Theory
The tension between speculative inflows and fundamental outflows continues to increase, causing violent price swings, until such point as those inflows are not sufficient to offset the rising tide of outflows. Like an inventory overhang that seems to appear out of nowhere in the wake of over-investment, the result is a supply–demand imbalance in the exchange rate. Demand collapses in order to restore equilibrium. In this case, that means a sharp reversal of speculative inflows, which are by nature more easily and more quickly reversed than their fundamental counterparts. Markets overshoot on both the upside and the downside, which means that the correction in the exchange rate to offset over-appreciation is likely to exceed what fundamentals suggest is required. Eventually it manages to stabilize again, starting off a new round of appreciation as fundamental inflows are attracted anew. The sharp correction in the exchange rate should help restore lost trade competitiveness. Just as real exchange rate appreciation must lead to external balance deterioration, so the cure for the latter is real exchange rate depreciation. This can happen either through nominal exchange rate depreciation or through a sharp fall in inflation. The easiest and most efficient way for this to happen is through the former. Once that correction or nominal depreciation happens however, the external balance should respond positively.
Practice
At the June 27 FOMC meeting, the Federal Reserve cut interest rates by 25 basis points as expected. Notably, risk appetite indicators did not improve in the wake of this, the first time all year that Fed monetary easing had failed to boost risk appetite. In hindsight, this should have proved a major warning signal, and not just for the Polish zloty but for global financial markets as a whole. A week later, the tremors of the earthquake to come were starting to be felt. On the Thursday, the dollar–zloty exchange rate was already heading higher, boosted by profit-taksing on long zloty positions by asset managers and by a lack of fresh demand for zloty from this quarter. Having bottomed out at around 3.92, dollar–zloty broke back above the 4 level to retest 4.10. Come Friday morning, dollar–zloty broke above 4.20, then 4.25 and then it broke above 4.30. Speculative money that had been long zloty, both against the US dollar and the Euro, either decided to close out their long zloty positions or were stopped out of them. Despite fundamental outflows, there were still asset managers who had substantial positions in Polish bonds and most of these were unhedged from a currency perspective. The spike higher in Euro–zloty and dollar–zloty forced these to currency hedge their bond positions, in the process greatly accelerating the move. Dollar–zloty leapt forward, screaming through 4.40, 4.45, 4.50, only peaking out at around 4.55. In the first six months of 2001, the zloty appreciated by around 10% against its old basket value, only to lose that and more in two days in July. From a peak of around +15.5% against its basket, the zloty fell to as low as +2.5% before finally managing to stabilize. The fall provided a major competitiveness boost to Polish exporters, who quickly took advantage of the opportunity to hedge forward by selling US dollars and Euro against the zloty at such elevated levels. In this way, fundamental buyers returned to both the zloty and to the Polish asset markets, in the form of corporations on the one hand and investors on the other. The cycle began again. Over the next six months, the zloty appreciated from +2.5% to over +14% before again correcting, this time to around +6.8% before stabilizing.
Thus, where we have the CEMC model for pegged or fixed exchange rates, the speculative cycle model can be used for floating exchange rates. Readers will of course note that these two models have been used in the context of emerging markets. The dynamics of the developed currency markets are slightly different in so much as they are much more liquid and therefore the transmission from portfolio flows to currency strength is less immediate. Equally, very few developed market currencies are pegged — indeed one could argue that the very act of moving from a pegged to a floating currency is itself one necessary aspect of progression from emerging to developed country status. Thus, while the CEMC is not of much use for developed market exchange rates in this context, the speculative cycle model can be used for both emerging and developed exchange rates.
