Week 8 - Currency crises

Question 1

Country risk & country risk premium

Answer 1

Risk of default on debt interest payments due to political instability

Country risk premium must be sufficiently high so that the EXPECTED (AVERAGE) RETURN from investing in, eg. Venezuelan bonds, = the return from investing in US bonds

Question 2

Currency risk & how the currency risk premium is determined

Answer 2

Risk of exchange rate fluctuations when investing in foreign assets
- If sterling depreciates against the US dollar, the investor makes a CAPITAL LOSS
- Investors require a HIGHER interest rate to compensate for the risk of exchange rate DEPRECIATION <- Currency risk premium is the extra amount

Determined by the uncovered interest rate parity (UIP) condition
rUK - rUS = % dep
> Interest rate differential between 2 countries must = the expected exchange rate depreciation in % terms

Question 3

2 effects of an increase in risk premium

Answer 3

Risk premium increases, domestic interest rate INCREASES to compensate.
1. INVESTMENT SPENDING decreases
2. increases opportunity cost of holding money → demand for money decreases (IGNORE this effect for simplification)

Question 4

Peso crisis

Answer 4

• Mexico fixed exchange rate to the US dollar. 1994 events sparked concerns among intl’ investors about the potential DEFAULT of Mexican govt on DEBT REPAYMENTS.
• Country risk premium soared
  1. Domestic interest rates increased, which decreased investment spending & hence AGGREGATE DEMAND
  2. IS* curve shifted left since (AD represents IS* curve)
  3. Fall in income decreased demand for money. So domestic int rate fell, led to CAPITAL OUTFLOWS & exchange rate DEPRECIATION
  4. Boosts export competitiveness, offset the fall in investment spending, no effect in output (point B)
  5. Bank of Mexico had to intervene since e<e, bought pesos & sold dollars to increase exchange rate
  6. Took pesos out of the economy, MONETARY CONTRACTION. LM* curve shifted left
  7. BoM kept buying pesos until exchange rate reverted to target level e. The problem is recession, OUTPUT has fallen below natural rate.
  8. b/c No longer have boost in export competitiveness, no more offsetting in fall of inv spending

Question 5

Eventually, BoM ran out of US dollars in its foreign exchange reserves b/c of the exchange rate interventions, could no longer defend the peso. Only choice:
Devaluation of the peso

Answer 5

By SELLING pesos & buying dollars.
1. BoM wants to devalue peso (selling pesos and buying dollars, increases supply of pesos on the FX market). These additional pesos are created from increasing its reserves
2. Money supply expanded, LM* curve shifted right until new eqm at point B. Exchange rate has fallen to e**
3. OUTPUT increased due to low exchange rate b/c Boosts Mexico export competitiveness, NET EXPORTS increase, AD increases.

Question 6

What happened after the first round of Peso devaluation?

Answer 6

• Devaluation prompted concerns about FUTURE devaluations.
• This led to CAPITAL FLIGHT - widespread sell-off of financial assets by foreign investors
• Currency risk premium increased even further, which decreased AD & deepened the recession.
  1. Mexico had to increase her domestic interest rates to offset the expected depreciation of the peso that American investors are worried about.
  2. INVESTMENT SPENDING fell b/c of higher cost of borrowing. So IS* curve shifted left, moved to new eqm at point C but below the fixed exchange rate e.
  3. BoM required to intervene & drive up value of peso by buying pesos in exchange for dollars. Bank of Santander deducts its reserves from BoM, MONETARY CONTRACTION, LM* curve shifted left until exchange rate moved back to target level e.
  4. Problem: OUTPUT fell again, economy is back to recession.

Question 7

Unable to ROLL OVER some of its debt that was maturing, the Mexican govt was on the brink of default. In Dec 1994, BoM allowed the peso to FLOAT FREELY.
2 consequences in the aftermath of the of the peso crisis

Answer 7

1. Financial crisis
2. Deep recession
   - But the freedom to DEPRECIATE CURRENCY meant the economy eventually recovered.

