Trade, investment, current account. How they lead into disaster Currency Crisis

Trade, investment, current account. How they lead into disaster

Currency Crisis

Currency crisis

• Basics of exchange rates• Anatomy of a breakdown: Russian Crisis 1997/98 as a typical example of a currency crisis • How do currency crisis appear• How to avoid crisis an step by step approach as proposal

07.04.2011Dipl.- Kfm. Thomas Stiegler, University of Göttingen.2

Today‘s topics

Currency crisis

• last two lectures: balance of payment as a RESULT of economic action. ceteris paribus view.• There are factors influencing the balance of payments AND the balance of payments is influencing such factors itself

• inflation rates. Imported goods can be cheaper, to much capital = money is available through inflow

• saving rate. As of the inflow of cheap foreign capital there is not a high pressure on domestic saving (investment)

• exchange rate. Changes lead to distortions of real import/export demand


Balance of payments‘ influence

Currency crisis

• if saying, the balance of payment influences and is influenced by the exchange rate, we need some facts about exchange rates. In general there are two types of exchange rate regime. All thinkable systems are a mixture of them:

1. fixed exchange rate regimes2. flexible (free floating) exchange rates


Basics about exchange rates

Currency crisis

• A Central Bank (or Central Banks) declare, that there is a certain exchange rate between currencies• However real economic development can show, there is more demand for one currency than for another. its price (exchange rate) would rise.

• As this is not allowed by treaties, the Central Bank has to act to keep the rate stable.Advantage: Stability in planning. Disadvantage: real economic development is braked out.


System of fixed exchange rates

Currency crisis

• In such a system, currencies float freely against each other.• This does not mean, that there’s no influence on the

exchange rate by central banks. In opposite, there is evidence, that western central banks were much

more active on international markets AFTER Bretton Woods break down• In such a system especially smaller states are in danger of speculative attacks. Politics is exposed highly to the world markets


System of free exchange rates

Currency crisis

• Major currencies as the US$, EURO, £, Japanese ¥, Swiss Franc are free floating against each other.• Most of the other states bound their currency at least to some extend to one of these currencies• Markets are highly speculative, even against big players like EU(2010), Japan (2011)


Current situation

Currency crisis

• After the hard transformation shock in Russia, the government managed to stabilize the Ruble by 1996. • After stabilizing the Ruble it was bound to the US Dollar to create trust in the Russian currency. (domestic and abroad)• Government was running large deficits (Tax base broke together, as about 50% of GDP was lost!)


Case: Russia 1997/1998

Currency crisis

• After stabilizing the ruble, the government tried to finance itself by issuing ruble bonds, as well as bonds in Dollar. (before they financed themselves by central bank! Inflation)• The demand for Russian bonds in Russia (as trust came back through stabilized Ruble) and abroad (as of the exchange rate aim) rose strongly!


Case: Russia 1997/1998 (2)

Currency crisis

• Starting by almost zero the foreign debt of the Russian state grew fast (in Rubles AND US Dollar), as government stayed deep in deficits.• Given the bond situation Russia developed into a promising Emerging market. A lot of foreign capital was invested in Russia• Portfolio investment in Russia rose from practically zero in 1995 to almost $100 billion in 1997


Case: Russia 1997/1998 (3)

Currency crisis


Case: Russia 1997/1998 (4)

As we can see in the graph of yesterday:The high foreign investment rate brought Russia’s Current Account (=Capital Account) into deficit! (Although there was high export of raw materials!)

Currency crisis

• As we saw yesterday: the absorption power of a young transformation country is quite low.

• remember: danger in stage one: fixed exchange rate and high interest rate lead to a to high inflow of foreign capital, that can not be invested properly (foil 14)

• the strong capital inflow created a bubble at stock exchange (from January 1996 to August 1997 the RTS raised by 326%!)


Case: Russia 1997/1998 (5)

Currency crisis

• We saw: the capital inflow to Russia was highly dependent on the rate of the ruble. However through the bad situation of the public households there was a latent pressure on depreciation • in July 1997 the financial crisis of Asian “Tiger states “ (Thailand, Indonesia, South Korea, Singapore) started. (the problems, that led into this crisis are very similar to the Russian ones)


Way into crisis

Currency crisis

• As of the Asian Crisis all other Emerging Markets were checked upon risks• Investors started to mistrust the situation in Russia and started to retract capital from Russia (from August 1997 till July 1998 the RTS lost 80%!)• As consequence of the break down in Asia, the prices for raw material were declining by more than 30% worsening the Russian Current Account


Way into crisis (2)

Currency crisis

• As of the fleeing capital in 1998 Russian government came into problems in refinancing.

• trust in the stability of the ruble rate was lost currency risk growing, the attractivity of Russian state bonds shrinking

• to be able to refinance, the interest rates had to be risen. End of 1997 the interest rate was already at 20% in May 1998 it reached 150%!!!

• through this development the real interest rates at banks rose up to more than 40%, destroying most credit financed firms in need of re financing


Anatomy of a brake down

Currency crisis

• The consolidation of state household was stopped through this development, as the credit costs rose extremely and the tax incomes broke away

To sum it up: international capital flew the country, interest rates for the state and firms rose largely, the raw material prices broke down, firms went bankrupt at large number, the state had to stop payments


Anatomy of a brake down (2)

Currency crisis

• Why not just to give the exchange rate into free floating to ease the pressure? • protecting interests of stakeholders

• private investors. Last capital inflow would come to an end as of risk

• banking sector. Loss at share market! Financed at large scale in foreign credits! AND invested largely in the insurances against exchange rate risks (forward contracting). These amounted to a sum of 3 times (!!!) of the banks total assets!

