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Monday, October 27, 2008

A few currency crises coming together?

So far, the global financial crisis was largely about financial firms and markets in the first world. This was a novel experience; it had never happened before. Now it might morph into a few currency crises hitting pegged exchange rates. This is an old movie; we have seen this many times before and we know a lot about it.

Speculative attacks on pegged exchange rates appear to be in the offing. The market is carefully analysing all countries with pegged exchange rates, looking at the possibility of large devaluations when the central bank runs out of reserves. Countries which have interfered with exchange rate devaluation are in focus now. Thankfully, by and large, India is not one of these.

A key mistake that is being made in thinking about these problems is that many countries hold reserves that are "large enough". As an example, writing in Financial Times, Charles Clover reports:

After two months of crisis, meanwhile, Russias currency reserves have dropped from $597bn in August to $515bn on October 17, partly as a result of defending the rouble. Capital flight is running at $12bn-$16bn a week. The Moscow interbank lending rate hit 22 per cent last week before settling back to 17 per cent, by far its highest level this decade, reflecting the scale of the stress in the banking system. Domestic banks are seeing depositors confidence evaporate four retail banks have experienced runs and been sold off in a hurry.

This month, the central bank instituted the first measures designed to prevent a speculative attack on the rouble when it banned currency swaps. But analysts are starting to ask how long the authorities can stand as substitute for the cut-off foreign investment and seized-up credit markets. They have enough reserves to last a year at this rate, maybe 18 months, says an economist at a Moscow bank.

This `economist at a Moscow bank' is not reckoning with the incredibly nonlinear behaviour of the system when a speculative attack comes together. Once a speculative attack starts, reserves can essentially vanish in no time. Linear extrapolation is a poor guide to the outlook for reserves.

Exchange rate flexibility is now highly desirable. If countries try to hang on to exchange rate targets (e.g. RBI was a bit squeamish about breaching INR 50 per dollar) then this could cause a lot of damage. In this environment, it's easy to get into a speculative attack. In contrast, exchange rate flexibility has a lot to offer. Countries that allow bad news to result in a sharp depreciation of the currency (and a sharp drop in asset prices) benefit from the lack of a perception of a one-way bet. A currency that has dropped in response to market forces (without interference by a government) has a good chance of going up the next day: there is no one-way bet in taking capital out of the country.

Holding "large" reserves is not a very good deal. In peacetime, they are not required, and in wartime, they are useless.

From an Indian point of view, as the Aziz, Patnaik, Shah paper has emphasised, there is a case for RBI using dollars to solve the dollar liquidity problems of Indian firms. The outer limit for the quantity of dollars that might get used in this fashion is $50 billion (partly because the London money market is showing some halting signs of life). There is no case for RBI to have any kind of exchange rate target. If RBI embarks on trading on the market in order to influence the exchange rate, this would be imprudent.

From a trader's point of view, the consequences of this are simple. Look for countries where there is exchange rate rigidity, where the central bank has sold reserves in doing market manipulation, and short those currencies / stock market indexes. In doing this, be careful to not mis-interpret a decline in reserves expressed in USD.

If a clutch of countries experiences speculative attacks, and then large devaluations take place, this would add to the negative outlook for the world economy, for we know that in the aftermath of a currency crisis, it takes a year or three for the country to put itself together. Hopefully, these countries will come back to life with better monetary policy frameworks, so in the long run, this will turn out to have been for the better. But in the short run, this could be quite painful.


  1. I enjoy reading your blog regularly, and I can easily say I don't know nearly as much as you about everything regarding $$$, economics, and probably math.

    But here is my question:

    What if the RBI simultaneously did two things, at least temporarily, which I know you are very much against.

    Continue the dollar peg while increasing opacity as to the RBI's intervention (I don't know if its possible to hide intervention).

    Wouldn't this prevent one way bets while maintaining a stable currency.


  2. Which peg's are under attack?? because there are not that many around these days, owing to the crisis that occurred during the 90's. Unless you know you can defend your peg very few governments opt for it as exchange rate policy and they certainly haven't been introducing them in any large numbers.

    There are a few if not many managed exchange rates, but peg's are few and far between these days and the ones that are around are very robust. Look at the Hong Kong dollar which did more than survive during the Asian Crisis, they managed to burn speculators outright with intervention.

    By Your own reckoning Russia has half a trillion in reserves, it can fend off speculators by simply sneezing, and in the current environment you find me a hedge fund that is not openly licking its wounds and hasn't haemorrhaged or is not in desperate need of cash. I am sure people would love to take a speculative positions on the devaluation of a currency, and hope that such positions would force a devaluation so they can profit, but the fact of the matter very few people have that ability in this current environment to run positions like that, certainly not large enough in size, that any economy worth doing it too could not defend itself.

