From The Archives: Rejoinder on What Causes A Currency Crisis

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November 26, 2013 4.52 PM / Bello-Osagie Aghatise Teslim

A central bank that adopts a fixed exchange rate signals to investors that they will do whatever it takes to support the value of their domestic currency. Most-times they use their foreign currency reserve to meet local demand for the pegged foreign currency. To remain credible, the central bank must always put words to action whenever investors or currency speculators need them to act. If for any reason, the central bank is forced to give up its fixed exchange rate policy, it must devalue its domestic currency in a sufficient manner to regain its credibility. If it fails, then a currency crisis becomes a self-fulfilling prophecy. To clarify my points, please find below an idyllic case study on Central Bank of Thailand.

The Asian meltdown began on February 5th, 1997 in Thailand. That was the date that Somprasong Land, a Thai property developer, announced that it had failed to make a scheduled $3.1 million interest payment on an $80 billion eurobond loan, effectively entering into a default. Somprasong Land was the first victim of speculative overbuilding in the Bangkok property market. The Thai stock market had already declined by 45% since its high in early 1996, primarily on concerns that several property companies might be forced into bankruptcy.

In the aftermath of Somprasong’s default it became clear that not only were several other property developers teetering on the brink on default; so where many of the country’s financial institutions including Finance One, the country’s largest financial institution. Finance One had pioneered a practice that had become widespread among Thai institutions --- issuing Eurobonds denominated in US dollars and using the proceeds to finance lending to the country’s booming property developers.

In theory, this practice made sense because Finance One was able to exploit the interest rate differential between dollar denominated debt and Thai debt (i.e. Finance One borrowed in US dollars at a low interest rate, and leant in Thai Bhat at high interest rates). The only problem with this financing strategy was that when the Thai property market began to unravel in 1996 and 1997, the property developers could no longer payback the cash that they had borrowed from Finance One. In turn, this made it difficult for Finance One to pay back its creditors. As the effects of over-building became evident in 1996, Finance One’s non-performing loans doubled, then doubled again in the first quarter of 1997.

In February 1997, trading in the shares of Finance One was suspended while the government tried to arrange for the troubled company to be acquired by a small Thai bank, in a deal sponsored by the Thai central bank. It didn’t work, and when trading resumed in Finance One shares in may they fell 70% in a single day. By this time it was clear that bad loans in the Thai property market were swelling daily, and had risen to over $30 billion. Finance One was bankrupt and it was feared that others would follow.

It was at this point that currency traders began a concerted attack on the Thai currency, the baht. For the previous 13 years the Thai baht had been pegged to the US dollar at an exchange rate of around $1=Bt25. This peg, however, had become increasingly difficult to defend. Currency traders looking at Thailand’s growing current account deficit and dollar denominated debt burden, reasoned that demand for dollars in Thailand would rise while demand for Baht would fall. (Businesses and financial institutions would be exchanging baht for dollars to service their debt payments and purchase imports). There were several attempts to force a devaluation of the baht in late 1996 and early 1997. These speculative attacks typical involved traders selling Baht short in order to profit from a future decline in the value of the baht against the dollar. In this context, short selling involves a currency trader borrowing baht from a financial institution and immediately reselling those baht in the foreign exchange market for dollars.

The theory here is that if the value of the baht subsequently falls against the dollar, then when the trader has to buy the baht back to repay the financial institution it will cost her less dollars than she received from the initial sale of baht. For example, a trader might borrow Bt100 from a bank for a period of six months. The trader then exchanges the Bt100 for $4 (at an exchange rate of $1=Bt25). If the exchange rate subsequently declines to $1=Bt50 it will only cost the trader $2 to repurchase the Bt100 in six months and pay back the bank, leaving the trader with a 100% profit! Of course, since short selling involves selling Baht for dollars, if enough traders engage in this practice, it can become a self-fulfilling prophecy.

In May 1997 short sellers were swarming over the Thai baht. In an attempt to defend the peg, the Thai government used its foreign exchange reserves (which were denominated in US dollars) to purchase Thai baht. It cost the Thai government $5 billion to defend the baht, which reduced its "officially reported" foreign exchange reserves to a two-year low of $33 billion. In addition, the Thai government raised key interest rates from 10% to 12.5% to make holding Baht more attractive, but since this also raised corporate borrowing costs it only served to exacerbate the debt crisis.

