Historical currency crises (after WWII)

Historical Currency Crises

'First Generation' Currency Crises: Brazil

Abb. 1: Brazil: First generation model

Source: Saxena (2004)
 The 'First Generation' Currency Crisis Model:
The Collapse of an Unsustainable Fixed Exchange Rate

Traditional explanation for collapse of a fixed exchange rate:

domestic economic policy which is incompatible with the
aim of a fixed exchange rate.

Standard example:

Expansive monetary policy leads to inflationary

pressure on the exchange rate

m  p  s 
 'First Generation' Currency Crisis Model

Naive mechanism:
• disequilibrium in the foreign exchange market ->
interventions of central bank -> decline of reserves -> at
some stage, central bank had to float because of depletion of
reserves

• Expectations again add a more complex element: because of

expected collapse, fixed exchange rate system is known to be
unsustainable and should, therefore, already collapse before
complete depletion of reserves. The collapse will occur
through a well directed speculative attack.
 'First Generation' Currency Crisis Model

Background: ‘flex price’ monetary model:

Put together, the result is:

 * ds 
m  s  p  y    i  
*

 dt 
ds
m  s  y  i  p  
* *

dt
: 

ds
m  s    .
dt

ds
With a fixed exchange rate s :  0, therefore :
dt
ms  
Money supply is the sum of the domestic central bank loans
D and central bank’s reserves of foreign currency, R:
m=D+R

Expansive monetary policy: dD

 .
dt
In a fixed exchange rate system we have:

m DR   s

dR dD
    .
dt dt

Reserves decline one-to-one with increase of money supply.

'First Generation' Currency Crisis Model

Ultimate collapse: a mechanical collapse of the system occurs

when Rt  0 . Reserves decline according to:

Rt  R0  t , (t  time),

So that the collapse would occure at

R0
T1  .

 'First Generation' Currency Crisis Model

Problem:

 predictable collapse of the fixed rate would lead to a perfectly

predictable exchange rate jump at T1

 potential profits for (rational) speculators would lead to

massive sales before the final collapse

 speculative attack would generate a collapse before T1

With a large number of competing speculators, the attack
happens at the earliest possible date: when the ‘shadow rate’
s* equals the fixed exchange rate.

Shadow rate is determined from:

ds
m  s*         
dt

since:
ds dp dm dD
    .
dt dt dt dt

Therefore: *
s  m    
 D  R     .
 At the time of attack T2 we have

s * (t  T2 )  D0  t  R    .
=0

The attack occurs as soon as the shadow rate equals the fixed
rate:
s  s* ( T2 )  D0  t    
s  D0    
 T2  .

Because of s  m    D0  R 0 -  it is

R0   R0
T2      T1 .
 
Fig. 1: The early
collapse of a fixed
exchange rate system
in the Krugman
model
 Preventing speculative attack by a Tobin Tax?

For simplification: capital turnover is taxed only once -> no

relevance of time horizon of investment:

 * ds 
Modified UIP: i  (1   ) i  ,  : tax rate
 dt 
therefore:

ds
m  s  y   (1   )i  p   (1   ) ,
* *

dt

~
y   (1   )i  p  
* *
Tobin Tax in 'First Generation' Currency Crisis Model

The shadow rate is:

~
s  m     (1   ) 
*

~
 D0  t  R     (1   )  .

Timing of attack:
~
s  D0     (1   ) 
s  s (T2 )  T2 ( ) 
*
.

~ R0
Because of s  D 0  R0    T2 ( )    (1   ).

Conclusion: Speculative attack does not prevent but only
postpone an attack
Expected change of the central bank's policy:
Market participants expect that after a successful attack the
central bank will stop its expansionary policy with a certain
probability (1 - q):
 ds 
E   q  .
 dt 

 s*  D0  t  R    q ,
R0
 T2 ( q )   q .


Conclusion: Speculative attack can only be prevented if change

of policy occurs with probability 1
'First Generation' Currency Crises: Brazil

Abb. 1: Brazil: First generation model

Source: Saxena (2004)
 'First Generation' Currency Crises: Peru

Abb. 2: Peru: First generation model

Source: Saxena (2004)
 “Second Generation” Models

New experience during the 1990s:

• currency crises without apparent fundamental problems (EMS
92/93, Mexico 94/95):
• no unsustainable developments in fiscal or monetary policies
• no change of strategy of monetary or fiscal policy
• no anticipation of crises by financial markets

Conclusion: even currencies that “should” be stable can be

targets of speculative attacks
 Currency Crises and Multiple Equilibria:
“Second Generation” Models

