INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT Lecture 2: Read on Your Own The International Monetary System: Attacking Currencies

Purpose of These Slides To demonstrate how markets attack foreign currencies.  Why an attack occurs and the conditions necessary for success. Success measured by the country abandoning its peg. To give you examples of currency attacks and the consequences of those attacks.  United Kingdom pound attack in  Asian currency attack in While these slides will deal with pegged currencies, attacks on poorly managed currencies can also occur and through the same process discussed in these slides.

Why Do Countries Abandon a Peg Regime? Sometimes the market forces them to do so.  If the market perceives that the country’s peg is “unrealistic” and “unsupportable” speculators may move against (i.e., attack) the currency.  If the speculation becomes too great, governments may be forced to abandon peg. Sometimes the government may abandon a peg as part of its own orderly process to move its economy towards a more open, market driven system.  Likely to be China’s motivation

Market Forcing Countries to Abandon Peg: An Attack on a Currency Attacks on currencies can occur for a variety of reasons, but essentially they all relate to:  Where the market believes that the established (pegged rate overstates (or understates) the currency’s “true” (intrinsic) value. Why might a currency be perceived as overvalued?  Inappropriate domestic monetary and fiscal policies.  Weakness in the country’s external (trade) position.  Weakness in the country’s key financial sector (banking). Why might a currency be perceived as undervalued?  Underlying strength in the economy of the country which is not reflected in the pegged exchange rate.

How Does the Market Attack a Currency: Necessary Conditions in Financial Markets The financial markets of a country must be fairly “open” for currency attacks to occur.  Open capital and currency markets.  Funds must be able to flow into or out of a country. Stock markets and currency markets.  It would be somewhat difficult to attack the Chinese currency today. Financial markets are still tightly controlled and not very open.

Attacking a Overvalued Pegged Currency Attacks on an Overvalued Currency:  Currency is sold short on foreign exchange markets. Speculators borrow currency, sell it now, and intend to buy it back later when currency weakens.  Speculators selling stock short on country stock markets. Provides them with needed foreign exchange (in pegged currency) and potential profits if currency weakens.

Attacking a Undervalued Pegged Currency Attacks on an Undervalued Currency:  Currency is bought (long) on foreign exchange markets. Speculators buy currency, and intend to sell it later when currency strengthens.  Speculators buying stock (long) on country stock markets. Potential profits when currency strengthens.

Essential Assumption Before Attack will Proceed In addition to the previously discussed conditions, the speculators must also be confident that the government of the country’s who’s currency is under attack:  lacks the will to defend its currency. Not willing to adjust interest rates  lacks the resources to defend its currency. Does not have sufficient foreign exchange to support its currency.  Would need dollars if currency is being sold.

British Pound Attack (1992) Britain joined the European Exchange Rate Mechanism (ERM) in October  ERM was designed to promote exchange rate stability within Europe. Under the ERM, European currencies were “pegged” to one another at agreed upon rates.  The British pound was locked into the German Mark at a central rate of about DM2.9/£  Generally feeling at the time was that this rate overvalued the pound against the mark.

Dominance of Germany in the ERM While the ERM included many European countries, Germany was the leading player.  Thus, the German mark was the dominant currency in this arrangement. Thus, German monetary policy had to be followed by the other members in order for the other member states to keep their currencies aligned with the German mark.  This was especially true with regard to German interest rates.

Cartoon Representing German Dominance

Series of Events Leading Up to the Attack on the Pound While the markets felt the pound was “overvalued” when it joined the ERM, a combination of events just before and after Britain joined convinced the market that the pound was ready for speculation. These events were:  The fall of the Berlin Wall in Nov 1989  The economic “recession” in the U.K. in German decided to raise interest rates in order to attract needed capital for the reunification of Germany. The issue for the U.K. was having to raise interest rates during their recession.  Political and economic component to this decision.

