Covers George Soros attack on GBP Thailand - Asian Contagion

1. Topic 12
Speculative Attacks on Currencies

2. Purpose of This Topic
 (1) To demonstrate how markets attack foreign
currencies.
 Why an attack occurs and the conditions
necessary for success.
 Success measured by the country
abandoning its peg (a peg is where the
government is managing its currency in a
very tight range to another currency, or
basket of currencies).
 (2) To give you examples of currency attacks
and the consequences of those attacks.
 United Kingdom pound attack in 1992.
 Asian currency attack in 1997.

3. Market Forcing Countries to Abandon Peg:
An Attack on a Currency
 Attacks on currencies can occur for a variety of
reasons, but essentially they all relate to:
 Where the market believes that the existing (i.e., pegged)
rate overstates (or understates) the currency’s “true”
(intrinsic) value.
 Why might a currency be perceived as overvalued?
 Inappropriate domestic monetary and fiscal policies.
 Weakness in the country’s external (trade) position.
 Weakness in the country’s key financial sector (banking).
 Why might a currency be perceived as
undervalued?
 Underlying strength in the economy of the country which is
not reflected in the pegged exchange rate.

4. Attacking a “Overvalued” Pegged
Currency
 Attacks on an Overvalued Currency:
 Currency is sold short on foreign
exchange markets:
 Short selling: Speculators borrow
“overvalued” currency, sell it on foreign
exchange markets, and intend to buy it
back later when currency weakens.
 Short selling puts downward pressure on
the overvalued currency.

5. Attacking a “Undervalued” Pegged
Currency
 Attacks on an Undervalued Currency:
 Currency is bought on foreign exchange
markets.
 Speculators buy “undervalued” currency,
and intend to sell it later when currency
strengthens.
 Buying the currency puts upward pressure on
the undervalued currency.

6. Assumptions Before Attack will Proceed
 Before attacking a currency, speculators
must also be confident that the government
of the country’s who’s currency is under
attack:
 (1) Lacks the will to defend its currency.
 Not willing to adjust interest rates (perhaps for political
reasons)
 (2) Lacks the resources to defend its currency.
 Does not have sufficient foreign exchange to support its
currency.
 Would need dollars or other hard currency if their currency
is being sold.

8. Case Study: British Pound Attack
(1992)
 Britain joined the European Exchange Rate
Mechanism (ERM) in October 1990.
 ERM was designed to promote exchange rate stability
within Europe.
 Under the ERM, European currencies were
“pegged” to one another at agreed upon rates.
 The British pound was locked into the German
Mark at a central rate of about DM2.9/£
 Generally feeling at the time was that this rate
overvalued the pound against the mark.

9. Dominance of Germany in the ERM
 While the ERM included many European
countries, Germany was the leading player.
 Therefore, the German mark was the dominant
currency in this arrangement.
 In addition, German monetary policy had to
be followed by the other members in order for
the other member states to keep their
currencies aligned with the German mark.
 This was especially true with regard to German
interest rates.

10. Cartoon Representing German Dominance

11. Series of Events Leading Up to the
Attack on the Pound
 While the markets felt the pound was “overvalued”
when it joined the ERM, a combination of events just
before and after Britain joined convinced the market
that the pound was ready for speculation.
 These events were:
 The fall of the Berlin Wall in Nov 1989
 The economic “recession” in the U.K. in 1991-92.
 German decided to raise interest rates in order to
attract needed capital for the reunification of
Germany.
 The issue for the U.K. was having to raise interest
rates during their recession.
 Political and economic component to this decision.

12. Response of British Government to
Speculative Attack: September 1992
 Pound currency attack begin in September1992
 Led by hedge funds: For example, George Soros.
 Wednesday, September 16 (“Black Wednesday”)
 Bank of England raised interest rates twice from 10% to
12% and then later in the day to 15%
 Move was an attempt to make U.K. investments more
attractive to overseas and domestic investors.
 During the attack the Bank of England spent 4 billion
pounds ($7 billion) in defense of its currency.
 Buying pounds (selling U.S. dollars and German marks).
 Estimates: 1/3 of its hard currency was spent.
 Thursday, September 17, U.K. left the exchange
rate mechanism and let the pound float!
 Pound fell from 2.7780 to 2.413; or -13.1%

13. British Pound: Jan 1991 – Dec 1992

14. 15% Change in British Pound

15. Pound Against the U.S. Dollar: 1992
 Down by 25%: What did this mean for U.S.
Companies operating in the U.K.?

16. Case Study: Asian Currency Crisis of
1997
 During the 1980s, a group of countries in
Southeast Asia – known as the “Asian Tigers”
– experienced exceptionally high economic
growth rates.
 The economic miracle was accompanied by
these countries opening up their financial
markets to foreign capital inflows
 Also, during this time, the currencies of these
countries were pegged to the U.S. dollar.

