Speculative attacks can force countries to abandon pegged exchange rates. Markets may attack currencies perceived as overvalued or undervalued. In 1992, the British pound was seen as overvalued against the German mark in the ERM. Speculators short sold the pound, forcing Britain to raise rates to 15% and eventually abandon the peg. In 1997, the Thai baht was seen as overvalued against the dollar and speculators attacked, Thailand depleted its reserves defending the peg but ultimately floated the currency. The Thai crisis spread regionally as other Asian currencies were also attacked and depegged.

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