Basic mechanisms: self-fullfiling expectations generating

multiple equilibria

The idea will be illustrated via

1. A simple game-theoretic approach
2. Multiple equilibria in a Krugman-type model
3. Multiple equilibria as a result of ‘optimizing’ economic policy
 Currency Crises and Multiple Equilibria:
„Second Generation“ Models

1. A simple game-theoretic approach

“Players”: 2 speculators; passive participant: the central bank

Assumptions:
• given amount of reserves R of the central bank as fundamentals
• both speculators have a given amount of domestic currency D at
their disposal
• in case of attack, they incur costs of 1 unit of currency
(opportunity costs, bid-ask spread)
• if attack is successful, central bank devaluates the currency by
50%
Speculators‘ payoffs:
• Unsuccessful attack: cost of 1 leads to payoff of -1
• Successful attack: gains form depreciation of 50% minus costs

Case 1: R=20, D = 6 (good

fundamentals)
 no prospect for a successful
attack
 payoffs are therefore
always 0 or -1
 unique equilibrium of no
attack
Case 2: R=6, D = 6 (poor
fundamentals)
 attack is profitable for both
speculators and will be
successful
 payoffs are therefore always
0.5*3 -1
 unique equilibrium of joint
attack
Case 3: R=10, D = 6
 no speculator can force a
devaluation on its own
 2 Nash equilibria: both stay
inactive or both attack
 coordination problem!
 Game-theoretic approach

Consequences:
• multiple equilibria can occur and depend on the quality of the
fundamental data (here summarized through R)
• an attack implies coordination of participants‘ expectations:
an attack can occur at any time but it might also be delayed
for a long time
• potential mechanisms for coordination: political events,
announcments, behavior of important market participants (e.g.
Soros)
 Multiple equilibria in a Krugman-type model:

New assumption:
• expected change in the growth rate of money supply if parity
is abandoned: μ1 > μ0
• analogy to the EMS situation: dropping out of the system
would have implied that the convergence criteria of the
Maastricht Agreement no longer have to be adhered to and a
domestically preferred expansive policy could have been
realized.
Multiple equilibria in a Krugman-type model:

Now there are two shadow exchange rates:

s*0 ,1  D0  i t    i , where i {0 , 1 }

no policy change:
attack in T2(μ0).

expected policy
change: attack
between T2(μ0).and
T2(μ1).
 Multiple equilibria as a result of ‘optimizing’ policy

Theoretical background (Barro-Gordon etc.)

• problem of monetary policy is to built up reputation for the

central bank‘s commitment to fight inflation
• if public believes in CB‘s commitment CB has an incentive
to switch to discretionary policy in order to foster
employment
• since the public knows of these incentives it does not believe
in the CB‘s commitment -> public maintains inflationary
expectations
• in a small open economy: one resolution of this problem is
pegging the exchange rate to the currency of a larger country
(e.g., Mexico)
• Europe: joint commitment via EMS
 Multiple equilibria as a result of ‘optimizing’ policy

Central bank minimizes the loss function:

* 2
L (y - y )  cz

y: output, y*: target level of output (s*: corresponding exchange

rate)
c: cost of a loss of reputation (credibility)
z ∈{0,1}: reputation
 ds 
Restriction: Phillips curve y - y* a(s - s* )  bE  
 dt 
 Policy alternatives

Credible defense of parity

then: s  s (  s* )

if it is credible:
 ds 
E   0
 dt 

this policy choice is preferable if: (a(s - s* ))2  c

 Policy options

Abandoning the parity

with a devaluation to s* the desired employment target can be

achieved.
Rational anticipation of markets implies:
 ds 
E    Es t 1  - s t  s* - s  0
 dt 

Loss becomes:
 * *
2
L  a(s - s )  b( s  s )  cz

 ( a  b )( s  s )  cz
* 2
 Policy options

Abandoning the parity will be the preferred alternative if:

( a  b )( s  s )
* 2
c

Maintaining parity will be better if:

(a(s - s* ))2  c

Note: conditions are not mutually exclusive!

