Lesson 4 Flashcards
Please outline the three exchange rate systems
Fixed/pegged rate system - Exchange rate is held constant or within narrow boundaries by govt intervention via its central bank
Managed float - A freely floating system with occasional govt. intervention (most common)
Free floar - Exchange rate is purely determined by mkt forces without govt intervention
Please outline some characteristics of fixed/pegged exchange rate as well as advantages and disadvantages
-Exchange rates are maintained by the central bank through it buying and selling its own currency on the global market
Advantages:
- Elimination of exchange rate uncertainty, promote international trade and cross-border investments
-Regional and international economic integration, promote inter-government policy coordination
-Loss of autonomy and vulnerable to speculative attacks. (If foreign investors suspect a currency is overvalued due to a certain peg which its economy is not able to sustain due to low growth, high inflation… they may start selling off the given currency. Forces CB to spend FX to keep price at peg
Please outline some characteristics of managed float/free float exchange rate as well as advantages and disadvantages
Automatic adjustment mechanism to correct trade imbalances
-National monetary policy autonomy, freedom to pursue monetary+fiscal policies
-Less vulnerable to speculative attacks but higher exchange rate volatility
Please outline the three types of financial crises
Banking crisis - A country’s banking sector becomes insolvent after absorbing a large number of defaults
-Sovereign debt crisis - A govt. fails to meet interest or principal payments on its debt obligations
Currency crisis - a country’s currency falls precipitously
Please outline a currency crisis
If a country embraces pegged exchange rate system while at the same time engaging in lax fiscal and monetary policy its currency can come under speculative attack
This forces central bank to buy domestic currency to stabilize
Foreign investors suffer as the values of their investments decline, therefore moving their funds out of the country, this puts further downward pressure on asset prices. It also causes a net capital outflow, further depreciating the currency.
Currency crisis often results in financial crisis and econ recession
Please describe what contagion is and why it may occur
Contagion is when a crisis spreads from one to other countries
Currency crisis contagion may occur due to:
Interconnectedness - Cross border trade and investments, linkages in financial and banking systems
Behavioral finance factors = Overreaction, herding and risk aversion, systemic risk and macroeconomic similarities, external shocks
Wake-up call - Crisis in one country seen signal of wider problems for other countries
Please describe the Mexican Peso Crisis
Mexican peso was loosely pegged to the USD. With Mexico joining NAFTA along with other neoliberal initiatives (privatization etc.). This leads to significant FDI. As a result the currency appreciates.
However, with two political assassinations and an overvalued Peso, Mexico enters a trade deficit as well as great civil and political unrest. This causes foreign investors to lose confidence in the Mexican economy.
As a result they begin selling Mexican assets, causing the Peso to depreciate against the USD. MX govt is forced to sell off FX to maintain the peg and are eventually forced to abandon the peg. Peso 50% of its value. This also has grim consequences for the entire region as ‘Tequila effect’ causes foreign investors to sell off assets in all LATAM countries
ERM Crisis (UK)
In the 90s the ERM was a managed float where the partaking currencies could fluctuate within a pre-specified range against the D-Mark.
UK joined the ERM when German reunification resulted in high inflation. UK economy was struggling while the German economy was dealing with high inflation. As Germany increases its interest rates, UK is forced to do the same.
GBP comes under speculative attack and BoE is forced to sell of billions of FX to maintain the peg. The high UK int. rate further halts UK econ. growth. At last UK is forced to abandon peg. Leads to crash of pound and econ. recession. Soros made billions
Asian Financial Crisis of 1997
Booming Asian economies with fixed or stable exchange rates. This leads to speculative cash flows into the region following the financial libralisation
The currencies of some Asian countries became overvalued, coupled with high debt levels in USD.
Speculative attacks on the Thai Baht forces the devalue the currency leading to a surge in default rates as banks/businesses struggle to pay their dollar denominated loans. Heavy capital loss by foreign investors
Economic slowdown in Asian countries. Ripple effect to countries like Russia, reform at IMF to strengthen the global financial system
Russian debt crisis 1998
The transition of the Russian Economy after the dissolution of USSR led to high inflation, budget deficit and an economy that relied on export of commodities. The ruble was at a floating peg with strong support from the central bank.
With the Asian financial crisis, the demand for commodities falls (Russian goods). Govt is forced to abandon peg and change to free float.
Foreign investors began to sell government bonds and Russian securities due to loss of confidence. Domestic banks ran out of liquiduty due to their investments in Russian govt. debts
Russian govt. defaulted on its debt, contagion to baltic countries and collapse of LTCM hedge fund
Argentine Peso Crisis
The period between 1999-2002 when Argentina experienced economic recession, currency depreciation and sovereign debt default
Background:
Arg. peso was pegged to the USD to control inflation and stabilize the economy. Argentina engaged in high public spending throughout the 90s financed partially by dollar denoted debt.
Causes
-Overvaled peso led to a loss of confidence in the Arg. Peso. Further, high levels of debt forced the govt. to allocate increasing resources to debt repayments -> investor confidence waned leading to rapid capital outflow.
-Inability to devaluate the currency meant the govt was limited in what they could do to foster growth
With rapid selloff of Peso Argentina was forced to abandon the peg. The Peso depreciated 70% which led to sharp inflation and econ. hardship. Govt defaults on debt in dec. 2001. They were cut off financial markets leading to difficulty in rebuilding the economy.
Latin American Debt crisis
1980s dubbed the lost decade in LATAM. Opec.
Due to the oil production cut of OPEC member nations, price surges. OPEC member nations deposit dollars in Western banks.
Western banks, keen to recycle these dollars as loans, lend heavily to LATAM countries who are experiencing a period of econ growth and a need for financing.
Through excessive borrowed spending, misman,, corruption LATAM countries take on significant dollar-denoted debt.
US is combating inflation and hike their interest rates. This leads to more expensive loans all while global commodity prices decline (low income for LATAM countries). High levels of default within LATAM countries
US and IMF forced to bail out countries through debt relief, debt for equity swaps and Brady bonds -> significant fear of LATAM defaulting on loans
EU sovereign debt crisis
-Adoption of the Euro created econ. imbalances between particular nation
-Several countries acc. high levels of public debt in violations of the EMU guidelines
-Excessive soveriegn debt issued for bank bailouts during 2007-2009
Downgrading of European sov. debts. –> Greece on the verge of default and contagion to Ireland, Portugal, Spain and Cyprus
As a result the most affected countries were bailed out by the EU and IMF –> with Austerity measures cut deficits and debt levels
Russian financial crisis 2014
Causes: Fall in oil price and international sanctions
Sharp depreciation of ruble
Stock market value evaporated. RTS lost 30% in Dec 2014.
Rising interest rate - 17% in Dec 2014. Temp. halt and suffering of foreign business
Consequences:
Central bank intervention
Downgrade of Russian debt
Financial contagion to international banks and other emerging economies
Turkish currency and debt crisis 2018
Background:
Overheated econ. fueled by credit expansion and govt. spending
Causes:
Authoritarianism and geoplolitical tension with the US. Failure to control inflation. Major devaluation of Lira
Consequences:
-Interst rate hikes
-Ending econ. growth
Pledge to cut spending
-Capital injection from Qatar
-Possible bailout by IMF
