Currency Crises Models - Essay Example

Currency Crises Models Abstract Currency crisis is the focus of extensive economic literature and research today in addition to it’s theoretical as well as empirical study. It is observed that when investors run away from a currency expecting it to devalue immense pressure on the currency is created in particular because the investor now lack confidence in the currency. This phenomenon highlights the significance of a currency crisis and the drastic effects it has on the economy. Throughout history we have witnessed a large number of currency crisis that have affected many economies worldwide. Unfortunately, the number of these crises has been increasing lately. In the 1990s, we observed three distinct regional currency crises including the European crisis in 1992, the Latin American crisis in 1994, and currently the Asian crisis. Although currency crises is the subject of extensive economic literature and study yet somehow there are many important issues that still remain to be solved. Each one of these crises contributes new predicaments. The main purpose of this essay is to provide a critical overview of currency crises. A comprehensive evaluation and analysis of the first-generation, second-generation and third-generation of currency crises models is given with reference to recent global economic catastrophes. In today’s world, a devastating currency crisis occurs at an average rate of 1 in every 19 months. Keywords: currency crisis, currency crisis models, global economy, global economy crisis, collapsing exchange rate market, contagious currency crises, comparison of currency crisis models Introduction A currency crisis is a catastrophe that takes place when a tentative attack on the exchange value of a currency leads to the devaluation or unexpected depreciation in a country’s currency value. A currency crisis can also lead to a balance-of-payments crisis or a huge exchange rate depreciation or even a massive international reserve loss, or all of the above. Most economists agree that a speculative hit in the foreign exchange market usually affects fixed exchange rate markets rather than floating exchange rate markets. Currency crisis can originate from a financial crisis associated with an actual economic crisis that can cause depletion of valuable reserves. The drastic effects of a changing value of currency can be very brutal to small economies as compared to relatively larger ones. The government or major bodies of authorities should regulate and defend the currency by fulfilling the surplus demand for a given currency using the currency reserves of the country or by using its foreign reserves or by elevating the interest rates. Throughout history we have seen a large number of currency crisis that have affected many economies worldwide leading to recessions like the economic crisis in Mexico in 1994, the Asian crisis in 1997, the case of the Hong Kong dollar in 1998 and Russian crisis in 1998. The rapid increase in the number of currency crises after the Latin American debt crisis in the 1980s was alarming. This resulted in extensive research and in the conception of many theories and models. Thus, the first methodical formation of currency crisis model came in 1979 by Paul Krugman in his extensive research based on Steve Salant and Dale Henderson’s paper published in 1978. This model was based on the study of how efficiently the trade prices of articles of trade could stabilize after concerned authorities had an insight that an investor will hold on to an exhaustible resource if he expects its price to rise quick enough offering him a profitable return rate. This concept is based on Hotelling lemma’s exhaustible resource pricing leading to a choking point when the price has risen to such a height that ultimately there isn’t any more demand left. The growing trend in the shadow price was provided by supposing that the government issues money to finance the country’s budget deficits, however the central bank is prepared to defend the exchange rate through international reserves. Hence, Salant further worked on a gold price stabilization technique. Following Salant, Krugman analysed a pegged currency market in an analogous way. First-generation currency crisis model Krugman based his analysis on the discrepancies between an excessively expansionary financial policy and the maintenance and upholding of a fixed rate peg. Suppose that a central bank finances a large and constant budget deficit or adds an enormous sum to support a troubled bank system, then the fixed rate peg concept cannot be functional. Here, we will suppose that changes in a currency’s value e are inversely associated to the changes in monetary base, M, then we can equate: e = - M The domestic credit D of the monetary base is issued by the central bank and R is the international reserves. M = D + R Now, if the central bank decides to finance a huge budget deficit by increasing the domestic credit, D, that will in turn increase the base M. In order to keep the supposed exchange unchanged, we can say: E=0, M=0 The rise in domestic credit, D is required to be equalized by a drop in R, the international reserves. But due to the limitation of the international reserves, a rising D cannot be supported by the limited R for an indefinite period. So, when R=0, that is the reserves equals