Currency CrisisCurrency Crisis

Presented By: Eruj Arshad

What is Currency?

A currency is a unit of exchange, facilitating the transfer of goods and/or services. It is one form of money, where

money is anything that serves as a medium of exchange, a store of value,

and a standard of value.

What is Currency Crisis?

A currency crisis, which is also called a balance-of-payments crisis, occurs when the value of a currency changes quickly, undermining its ability to serve as a medium of exchange or a store of value.

Currency crises can be especially destructive to small open economies or bigger, but not sufficiently stable ones.

Governments often take on the role of fending off such attacks by satisfying the excess demand for a given currency using the country's own currency reserves or its foreign reserves (usually in Euros or United States Dollar).

Crises develop as an interaction between investor expectations and what those expectations cause to happen.

What Causes Currency Crisis?

Government Policy, Central Banks and the Role of Investors

Fixed-exchange rate economies have 2 options- Eat into the country’s foreign reserve Let the exchange rate fluctuate

Cont…

Anatomy of a Crisis Capital Flight Results in worse exchange rate Difficult to fund country’s capital spending

Currency Crisis Faced by Different Countries

Asian Crisis Latin America Crisis Russian Currency Crisis Argentina Crisis

Common Factors

The countries borrowed heavily Currency values increased rapidly Uncertainty over the government's

actions made investors jittery

Asian Crisis [mid 1997] The East Asian crises, which erupted in mid-1997, have been one of

the most serious and challenging economic events of the 1990s. Also known as the IMF crisis. East Asia consists of Japan, China, South Korea, Taiwan, and the

countries of the Association of Southeast Asian Nations, ASEAN Thailand, Indonesia and South Korea had large private current

accountdeficits and the maintenance of Fixed exchange rate encouraged external borrowing and led to excessive exposure to foreign exchange risk.

Different opinions about the causes of crisis1) Misguided macro-management2) Irresponsible, and over reactive behavior of external Financial

markets3) Importance of a combination of fragile domestic financial

markets (a result of inadequately administered financial deregulation and opening) and large and volatile capital inflows and outflows.

How it started?

The crisis started from Thailand

As the crisis spread, most of Southeast Asia and Japan saw slumping currencies, devalued stock markets and other asset prices, and a precipitous rise in private debt.

IMF stepped in to initiate a $40 billion program to stabilize the currencies of South Korea, Thailand, and Indonesia, economies particularly hard hit by the crisis.

Reasons

1) Thailand, Indonesia and South Korea had large private current account deficits and the maintenance of fixed exchange rates.

2) As the U.S. economy recovered from a recession in the early 1990s, the U.S. Federal Reserve Bank under Alan Greenspan began to raise U.S. interest rates to head off inflation. This made the U.S. a more attractive investment destination relative to Southeast Asia, which had attracted hot money flows through high short-term interest rates, and raised the value of the U.S. dollar, to which many Southeast Asian nations' currencies were pegged, thus making their exports less competitive. At the same time, Southeast Asia's export growth slowed dramatically in the spring of 1996, deteriorating their current account position.

3) Policies adopted that distorted incentives within the lender-borrower relationship.

4) Strict monetary and contractory fiscal policies implemented by the governments on the advice of the IMF in the wake of the crisis led to bank run kind of a situation.

Latin- America Crisis [1998-1999]

External Factors: Massive short-term capital outflows provoked a deep

recession. If Latin America had grown 5.3% in 1997, in 1998 growth diminished to 2.3% and in 1999, regional GDP growth was a mere 0.3%

‘Rescue’ loans were intended to save and bail out the big international creditors’ investments, which were of a mostly short-term nature, thus increasing ‘moral hazard’.

Latin American countries borrowed at historically low rates, but then interest rates increased sharply

Most of the debt was US dollar denominated. Hence, to pay for the debt, LA nations needed US dollars.

Capital began leaving the countries.

