Lecture 10 Currency crises

Question 1

What’s a currency crisis vs. banking crisis?

Answer 1

Currency crisis: Occurs when an attack on the currency leads to substantial reserve losses, a sharp decline in the value of the currency, or both.

Banking crisis: The closure, merging, or takeover of financial firms by the government, often preceded by bank runs.

Question 1

Describe a typical speculative attack

Answer 1

Market participants (aka speculators) suspect some aspect of an economy is unsustainable — be it a fixed foreign exchange rate, its financial system, its current account deficit, or its ability to service its debt.

They then take a short position in the country’s currency or local-currency-denominated financial instruments.

The short FX position would likely be a forward exchange contract. They could also short local-currency debt or even equities.

  	— Short sales involve borrowing the assets, replicating any 	cash flows to the lender, and selling them in the spot market in 	hopes of buying them back at a lower price.

Question 2

How to defend against speculative attack

Answer 2

1. Central banks can spend their reserves, hoping the selling pressure runs out before their reserves are exhausted.
2. If their reserves are running low they can borrow from the IMF or other central banks.
3. They can raise domestic interest rates, making it expensive to borrow in local currencies. By doing this, however, they risk a severe recession — something speculators are betting they will not do for long.