OLEMISS FIN 634 - A Case Study of a Currency Crisis

Unformatted text preview:

NOVEMBER/DECEMBER2002 7A Case Study of aCurrency Crisis: TheRussian Default of 1998Abbigail J. Chiodo and Michael T. OwyangAcurrency crisis can be defined as a specula-tive attack on a country’s currency that canresult in a forced devaluation and possibledebt default. One example of a currency crisisoccurred in Russia in 1998 and led to the devaluationof the ruble and the default on public and privatedebt.1Currency crises such as Russia’s are oftenthought to emerge from a variety of economic condi-tions, such as large deficits and low foreign reserves.They sometimes appear to be triggered by similarcrises nearby, although the spillover from these con-tagious crises does not infect all neighboring econ-omies—only those vulnerable to a crisis themselves. In this paper, we examine the conditions underwhich an economy can become vulnerable to acurrency crisis. We review three models of currencycrises, paying particular attention to the events lead-ing up to a speculative attack, including expectationsof possible fiscal and monetary responses to impend-ing crises. Specifically, we discuss the symptomsexhibited by Russia prior to the devaluation of theruble. In addition, we review the measures that wereundertaken to avoid the crisis and explain why thosesteps may have, in fact, hastened the devaluation.The following section reviews the three genera-tions of currency crisis models and summarizes theconditions under which a country becomes vulner-able to speculative attack. The third section examinesthe events preceding the Russian default of 1998 inthe context of a currency crisis. The fourth sectionapplies the aforementioned models to the Russiancrisis. CURRENCY CRISES: WHAT DOESMACROECONOMIC THEORY SUGGEST?A currency crisis is defined as a speculativeattack on country A’s currency, brought about byagents attempting to alter their portfolio by buyinganother currency with the currency of country A.2This might occur because investors fear that thegovernment will finance its high prospective deficitthrough seigniorage (printing money) or attempt toreduce its nonindexed debt (debt indexed to neitheranother currency nor inflation) through devaluation.A devaluation occurs when there is market pres-sure to increase the exchange rate (as measured bydomestic currency over foreign currency) becausethe country either cannot or will not bear the costof supporting its currency. In order to maintain alower exchange rate peg, the central bank must buyup its currency with foreign reserves. If the centralbank’s foreign reserves are depleted, the governmentmust allow the exchange rate to float up—a devalu-ation of the currency. This causes domestic goodsand services to become cheaper relative to foreigngoods and services. The devaluation associated witha successful speculative attack can cause a decreasein output, possible inflation, and a disruption inboth domestic and foreign financial markets.3The standard macroeconomic frameworkapplied by Fleming (1962) and Mundell (1963) tointernational issues is unable to explain currencycrises. In this framework with perfect capital mobil-ity, a fixed exchange rate regime results in capitalflight when the central bank lowers interest ratesand results in capital inflows when the central bankraises interest rates. Consequently, the efforts of themonetary authority to change the interest rate areundone by the private sector. In a flexible exchangerate regime, the central bank does not intervene inthe foreign exchange market and all balance of pay-ment surpluses or deficits must be financed byprivate capital outflows or inflows, respectively.The need to explain the symptoms and remediesof a currency crisis has spawned a number of modelsdesigned to incorporate fiscal deficits, expectations,and financial markets into models with purchasingpower parity. These models can be grouped intothree generations, each of which is intended toexplain specific aspects that lead to a currency crisis.1Kharas, Pinto, and Ulatov (2001) provide a history from a fundamentals-based perspective, focusing on taxes and public debt issues. Weendeavor to incorporate a role for monetary policy.2The speculative attack need not be successful to be dubbed a currencycrisis.3Burnside, Eichenbaum, and Rebelo (2001) show that the governmenthas at its disposal a number of mechanisms to finance the fiscal costsof the devaluation. Which policy is chosen determines the inflationaryeffect of the currency crisis.Abbigail J. Chiodo is a senior research associate and Michael T. Owyangis an economist at the Federal Reserve Bank of St. Louis. The authorsthank Steven Holland, Eric Blankmeyer, John Lewis, and RebeccaBeard for comments and suggestions and Victor Gabor at the WorldBank for providing real GDP data. ©2002, The Federal Reserve Bank of St. Louis.First-Generation ModelsThe first-generation models of a currency crisisdeveloped by Krugman (1979) and Flood and Garber(1984) rely on government debt and the perceivedinability of the government to control the budgetas the key causes of the currency crisis. These modelsargue that a speculative attack on the domesticcurrency can result from an increasing currentaccount deficit (indicating an increase in the tradedeficit) or an expected monetization of the fiscaldeficit. The speculative attack can result in a suddendevaluation when the central bank’s store of foreignreserves is depleted and it can no longer defend thedomestic currency. Agents believe that the govern-ment’s need to finance the debt becomes its over-riding concern and eventually leads to a collapseof the fixed exchange rate regime and to speculativeattacks on the domestic currency.Krugman presents a model in which a fixedexchange rate regime is the inevitable target of aspeculative attack. An important assumption in themodel is that a speculative attack is inevitable. Thegovernment defends the exchange rate peg with itsstore of foreign currency. As agents change the com-position of their portfolios from domestic to foreigncurrency (because rising fiscal deficits increase thelikelihood of devaluation, for example), the centralbank must continue to deplete its reserves to staveoff speculative attacks. The crisis is triggered whenagents expect the government to abandon the peg.Anticipating the devaluation, agents convert theirportfolios from domestic to foreign currency by buy-ing foreign currency from the central bank’s reserves.The central bank’s reserves fall until they


View Full Document

OLEMISS FIN 634 - A Case Study of a Currency Crisis

Download A Case Study of a Currency Crisis
Our administrator received your request to download this document. We will send you the file to your email shortly.
Loading Unlocking...
Login

Join to view A Case Study of a Currency Crisis and access 3M+ class-specific study document.

or
We will never post anything without your permission.
Don't have an account?
Sign Up

Join to view A Case Study of a Currency Crisis 2 2 and access 3M+ class-specific study document.

or

By creating an account you agree to our Privacy Policy and Terms Of Use

Already a member?