Where do currency crises come from? (Note)

Where do currency crises come from?

Summary:

· A currency crisis occurs in a country when the value of its currency is attacked on the markets. These crises are frequent and have a cost for the economy;

· The first generation of models explains this by a conflict between the fixed exchange rate regime and economic policy choices that deplete official reserves;

· The second generation explains it as being caused by a loss of market confidence in the government’s willingness to defend the fixed exchange rate.

· The third generation attributes it to a twin crisis consisting of a currency crisis and a financial crisis that reinforce each other.

Particularly since the 1980s and 1990s, many countries have been affected by currency crises (Figure 1). A currency crisis is considered to have occurred when a country’s currency falls sharply (by at least 15% against the dollar or an anchor currency in the case of a crawling peg) and/or when the central bank’s official reserves collapse to a level below three months of imports. Their frequency and cost to the real economy make it important to study their causes and the chain reactions that cause them to spread to the rest of the economy. In particular, the literature seeks to construct models to explain how a rational market attack causes a devaluation that ends a fixed exchange rate regime.

Figure 1: Percentage of countries experiencing annual depreciation of more than 15%

Sources: BSI Economics, Reinhart and Rogoff, http://www.carmenreinhart.com/this-time-is-different/

What is a currency crisis?

A currency experiences a currency crisis when markets, anticipating that its value will collapse, sell off their holdings denominated in that currency, often in a panic, causing demand for it to fall and thus its value. This can manifest itself in a sharp fall in the central bank’s official reserves or a sudden drop in the nominal exchange rate, with one potentially leading to the other. It mainly affects fixed exchange rate regimes, where the value of a currency is pegged to that of another currency or a basket of currencies.

These regimes must be extremely credible, based on consistent central bank announcements or mechanisms such as a currency board, for example. The aim is to reassure markets that the exchange rate will remain stable in the long term, even though a fixed exchange rate can create real imbalances in terms of competitiveness, for example (by causing inflation). Even regimes that are accompanied by institutional arrangements are not completely immune to crises, as demonstrated by the collapse of Argentina’s currency board in 1992.

When the fixed exchange rate regime is under attack, i.e., when markets are betting on its collapse, the central bank can either:

– either raise the key interest rate to stem the fall in demand, but this has a recessionary effect on the rest of the economy;

– sell its official foreign exchange reserves to buy back its own currency on the foreign exchange market and thus defend its value.

For example, the Chinese central bank’s foreign exchange reserves have recently melted away in order to support the yuan (see the BSI Economics chart on this subject). But these reserves are not infinite, and a currency crisis occurs when they are rapidly depleted and the central bank can no longer counteract the decline in demand.

Currency crises therefore affect these regimes more frequently because once they end, the exchange rate falls sharply. But they also hit countries that allow their currencies to float, such as Russia, whose currency depreciated by more than 43% between January 2014 and January 2015.

In all cases, a currency crisis has a real impact on the economy. It can boost exports through a fall in the exchange rate, but these effects are not apparent in the short term (according to the theory of critical elasticities). On the other hand, the fall in the value of the national currency immediately causes a revaluation of debts denominated in foreign currency, which can lead to banking and financial crises, which can themselves lead to sovereign debt crises (see the BSI Economics article). It is also a balance of payments crisis because foreign countries stop financing the country (known as a sudden stop). The frequency of currency crises and their impact on the economy have led to a large body of literature attempting to identify their causes and thus make it possible to predict them.

The first generation: the role of macroeconomic fundamentals

The first generation explains a currency crisis as a conflict between a country’s economic policy decisions and its fixed exchange rate regime[i]. As we have seen, this type of regime is constrained by limited foreign exchange reserves. An increase in the money supply or budgetary imbalances due to a widening budget deficit mean that the central bank must sell its official reserves on the foreign exchange market in order to maintain a constant money supply and thus maintain its fixed exchange rate. But since reserves are not inexhaustible, the central bank may not have enough reserves to do so. When fears of an exit from the exchange rate regime become too strong, markets anticipate that devaluation is inevitable and immediately convert their holdings into foreign currencies while the rate is still fixed, as devaluation would cause them to incur losses. The exchange rate regime comes under attack and collapses in a self-fulfilling manner. Indeed, fears of reserves running out actually cause this to happen, in the same way that during a bank run, depositors’ withdrawals cause the bankruptcy they feared. The remaining reserves are immediately depleted and a sharp devaluation puts an end to the fixed exchange rate: this is the currency crisis.

This generation of models explains the crisis as being caused by economic policies that trigger a loss of confidence and a rational attack on the markets, which rapidly deplete official reserves. It applies to the case of the Mexican peso crisis of 1994 (Figure 2). During the three years preceding it, the peg to the dollar led to massive capital inflows and a large balance of payments deficit, combined with inflation and an increase in the money supply. The central bank was forced to sell its dollar reserves to defend the parity, but panic in the markets, which were divesting themselves of their peso positions, made devaluation inevitable.

