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International Fixed Income

Topic 6A: Currency Crises

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Outline

DescriptionEffect on international bond market

» local currency

» $-denominated

Examples» ERM crisis (1992)

» peso crisis (12/94)

» russian default (8/98)

» Asian currency crisis (1997-98) (see http://www.stern.nyu.edu/~nroubini/asia/AsiaHomepage.html)

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I. Currency Crisisa First Look

Central bank uses reserves to maintain XRs within a bandFor various reasons

» Domestic money demand falls

Dom inflation, loss of competitiveness, economic slow-down, corporate failure, foreign withdrawals (political turmoil)

AND/OR» Domestic money supply rises

Fiscal financing via printing, excess dom credit

Central bank loses reservesCrisis ( when reserves are exhausted(?) )

» withdrawal from peg into float» withdrawal from convertibility into exchange controlstimetime

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Review of XR Regimes

Source: IMF publications, 1997Source: IMF publications, 1997

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Currency Crisis: Uncertainty

Non-zero minimal reserve thresholdThere may be an outside infusion (IMF aid, hence negative

minimal level) to allow more time for correcting macroeconomic measures ==> Peg may survive an attack

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The Attack

Reasons/triggers for a speculative attack may varyWhat is common?

» Investors are rational and forward looking

» When expected (risk adjusted?) return on DomXR lower than FX, investors/speculators sell DomXR and reserves decline

» As a defense, domestic interest rates often rise. Then it is the question of the probability, size and timing of the devaluation

» Investors see the end-game, and try to switch from high yield domestic into hard currency just at the right time

» w.r.t. timing, look for “coordination signals”

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Factors Affecting Speculative AttacksFactors which increase the sustainability of a pegged rate

» Large stock of reserves

» Low domestic rate of credit creation

» High demand for domestic money (high income / low interest rates)

» Low expected inflation in the case of a collapse

Factors contributing to a currency crisis» Overvalued domestic currency

» <==> Large and persistent current account deficit

» Excess credit creation (vulnerable banking system => liquidity crunch)

» Low FX reserve relative to short term sovereign debt (liquidity)

» Conflict in the gvm’t policy objectives(government needs to subject dom monetary policy & resulting implications to pegging partner’s currency

fluctuations. May result in loss of competitiveness, slowdown, unemployment ==> politically unsustainable)

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Predictive Currency Crisis Variables

Rank leading indicators based on» Probability of crisis given indicator signal

» Avg. number of month prior to signal that indicator signal is issued

» Persistence of signal ahead of crisis

Most prominent signals» Hard currency reserves

» Real exchange rates

» Domestic credit

» Credit to the public sector

» Domestic inflation

» Interest rate differential widens

» Equity crash

Source: Kaminsky, Lizondo & Reinhart, “Leading indicators of Currency Crisis,” IMF WP 97/79, July 1997

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Example: Brazilian Real (1998-…)

0

0.5

1

1.5

2

2.51/

1/19

98

4/1/

1998

7/1/

1998

10/1

/199

8

1/1/

1999

4/1/

1999

7/1/

1999

10/1

/199

9

1/1/

2000

4/1/

2000

Bz. Real

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Example: Brazilian Real (1998-…)

0

0.5

1

1.5

2

2.5

1/1/

1998

4/1/

1998

7/1/

1998

10/1

/199

8

1/1/

1999

4/1/

1999

7/1/

1999

10/1

/199

9

1/1/

2000

4/1/

2000

0

5

10

15

20

25

30

Bz. RealBrady Yield

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Example: Brazilian Real (1998-…)

0

0.5

1

1.5

2

2.5

1/1/

1998

4/1/

1998

7/1/

1998

10/1

/199

8

1/1/

1999

4/1/

1999

7/1/

1999

10/1

/199

9

1/1/

2000

4/1/

2000

0

10

20

30

40

50

60

Bz. RealBrady YieldBz. Int. Rte

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Example: Brazil -- 9/13/1998

Reserves: declined from $80Bil to $55Bil. $1Bil/day outflow rate that week

Stockmarket: 75% lower y.t.d., 35% over the previous month

Int Rate: from 30%pa to 50%pa (approx. 5-7% inflation). Currency overvalued (?).

Deficit: 8% of GDPPolitical scene: election was in 3wksEffect on the US: 15th largest trading partner, 1.7% of

trade

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Contagion

What do we mean by “CONTAGION EFFECT” ?Study examines crisis index in the post MexPeso collapse

INDEX=a*(currency depr) +b*( loss in reserves)

Index rises for countries w/ highly overvalued RXR, low reserves, and a recent lending boom

==> The “Tequila Effect” is not random Some debate still exists

Source: Sachs, Tornell & Valasco, “Financial Crises in EM: lessons from 1995”, Brookings Papers on Economic Activity N0.1 1996, 147-215

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Correlation breakdown

Event Date Variables Prior to During

ERM Sep92 GBP/$ , GBP LIBOR -0.10 0.75

Mexico Dec94 Peso/$ , 1mo Cetes 0.30 0.80

87 crash Oct87 Junk yield , 10yr Treasury 0.80 -0.70

Iraq Aug90 10yr JGBs , 10yr Treasury 0.20 0.80

AsianCrisis

1997/8 Brady debt of Bulgaria andthe Philippines

0.04 0.84

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Loose Ends

Selection bias: a currency crisis may or may not have developed

(country may take pain now to avoid more pain in the future)

How far is down?» Currency likely to overshoot if/when devaluation occurs

» Exactly by how much is critical for speculator’s profitability calculations

Speculators solve for:» Expected gain given a crisis VS expected loss w/o one

» Function of size, magnitude and timing of crisis

Has a structural change in crises occurred (IMF role) ?

===> PROFITABLE TRADING strategies may exist!

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II. International Bond Pricing

Two primary effects» Default premia for emerging market countries goes up. (See next

page graph from last class on Cetes and Tesebonos).

» Currency premia (from expected devaluation) goes up. (See next page graph from last class on Cetes and Tesebonos).

» Both of these lead to increases in the bond’s “yield”, i.e, a severe drop in the bond price.

Secondary effect (though potentially important)» Impact on US market via “financial crisis”.

» Contagion effect across other markets facing similar issues.

» Liquidity effect.

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III. Examples

ERM crisisPeso crisisRussian debt default (during Asian Contagion)

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A. ERM crisis

1979 Exchange Rate Mechanism (ERM) led to stable and narrow target zones among European countries

In 1992-93, however,

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Implied vol: the GBP crash of 1992

DMDM/L/L

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Russia, $-denominated 3%, 2003

01020304050607080

4/3/

1996

10/3

/199

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4/3/

1997

10/3

/199

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4/3/

1998

10/3

/199

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4/3/

1999

10/3

/199

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4/3/

2000

Russia Bond

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Cetes & Currency

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Cetes-91Cetes-182MP/$