Currency Crises 2

8/20/2019 Currency Crises 2

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Exchange Rate Crises


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The Argentine Convertibility Plan

before the Tequila Crisis

• The Convertibility Plan Argentina maintained a one-for one peg against the

dollar, with Epeso/$ = 1

Te!"ila Crisis was an e#hange rate and finanialrisis in %e#io in &eember 1''( )"t it hadonse!"enes for Argentina

*ere, we onsider the beginning of the risis+theaftermath is dis"ssed in more detail in a laterappliation

e an e#amine how the money s"pply and reservesfl"t"ated 1''.1'', and then plot these on theentral ban0 balane sheet diagram


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• Central )an0 )alane heet, 1''.1''


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• %oney &emand ho0s, 1''-1''( April 1'', point 1

% = 12 bil pesos, 3 = 4 bil pesos, ) = ( bil pesos

)a0ing ratio = 4/12 = 56

7ovember.&eember 1''(, point 2 %oney demand and s"pply inrease, reserves grow

)a0ing ratio rises slightly to 11/18 = 6

9an"ary.:ebr"ary 1''8, point Te!"ila risis in %e#io leads to an inrease in ris0 premi"m

on Argentine deposits ome flight from ban0 deposits todollars

3eserves, money s"pply fall slightly, by 1 bil

)a0ing ratio remains relatively high at 1;/1( = 16


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• The inrease in Argentina


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Defending the Peg II: Changes in the

Composition of the Money Supply

•

o far, entral ban0

• 7ow, we onsider hanges to the omposition of

the money s"pply, holding the level of the moneydemand and s"pply fi#ed

• The entral ban0 employs sterilization to hold themoney s"pply % fi#ed, by ens"ring e!"al andopposite hanges in ) and 3

f C


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•

A ho0 to &omesti Credit The entral ban0 an b"y/sell domesti bonds, affetingthe omposition of the money s"pply

E#ample? entral ban0 b"ys 1;; billion in domesti

bonds terili@ation implies that reserves deline by 1;; billion to 0eep

the money s"pply "nhanged

D f di h P II Ch i h


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Point 2? nrease in ) implies 3 dereases%ovement along the fi#ed line Point is reverse>

D f di th P II Ch i th


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•

hy does the omposition of the money s"pplyfl"t"ateB The entral ban0 may b"y or sell domesti redit for

one of two reasons

To infl"ene interest rates on different bonds To lend in an emergeny+to s"pport the private finanial

system And b"ild "p s"h reserves before/after>

• E#tend redit to ban0s d"ring a risis to assist str"gglingban0s in meeting their obligations to depositors and/or other

reditors, inl"ding other ban0s>• Prevent spread of a ban0ing risis aross the finanial

system and limit effets on real eonomi ativity

• To address either insolvency or illiquidity at ban0s



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• To "nderstand the wor0ings and impat of entralban0 lending to private ban0s? e have to rela# the ass"mption that the monetary

base %;> is e!"al to the money s"pply %1 or %2>

e have to "nderstand the two types of ban0ingproblems and their sol"tions nsolveny and bailo"ts

lli!"idity, ban0 r"ns and lender-of-last-resort



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• nsolveny and bailo"ts A private ban0 is insolvent when its liabilities e#eed

its assets This o"rs when ban0s s"ffer from losses inassets as a res"lt of loan defa"lts

The government may prevent the ban0


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nsolveny and bailo"ts



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• lli!"idity and ban0 r"ns A private ban0 may be solvent, b"t illiquid? has

little ash, and most assets loans> are illi!"id Ban run? f too many depositors try to withdraw ash at

one, ban0 "nable to honor payments

)an0 r"n reflets inrease in money demand for ash>

!ender of last resort? Central ban0 e#pands the moneys"pply to meet inrease in money demand

&omesti redit inreases 3eserves "nhanged



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lli!"idity and ban0 r"ns



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• 3efletions nsolveny and illi!"idity hard to tell apart in reality

n bad timesD many assets val"es rash Eg 2;;-;4>

ho"ld ban0 be savedB *ow to val"e its portfolioB At the oldnormalD prie or the prevailing rashD prieB

3is0 of systemi risis hard to ga"ge f people annot tell good ban0s from bad ban0s, or if bad

ban0s owe money to good ban0s

i!"idity provision will not endanger reserves if peso provision

to ban0s offset by new peso demand by people

Th A ti C tibilit Pl


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after the Tequila Crisis

• Argentina had e#periened money demandsho0s 1''.1''(>, b"t s"essf"lly defendedthe e#hange rate peg

•

)an0ing Crisis,1''8 The sharp inrease in Argentina


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• )an0ing Crisis,1''8 9an"ary/:ebr"ary.%ay 1''8

Central ban0 e#panded domesti redit in response toinsolveny and illi!"idity

7et effet was little hange in money demand/s"pply and alarge red"tion in reserves

)a0ing ratio fell sharply from 16 in :ebr"ary 1''8 to 56by %ay 1''8 "t in half>

Argentina was r"nning o"t of reserves rather !"i0ly



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• )an0ing Crisis,1''8 Point . Point (>



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• )an0ing Crisis,1''8 Point . Point (>



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• *elp from the %: and 3eovery :ollowing Te!"ila risis, %: loans dollars to

Argentina, inreasing reserves, and a f"nd isestablished to bail o"t failing ban0s

