Essay Speculative Attacks On Fixed Exchange Rates

Speculative attacks on fixed exchange rate regimes

Introduction

In my essay I will focus on the problem of speculative attacks on the countries with fixed exchange rate regimes.

By definition a speculative attack on a fixed exchange rate is the attempt of currency market participants to force Central Bank to abandon the support of fixed exchange rate regime, thus getting profit from the jump in exchange rate of foreign currency. Obviously, appreciation of domestic currency as the result from speculative attack can not be achieved (Central Bank will only increase its reserves), that's why any speculative attack is aimed at depreciation of domestic currency. For the attack to be successful speculators must create substantial short term demand for foreign currency, which can not be satisfied by Central Bank at current fixed exchange rate because of the lack of foreign reserves.

Speculative attacks are a very widespread phenomenon: they were in tens of countries in the world, including Russia on October 11, 1994. In a short term these attacks harm the economy: the stock market goes down, domestic currency depreciates, inflation pressure grows. But on the other hand, we may look at this process as on inevitable clearing the world from weak and inappropriate monetary and currency policies.

In this work I will cover the conditions, which are to be satisfied for the attack to be successful, will briefly talk about various models for speculative attacks (first and second generation, etc.), will discuss the strategies of the players in this game. I will also refer to and investigate Russia's experience in 1998. And I will finish with a discussion on possible Central Bank's policies to avoid speculative attacks.

Theoretical Coverage

First Generation Models

The easiest understanding of first speculative attacks was reflected in the so-called models of first generation. The description can be found in works of Krugman , Flood and Garber , Blanco and Garber and others. The main reason for currency crises becomes rapid growth of internal credit in comparison with demand for money in the economy, which under fixed exchange rate leads to purchases by investors of foreign currency from central bank with the purpose of investing in foreign assets. When the accumulated reserves come close to depletion a speculative attack may be undertaken, which would lead to abandonment of fixed exchange rate regime.

Models of a given type allow:

Ð'* to calculate shadow exchange rate, based on which it becomes possible to judge about under- or overvaluation of the foreign currency. The attack can be successful only if foreign currency would appear undervalued and the shift to floating regime would lead to its appreciation.

Ð'* to illustrate a well known empirical fact that speculative attack very often takes place even before the central bank runs out of reserves.

So the key place in the model is occupied by the dynamics of foreign reserves. If the exchange rate is fixed and internal credit is constantly growing under PPP and UIP it means that foreign reserves should decrease. As the internal credit grows agents will use excess money, issued by CB, to by foreign assets and, consequently, it will result in foreign reserves depletion. When CB's position in foreign reserves go down, it loses its power in defending the fixed exchange rate regime. The main engine of speculative attack here becomes the relation of fixed and shadow exchange rates. Speculative attack will take place only when a shadow rate of foreign currency would be higher than current fixed exchange rate.

Such models might be somehow useful in forecasting when speculative attack will take place. They say that:

Ð'* the more international reserves CB has now, the later collapse of fixed exchange rate would be

Ð'* the faster internal credit is growing (the faster international reserves are sold out), the closer speculative attack is

Ð'* the lower is the reaction of demand on interest rate, the later the attack would be

To sum it up models of first generation demonstrate that speculative attacks are the result of unsustainable economic policies and structural imbalances.

Second Generation Models

Here I will give only key characteristics and ideas of such models. The main idea behind second generation models is to show that Central Bank can provoke the attack even if it could be avoided otherwise.

In first generation models not coordinated policy of Central Bank can lead economy to the attack, in second generation models even with coordinated policy the planned actions of Central Bank for the case of a speculative attack can bring currency crisis closer. An illustrative example may be the sterilization of money during speculative attack. As soon as speculators will know about sterilization of money during the attack, they will immediately start it.

Another important feature, which demonstrates the difference between models of first and second generation is the presence of several equilibriums in second generation models. For example, if the agents are not sure, that the attack would be successful, or they don't have a leader, who will make the first step, economy can exist for a long time without speculative attack, although fundamentals may say that it should start.

So it turns out that much depends on the structure of speculators: attack may happen (fundamental conditions are satisfied and in case of successful attack all participants will profit), or may not happen (no one wants to risk and make the first step). In case speculators have a large player like Mr. Soros, then there are all chances to get to the equilibrium with speculative attack. If agents on the market are highly fragmented and small, then a failure will cost them money, so every one would be waiting for a signal from partners to start in order to avoid excessive risk.

To sum up this models add self fulfilling expectations and the possibility of multiple equilibria.

Third Generation Models

The latest models were developed as the reaction to crises, which happened in the 90th and beginning of 2000th. These models argue that fragility in the banking and financial sector reduces the amount of credit available to firms and increases the likelihood of a crisis. They put special emphasis on moral hazard and imperfect