Multiple equilibria exist if

a(s - s )
* 2
 *
 c  (a  b)(s - s )  2
 Multiple equilibria

Self-fulfilling expectations in the region of multiple equilibria

• If market expects a defense of the parity: E[ds/dt]=0 and

it holds that:
s(s - s )
* 2
c

• If markets expect a devaluation, the cost of maintaining the

peg increases, so that it becomes preferable for the CB to step
out of the exchange rate system:
( a  b )( s  s* )2  c
 Chronology of the EMS-Crisis

• European Monetary System (EMS) (2.25% margins around

parity), no realignments since 1987, convergence of interest
rates and inflation rates, unilateral target zone for Scandinavian
countries, Maastricht Treaty: plan for a conversion of the EMS
into the European Monetary Union (EMU)

• German reunification: expansionary fiscal policy, currency

conversion rule leads to growth of money supply in unified
Germany, subsequently restrictive monetary policy by
Bundesbank because of the fear of future inflation, interest rate
differential (German prime rate 1991/92: ~8%, USA and
Japan: 3-4%), real depreciation of DM, 1992: onset of
recession in Europe
 Chronology of the EMS-Crisis

June 2nd, 1992

• Danish referendum, rejection of the Maastricht Treaty,
• this leads to speculative attacks against Lira, British
Pound, Spanish Peseta, Dan. and Swed. Krona, Fin.
Markka.

Beginning of September
• Finland abandons its target zone, Sweden and Ireland
raise short term interest rates up to 500% (p.a.),
• Realignment of Lira (depreciates 7%)
Chronology of the EMS-Crisis

September 16th, 1992

• Black Wednesday: Pound and Lira quit EMS,
realignment of Peseta (depreciates 5%),

September 20th, 1992

• French referendum, acceptance of the Maastricht
Treaty with 51%
• constraints on capital movements in Spain, Ireland,
Portugal, unsuccessful speculative attacks against
French Franc (loss of reserves of 80 Bill. Franc)
Chronology of the EMS-Crisis

November
• Floatation of Swedish Krona (depreciates by 12,5%) and
Norwegian Krona,
• Realignments of Span. Peseta and Port. Escudo (-6%)

January of 1993
• Depreciation of the Irish Pound (-10%)

May
• Depreciation of Span. Peseta and Port. Escudo (-6,5%)

July
• Transition to target zone with bandwidth ~ ±5%.
 Application of 2nd generation model to EMS

• expansive fiscal and monetary policies in Germany after

unification
• inflationary concerns, leading to high interest rates and
appreciation of the Deutsche Mark
• deterioration of fundamental data in partner countries (start of
recession)
• domestic policy considerations create incentives for
devaluation
• costs: c*z stands for the foregone benefits of not joining the
next phase of EMU
• multiple equilibria because of uncertainty regarding the
preferences of governments
• coordination of expectations: political events, e.g. Danish
referendum on June 3rd 1992
Macroeconomic indicators: Germany
Macroeconomic
indicators: UK
 How Do Speculative Attacks Work in Practice?

Non-banks prefer to operate by using forward contracts instead of

trading in the spot markets.

Example: Speculative attack on the Thai Baht

Selling forward: Bath against US$

In case of a successful attack the Baht/US$ rate will rise during

the time horizon of the contract: riskless speculative gain if
the attack leads to a depreciation of the Baht.
Commercial banks are able to balance their positions in the
interbank market:
Balance of both positions through transaction in the spot market
in order to fullfill the forward contract where e=Baht/$ = 25
(beginning of 1997)

-> Balancing of currency positions, but maturity mismatch

2nd transaction:
swap transactions in order to balance the maturity mismatch of
the previous transactions :
Conversion of $/Baht today against Baht/$ in the future
 Downstream transaction during a crisis

 dominance of forward contracts for sales of the Thai Baht.

 leads to sales of Baht in the spot market
 absorption by the central bank
 loss of international reserves
 since commercial banks exchange domestic against foreign
currency, larger demand for central bank money
 central bank ends up ‘financing’ the speculative attack
 increase in short-term interest rates in order to prevent a
speculative attack
 Mechanism for Speculative Attacks

Downstream transactions during a crisis:

Amplification of speculative pressure from derivative
markets

Assume: Portfolio positions in the depreciating curreny hedged

through put options, that means: option to sell Baht at the
exercise price

During a currency crisis:

• exercise of put option becomes more likely,
• increasing probability for the option writer (commercial
banks) to deliver the appreciating currency,
• to keep balanced positions: sales of the weak currency,
• further increase of pressure on weak currency.
“First” vs “Second Generation” Models
Remarks:
• 2nd geration models display strategic complementarity with
respect to the behavior of speculators
• Strategic complementarity is central mechanism in many
theoretical approaches in contemporary economics (choice of
technologies, choice of locations, even economic activity)

Unresolved problems:
• no explanation of the process of coordination
• no information on selection of equilibria
 Banking and Currency Crisis in Southeast Asia:
“Third Generation of Models”

Again, previous models of 1st and 2nd Generation are no longer

applicable:

Prior to the crisis hardly any economic/ policy problems:

• strong economic growth in emerging markets of Southeast Asia,
• moderate inflation,
• moderate interest rates,
• large amounts of currency reserves,
• small budget deficites,
• peg to US $ without prior tendencies towards devaluation.
 Asian Crisis

 No target conflicts in economic policy, as in the EMS and

Mexico cases.

