Exchange Rate Policies

Why Study Exchange Rates? To understand the economic environment Forecasting for planning purposes To understand exposure to currency risk Financial impact of exchange rate move varies With the nature of the asset/liability With the cause of the move

Outline: Exchange Rate Determination Role of Government Market Forces Real economic effects Monetary effects

Exchange Rate Policy The role of government

Exchange rates are determined by supply and demand for the currencies

How governments affect exchange rates Currency market intervention (intentional) Central Bank buys/sells home currency in exchange for its foreign currency reserves. Monetary policy (unintentional through impact of inflation) Central Bank buys/sells home currency in exchange for bonds

Types of Exchange Rate Policies free float (no intervention) “dirty”or managed float(some intervention) fixed exchange rate or “peg” (unlimited intervention at a fixed rate) through central bank policy currency board dollarization

Asian Financial Crisis of 1997 and its aftermath Some Policy Examples Asian Financial Crisis of 1997 and its aftermath

Thailand - background “Young Asian tiger” - attracted heavy foreign investment; low cost of labor open financial markets Prosperous and growing export sector Once growth began, country grew even more attractive to investment.

Exchange rate policy: baht pegged to US $ Problems: U.S. dollar appreciated throughout the 90s Therefore baht appreciated as well Consequence 1: Declining export competitiveness Normal exchange rate response precluded by peg Reduced fundamental strength of economy

baht pegged to appreciating US $ Consequence 2: apparent financial arbitrage Thai interest rates higher than those of US Normal exchange rate response precluded by peg Thai firms (and others) borrowed dollars to invest in short-term Thai financial assets. (“carry trade”)

Currency market implications Market response Falling demand for baht to pay for Thai exports Increasing supply of baht to buy dollars to service loans Thai central bank found itself constantly buying baht and selling dollars to maintain the peg

Collapse of the peg Eventually, some came to believe the central bank would run out of dollar reserves and be forced to abandon the fixed exchange rate. Speculative response As a result, peg was “broken”, exchange rate was allowed to float and immediately lost value. Capital flight, heavy currency losses to Thai businsses and financial crisis

Discussion In such cases, central banks often blame speculators for the collapse of the exchange rate. To what extent is this justified? What ethical considerations should govern speculation on currency or financial markets?

Weak regulation of the banking sector Some structural features of the Thai financial sector made the crash worse Weak regulation of the banking sector During the boom, many banks made a lot of weak loans, often as a result of political influence Asset price “bubbles” resulting from heavy inflow of financial capital from the “carry trade”

Spread of the crisis Currencies perceived to be in circumstances similar to the Thai baht also came under selling pressure Indonesia Korea Less affected by currency crisis directly Japan (imposing foreign currency reserves) China (financial still highly insulated from the world) Philippines (no previous boom to crash from)

Hong Kong Hong Kong dollar also subject to heavy selling pressure. Pegged exchange rate supported by a currency board Hong Kong dollar also subject to heavy selling pressure. Because the currency board had sufficient reserves, the fixed exchange rate survived. Consider resulting impact on Money supply Interest rate Economic activity

Spread of Crisis beyond Asia Further currencies subject to speculative attack Russia 1998 Brazil 1999 Brazil very promptly abandoned its peg to the dollar. The currency dropped greatly in value, Economy recovered in subsequent years

Argentina: Collapse of a currency board Like Brazil, currency was pegged to U.S. dollar Like Brazil, came under attack in 1999 However, because the peg was supported by a currency board, Argentina attempted to maintain the fixed exchanger rate. (Like Hong Kong)

Consequences for Argentina Terms of trade with Brazil, major trading partner, became very unfavorable. Exports collapsed, Imports increased, Deep economic recession

Consequences for Argentina Although the currency peg controlled inflation of the currency, Argentina maintained a large fiscal deficit. Funded by borrowing on international markets Eventually limit of borrowing capacity was reached. Policy options then were: Reduce expenditures = political consequences Abandon currency board and create money to cover obligations (inflation) – occurred in 2002. Accompanied by a default on past foreign debt

Lessons about Exchange Rate Policy Policy matters (especially in the short run). In the long run no policy can overcome market forces.