exchange.

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China also sold U.S. dollars into the foreign exchange
markets in defense of the Hong Kong dollar.

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They do this to offset the selling of hedge funds and thus
stabilize common stock prices.
They do this to offset speculator short selling of the Hong
Kong dollar on foreign exchange markets.
Throughout the crisis, the Hong Kong dollar peg was
successfully defended and the peg remains today.
Hong Kong Dollar During the Asian
Currency Crisis (1997): Hardly a Ripple