So far, the global financial crisis was largely about financial firms and markets in the first world. This was a novel experience; it had never happened before. Now it might morph into a few currency crises hitting pegged exchange rates. This is an old movie; we have seen this many times before and we know a lot about it.
Speculative attacks on pegged exchange rates appear to be in the offing. The market is carefully analysing all countries with pegged exchange rates, looking at the possibility of large devaluations when the central bank runs out of reserves. Countries which have interfered with exchange rate devaluation are in focus now. Thankfully, by and large, India is not one of these.
A key mistake that is being made in thinking about these problems is that many countries hold reserves that are “large enough”. As an example, writing in Financial Times, Charles Clover reports:
After two months of crisis, meanwhile, Russias currency reserves have dropped from $597bn in August to $515bn on October 17, partly as a result of defending the rouble. Capital flight is running at $12bn-$16bn a week. The Moscow interbank lending rate hit 22 per cent last week before settling back to 17 per cent, by far its highest level this decade, reflecting the scale of the stress in the banking system. Domestic banks are seeing depositors confidence evaporate four retail banks have experienced runs and been sold off in a hurry.
This month, the central bank instituted the first measures designed to prevent a speculative attack on the rouble when it banned currency swaps. But analysts are starting to ask how long the authorities can stand as substitute for the cut-off foreign investment and seized-up credit markets. They have enough reserves to last a year at this rate, maybe 18 months, says an economist at a Moscow bank.
This `economist at a Moscow bank’ is not reckoning with the incredibly nonlinear behaviour of the system when a speculative attack comes together. Once a speculative attack starts, reserves can essentially vanish in no time. Linear extrapolation is a poor guide to the outlook for reserves.
Exchange rate flexibility is now highly desirable. If countries try to hang on to exchange rate targets (e.g. RBI was a bit squeamish about breaching INR 50 per dollar) then this could cause a lot of damage. In this environment, it’s easy to get into a speculative attack. In contrast, exchange rate flexibility has a lot to offer. Countries that allow bad news to result in a sharp depreciation of the currency (and a sharp drop in asset prices) benefit from the lack of a perception of a one-way bet. A currency that has dropped in response to market forces (without interference by a government) has a good chance of going up the next day: there is no one-way bet in taking capital out of the country.
Holding “large” reserves is not a very good deal. In peacetime, they are not required, and in wartime, they are useless.
From an Indian point of view, as the Aziz, Patnaik, Shah paper has emphasised, there is a case for RBI using dollars to solve the dollar liquidity problems of Indian firms. The outer limit for the quantity of dollars that might get used in this fashion is $50 billion (partly because the London money market is showing some halting signs of life). There is no case for RBI to have any kind of exchange rate target. If RBI embarks on trading on the market in order to influence the exchange rate, this would be imprudent.
From a trader’s point of view, the consequences of this are simple. Look for countries where there is exchange rate rigidity, where the central bank has sold reserves in doing market manipulation, and short those currencies / stock market indexes. In doing this, be careful to not mis-interpret a decline in reserves expressed in USD.
If a clutch of countries experiences speculative attacks, and then large devaluations take place, this would add to the negative outlook for the world economy, for we know that in the aftermath of a currency crisis, it takes a year or three for the country to put itself together. Hopefully, these countries will come back to life with better monetary policy frameworks, so in the long run, this will turn out to have been for the better. But in the short run, this could be quite painful.
Originally published on Oct 27 at Ajay Shah’s Blog and reproduced here with the author’s permission.