18. Thailand: Background
 Thailand was part of the southeast Asian
region which experienced double digit real
growth up to the mid-1990s.
 Exports were critical to the regions exceptional
growth.
 Thailand’s exports had increased 16% per year from
1990 to 1996.
 Economic growth in the region was fueled by
massive increases in foreign borrowing.
 Government borrowing for infrastructure investment
 Corporate borrowing for investment expansion.

19. The Thai Baht: A Pegged Currency
The Thai baht had been pegged to the U.S. dollar at
25 to the dollar for 13 years.

20. Thailand Begins to Unravel
 The massive increase in foreign investment
eventually resulted in:
 Overcapacity in Thailand
 Poor lending/investment decisions
 Investment in speculative activities (especially the property
markets)
 On February 5, 1997, the Thai property developer,
Somprasong Land, announced it could not make a
$3.1 million interest payment on an outstanding $80
billion loan.
 Other Thai development companies followed and the Thai
property market began to unravel.

21. Currency Traders Assess the Situation
 Currency traders were aware of the following:
 Thailand’s enormous external debt which was
denominated in U.S. dollars would require a large
demand for dollars.
 Coupled with the debt burden, Thailand’s export
growth began to slow and moved into deficit.
 Question: Where would the dollars come from the
finance the external debt?
 Traders believed the baht was “overvalued at 25
to the dollar.

22. The Attack on the Thai Baht Peg
 Believing the baht was overvalued,
speculators:
 Start to sell the baht short in May1997
 Traders borrowed bahts from local banks
and immediately resold them in the foreign
exchange markets for dollars.
 If the baht did weaken, traders could buy
the bahts back and pay off the loan and
make a profit on the dollar appreciation.

23. Response of the Thai Government
 The Thai Government initially responded by:
 Purchasing bahts on foreign exchange markets
 Used $5 billion in this effort
 Raising interest rates from 10 to 12.5%
 Thailand was quickly running short of U.S. dollars
 They had just over $1 billion left to support the
baht.
 The higher interest rates raised the cost of
borrowing and adversely affected floating rate loan
liabilities.
 Bottom line: Continuing to defend the peg was
quickly approaching an impossible situation.

24. Releasing the Peg
 On July 2, 1997, the Thai government announced
they were abandoning the peg and would let the
currency float.
 The baht immediately lost 18% of its value
 By January 1998, it was trading at 55 to the dollar.

25. Baht’s 55% Fall Against the Dollar

27. Contagion Effect in Asia (1997)
 The attack on the Thai baht, quickly spread to
other Asian currencies
 Example of a regional contagion effect
 Concern mounted regarding the economic and
financial “soundness” of these countries as well.
 As a direct result, many of these Asian countries
were forced to abandon their pegged regimes.
 For a complete discussion of the crisis see:
 http://www.wright.edu/~tran.dung/asiancrisis-hill.htm

28. Indonesia Rupiah, Jan 1997 – Dec 1997

29. Philippine Peso, Jan 1997 – Dec 1997

30. Taiwan Dollar, Jan 1997 – Dec 1997

31. Korean Won, Jan 1997 – Dec 1997

32. Malaysian Ringgit, Jan 1997 – Dec 1997

33. Malaysian Ringgit: 1997 – June 2005

34. July 21, 2005: Malaysia Moves To a
Managed Float.

35. Exchange Rate Changes in Asia: June
1997 to June 1998

36. One Government, However, Was Able
to Successfully Defend Its Currency
 Hong Kong Dollar
 China purchase massive amounts of stock being
sold on the Hong Kong stock exchange.
 Offset the short selling of hedge funds.
 China sold massive amounts of U.S. dollars in
defense of the HK$
 Offset the selling of the Hong Kong dollar on foreign
exchange markets.
 The HK$ peg was successfully defended and
remains so today.

37. Hong Kong Dollar in 1997