April 19, 1996

Models of Currency Speculation: Implications and East Asian Evidence

Ramon Moreno

In recent years, there has been growing interest in the causes of speculative pressures on currencies, stimulated by the attack on the exchange rate mechanism of the European Monetary System in September 1992 and more recently by the devaluation and float of the Mexican peso in December 1994. In a number of Asian economies, interest in speculative pressures has recently been heightened by concern about the possible reversal of the vast foreign capital inflows they have experienced in the last decade (see Glick and Moreno 1995).

International economists offer at least two general explanations for why an exchange rate may be subject to speculative pressures. First, macroeconomic policies (such as loose monetary and fiscal policies), may be inconsistent with a government’s exchange rate target; this explanation is suggested by a line of research originated by Krugman (1979) . Second, even when macroeconomic policies are consistent with an exchange rate peg, the beliefs of speculators or adverse economic conditions may affect the willingness of a government to defend a peg, so that expectations of a currency realignment take on the characteristics of self-fulfilling prophecies; this explanation is offered by Obstfeld (1994) among others.

This Letter discusses these two explanations for speculative pressures and reviews some evidence from East Asian economies.

Inconsistent macroeconomic policies

How might macroeconomic policies lead to speculative pressures on a currency? Suppose there is a country called Latinia, whose currency, the peso, is pegged to the U.S. dollar. Other things equal, the value of the peso depends on the relative quantities of pesos and dollars. Now suppose that Latinia keeps running budget deficits and that the government pressures the central bank to help finance them. In that case, the central bank expands domestic credit, which creates money for the government to use to pay its bills, and that pumps more pesos into the economy. The excess supply of pesos leads to a depreciation in the peso’s value, because people will want to dump pesos from their portfolios and switch to foreign currency instead.

To defend the peso’s value and the peg to the dollar, the central bank has to do an about-face–instead of pumping pesos into the economy, it has to take them out of the economy. It does this by buying them with its foreign currency reserves. And therein lies the rub. The peso cannot be defended indefinitely, but only so long as the central bank has foreign currency reserves. Once they are depleted, the peso can no longer be defended.

Krugman’s analysis shows that in a case like Latinia’s, the collapse of the peg will be sudden, as forward-looking speculators who observe the gradual depletion of reserves will attack the peso before reserves are exhausted. At the time of the collapse, Krugman’s model predicts that the central bank will be forced to use up all its foreign exchange reserves in a futile attempt to defend the peg. Latinia’s example thus illustrates how fiscal deficits tend to produce imbalances in the money market and in the balance payments that are ultimately inconsistent with a pegged exchange rate.

Self-fulfilling expectations

A number of observers point out that the preceding explanation does not seem to describe a couple of recent cases of speculative pressure. For example, in 1992-1993, some European countries faced speculative pressures on their exchange rates pegs to the deutschemark. But, at that time, these countries had ample foreign exchange reserves and in some cases at least, such as France, their macroeconomic policies were not obviously inconsistent with the stability of their currencies against the deutschemark. Similarly, after the collapse of the Mexican peso peg in December 1994, the currencies of Hong Kong and other countries were under speculative pressures, despite the fact that they had ample foreign exchange reserves and conservative macroeconomic policies.

These differences have prompted some economists to consider explanations in which the beliefs of speculators may affect the government’s incentive to defend or abandon a currency peg, leading to self-fulfilling currency crises (see Obstfeld 1994). For example, consider another country, Islandia, with a fixed exchange rate and conservative monetary and fiscal policies. Wages there are relatively inflexible, so that the government can increase competitiveness and (temporarily) reduce unemployment by devaluing the currency. (If wages were completely flexible, they would rise immediately in response to the devaluation, and the devaluation would have no effect on employment.) However, the government must weigh the short-term benefits of a devaluation against the higher prices that would result in the long run, which would impose political costs and possibly a loss of the government’s credibility as an inflation fighter.

Islandia’s government will maintain a stable exchange rate indefinitely, so long as it estimates that the benefits of devaluing are smaller than the costs. However, shifts in market expectations can alter the government’s calculations, resulting in a devaluation. For example, if the market for some reason believes that the government is going to devalue the exchange rate, market participants would expect higher inflation to ensue. This would prompt workers to demand higher wages, which would reduce the competitiveness of the economy and increase unemployment. Faced with the rise in unemployment, the government may in fact devalue. Thus, a shift in expectations can lead to an exchange rate crisis and devaluation that otherwise might not have occurred. The shift in expectations in this case may have nothing to do with the soundness of domestic economic policy or other market fundamentals, but may reflect arbitrary and unpredictable factors.

The importance of expectations in determining the timing and success of speculation against a currency suggests that a reputation for “toughness” may help policymakers deter such speculation and preserve a peg. (This appears to be the rationale for proposals such as the adoption of currency boards, which can make it less likely that money will be issued in a manner inconsistent with a peg and also make it more difficult to adjust a peg.) Drazen and Masson (1994) investigate this question and point out that even “toughness” may not deter speculative pressures. For example, if a government is “tough” in resisting speculative pressures in one instance, speculators may infer that defense in that episode was so costly that the government could not possibly resist future speculation against its currency. This seems to fit Sweden’s experience. In September 1992, Swedish authorities successfully resisted speculation against the krona by temporarily raising the domestic interbank rate up to 500 percent (annualized). However, they responded to a second episode of speculation in November 1992 by floating the currency. The cost of defending the peg, given existing unemployment, was simply too high. It can be argued more generally that any event that creates the perception that the government is unwilling or unable to defend a peg (such as a cyclical increase in unemployment, elections, or a fragile financial sector) may trigger speculative pressures that can result in an adjustment of the exchange rate.