CURRENCY CRISIS often leads to financial crisis. Why?
- Massive depreciation of peso against dollar, much more expensive to repay debt. Increased the debt burden on Mexican banks. Wiped out capital (down to 0), hence the banks became INSOLVENT → financial crisis

Question 8

Key benefit of having a fixed exchange rate (ref. to free capital flows also) + 2 key costs

Answer 8

Benefit: “SHOCK ABSORBER” AGAINST MONEY MARKET VOLATILITY (reduces exchange rate volatility)
Volatility is harmful to trade flows, esp. with FREE CAPITAL FLOWS
1. A surge in capital inflows can be destructive for EXPORTERS (esp. emerging markets)
2. A surge in capital outflows increases INSOLVENCY RISK for firm/banks holding FOREIGN CURRENCY DEBT (increases debt burden in terms of domestic currency)

Key costs
1. Loss of MONETARY INDEPENDENCE
2. Vulnerability to a SPECULATIVE ATTACK

Question 9

Problem of Capital controls
^Fix exchange rate but also impose RESTRICTIONS on the free movement of capital across borders.

Answer 9

Capital controls impede the flow of capital to its MOST PRODUCTIVE USES (Decrease allocated efficiency).
- CC stops capital from flowing to where they can get high return on capital. Impedes economic growth of developing countries to catch up with advanced countries.

Misaligned exchange rates combined w/ capital controls can also cause GLOBAL ECONOMIC IMBALANCES
- leading to political tensions, eg. China’s trade surplus with the US

Question 10

From the late 1990s onwards, China has run persistently large TRADE SURPLUSES with the US. Trump labelled China as the “world champion” of CURRENCY MANIPULATION.

What was Trump’s main concern about US running large trade deficits with China?

Answer 10

Trump’s main concern is the DEPRECIATION in the RENMINBI witnessed in recent years, made Chinese imports CHEAPER relative to US goods.
So, Trump imposed TARIFFS (taxes) on Chinese goods to encourage ppl to buy domestic goods to narrow the US deficit.

Question 11

How does China’s extremely HIGH SAVINGS RATE lead to a TRADE DEFICIT in the US?

Answer 11

1. China exports her excessive savings to the US, ie. investing in US financial assets
   - based on the national income accounts identity, a higher savings rate implies a higher trade surplus
   - Goods & services flowing in 1 direction are paid for by financial assets flowing in the opposite direction
   » NX = NCO (net capital outflows)
2. Supply of loanable funds shifts right, decreasing US real interest rates
3. This encourages excessive borrowing & spending by US govt and consumers, leading to a trade deficit & increased demand for dollars
   - Renminbi depreciates against the dollar

Question 12

Why is China NOT a currency manipulator? How to reduce China’s trade surplus / excessive savings?

Answer 12

1. Capital outflows from China to US means that Chinese investors CONVERT RENMINBI to dollars, price of dollar increases, DOLLAR APPRECIATES against RMB (demand for dollars increased) & and conversely the renminbi depreciates against the US dollar.
   So, it is b/c of MARKET FORCES, INTERACTION between supply & demand in the market for FX.
2. To reduce China’s trade surplus, INCREASE DOMESTIC DEMAND (decrease China’s savings rate)
   - which will REVERSE the capital outflows from China to US.
   *This effectively cuts off the supply of cheap credit that the US government and consumers are using to fund their excessive borrowing. This would encourage them to cut their spending, which means less Chinese imports and which shrinks the US trade deficit.
   - hence, less demand for US dollars & DOLLAR DEPRECIATES against RMB

Question 13

2 causes of China’s high savings rate

Answer 13

1. One child policy
   - high savings act as a substitute for old-age support from offspring (Keyu Jin et al., 2017)
   - the TRANSFER CHANNEL. Parents shift investment in the form of children to the form of financial assets
   - evaluated through a counterfactual TWIN experiment & found that in the long run, savings rate of households with twins were substantially LOWER than households with 1 child b/c anticipated 2 sources of financial transfer