• state. The states incomes are in rubles. However there is a large foreign debt in Dollars. A sharp depreciation drives the costs up sharply thus


Free floating as a way out?

Currency crisis

• Finally Банка России could not stand the pressure and had to abandon the fixed rate of the ruble• within a short time the ruble lost about 75% of its value

07.04.201118

August 17th 1998 and the consequences

Currency crisis

• The Russian government declared the state as bankrupt and set a moratorium of 3 months within which no payment towards the debt would be done• The state declared short run ruble debt as long run and refused to repay them in the short run

• A hair cut (currently discussed in Greece) towards foreign currency debt was inacted


Consequences

Currency crisis

• Foreigners being invested in Russian Dollar bonds directly lost money through the hair cut• Foreigners being invested in RR bonds lost through the limitation in money disposability. Even worse was the loss through exchange rate changes. Although they had done forward contracts The trust in investments in Russia was largely destroyed


Consequences (2)

Currency crisis

• As of high exchange rate risk deals (re financing in Dollar, forward contracts in RR) and as of the brake down of the RTS as well as the bankruptcy ofthe state the banks lost almost all their assets• Russians started to retract all their assets from the banks, so the banking system broke down completely• As of this no credits could be given to companies any they went bankrupt


Consequences (3)

Currency crisis

• Taking data of the World Bank 15 of the biggest 18 Russian banks went bankrupt and still were insolvent in 2002! Just by Russian laws avoiding the break down of insolvent banks (and firms) they could continue working• The central bank took its responsibility as a lender of last resort and avoided the total break down by lending money to the banking system


Consequences (4)

Currency crisis

• We took the example of the Russian crisis, however it is typical for capital account / current account driven currency crisis in Emerging Markets. (like in Asia (1997), Argentina (2002), Mexico (1994) etc.)• We could show clearly how important it is to observe the rational development as we modeled it yesterday and act as stabilizing politics.


Russian crisis – a very specific one?

Currency crisis

• Emerging markets are opening to world financial markets• High growth rates with high potential of profits• FIXED EXCHANGE RATES eliminating risks of losses• World financial markets insert huge amounts of capital• Banking system in Emerging Markets are usually inefficient• Ability to absorb capital to low (not enough projects)• Capital flows into consummation


Anatomy of Currency Crisis

Currency crisis

• As of consummative credits and usually high deficits of the state the productivity of the capital shrinks. The economy is vulnerable.• If an asymmetric shock appears, investors get into panic, as they notice the risk at once. They retract their capital at once to keep their values.• A herd effect appears leading to a break down of share markets, credit markets, banking system and the ability of the government to re finance itself


Anatomy of Currency Crisis (2)

Currency crisis

For emerging markets it‘s without alternative to open themselves to the world markets to develop. (need for capital, need for export markets) However opening should be done carefully• As capital inflows are important, they should be allowed, however we have seen: speculation causes huge damage!

• example Chile: to avoid speculative capital each foreign capital importer had to pay 30% of the investment amount to a non interest account at central bank.

• restriction to invest in share markets, but free access to FDI (China)


Emerging Markets – helpless to the markets?

Currency crisis

• However regulation ALWAYS causes distortions and there are always detours to avoid them.

• Chile/ China: taking a domestic investor „on the paper“

• Main problem: greed. Wanting to much to fast (+easy for government).• As we saw, the key problem is the inefficient domestic capital market, not being able to absorb the foreign capital


Domestic capital market.

Currency crisis

The way to avoid a crisis is preparing a country for the entry on world markets. Let‘s develop some proposed steps:• Consolidate state finances, build up reliable state institutions• Subsidize industries which are able to sell their products on world markets. They should develop technically as well as economically• Open the good‘s markets


Ways to avoid a currency crisis – step by step

Currency crisis

• Adopt the fixed exchange rate in regular distances. Most likely it will rise. • Open the country to investments in production (however NOT in the industries you subsidized before)• Develop a banking system with strong rules concerning risk control of credits given.• After stabilizing state finances and building up a risk adverse banking system and stabilizing currency by fixed exchange rate, ease the monetary policy lower interest rates


Ways to avoid a currency crisis – step by step (2)

Currency crisis

• ( the last point is only possible if there is a appreciating pressure on the local currency, which should appear through successful exports)

• Observe the situation in the banking system after expansive monetary policy. (IMPORTANT STEP!) Goes the money available into desirable projects or mainly into consummation?• If it goes into consummation: Adjust the system above and improve the banking system



Currency crisis

• if it goes to profitable projects and is not given away at large scale for consummation: open the country for portfolio investments

• As the profits realizable in the country will be high, there could be a tax on buying portfolio investments implemented to avoid short run speculation

• Minimal holding times could be implemented

• Check the behavior of the banking sector again.• if it works properly: open to international credit markets



Currency crisis

• By following the steps, which can take 10 years or even more, the country should be able to go on a sustainable path into world markets • As the country now gained enough trust through its rational behavior, the fixed exchange rate should be abandoned in steps, taking away the risk of distortions in the exchange rate• A currency crisis is avoided


Switch to free floating

Currency crisis

• Free market powers can sharply damage emerging markets through imbalances in Capital and Current Account • Currency crisis can lead to a total break down of economic activity• A way out is, to develop sustainable structures and prepare a country carefully before opening to the world markets


Conclusion

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Thank you very much for your attention!


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Trade, investment, current account. How they lead into disaster Currency Crisis