zero, then M=D, that is the monetary base and domestic credit will begin to increase at the same rate. If R = 0, Then M=D This makes the investors self-assured. But when they will apprehend the certainty of a failure at t1, then the investors will launch an attack to raise profits prior to the depletion of resources making t0 the time of estimation. Figure 1: First Generation Currency Crisis Model The drawback of this model is the unreasonable portrayal of elimination of the peg by the central bank. Another assumption is that the policymakers are inactive but can choose to devalue. The collapse of the peg thus leads to no discrete change in the exchange rate. The lack of common knowledge will lead to a discrete devaluation once the peg finally collapses. Second-generation currency crisis model The second-generation model derived from a wide range of models that were published in the paper by Obstfeld in 1986. These models consisted of two important characteristics: 1. Multiple Equilibria: Multiple solutions i.e. more than two outcomes could be produced in order to make the fixed exchange rate system survive, counting on the behaviour of the speculators. Equilibrium with an attack and equilibrium without an attack could be established. The second-generation model could also correspond to the self-fulfilling crisis. 2. Optimising Agent: In the second-generation model, the government exclusively acted as an optimising agent having power over its environment as well as directing exactly when to devalue the currency depending on the financial conditions. The main focus of second-generation models was on impending essential non-linearities in the government’s authoritative behaviour pointing out to the fact that good policies cannot always shield you from attacks. The non-linearity in the government’s policy reaction function to changes in classified behaviour, to wanting to keep unemployment down, to facing a precise trade-off between the fixed exchange-rate policy can lead to the possibility of multiple equilibria. The mutually related phenomena of self-fulfilling attack, herding and information cascade are associated with the second-generation model. The second-generation model is capable of controlling the inherent instability of the private currency market. The government can sustain exchange rate stability by applying a fixed macro policy, which might eventually become extremely expensive. This can lead to the government opting for other regimes of floating the currency to overcome the domestic pressure. The market is the deciding factor when it comes to choosing a solution depending on the onset of an attack. Third-generation currency crisis model The third-generation currency crisis model emphasizes on the difficulties in the financial and banking system when a currency crisis takes place and its effects on the rest of the country’s economy. The basic concept of over borrowing by banks to finance crucial balance-of-payments and providing loans was in fact a masked government debt, was given by Krugman and McKinnon & Pill. Sometimes the governments even had to go to the extent of totally paying out a collapsing bank. A currency crisis can lead to a banking crisis if local banks have loans and debts denominated in foreign currency. A banking system is more susceptible to attacks when a government assures the bank to take on foreign debts. However, according to the third-generation model a currency crisis can lead to a number of difficulties in the financial system and elevated interest rates can damage the economy. Instead, the third-generation model proposes that the banks should keep giving credit in the time of crisis and the real interest rates should be kept very low to keep the financial system functioning on the whole. Comparison First-generation model supposes that the information regarding the level of reserves of a central bank is general information. This led to the misconception that the exact timing of a speculative attack on the currency could be accurately predicted. This lack of general information can result in a collapse of the peg thus leads to a discrete devaluation but there is no discrete alteration in the exchange rate. The first-generation model also failed to explain the contagious currency crisis. However, the second-generation model can explain the contagious currency crisis by financial or trade channel or neighbouring trade partners or by having similar macroeconomic attributes. Both the first-generation and the second-generation models could not offer any theory on policy management. Typical recommendation for a currency crisis is to increase the interest rates and avoid capital outflows at all costs. However, according to the third-generation model a currency crisis can lead to a number of difficulties in the financial system and elevated interest rates can damage the economy. Instead, the third-generation model proposes that the banks should keep giving credit in the time of crisis and the real interest rates should be kept very low. Together the three generations of currency models indicate four factors leading to a currency crisis: Domestic public and private debts, Pegged exchange rate, Expectations and State of the financial markets. The second-generation currency crisis model can indicate the options of multiple equilibria but cannot indicate exactly which