 Deregulation of financial markets after 1990:

 large capital inflows,
 strong increase in domestic lending,
 more than proportional increase in short-term liabilities to foreign
countries.
Forward rates of
Mexican peso and
Thai baht prior to
their crises:

no “peso”
phenomenon
Course of events:

• Breakdown of several financial and real estate companies in

Thailand in the first half of 1997,
• speculative attack against the Baht (14/15 May 1997), peg was
abandoned after massive depletion of currency reserves in July
1997,
• immediately followed by attacks against and devaluations of:
Malaysian Ringgit (14 July), Phillip. Peso (11 July),
Indonesian Rupia (14 August)
Course of events:

• August/ September: Capital controls in Malaysia, IMF program

for Thailand,

• October 1997: Devaluation of Taiwan $, attack against Hong

Kong $, major losses on Hang Seng index (-30%),

• November 1997: devaluation of the Korean Wong, IMF

programs for Indonesia and Korea.
 Asian crisis

Proposed explanations:

1. Crisis due to liquidity problems

2. Crisis as a consequence of overinvestment and moral hazard

Explanation I: Crisis as a liquidity problem

International analogue to national bank run:

• international investors suddenly withdraw their capital,

• reversed capital flows,

• conversion of investments into US $ leads to pressure in exchange

market,

• devaluation of domestic currency.

The canonical bank run mechanism (Diamond and Dybvig,
1983)

• Bank borrows to investors, these credits yield a return after

investment of R>1 per unit of capital in T=2; if a project is
abandoned in T=1, the investor can merely repay the credit,

• Consumers deposit their wealth in T=0 but might be forced to

withdraw (prematurely) in T=1 due to liquidity problems,

• Risk averse consumers prefer to receive similar returns on their

deposits in both periods (T=1,2).
• Bank offers the following repayment structure in order to provide incentives
for potential creditors:

c1  r  1 (in T  1) and c 2  R (in T  2)

• the return for consumers who do not withdraw in T=1 is

R( 1  tr )
c2  R
1t
in T=2, where t: proportion of consumers who withdraw deposits in T=1.
2 Nash equilibria:

(1) only creditors who do face liquidity problems withdraw their

deposits: t corresponds to the average E[t] (law of large numbers),
in this case “normal” returns would be realized: c1 < c2 < R:
normally functioning financial intermediation

(2) Bank panic: all creditors withdraw their funds, i.e. t=1, R=0 < r and
it is rational for each agent to withdraw funds if all others do this.
Implication for the real side: profitable investments must be
abandoned.

Again: strategic complementarity!

Alternative explanation: Crisis as a consequence of
overinvestment and moral hazard

Conjecture:
Deregulation of financial markets and explicit (or implicit)
guarantees by national governments and supranational
institutions led to overinvestment and moral hazard.
Illustration:

Production function with decreasing marginal returns:

Q  ( a0  w )K  a1K 2

with a0, a1 parameters, w capturing exogeneous factors.

Risk-neutral agents choose capital stock so that:

dE [ Q ]
 a0  E [ w ]  2a1 K  i
dK
* a0  E [ w ]  i
K 
2 a1
Gurantees have the following effect:

• under good conditions, w > E[w], above-average returns,

• under bad conditions w < E[w], incurred losses are assumed to be
covered by government.

Assume very simple stochasticity:

w w
w  { w, w } and E[w] 
2
Investors only consider good case:

** a0  w  i
K  overinvestment of K** - K*!
2a1
• overinvestment only becomes evident if negative realization
occurs,
• guarantees are not sustainable and capital is withdrawn.
Consequences for stock markets:

according to the EMH: 

1
Pt*   ( 1  i )s E [ d t  s | I t ]
s 1

assume the good (bad) realizations of

the state of nature lead to high (low)
dividends:
w w
w
 d t 
h , w. prob. q
b , w. prob. 1- q
moral hazard leads to an overvalued
stock market

1 qh(1q )b
stock market crash when
overinvestment becomes apparent
Pt*  (1i )s ( qh(1q )b)  i
s1