Russian Crisis-A glimpse of Events

Russian Crisis [1998] Also known as the Ruble Crisis Petroleum, natural gas, metals, and timber accounted for more

than 80% of Russian exports When the East Asian financial crisis broke out in 1997, prices for

Russia's two most valuable sources of capital flows, energy and metals, dropped.

Non-payment by the manufacturing & energy sector-main cause of the crisis

Ruble was allowed to float freely. By 1998 inflation had reached 84% The government began facing difficulties selling ruble denominated

debt due to adverse domestic political developments, weak commodity prices, and global economic events.

On August 13, 1998, the Russian stock, bond, and currency markets collapsed as a result of investor fears that the government would devalue the ruble, default on domestic debt, or both.

Russian government abandoned to defend the exchange rate peg, declared unilateral default on $40 billion in short-term domestic treasury debt, of which about one third was held by foreign investors, and placed a 90-day halt on commercial external debt payments.

Argentina Crisis

A result of bad policies by the Government

Main blunders : increasing tax rates, freezing bank deposits, devaluing the peso, and forcibly converting dollar bank deposits and contracts into pesos (“Pesofication”).

Cont.. The conventional view of Argentina’s crisis as it

unfolded in 2001 was that Argentina’s monetary system, locally known as

“convertibility,” was a currency board; The peso’s exchange rate of 1 per dollar made the

peso persistently overvalued; Argentina’s exports suffered, triggering recession and

default.

According to the conventional view, the way to end the recession was to allow the peso to float.

Causes of Crisis

External forces provoked a recession. Impact of The East Asian currency crisis of 1997-98 and the

Russian currency crisis of August 1998 Brazil, Argentina’s largest trading partner In Jan 1999, Brazil allowed its currency to float. The Brazilian real quickly depreciated from 1.21 per dollar

to 2.18 per dollar before recovering somewhat. Brazil’s economic growth fell from 3.3 percent in 1997 to 0.1 percent in 1998 and was only 0.8 percent in 1999. After years of gains, Argentine-Brazilian trade was flat in 1998 and shrank in 1999.

Cont..

Menem’s Debt Mishandled government finance Avoided tackling the big problems of inflexible labor laws,

inefficient mandatory health care organizations, and overstaffed government bureaucracies

Starting in 1994, the federal budget was in deficit continuously.

The government financed the deficit through debt borrowing. Argentina relied heavily on international capital flows to finance the large gap in national spending.

1994, the federal government’s gross debt was about US$70 billion

By the third quarter of 2001, the debt was twice as large, at US$141 billion, while GDP was US$271 billion—only 5 percent bigger than 1994 in nominal terms and smaller in real terms per person.

Cont.. De la Rúa’s Tax Increases:

Responded incorrectly to the debt problem. Instead of reducing government spending, the country attempted to

levy taxes against the citizens to solve their problems. Historically, Argentines paid very little taxes with about 40% not

paying any taxes. Thus, increasing taxes was met with high resistance and little success

Three large tax increases1. Took effect in January 2000, increased income tax rates for

people earning more than 30,000 pesos a year; subjected retirement benefits of more than 24,000 pesos a year to tax; and increased the wealth tax (assets tax), beverage taxes, tax surcharges on automobiles, and the special tax on tobacco.

2. The so-called Competitiveness Law imposed a financial transactions tax, which became effective in early April 2001. The rate was initiallyset at 0.25 percent and later raised to 0.4 percent.

3. In August 2001, the government raised the financial transactions tax by decree to the legal maximum of 0.6 percent

Cont.. Loss of Export Competitiveness

High government deficits and debt would not have been a major problem if the economy had been able to generate capital inflows through trade. But, the economy had very poor export growth and entered a recession in the late 1990’s.

As the dollar strengthened against other currencies in the 1990’s, Argentina’s exchange rate became overvalued.

An overvalued fixed exchange rate eroded Argentina’s export competitiveness. Also, the Brazilian currency devaluation hurt Argentina. Brazil was their main trading competitor, so Brazilian goods were relatively much cheaper.