outcome is expected to materialize empirically afterwards. Both the first and second-generation currency crisis models suggested very diverse policy propositions. In case of first-generation model, basic flaws in the fundamentals cause the currency crisis. But in case of the second-generation model, natural instability in the private sector behaviour can cause a crisis. Hence the idea of a free economy is not appropriate if financial markets are inherently unstable and deteriorating. It is the government’s responsibility to control and regulate markets instead of allowing them to work without any restraints. The over borrowing syndrome of the developing countries was created by Professor Ronald McKinnon and his student Huw Pill of Stanford University. In their paper, over borrowing syndrome is observed in the domestic banking system that is weighed down by the moral hazard predicaments. Thus, a domestic banking system is more susceptible to speculative attacks when the bank takes foreign debts and indulges in massive over-borrowing by opening the financial sector to the world. Hence we can say that global financial incorporation can amplify a domestic currency crisis. In case of a financially repressed economy, unfortunately banks cannot execute their business due to exceptionally high government taxes through elevated inflation. This leads to an increasing disparity between the lending interest rates and the deposit interest rates. Studies show that many cross-country differences are the origin of a currency crisis. For example, East Asia was involved in banking crisis; Russia and Latin America were involved in huge economic deficits. Studies prove that it is indeed more complicated to predict the future than to describe the patterns of the past crisis. It has been observed that the second-generation currency crisis model can present the possibility of a speculative attack even with definite macroeconomic fundamentals. Unstable global market reactions can also cause currency crisis making it impossible to calculate upcoming crisis in the future from domestic macroeconomic variables. For example when the government of Thailand gave up trying to maintain a stable exchange rate for their currency, bath; it drastically decreased in value by more than 20%. This led other neighbouring countries to follow resulting in an unstable exchange rate. We can call this as a defining feature of a currency crisis, when investors run away from a currency expecting it to devalue because they lack confidence in the currency. We can examine three different regional currency crises in the 1990s: the European crisis in 1992, the Latin American crisis in 1994, and currently the Asian crisis. Although currency crisis is the focus of extensive economic literature and research today yet many vital problems remain unsolved. Another classic example of a government permitting its currency to devalue is that of the attacks on the French franc during the 1920s. These attacks were caused primarily due to the speculated inflation in debt by the government. However, as long as a government is committed to a fixed exchange rate; it cannot inflate debt rates. Another example is of Britain’s desertion of gold measurements in 1931 since the country was enduring unemployment. The fixed exchange rate and nominal wage rate made it impossible to initiate a growing economic policy. In 1992, Britain excluded itself from the European Monetary System. In 1994, Obstfeld highlighted the fact that defending a fixed rate is expensive if it was expected to decrease in value in the past. For instance, debt-holders can claim a high rate of interest if they are certain that the fixed rate will decrease in value. Unfortunately this can result in massive debt burden, so huge that it is impossible to control without reducing the high rate of interest. Likewise, unions can deposit incomes at levels that can leave the industry passive at the existing exchange rate in similar circumstances. A proposed solution can be that debt-holders claim elevated short-term interest rates. Sadly, these elevated short-term interest rates can deteriorate the cash flow of the indebted enterprises or even the government causing the production and employment to diminish. The effect of currency crises on inefficient markets exposes the typical case of herding when currency traders and international investors behave like a herd of buffalos following the leader without thinking. In 1989, a study on the behaviour of investors was carried out by Shiller. The phenomenon of herding was witnessed during the 1987 stock market crash when investors panicked and sold massive number of stock just by following other investors. Many theorists have proposed numerous causes of herding mainly including the bandwagon theory in which hot money is made by the confidential information provided by the investors. The regional currency crises of the 1990s appeared to be unlinked but faced a common predicament originated the concept of crisis contagion. For example, in case of the current Asian currency crisis a Thai depreciation can lead to lower Malaysian exports to such an extent that Malaysia could face a crisis. Some theorists justify crisis contagion between contrasting economies by identifying familiar terms and characteristics between them. Although the Latin American countries have a common