1 h *
Pt**  (1i )s h  i  Pt
s1
Remarks:
• there is still no overall consensus about which of both explanations gets
closer to the core of the Asian Crisis,
• The Asian crisis generated a new literature on contagion of crises. Possible
channels ae:
– trade connections: devaluation in one country leads to loss of
competitiveness of other countries
– monetary channels: lenders change their portfolio composition in the
face of a crisis,
– information channels: Crisis in one country as a signal of high
probability for crisis in other countries with similar development,
– change of investors‘ expectations: coordination of expectations, herd
behavior
• note the different normative implications of the candidate explanations:
– bank run is more in line with self-fulfilling prophecies of the second
generation crises models,
– overinvestment and moral hazard imply that non-sustainable policy was
the origin of the crisis (first generation).
 The Financial and Sovereign Debt Crisis 2008 -

• New investment opportunities through ‘structured’ products:

overinvestment?
• Breakdown of trading in interbank market led to
‘unconventional’ monetary policy: bank run (of banks on
banks)
• Divergent macroeconomic developments in the EURO zone:
would have created pressure on exchange rates in a target zone,
but could not be exploited due to joint currency
• Stress in the sovereign debt market rather than the forex
market: expectations of breakup of EURO zone reflected in
extreme risk premia: multiple equilibria
• Policy interventions: “European Central Bank President Mario
Draghi said policy makers will do whatever is needed to
preserve the euro.”
Background:

• Financial innovations: Surge of “structured” products

• CDOs (collateralized debt obligations): formation of large
portfolio of mortgages, loans or bonds and slicing into different
tranches with different risk characteristics (different risk
premia, different ratings)
• Credit risk could be better diversified and spread over more
parties (in principle)
• Securization allowed banks to save regulatory capital, to
increase lending (“securization increased the risk appetite of
banks”, overinvestment?)
 Basic structure of a CDO
• A bank sells loans to a special purpose vehicle
• All cash flows from the underlying loans are collected and
are allocated to the different tranches of an ABS
• The SPV issues bonds for the different tranches
• Payment of interests and principal are made in order of
seniority. Losses from the default on single loans affect
lower tranches first.
 Bank SPV Investors

AAA
Loans
Loans A
Loans
Loans
Loans
Loans BB
Loans
mostly equity piece
kept / first loss

Bank sells part of his loans SPV pools cash Investors buy CDOs (differ in
to the SPV. flows and passes riskiness) and receive interest
Balance sheet: cash against them to tranches and principal from the
loans by seniority underlying loans
The Complexity Tree: What you would have to know to
evaluate typical credit derivatives

Source: Haldane (2009, p. 37), Rethinking the Financial Network

 From the Subprime to the Liquidity Crisis

• “Structured” products are typically transferred to off-balance-

sheet vehicles (SIVs: structured investment vehicles)
• SIVs had typically strategies of investing in long-term assets
and borrowing short term via asset-backed commercial paper
(ABCP)
• With first downgrading of CDO tranches, maturity mismatch
led to problems of banks of SIV to roll over their short-term
liabilities
• Further effects: margin calls for leveraged products leads to
fire sales of liquid assets, uncertainty about risks and liabilities
led interbank lending to dry up, true bank runs occured …
Risk Management and Governance
Issues
• Risk diversification was largely illusionary, but risk has been
sliced and repackaged in intransparent ways
• By lower tranches of CDOs, new assets have been created with
very high correlation (as they were basically subject to
macroeconomic risk factors)
• Lack of experience in evaluation: rating agencies used scenarios
with ever increasing housing prices
• High sensitivity of CDO payoffs to assumed fundamentals
• High complexity of evaluation
• Procyclicality of mark-to-market evaluation
• Lack of regulation of CDO market as it was ‚outsourced‘ to
SIVs (shadow banks)
After the collapse of the real estate
and CDO market…
• Default of Lehman, collapse of interbank market
• Worldwide spread due to high connectivity of the financial
sector
• Substitution of interbank market by central banks
(unconventional moneatry policy)
• ‚Flight to quality‘, re-evaluation of risks of other asset
classes (G-bonds)
• High debt burden of bail-out and rescue schemes for the
banking industry
• Different macroeconomic developments in EU… European
debt crisis
 New issues on the agenda
• The structure of the financial sector (too-big-to fail, too-
interconnected-to-fail, too-central-to-fail etc)
• How to regulate the financial sector (macroprudential
regulation)
- avoiding contagion effects due to high connectivity
- regulating off-balance entities
- avoiding procyclical capital requirements
- regulating rating agencies
- regulating the shadow banking sector
• How to revive the interbank market and exit from non-standard
monetary policy