Since Argentine exports were too expensive relative to their competitors, the economy exported too little and imported too much.

Cont.. The Argentine government entered a “debt trap” by mid

2001 The government financed the deficit through debt borrowing.

Argentina relied heavily on international capital flows to finance the large gap in national spending.

Interest rates in dollars within Argentina rose substantially, because of concern that loans and deposits in dollars were also at risk from government policies.

Lack of confidence in government. In July 2001, when rating agencies reduced the credit rating of

Argentina’s government debt, it rose above 16 percentage points, and by the end of October it exceeded 20 percentage points.

Government policies “contaminated” the private sector in late 2001 and 2002 Problems spread to the private sector. Fear of freezing bank deposits was developed Pesofication.

Lessons Learned

An economy can be initially solvent and still succumb to a crisis. Having a low amount of debt is not enough to keep policies functioning.

Trade surpluses and low inflation rates can diminish the extent at which a crisis impacts an economy, but in case of financial contagion, speculation limits options in the short run.

Governments will often be forced to provide liquidity to private banks, which can invest in short-term debt that will require near-term payments. If the government also invests in short-term debt, it can run through foreign reserves very quickly.

Maintaining the fixed exchange rate does not make a central bank's policy work simply on face value. While announcing intentions to retain the peg can help, investors will ultimately look at the central bank's ability to maintain the policy. The central bank will have to devalue in a sufficient manner in order to be credible.

Is Pakistan Facing Currency Crisis? As Reuters reports, 

“Pakistan has been running unsustainable fiscal and balance of payments deficits”.

Pakistan’s economy is the weakest and most vulnerable to rising oil prices and international financial crisis.

The country’s foreign reserves have dwindled to around $4.5 billion

The political crisis has contributed to a huge exodus of foreign capital and exacerbated the country’s economic problems.

As much as $1.2 billion a month was fleeing Pakistan in the summer. The rupee has slumped by more than 30 percent against the US dollar since the beginning of the year and share prices have crashed by 40 percent since their all-time high in April.

Devaluation of Rupee

Devaluation is nothing but an official decrease of value of a currency in relation to gold and other currencies indicating

a desperate attempt made by the government to promote and boost its exports.

Pakistan’s economy has been crippled by fuel and food inflation and a domestic insurgency which has panicked foreign investors. This combination of factors has triggered a 25-30 per cent devaluation of the rupee since the start of the year, a crash within the stock markets and a looming foreign debt crisis.

Rupee record low against dollar Factors involved in dollar-rupee parity

law and order situation flight out of capital meager foreign exchange reservoirs huge gap between import and export bill

Cont..

Inflation rate floating more than 25 percent Widening current account deficit Heavy government borrowing to cover a budget deficit $500 million euro bond debt obligation which was due in

February Mismanagement in privatization process and Last but not the least the lack interest of financial managers

to formulate such policies which could pull the country out of crises.

Why devaluation ? Two reasons:

1. persistent adverse trade balance and 2. disequilibrium in balance of payment

Export primary goods Government has only one option in hand to stop the

imports of luxury items Pakistan is perhaps the second country after the US,

which has seen its trade deficit widen irrespective of the value of the currency.

What should be done?

Do not depend on US

Must keep the people informed about all crucial decisions

some of the demands of the IMF, i.e., increasing revenue, reducing budget deficit and bank

borrowing, cutting down non-developmental expenditure are the measures any sensible government should have undertaken to keep the economy of the country on sound footings

Cont…Out look

The country needs a bail-out package to avert current financial crisis.

Pakistan will continue to remain at the bottom line in the region Fears of prolonged economic crisis. Unsettled local and foreign investors There will be no restructuring of economy in the near future GDP growth will be further affected Fresh Investment will take time to make in-roads Government's policy towards foreign investment got the setback Exportable surplus to remain low Foreign exchange reserves position getting from bad to worse Inflation continues in double digit local products eroding

Thank You!!