One should note however that the time period over which speculative cycles last in the developed exchange rate markets can be significantly longer — years rather than months — than is the case in the emerging markets. This is so because developed exchange rate markets are substantially more liquid, but more importantly because the size of capital flows has such a disproportionately larger impact on the real economy of emerging markets than is the case with developed economies. Capital flows that can have only a lasting impact on the real economy of a developed market after a substantial period of time are so large by comparison with the size of an emerging market economy that they have a much more significant impact. If we look at what happens within the developed exchange rates, the speculative cycle of exchange rates also has major relevance, with the proviso that it takes place over a much longer period of time. The starting place for developed market exchange rates is of course the US dollar. If we examine the performance of the US dollar from 1991 to 2001, we can indeed see the speculative cycle of exchange rates at work. Roughly speaking, from 1991 to 1995, the US dollar was in a clear downtrend. Initially, this was due to fundamental concerns, both of valuation and of growth prospects. The Gulf War in 1990–1991 gave way to a deep if brief recession in 1991–1992. From 1993, this was exacerbated by the market’s increasing view that the new Clinton administration had a deliberate policy of devaluing the US dollar in order to boost US export competitiveness and reduce the US trade and current account deficits, particularly against Japan. While US officials now say that this was never the case, at the time US officials made repeated statements that could easily have been interpreted as such, suggesting the US wanted a weaker currency. Fundamental investors increasingly sold their US assets during 1991–1993, and during 1993–1995 this process increased despite US economic recovery on the view that the US was deliberately devaluing the dollar. Eventually, as these things tend to do, this fundamental selling attracted the attention of the speculators, who also started to sell en masse. The speculative pressure grew and grew, causing the US dollar to fall in value against all of its major currency counterparts, such as the Japanese yen and the German Deutschmark. This increasingly happened as the fundamentals of the US were starting to improve, helped in large part by the dollar depreciation that had reduced that US trade deficit by making US exports more competitive. Fundamental investors started to get back into US assets, however the speculators, attracted even more by irresponsible US official comments on the currency, were still selling. Eventually, the patience of the US authorities snapped and the Federal Reserve intervened on several occasions in 1995 to stem the tide of speculative selling. The current Undersecretary of the US Treasury Peter Fisher was at the time the head of open market operations at the New York Fed and therefore responsible for the Fed’s intervention in the foreign exchange markets. Fisher explained the Fed’s aim not so much as to defend a specific currency level or to of necessity stop a currency from weakening, but rather to intervene in order to recreate a sense of two-way risk in the markets. The Fed uses a number of market pricing indicators to tell whether or not two-way risk — the risk that a currency can go up or down — exists and most if not all of these were at the time suggesting that the market viewed all the US dollar risk as being to the downside. The Fed’s intervention, carried out in conjunction with the Bank of Japan and also with monetary policy change by the BoJ, helped cause a sea-change in market sentiment. The US thus achieved what they were looking for, two-way risk in the dollar. In the wake of this, the fundamental buyers increased significantly in number and the speculators reversed and also started buying. Thus, the speculative cycle worked, albeit with somewhat of a delay due to the view that the US was deliberately trying to devalue its own currency. From 1995, the US dollar thus has been on a trend of appreciation, more than reversing the weakness seen in 1991–1995. Readers will of course be aware that the speculative cycle works both ways, when a currency is appreciating and also when it is depreciating. Thus, the US dollar strength that we have seen since 1995 has indeed caused fundamental deterioration. If the speculative cycle holds up, the speculative buying will be overwhelmed by the fundamental selling by asset managers and the US dollar will reverse sharply lower. The warning sign for that to come will be when we see a sharp spike in options volatility without any major moves in the spot market, reflecting major flow disturbance in the market as the fundamental selling pressure intensifies.
In recent years, the economic community has developed a very large number of exchange rate models for analysing currency crises, and it is certainly not for here to repeat a list of them. That said, they can be classified into three broad categories of currency crisis model.
First-generation crisis models focus on the “shadow price” of the exchange rate; that is the exchange rate value that would prevail if all the foreign exchange reserves were sold. These models generally view as doomed a central bank’s efforts to defend a currency peg using reserves if the shadow price exchange rate is in a long-term uptrend. It is assumed that rational speculators will immediately eliminate a central bank’s foreign exchange reserves as soon as the shadow price exceeds the peg level. A key feature of first-generation currency crisis models is that they generally see currency crises as being due to poor government economic policy; that there was a degree of blame involved, that poor government policy caused the currency crisis.
