FRBSF Economic Letter
96-13; April 19, 1996
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.
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 intothe 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.
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.
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 this newsletter 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. Editorial
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