Response of British Government to Speculative Attack: September 1992 Pound currency attack begin in September 1992  Led by hedge funds: George Soros. Wednesday, September 16 (“Black Wednesday”)  Raised interest rates twice from 10% to 12 and then to 15%  Attempt to make U.K. investments more attractive. During the attack the Bank of England spent 4 billion pounds ($7 billion) in defense of its currency. Buying pounds (selling U.S. dollars and German marks). Estimates: 1/3 of its hard currency was spent. Thursday, September 17, U.K. left the exchange rate mechanism and let the pound float!  From (ERM floor) to 2.413; or -13.1%

British Pound: Jan 1991 – Dec 1992

% Change in British Pound

Pound Against the U.S. Dollar: 1992 Down by 25%: What did this mean for U.S. Companies operating in the U.K.?

Asian Currency Crisis of 1997: Background During the 1980s, a group of countries in Southeast Asia – known as the “Asian Tigers” – experienced exceptionally high economic growth rates. The economic miracle was accompanied by these countries opening up their financial markets to foreign capital inflows Also, during this time, the currencies of these countries were pegged to the U.S. dollar.

Thailand: Background Thailand was part of the southeast Asian region which experienced double digit real growth up to the mid-1990s.  Exports were critical to the regions exceptional growth. Thailand’s exports had increased 16% per year from 1990 to  Economic growth in the region was fueled by massive increases in borrowing. Government borrowing for infrastructure investment Corporate borrowing for investment expansion.

The Thai Baht The Thai baht had been pegged to the U.S. dollar at 25 to the dollar for 13 years.

Thailand Begins to Unravel The massive increase in investment eventually resulted in:  Overcapacity  Poor lending/investment decisions  Investment in speculative activities (especially the property markets) On February 5, 1997, the Thai property developer, Somprasong Land, announced it could not make a $3.1 million interest payment on an outstanding $80 billion loan.  Other Thai development companies followed and the Thai property market began to unravel.

Currency Traders Assess the Situation Currency traders were aware of the following:  Thailand’s enormous external debt which was denominated in U.S. dollars would require a large demand for dollars.  Coupled with the debt burden, Thailand’s export growth began to slow and moved into deficit. Where would the dollars come from the finance the external debt?  Traders believed the baht was “overvalued at 25 to the dollar.

The Attack on the Thai Baht Peg Believing the Baht was overvalued, speculators:  Start to sell the Baht short in May 1997 Traders borrowed Bahts from local banks and immediately resold them in the foreign exchange markets for dollars.  If the Baht did weaken, traders could buy the Bahts back and pay off the loan and make a profit on the dollar appreciation.

Response of the Thai Government The Thai Government initially responded by:  Purchasing the Baht on foreign exchange markets Used $5 billion in this effort  Raising interest rates from 10 to 12.5% Thailand was quickly running short of U.S. dollars  They had just over $1 billion left to support the Baht. The higher interest rates raised the cost of borrowing and adversely affected floating rate loan liabilities. Bottom line: Defending the peg was nearing impossible.

Releasing the Peg On July 2, 1997, the Thai government announced they were abandoning the peg and would let the currency float.  The Baht immediately lost 18% of its value  By January 1998, it was trading at 55 to the dollar.

Baht’s % Fall Against the Dollar

Contagion Effect in Asia (1997) The attack on the Thai Baht, quickly spread to other Asian currencies  Regional contagion effect Concern mounted regarding the economic and financial “soundness” of these countries as well. As a direct result, many of these Asian countries were forced to abandon their pegged regimes. For a complete discussion of the crisis see: 

Indonesia Rupiah, Jan 1997 – Dec 1997

Philippine Peso, Jan 1997 – Dec 1997

Taiwan Dollar, Jan 1997 – Dec 1997

Korean Won, Jan 1997 – Dec 1997

Malaysian Ringgit, Jan 1997 – Dec 1997

Malaysian Ringgit: 1997 – June 2005

July 21, 2005: Malaysia Moves To a Managed Float.

Exchange Rate Changes in Asia: June 1997 to June 1998

Some Governments, However, Were Able to Successfully Defend Their Currencies Hong Kong Dollar  China purchase massive amounts of stock being sold on the Hong Kong stock exchange. Offset the short selling of hedge funds.  China sold massive amounts of U.S. dollars in defense of the HK$ Offset the selling of the Hong Kong dollar on foreign exchange markets.  The HK$ peg was successfully defended and remains so today.

Hong Kong Dollar in 1997