culture and characteristics yet these similarities cannot be implied to economic policies. In 1982, Latin American countries suffered a crisis due to a dollar denominated debt that began to spread to Argentina, Brazil and Mexico. Yet the Philippines were not affected until almost a year since investors thought it to be a former Spanish colony. Crises that are created by self-fulfilling or herding can lead to beneficial market manipulation by many speculators. In 1996, Krugman termed these supposed agent as "Soroi". Market manipulation can be illustrated by George Soros' attack in 1992 on the British pound. Although, it seemed possible that the pound was disappearing of the exchange rate mechanism yet Soros' market manipulation caused a quicker wipe out. Currency crises due to market manipulation occurs due to a predictable disintegration of the exchange regime. Currently the Asian crisis is still in flux. Most economists began to predict in 1995 that wonder the countries of Southeast Asia were indeed susceptible to a Latin American crisis. The countries of Southeast Asia were distressed due to many financial limitations like serious investments in extremely speculative real estate enterprises, financially aided by foreign sources or through credit taken from under-regulated domestic financial organizations. However it is a known fact now that officials from the IMF and World Bank warned the governments of Malaysia, Thailand and other countries in 1996 of potential threats and insisted on remedial strategies. However, those governments insistently rejected the warnings. On July 2 2010, Thailand was forced to float the bath that directed suppositions towards other local currencies in Malaysia, Indonesia, and the Philippines. Thailand eventually did receive an emergency financial benefit from the IMF but had to clearout its financial system. Currently the actual outcome of the Asian crisis is not known. However theorists confirm that the growth in Thailand’s economy will diminish estimating from the 9% usual rates of today to 0% growth over the next year. To what an extent this contagion will go is still very vague. South Korea and China also have alarming internal financial problems as well as enormous internal debts and financial credit debits. An intriguing contradiction to the Latin American crisis is presented by Hong Kong, which like Argentina has the U.S. dollar currency but is not threatened in any way, and has shielded itself from the current Asian crisis. Conclusion and Prevention The government or major bodies of authorities should regulate and defend the currency by fulfilling the surplus demand for a given currency using the currency reserves of the country or by using its foreign reserves or by elevating the interest rates. The government can sustain exchange rate stability by applying a fixed macro policy or by joining currency unions. This can lead to the government opting for other regimes of floating the currency to overcome the domestic pressure. The market is the deciding factor when it comes to choosing a solution depending on the onset of an attack. The banks should keep giving credit in the time of crisis and the real interest rates should be kept very low to keep the financial system functioning on the whole. Typical recommendation for a currency crisis is to increase the interest rates and avoid capital outflows at all costs. The idea of a free economy is not appropriate if financial markets are inherently unstable and deteriorating. It is the government’s responsibility to control and regulate markets instead of allowing them to work without any restraints. Summarizing, governments need to work on proposed remedial strategies by the IMF and the World Bank instead of over looking them and follow sound and consistent policies by signing formal treaties so they can remain secluded from all kinds of speculators attacks. Discussion Many cross-country differences can originate a currency crisis. An intriguing contradiction to the Latin American crisis is presented by Hong Kong, which like Argentina has the U.S. dollar currency but is not threatened in any way, and has shielded itself from the current Asian crisis. References Salant, S. and Henderson, D. (1978) Market anticipation of government policy and the price of gold, Journal of Political Economy 86:627-648. Krugman, P. (1979) A model of balance of payments crises, Journal of Money, Credit, and Banking 11: 311-325 Krugman, P. (1996) Are currency crises self-fulfilling?, NBER Macroeconomics Annual Obstfeld, M. (1984) The logic of currency crises", Cahiers Economiques et Monetaires 43:189-213. McKinnon and Pill, Kaminsky, Lizondo and Reinhart. (1996) Currency Crisis Models and the Early Warning System Retrieved from http://www.grips.ac.jp/teacher/oono/hp/lecture_F/lec12.htm Drazen, A. (1997) Contagious currency crises, mimeo Drucker, P. (1997) The global economy and the nation-state, Foreign Affairs, Sept./Oct. Eichengreen, B., Rose, A. and Wyplosz, C. (1995) "Exchange market mayhem: the antecedents and aftermath of speculative attacks", Economic Policy 21:249-312. Flood, R. and Garber, P. (1984) "Collapsing exchange rate regimes: some linear examples", Journal of International Economics 17:1-13 Rose, A. and Svensson, L. (1994) European exchange rate credibility before the fall, European Economic Review 38:1185-1216 Read More