Unlike with the first-generation model, second-generation crisis models do not see a currency crisis as being due to poor government economic policy, but instead due to the currency peg being at an uncompetitive level. The main inspiration for second-generation crisis models was the ERM crises of 1992–1993. In 1992, the UK was not willing to take the economic pain required to keep their peg of 2.7778 against the Deutschmark. In August 1993, most of continental Europe was forced to abandon their 2.25% bands. However, instead of allowing their currencies to float freely, they widened the 2.25% band to 15%, a compromise solution between a full flotation and a pegged exchange rate. In the cases of the UK and of continental Europe, the de-pegging of the exchange rate did not cause the much anticipated economic recession. Indeed, the cost of defending the peg was very high interest rates, thus hurting the economy. With the currency pegs gone, there was no longer any need for such high interest rates. Thus, the de-pegging of the exchange rate was on the one hand due to the government’s unwillingness to take the economic pain needed to defend the peg, but on the other hand that pain was due to an uncompetitive exchange rate peg level. For the UK in particular, the depegging of sterling, which came to be known as “Black Wednesday”, was the best thing that had happened to the UK economy for several years. Interest rates are lowered and exchange rates stabilize at a much more competitive and appropriate level when currency pegs are broken, according to second-generation models.
Third-generation currency crisis models, which developed in the wake of the Asian currency crisis, involved “moral hazard”, that is the idea that private sector investment in a specific country will result if a sufficient number of investors anticipate that country will be bailed out by multinational organizations such as the IMF. Inward investment and external debt rise in parallel as a country continues to be bailed out until such time as the situation is untenable. The currency is one main expression of that situation’s collapse.
With the first-generation currency crisis model, the focus is on blaming poor government economic policy, particularly poor fiscal policy. With the second-generation model, the issue of blame is less clear and the focus is more on an uncompetitive exchange rate rather than poor government economic policy. For its part, the third-generation model focuses not on the reason for the currency crisis but the result, or more specifically the massive real economic shock that came from “moral hazard” investment caused by the combination of currency devaluation and external debt. Put simply, second-generation models can be “good”, but third-generation models are unequivocally “bad”.
Speculative Flow Reverses — The Local Currency Collapses
Speculators Join the Crowd — The Local Currency Continues to Rally [practice]
From October 2000 through March 2001, Polish bonds roared higher, benefiting from cuts in official policy interest rates in response to clear signs of slowing economic activity within the Polish economy. The dollar–Polish zloty exchange rate, which at one time had been as high as 4.75 extended its downward trend, at one point breaking through the 4.00 barrier. More and more leveraged money funds sold US dollars or Euro and bought zloty on the back of this move. For a time, “real money” asset managers did the same, increasing their currency exposure as a result of their buying of Polish bonds. There was no incentive to hedge that currency risk. Indeed, there appeared to be every incentive not to hedge — the high cost, the appreciating trend in the zloty and the desire to keep the carry of the original investment (which hedging would reduce or even eliminate).
USE OF INTEREST RATE DERIVATIVES
There is now a wide range of interest rate derivatives available in most developed markets. These derivatives provide bank treasuries with tools to change their exposure to shifts in interest rates without having to act to change the composition of the banks’ balance sheet directly. The latter is difficult to achieve quickly and efficiently in practice.
Derivatives are not recorded on the bank’s balance sheet and are hence described as “off-balance sheet”. Over the years most regulators have acted to force greater disclosure of these off-balance sheet items and their related exposures.
Banks have resisted this trend to greater transparency arguing that by providing more information they risk giving commercially sensitive information to competitors that will be able to exploit perceived weaknesses in balance sheet structure at an individual bank. There is little merit to this argument.
We now need to look at some of these derivatives in order to show how a bank can use them to adjust its exposure to shifts in the yield curve.
Forward Rate Agreements
A forward rate agreement is a contract, based on a notional principal, between two parties to exchange interest at some defined future date based on the difference between two different benchmark rates. These benchmark rates may be floating, such as an interbank rate, or fixed.
It is easiest to explain most of these derivatives using diagrams. The following example of a 90-day FRA assumes a notional principal of $100m. One part of the agreement is based on payment at a fixed 12% annual rate. The other part is based on LIBOR + 4% (LIBOR is the rate at which credit-worthy banks lend to one another and stands for the London Inter Bank Offer Rate). For our example we will assume LIBOR currently stands at 8%.
