financial crisis in-depth - Currency Collapse...

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Unformatted text preview: Currency Collapse ----------------- Central bank of country keeps its currency pegged to another currency (for all intents and purposes doing well) like the dollar Currency does well when liquidity is present, where the country does not build up debt and continues to please confident investors with strong economy, having manageable level of inflation and little trade deficit When not doing well, central bank of country borrows a lot of dollars to keep the exchange rate "pegged" or more or less fixed near value of the dollar; it does this by borrowing dollars to maintain a dollar reserve supply, substantiating the exchange's demand for dollars when the dollar supply is low ~ prevents traders from charging a higher amount of the currency for the dollar, which would devalue the currency Creates pressure as more dollars borrowed and reserves decline, causing a massive buildup of debt, and liquidity decreases because the more debt the central bank has the less credit worthy they are to lenders, who are less and less willing to lend Breton Woods era (after WW2 and ending in 70's): world currencies fixed on USD standard ~ problem arose when inflation in these countries rose in the presence of fixed exchange rate, which caused central banks to mass-borrow USD Investors eventually catch on through economic factors like the extremely small ratio of GDP to defecit in the country; they lose confidence and withdraw by selling their positions on the currency Selling pressure causes the central bank to increase interest rates in order to keep exiting investors, which causes collapse of banks and firms who were heavily exposed to the interest rate risk and FX risk involved (their short-term liabilities become too high) Currency then collapses because the central bank abandons the fixed or pegged exchange rate in order to attract demand for their currency and bring back investors to absolve the drop in their currency's value, also to keep inflation from getting out of control Currency exchange rate often overshoots the "real" value based on inflation indices because of panic selling on a massive scale Becomes a vicious cycle, and in the background banks and firms are defaulting on loans (when they can't pay the high interest rates on their debt), which causes collapse of parties exposed to that sort of credit risk When probability of reserves being exhausted is significant, holders of currency want to trade the currency for government reserves In wartime, the printing of money to finance an army aggresively increases the money supply, which will give way to massive inflation and wartime debt, and may cause currency collapse eventually Moral of the story: don't try to control inflation by pegging currency to another; keep it floating to avoid crisis and moderate it by raising interest rates Bank Runs --------- In financial crisis, banks are stuck with exposure to liquidity risk because it exists to provide "liquidity transformation" (services borrowers and lenders at the same time and collecting a spread) If banks hold opposite-maturity assets and liabilities, it faces liquidity risk of interest rate increase, which causes long term assets to be lowered in value (since an increased rate for the same future value will yield a lower present value for fixed income holdings for example), which they cannot sell at the good price to finance the interest payments of their liabilities to depositors; another way to look at it is long-term assets cannot be refinanced at the higher interest rate, etc. One way to avoid bank run is to hedge the liquidity risk by entering into interest rate swap to obtain a floating rate on long-term assets, or interest rate call options Bank could also hold same-term assets and liabilities Speculator Attack ----------------- Government does not want to aggravate speculator attack by making statements that lead to decreased confidence in its currency; doing so may cause speculators to short the currency and sell spot and forward; one sign of devaluing currency is when people inside government start taking short positions on currency questions: inflation good to a point? but eventually what happens when inflation gets out of control? why is it that bad? people could still afford goods if their salaries are growing at the same rate CPI excludes food and energy ~ why? wouldn't that misrepresent the real rate of inflation? mechanics of trade deficit and how it can cause collapse can high level of investment in the currency cause crisis like the internet bubble in tech equities? (causing overvalued currencies with no real backed reserves i.e. revenue to show for it) Governments peg currencies to the dollar to stabilize their value. To maintain a peg, the central bank attempts to control the dollar price of its currency by intervening in currency markets. For example, if the market's dollar supply is not enough to meet dollar demand at the official exchange rate, then the government supplies dollars out of its reserves. This action prevents traders from demanding more currency for dollars and causing a currency to depreciate. ...
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This note was uploaded on 09/24/2007 for the course AEM 4420 taught by Professor Christy,r. during the Fall '06 term at Cornell University (Engineering School).

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