1. Leading Indicators of a Currency Crisis: From Fundamentals to Contagion Edward Mongon, Syed Zillur Rehman, and Divya Yerraguntla International Capital Markets 11/25/08
In the long run, a currencies value mirrors the fundamental strength of the underlying economy. In the short run, investor sentiment plays an important role. “ Fight or flight” mentality Currency crises becoming self-fulfilling prophecies
First Generation Models (Krugman, 1979) Focus on macroeconomic fundamentals and fiscal/monetary policy Excessive expansionary monetary and/or fiscal policy eventually leads to a recurrent loss of international reserves that ultimately makes crisis unavoidable. Political/legal instabilities act to augment risk. Second Generation Models (1992) Focus on the relationship between investor expectations and actual results from policymaking. “ A currency crisis can be thought of as a shift in expectations toward the devaluation outcome. Such a shift suddenly makes the defense of the exchange rate peg excessively costly.” – Paolo Pesenti and Cedric Tille Investor sentiment of long-term macroeconomic movements plays a large role in future currency crises Third Generation Models (1992) Point to the role of contagion “ In the absence of common shocks, a currency crisis can be transmitted from one country (A) to another (B) if structural links and international spillovers make the economies of countries A and B interdependent. That is, if the currency devaluation by country A has a negative impact on country B’s fundamentals, it will eventually force country B’s currency devaluation.” – Pesenti and Tille Links in trade and finance Economies of developing countries with liberal laws regarding capital flows are more susceptible to crisis than those nations with strict controls on foreign investment/repatriation.
Capital Account Explained Includes all purchases and sales of assets, such as stocks, bonds, banks accounts, real estate, and businesses.” – Eun and Resnick. In aggregate, represents the difference between the sale of US assets to foreign nations and the purchase of foreign assets by the U.S. Variables that may act as leading indicators from the Capital Account include: reserves, real interest rate differential, foreign debt/exports, capital flight.
Exchange rate depreciation - At the beginning of the year, the spot rate was about 15,800 dong per U.S. dollar. During the middle of the summary, the rate moved to about 16,800 dong per U.S. Dollar. Much of this is due to the widening the band at which the dong may fluctuate from the dollar.
Argentina is likely to undergo another currency crisis because of High inflation rate (official 8% vs actual 25%) 40% debt in form of government issued inflation linked bond yielding 8.9% domestic default Irresponsible fiscal and monetary policies Introduced export taxes, upset farmers (mainly commodities such as soybean, corn. Pension funds became public to pay off foreign debt. Low interest rate resulting in inflation (failed to raise it during good times) Overvalued exchange rate 1$ (US) : 3.30 (Arg peso) (‘defending at all cost’ approach by depleting reserves, won’t be able to sustain for long) Current account reduction In 2007, it was $2.812 (%change: -48.05) In 2008, it is $1.816 (% change: -57.82) Decrease in GDP growth In 2008, it reduced by 19.74%. No trust on government Argentineans have low level of confidence because of past experiences, withdrawing money in large amounts which may lead to run on banks. Investors and creditors especially foreigners are afraid because of previous default. Declining commodity prices Exporter of soybean, corn, would see drastic reduction in balance of payment account. Hugo Chavez won’t come to rescue, decreasing oil prices and other internal political problems.
Argentina is likely to undergo another currency crisis because of High inflation rate (official 8% vs actual 25%) 40% debt in form of government issued inflation linked bond yielding 8.9% domestic default Irresponsible fiscal and monetary policies Introduced export taxes, upset farmers (mainly commodities such as soybean, corn. Pension funds became public to pay off foreign debt. Low interest rate resulting in inflation (failed to raise it during good times) Overvalued exchange rate 1$ (US) : 3.30 (Arg peso) (‘defending at all cost’ approach by depleting reserves, won’t be able to sustain for long) Current account reduction In 2007, it was $2.812 (%change: -48.05) In 2008, it is $1.816 (% change: -57.82) Decrease in GDP growth In 2008, it reduced by 19.74%. No trust on government Argentineans have low level of confidence because of past experiences, withdrawing money in large amounts which may lead to run on banks. Investors and creditors especially foreigners are afraid because of previous default. Declining commodity prices Exporter of soybean, corn, would see drastic reduction in balance of payment account. Hugo Chavez won’t come to rescue, decreasing oil prices and other internal political problems.
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