Let us assume that on the settlement date LIBOR has risen to 12%. On this day both parties calculate how much each owes the other. The floating rate payer owes the fixed rate payer $4m while the fixed rate payer owes the floating rate payer $3m. These are simply netted and the floating rate payer pays the resulting $1m to the fixed rate payer. If interest rates had fallen the payment would be in the opposite direction.
There is no exchange of principal, a FRA is simply a contractual agreement.
In this example we have used a fixed/floating FRA but the range of possible benchmarks is much wider. A floating/floating FRA could be based on yields at different maturities on the yield curve, 90-day LIBOR rates versus five-year government bond yields for example. FRAs are highly standardized contracts and have been successful for two principal reasons:
Flexibility. Because FRAs represent single netted payment transactions they provide huge flexibility to treasurers.
Comparative advantage. One party may have a relative cost advantage at borrowing floating rate but require fixed rate funding. The other may have the opposite position.
Fundamental Deterioration — The Local Currency Becomes Volatile [practice]
From March to mid-June 2001, the Polish zloty continued to appreciate, albeit in an increasingly chaotic and volatile manner. Frequent sell offs would be followed by sharp rallies. Asset managers were more and more aware of the degree of slowdown in the national economy. While this should conversely be good news for fixed income investors as it caused inflationary pressures to decline further, it was a source of increasing concern for equity investors. The market’s general appetite for risk remained relatively high, helped in large part by continued monetary easing by the Federal Reserve. Next, the National Bank of Poland was also cutting interest rates, albeit cautiously in the face of clear evidence of abating price pressures. Yet,both the pace and extent of zloty strength were a cause of concern to investors, and it seems also to the Polish government. Ahead of elections in September, the AWS-led government was increasingly desperate to boost the flagging economy, whether by interest rate cuts, fiscal expansion or a weaker zloty. Markets feared a change in exchange rate policy, either by the existing government or more likely by the opposition, which looked increasingly likely to win the election and in the end did indeed do so. Around June, given the gains seen by then in both Polish bonds and the currency, a combination of market concerns over fundamental deterioration in the economy, notably in the trade balance, and over the prospect of a likely SLD election victory in September triggered increasing interest by investors, particularly offshore investors, to take profit on those gains.
Fundamental Deterioration — The Local Currency Becomes Volatile [theory]
Fundamental investors and speculators do not necessarily sit easily together. They have different investment aims and parameters, the first looking for regular investment capital gain or income over time, the latter looking frequently for short, quick moves. Granted, this is a gross exaggeration and generalization, but it gives at least something of a flavour for the different dynamics at work between the two investor types. The longer the trend continues the more speculative it becomes in a number of ways. In the first case more and more speculators join the trend, sure of easy money to be had. Equally, however, the longer this trend appreciation goes on, the more damage it does to the external balance and thus the more speculative it becomes in the sense of not being fundamentally justifiable. Real exchange rate appreciation must lead to external balance deterioration. Indeed, fundamental market participants, such as asset managers and corporations, increasingly reduce their currency risk for the very reason that there are such fundamental concerns. The ability of speculative inflows to offset fundamental outflows from the currency is increasingly reduced. Because of this increasing tension between fundamental and speculative flows, option implied volatility picks up in the face of increasingly choppy and volatile price action.
Speculators Join the Crowd — The Local Currency Continues to Rally [theory]
Most speculators, though admittedly not all, are trend-followers. Thus, the longer the fundamental trend continues, the more trend-following speculators are attracted to what seems risk-free profit and thus ultimately the more speculative the trend becomes. As the exchange rate continues to appreciate, nominal interest rates to decline and capital inflows to continue, so the other side of the balance of payments starts to deteriorate. The balance of payments must balance and therefore including errors and omissions, a rising capital account surplus must be offset by a widening current account deficit. Equally, real exchange rate appreciation must lead to external balance deterioration. For now, the deterioration is not sufficient to cause concern among fundamental investors and is more than offset by speculative inflows, thus the trend becomes self-fulfilling as more and more speculators join the trend.