+ In advanced economies, middle-aged ppl tend to save more, which OFFSETS the DISSAVING (ie. borrowing) by the young
^Modigliani’s LIFE-CYCLE HYPOTHESIS

2. Borrowing constraints
   - In China, consumers face ^ due to the INEFFICIENT STATE-CONTROLLED BANKING SYSTEM, which was dominated by the “big 4” banks
   - lending mostly to state-owned enterprises & NOT MUCH to the PRIVATE SECTOR
   > Chinese households wanted to increase spending & consumption but they can’t; Banks won’t lend to them.

> The obvious solution is for Chinese citizens to BORROW FROM FOREIGN BANKS to bridge their income shortfall and boost their spending
(but capital controls prevent capital inflows from foreign banks)

Question 14

Why does China need to embrace financial globalisation?

Answer 14

1. China should DISMANTLE capital controls and…
2. …open up the economy to capital INFLOWS & financial firms from abroad, like the Asian tiger economies during 1990s.
   (should expand the availability of credit to firms & households who want to take out loans and credit cards to increase their spending)
3. This would shift China away from the investment-led export-led growth model to a CONSUMPTION-LED GROWTH PATH.
   - Better way to tackle the trade surplus than a trade war!

Question 15

In 2015, China abolished the one child policy.
What do you think will be the long run effects on China’s savings rate, trade balance with the U.S. and the renminbi-dollar exchange rate?

[12m, Specimen paper]

Assuming a balanced budget,
S - I ≡ NX

Answer 15

The abolition of the one child policy is likely to reduce China’s savings rate, erode the trade surplus with the U.S. and appreciate the renminbi-dollar exchange rate.
1. Refer to the TRANSFER CHANNEL (Keyu Jin et al., 2017 ): now permitted to have larger families, parents no longer need to increase their savings as a substitute for old-age support from offspring.
2. From the national income accounts identity, a lower savings rate implies a smaller trade surplus.
3. A reduction in China’s savings rate means less capital flowing to the U.S. shifting its supply of loanable funds leftwards and driving up US real interest rates, which decreases borrowing and spending by the US government and consumers and thus SHRINKING the TRADE DEFICIT with China.
4. The decrease in demand for dollars due to China’s reduced purchase of U.S. financial assets causes the DOLLAR to DEPRECIATE against the renminbi.

Question 16

Why are there concerns that Argentina’s currency crisis may mutate into a financial crisis? Give two reasons.

[7m, 2021]

Answer 16

The currency crisis meant banks were battered on both sides of their balance sheet.
- Rising interest rates due to the country and currency risk premium meant widespread BORROWER DEFAULT hence impairment of the ASSETS SIDE of their balance sheet.
- As many Argentinian banks had borrowed money from US banks, the DEPRECIATION of the peso against the dollar meant it became more EXPENSIVE to REPAY that DEBT, increasing the LIABILITIES side of the
balance sheet.
- Both effects implied an erosion of bank capital, increasing the risk of insolvency.

Question 17

Widespread capital flight led to a collapse in the value of the peso, so that Argentina was forced to seek a bail-out package from the IMF. However, the IMF made the bail-out loans contingent on the Central Bank of Argentina’s non-intervention in the foreign exchange markets.
What was the unintended consequence of this policy?

[7m, 2020]

Answer 17

1. Consequence: a SPECULATIVE ATTACK on the currency.
2. Market speculators expected the exchange rate to DEPRECIATE given that the central bank was no longer permitted to defend the currency.
3. They therefore SHORT-SOLD the peso whilst its value was high, in anticipation of buying back once the price had fallen and thereby banking huge PROFITS.
4. Through their actions, they caused the value of the peso to collapse further.