Figure 2: Exchange rate and official reserves of Mexico

Sources: BSI Economics, Agnès Benassy-Quéré, International Monetary Economics (2015)

The second generation: the role of market confidence in the regime

However, this model does not correspond to the crisis of the European Monetary System in 1992-1993. European countries were not characterized by expansionary monetary policies, depleted reserves, or current account deficits. A second theoretical generation therefore seeks to explain this crisis by the markets’ unfavorable expectations regarding the government’s willingness to defend the fixed exchange rate[ii]. In this context, monetary authorities must choose between maintaining the exchange rate regime and pursuing long-term domestic objectives. If they give the impression of wanting to pursue these objectives at the expense of the fixed regime, for example by increasing the money supply to combat unemployment, the markets may lose confidence in their determination to avoid devaluation. This creates a circular dynamic between the government and the markets, where expectations of devaluation raise the cost of defending the regime in terms of internal objectives, which in turn undermines confidence in the fixed exchange rate regime and thus exacerbates expectations. The crisis occurs when the markets anticipate that the authorities will give up and attack the exchange rate regime, forcing devaluation. This is a self-fulfilling prophecy, where fear of the crisis creates the conditions for its realization, without any prior worsening of the determining factors. This is the difference with the first generation, according to which the deterioration of fundamentals causes the crisis.

This model of circularity between government and markets and multiple equilibria explains well the exit of the pound sterling from the European exchange rate mechanism (exchange rate variations limited to 2.25% between European countries) in 1992. When the markets doubted the British government’s willingness to maintain parity with its European partners and attacked the pound, the cost of maintaining it increased. The authorities then reacted with only a slight increase in interest rates, confirming that parity would be abandoned. The attacks intensified and devaluation took place later that day.

The third generation: the role of the banking and financial system

However, this framework fails to explain the Asian crisis of 1997-1998. The countries affected did not suffer from particularly unfavorable fundamentals, and the authorities showed no signs of exhaustion in defending the fixed rate that would have prompted the markets to rush it. The third generation therefore seeks to explain it by a combination of a financial crisis and a currency crisis, or twin crisis. Depending on the version, the currency crisis is caused by a run on deposits or by a reversal of foreign capital (mostly invested in the short term) which, after a massive inflow, flees the country (sudden stop). In both cases, the markets anticipate that the central bank, as lender of last resort, will be forced to refinance the banks to stem the liquidity crisis. Since this bailout will involve money creation, and therefore a weaker currency, they attack the exchange rate and force devaluation, which in turn aggravates the financial crisis as banks are indebted in foreign currency in the short term. The more banks are in difficulty, the more the markets attack the exchange rate, which further exacerbates the banking crisis: the two crises reinforce each other.

Here, the crisis is explained by the fragilities of the financial system, particularly those of bank balance sheets. Suffering from currency mismatch ( assets in domestic currency, liabilities in foreign currency) and maturity mismatch (long-term assets, short-term liabilities), these are particularly vulnerable to depreciation and sudden stops. From a prudential perspective, a lack of supervision and poor risk assessment encourage bad debts. Finally, the initial panic can be triggered by sectoral weaknesses such as the bursting of a credit bubble, linked, for example, to a disconnect between credit supply and sector fundamentals, pushing up prices and bad debts. For emerging countries in particular, these vulnerabilities are all the more likely to emerge and cause a loss of confidence because they stem from the very nature of the exchange rate regime, which they will cause to collapse (stable exchange rates encouraging capital inflows, a financial system that does not allow borrowing in local currency, etc.).

The twin crisis spreads to the real economy, particularly if the authorities exacerbate the recession by raising interest rates to retain foreign capital. This is often what they do, and to no avail, as in Russia, where interest rates rose from 6.5% to 17% in one year in 2014. Furthermore, and this is another subject of study for the^third generation of models, it can spread to other countries through contagion effects, as was the case in Asia. The Thai baht was the first to abandon its fixed exchange rate with the dollar in 1997, and the crisis then spread to Malaysia, South Korea, and Taiwan (see the BSI Economics article on this subject). Countries are exposed to each other’s vulnerabilities because they are trading partners, so when one country’s economy contracts, it reduces opportunities for others.

Banks in crisis also repatriate the investments and loans they have granted to neighboring countries. Finally, the loss of market confidence in one country causes them to reassess the risk for others, which can trigger self-fulfilling crises. These factors form the basis for an analysis of these crises as components of systemic crises. In particular, Krugman (2001) presents a draft 4th generation model inspired by the IS-LM framework, which models bank balance sheet imbalances and financial bubbles.

Conclusion

The study of currency crises reveals the interconnectedness of economic agents and the role of market psychology. Through self-fulfilling expectations, markets cause devaluation by the very fact of fearing it. Self-reinforcing loops exacerbate currency and financial crises. Finally,spillover effects contaminate other countries.

But since each generation that has sought to understand a crisis fails to understand the next one, there is reason to fear that existing models are also powerless to anticipate future currency crises.