    The Dollar continues to rally and currencies continues to fall against it as a flight to supposed quality continues to occur. That is why we see the movements we see, not because the market has taken a view that a currency seems to be weak and a peg cannot be defended.

    I see no speculative attacks on anyone's currency, no one has the muscle right now to do that as much as they might like too. There may be a few shorts or even many I don't dispute that as some people will be enjoying momentum but employing leverage right now, try borrowing for a start, very difficult and people are in the midst of reducing their risk not increasing it.

  3. Sharat,

    I feel oddly squeamish naming countries because that's part of how these things get out of hand.

    You don't need hedge funds to get speculative attacks that work. Speculative attacks have been a part of our experience well before hedge funds came along. Yes, leverage in the hands of modern players has helped. But it's by no means the big thing. The most important sources of breakdown of East Asian exchange rate regimes in 1997 were locals.

    The word `peg' is used a bit differently from the way you seem to assume. Perhaps part of our difference of perception is nomenclature.

    I feel quite confident that Russia is not safe with their hoard of reserves. The protection that big numbers for reserves yield is much more limited than generally meets the eye. I wonder what's the implied pdf of the ruble exchange rate right now.

  4. Anonymous,

    There are no real secrets. RBI staff have friends and they have friends and all you gain from the non-transparency is a non-level playing field in the world of information.

    The checks and balances of democracy work less when there is opacity. E.g. if Thailand in 1997 had more transparency, the mistakes they made on forward trades would not have been made. Similarly, I believe that it was the broad intellectual consensus in India that stopped RBI from dogmatically buying dollars in 1997. So there are deeper costs from doing things in darkness.

  5. Hi Ajay,

    Thanks for coming back to me. I have to say a peg, in the strictest sense of the word is exactly what the name suggests, a peg to a particular currency, usually the dollar at a particular value or very very narrow band, using a currency board system to maintain that very narrow band. Peg's allow zero flexibility on the part of the government who use them and monetary policy is determined by the country whose currency is being pegged to.

    These days the more favoured approach by governments in exchange rate policy and what you refer to is a managed float where the currency trades against an opaque basket of currencies and is allowed much more freedom to move which means countries can determine their own interest rate policy. Though India does prefer to benchmark against the dollar for whatever reason.

    I have to be pedantic I cannot allow liberal use of the term peg to describe a managed exchange rate for two good reasons. They are very different things, and more importantly, I grew up in Hong Kong and lived there for over 30 years, and the currency that was in my pocket during that entire time had a value that was pegged to the US$ using the currency board system. To use the term to describe a managed float is faux pas. Forgive me, I do not wish to sound arrogant in the slightest, but if someone used the term hills to describe the Himalayas we as Indians would have to correct them and say they are mountains.

    I have to respectfully disagree with you however, for hedge funds or any institution to take positions in a market particularly the currency markets, and again I say this after having worked on trading floor right next to the prime brokerage desk during the Asian financial crisis. Leverage is required. These funds without leverage are puny. look at Citadel which is facing difficulty right now, one of the most successfully managed hedge funds ever, with $15 Billion under management, its a minuscule amount of money. If they want returns then they need to lever up, otherwise they cannot return the 30% per annum that they were doing the previous 5 years

    I have to disagree with your view on reserves as well, they can be very potent weapons and a means of defence. I was there the day the Hong Kong government intervened to fend off speculators and bought US$30 Billion worth of equity over a two day period. Not only did currency speculators who were shorting dollar and the index cave they got badly burned and to date I have never seen so much frenzy on the floor.

    You are right, a concerted attack by a market that lasts weeks or months cannot be defended against no matter how much you have in reserves, but a short one where speculators do not have the wherewithal to take the pain on immediate losses can, and I have seen it work with my own eyes as it happened and even participated in it.

    Honestly speaking with the way asset markets are selling off right now investors are trying to stem their own haemorrhage, there isn't a manager out there looking at running a speculative position other than an unleveraged short perhaps at best and no one has the ability to lever up, and I respectfully disagree again, if you want a decent return on a position you need some degree of leverage, which is simply not feasible right now. In fact the term leverage right now is a dirty word and nobody wants to hear it.

  6. You might want a short read of my stuff. I don't get to be as wonkish as you are allowed to be, the luxury of a personal blog means you can write when you want and about exactly what you want about and I envy that, but about once a week or so I write something of interest to me personally

  7. Ajay
    can you pls help to understand drop in australian dollar???



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