What the world financial community did not know at this point, was that with the blessing of his superiors, a foreign exchange trader at the Thai central bank had locked up most of Thailand’s foreign exchange reserves in forward contracts. The reality was that Thailand only had $1.14 billion in available foreign exchange reserves left to defend the dollar peg. Defending the peg was clearly now impossible.

On July 2nd, 1997, the Thai Central bank bowed to the inevitable and announced that they would allow the baht to float freely against the dollar. The baht immediately lost 18% of its value, and started a slide that would bring the exchange rate down to $1=Bt55 by January 1998. As the baht declined, so the Thai debt bomb exploded. Put simply, a 50% decline in the value of the baht against the dollar doubled the amount of baht required to serve the dollar denominated debt commitments taken on by Thai financial institutions and businesses. This made more bankruptcies such as Finance One all further pushed down the battered Thai stock market. The Thailand Set stock market index ultimately declined from 787 in January 1997 to a low of 337 in December of that year, and this on top of a 45% decline in 1996!

On July 28th the Thai government took the next logical step, and called in the International Monetary Fund (IMF). With its foreign exchange reserves depleted, Thailand lacked the foreign currency needed to finance its international trade and service debt commitments, and was in desperate need of the capital the IMF could provide. Moreover, it desperately needed to restore international confidence in its currency, and needed the credibility associated with gaining access to IMF funds. Without IMF loans, it was likely that the baht would increase its free-fall against the US dollar, and the whole country might go into default. IMF loans, however, come with tight strings attached. The IMF agreed to provide the Thai government with $17.2 billion in loans, but the conditions were restrictive. The IMF required the Thai government to increase taxes, cut public spending, privatize several state owned businesses, and raise interest rates – all steps designed to cool Thailand’s overheated economy. Furthermore, the IMF required Thailand to close illiquid financial institutions. In the event, in December 1997 the government shut some 56 financial institutions, laying off 16,000 people in the process, and further deepening the recession.

The objectives of the Central Bank of Nigeria as laid out in the CBN ACT are Price stability, Protection of the external value of the Naira (Exchange rate Stability), Management of the foreign reserves and financial system stability.

For the purpose of the points raised I will explicitly look at price stability. Price stability was aptly defined by two Former Federal Reserve Chairmen Paul Volcker and Alan Greenspan. They defined price stability as having a macroeconomic environment in which inflation is not a factor in the decisions of consumers and businesses. It has been interpreted as a “low and stable” rate of inflation. Other central banks have defined price stability as a numerical target for inflation in a particular price index. For example, the Bank of England defines price stability by an inflation target set by the Government of 2% annual inflation in the consumer price index.

Bearing this in mind, Central banks have addressed price stability through inflation targeting or price-level target.

Under a price-level target, a central bank would adjust its policy instrument typically a short-term interest rate in an effort to achieve a pre-announced level of a particular price index over the medium term. In contrast, under an inflation target, a central bank tries to achieve a pre-announced rate of inflation that is, the change in the price level over the medium term.

The probing question is how does the monetary policy committee of Nigeria address price stability? To be candid the answer as rightly observed by Wale is that they are simply kicking the can down the road. When SLS was asked recently about easing monetary policy, he said when I am satisfied that conditions are conducive.

In my view, SLS led MPC decision to stifle inflation and peg the Naira +/- 3% against the dollar has been successful so far due to following which i consider germane.

Firstly, SLS earned a lot of credibility by putting words into action when he stemmed liquidity concerns that plagued the banking sector before his arrival as a result of the great recession, fall in crude oil price, poor corporate governance, and illiquidity of loan collateral, misappropriation of funds and poor regulations and supervision etc.

Secondly, the upward trajectory of the price of crude oil that is responsible for roughly 95% of foreign earnings leading to an increased foreign reserve buffer and continuous current account surplus.

Thirdly, the appointment of a globally known minister of Finance. Her appointment has helped attract excess liquidity, available due to quantitative easing and record low interest rates from Federal Reserve, European Central Bank, Bank of Japan etc.

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