East Asian evidence

A recent study (Moreno 1995) uses the preceding models as a framework for interpreting episodes of speculative pressure in Indonesia, Japan, Korea, Malaysia, the Philippines, Singapore, Taiwan, and Thailand during 1980-1994. (For a discussion of recent European experiences, see Rose 1996.) The study inquires whether there are significant differences in macroeconomic behavior during periods of speculative pressure and periods of tranquility, which may shed light on the plausibility of alternative explanations for speculation in foreign exchange markets.

For example, a finding that episodes of speculation are associated with unusually rapid growth in Central Bank domestic credit or large budget deficits would be consistent with Krugman’s model of speculative attacks. Alternatively, a finding that output is unusually sluggish, domestic inflation is relatively high, or the current account is unbalanced during episodes of speculative pressure might indicate that speculative episodes occur when the government might find it costly to defend the exchange rate, as suggested by Obstfeld and Drazen and Masson. If no relationship between macroeconomic conditions and episodes of speculative pressure is found, this may suggest that speculation is largely governed by arbitrary changes in expectations, as described by Obstfeld.

Three points are worth bearing in mind when analyzing East Asia’s experience. First, regardless of the type of exchange rate regime (de facto peg, basket peg, managed float, generally free float), policymakers as a rule do attempt to prevent very sharp movements in the exchange rate, even if they do not always maintain a rigid peg.

Second, the theoretical models discussed earlier focus on cases when speculative pressures always succeed in ending a peg, which means speculative episodes may be identified by identifying instances of large changes in the exchange rate. In practice, however, monetary authorities often successfully resist speculative pressures, so speculative episodes may occur, but the exchange rate may barely move. To take this into account, episodes of speculative pressure are identified not only by considering periods when there were unusually large changes in the exchange rate of a currency against the U.S. dollar (approximately half the episodes identified), but also by considering periods when a central bank appeared to be resisting pressures for the currency to adjust, as indicated by large changes in foreign exchange reserves of the central bank or in domestic relative to U.S. interest rates.

Third, while most discussions of speculation focus on devaluationpressures, in East Asia there is often pressure on the currency to appreciate. (Episodes of appreciation pressures accounted for about 40 percent of the episodes analyzed.)

Statistical (nonparametric) tests were performed to see whether episodes of speculative pressure appear to be related to unusual behavior in a country’s monetary or fiscal policy, or in economic conditions. The statistical analysis reveals that episodes of depreciation in East Asia are associated with larger budget deficits and growth in central bank domestic credit than are episodes of appreciation or periods of tranquility. This is broadly consistent with speculative pressure arising because macroeconomic policies are not consistent with an exchange rate peg. In addition, inflation tends to be higher, and growth tends to be slower during periods of depreciation than during periods of appreciation or tranquility. This suggests that episodes of speculative pressure also may arise when economic conditions make it costly for the government to maintain a stable exchange rate.


Recent advances in the analysis of foreign exchange markets shed light on how macroeconomic policies or the economic outlook may interact with expectations so as to trigger speculative pressures on a currency. By identifying (at least theoretically) conditions that may lead to speculative pressures, these models eventually may help us predict when speculative episodes may occur.

An empirical analysis of episodes of speculative pressure in East Asia suggests that policies designed to prevent imbalances in the balance of payments and money markets may help deter speculation against currencies in the region. In addition, policymakers need to take into account how business cycle fluctuations or other events may affect market perceptions of the government’s ability and willingness to preserve a stable exchange rate. Changes in such perceptions may be very sudden and may require costly adjustments to maintain exchange rate stability.

Ramon Moreno
Senior Economist


Drazen, Allan, and Paul R. Masson. 1994. “Credibility of Policy versus Credibility of Policymakers.” Quarterly Journal of Economics 3, pp. 735-754.

Glick, Reuven, and Ramon Moreno. 1995. “Capital Flows and Monetary Policy in East Asia.” In Monetary and Exchange Rate Management with Capital Mobility, ed. Hong Kong Monetary Authority.

Krugman, Paul. 1979. “A Model of Balance of Payments Crises.” Journal of Money, Credit and Banking 11, pp. 311-325.

Moreno, Ramon. 1996. “Macroeconomic Behavior During Periods of Speculative Pressure or Realignment: Evidence from Pacific Basin Economies.” FRBSF Economic Review 1995, No. 3.

Obstfeld, Maurice. 1994. “The Logic of Currency Crises.” NBER Working Paper No. 4640.

Rose, Andrew. 1996. “Are All Devaluations Alike?” FRBSF Weekly Letter 96-06.

Opinions expressed in FRBSF Economic Letter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System. This publication is edited by Sam Zuckerman and Anita Todd. Permission to reprint must be obtained in writing.

Please send editorial comments and requests for reprint permission to

Research Library
Attn: Research publications, MS 1140
Federal Reserve Bank of San Francisco
P.O. Box 7702
San Francisco, CA 94120