11. Currency Crisis and Russian Crisis

Question 1

What is a currency crisis and when does it occur?

Answer 1

• A currency crisis occurs when there’s a speculative attack on the currency of a country as a result of agents attempting to alter their portfolio by buying foreign currency using the domestic one
• Reasons why it occurs
  1. Government finances its debt by printing money
  2. Government finances its non-indexed debt by devaluing the currency
  3. Country is unable or unwilling to bear the cost of maintaining the peg

Question 2

What is the first generation model?

Answer 2

• Developed in the late 70’s and early 80’s, it highlighted the tension between fixed exchange rates and fiscal policy
• The rate at which agents change the composition of their portfolio by switching to foreign currency accelerates when pressure is put on the peg. The crisis is triggered when the peg is expected to collapse.
• Domestic currency depreciates
• What the first model does not explain:
• The sudden rise in expectation of a devaluation
• Why the currency crisis spreads to other countries

Question 3

What is the second generation model?

Answer 3

• Developed in the mid 90’s before the East Asian crisis, they believed that currency crises are self-fulfilling and contagious
• The devaluation of one currency increases the likelihood of another country’s currency devaluing because:
• Common shocks, common trade links, common macroeconomic policies and conditions, expectations, and world financial markets

Question 4

What is the third generation model?

Answer 4

• Developed in the late 90’s and early 2000’s, they examined the role of monetary policy and the weakness of financial institutions
• Beneficial to lower interest rates during the crisis, because when interest rates rise, investment decreases, and firms are more likely to default

Question 5

According to the third generation model, what are the four factors that determine the magnitude of a crisis?

Answer 5

1. Domestic private and public debt
2. State of financial markets
3. Pegged exchange rates
4. Expectations

Question 6

Describe the bad, good, and awful years of the Russian Crisis?

Answer 6

• The bad years, prior to 1996 and 1997
• Russia was characterised by poor economic policies because it was a new country that came out of the collapse of the soviet unions
• Corruption was rampant, mismanagement, lower consumer confidence, and high inflation
• The good years, during 1996 and 1997
• The president created an economic dream team, leading to output recovery, inflation was brought down to single digits, consumer confidence began to grow, and short term governmental debt accumulated to fund spending (taxes were low, did not want to print money, so they had to borrow)
• However, there were also some negative aspects during the good years:
• Wages remained low
• Domestic investment remained low
• Tax revenue remained low (love taxes, high tax evasion)
• Foreign lending increased, especially the short-term forward contracts
• The awful year, during 1998:
• Economic and political situation becomes more dire
• Economic cost of war on Chechnya is high

Question 7

Describe the timeline of events that took place before the Russian Crisis

Answer 7

• April 23rd: Yeltzin fires the entire government and appoints 35-year old Kiriyenko to be the prime minister
• April 24th: Chairman of the Russian central bank warns cabinet ministers of imminent debt crisis, that they’re not able to repay debt and Russia is about to default, without knowing that reporters are in the room, leading to the collapse of consumer confidence
• May: Larry Summers, treasure of US secretary, flies to Russia to meet the PM. He is kept waiting outside the PMs office and no meetings take place
• May 18th: Bond prices collapse, yields go up, and bank stop purchases fearing default
• August 13th: Soros publishes a full-page article on FT stating the economy is in terminal state and that major steps and devaluation is needed
• August 16th: Russia defaults