%ay 1''8.7ovember 1''5 Point (.Point 8> )an0ing risis over, entral ban0 replenishes reserves,

red"es domesti redit, via sterili@ed intervention

)a0ing ratio ret"rns to 16 by 7ovember 1''5

7ovember 1''5.%ay 1'' Point 8.Point 5> Central ban0 ontin"es inreasing reserves and dereasing

domesti redit

)a0ing ratio ontin"es to rise 1;;6 by %ay 1''



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• Postsript ith 1;;6 ba0ing ratio, Argentina o"ld have

adopted a strit currency board system,strengthening its peg against the dollar, b"t did notformally do so

ope for disretionary hanges in domesti reditsterili@ation> remained The Convertibility Plan ended in 2;;1 with another ban0ing

system ollapse related to a fisal/defa"lt risis> that isdis"ssed in more detail in Chapter 11

"he Central Ban Balance Sheet and


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"he Central Ban Balance Sheet and

the #inancial System

• A %ore Feneral )alane heet A more realisti and detailed entral ban0 balane

sheet allows "s to? &isting"ish between different types of foreign and domesti

assets, and also allow for liabilities

Tra0 more omple# entral ban0 operations

t"dy the entral ban0


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$ More %eneral Central Ban Balance Sheet

• Assets :oreign "rreny assets+to defend the peg

:oreign "rreny reserves in all :G "rrenies>, and also in gold

&omesti assets+lending by entral ban0 &omesti government bonds p"rhased by entral ban0

Central ban0 lending to ommerial/private ban0s• iabilities

:oreign "rreny liabilities :oreign "rreny borrowing by entral ban0 :G debt iss"e>

&omesti "rreny liabilities &omesti "rreny borrowing by entral ban0 peso debt iss"e>

%oney s"pply, % C"rreny in ir"lation+"rreny in the hands of the p"bli

3eserve liabilities to ommerial ban0s+"rreny in ban0 va"lts, not inir"lation


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E#ample

7et foreign assets = ';; 7et domesti assets = 1;;

% = 1,;;;


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• hy do entral ban0s borrow iss"e liabilities>B E#ample? terili@ation )onds

ss"e loal "rreny debtH "se proeeds to b"y reserves

As in the simple entral balane sheet, this sterili@ation affetsba0ing ratio and omposition of the money s"pply, witho"t

hanging the level of the money s"pply Can be done even if domesti assets are @eroI

A way to a!"ire reserves in e#ess of %;

• The entral ban0 an have net domesti assets J ;thro"gh iss"ing these sterili@ation bonds entral ban0-iss"ed bonds>, with foreign assets e#eeding %, and theba0ing ratio an then e#eed 1;;6

• %ay be employed if a"thorities fear large reserve losses"nder flight from ban0ing system %2>

The Great Reserve Accumulation


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in Emerging Markets

• People 1''8.2;;

7et domesti redit grows slowly while eonomi

e#pansion leads to a dramati inrease in money demand E#pansion of the money s"pply was absorbed in reserves

and the ba0ing ratio rose from 26 to 856

2;;.2;;5 7et domesti redit dereasing, falling below ;6 by 2;;5

%oney s"pply ontin"es to e#pand, so entral ban0a"m"lates massive reservesH ba0ing ratio rises to1;'6



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in Emerging Markets



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in Emerging Markets

• The sit"ation in China is not "ni!"e



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in Emerging Markets

• Ca"ses of the 3eserve A"m"lation Co"ntries fear a s"dden stop of foreign apital in> or

s"dden flight of home apital o"t>

&esire for a larger ba0ing ratio to maintain a stronger peg inresponse to money demand sho0s

%ore reserves allow the entral ban0 to provide li!"idity tothe ban0ing system temporarily? reserves an absorb a flightfrom %2 to foreign "rreny

After Asian risis, o"ntries a"m"lated reserves to b"ild "pli!"idity in ase of another ban0ing risis

3eall, ban0ing rises and e#hange rate rises depend oneah other f the o"ntry has s"ffiient reserves to defend thepeg, it is less li0ely a ban0ing risis will o"r


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Too Much of a Good Thing?

• :rom the K perspetive &eveloping o"ntries and emerging mar0ets are

a"m"lating reserves, espeially K dollars K

Treas"ry bonds> This has been one way often a maLor way> in whih the K

finanes its "rrent ao"nt defiit

These o"ntries "se sterili@ation to prevent hanges in themoney s"pply, while a"m"lating reserves


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• :rom the emerging mar0et perspetive )enefit

terili@ation and reserve a"m"lation allows o"ntries to

effetively defend the peg, while preventing money s"pplye#pansion and inflation>

A form of self-ins"rane against a risis triggered by flightfrom loal ban0s to dollars

Cost

terili@ation bonds "s"ally pay higher interest than theinterest reeived on K dollar reserves

Co"ntries fae an opport"nity ost assoiated withsterili@ation


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• Mey iss"es and statistis terili@ation bonds in poorer o"ntries pay ro"ghly

126 interest ompared with 86 interest on K

Treas"ry bonds f a risis has 1;6 probability, osts 1;6 of F&P,

then ins"raneD sho"ld ost J16 of F&P

everal o"ntries have a"m"lated s"h large

reserve holdings that osts are m"h larger 3eserves held by developing o"ntries do"bled in

years, reahing $2' trillion at the end of 2;;8

Currency Crises 2

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