Speculative Attack

5 Key excerpts on "Speculative Attack"

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  eBook - ePub

  Global Financial Crises and Reforms

  Cases and Caveats

  • B. N. Ghosh(Author)
  • 2000(Publication Date)
  • Routledge

    (Publisher)

  There is a general belief among politicians that the currency crisis in the East Asian economies is brought about by greedy international speculators. There might be some kernel of truth about speculation. But it should be noted that a currency crisis cannot at the first instance be caused by speculation unless economic fundamentals are very weak in a country. Speculators try to attack a currency, and become quite successful in their endeavor when at least the following five factors are present (Ghosh, 1998: 201–2): (1) the currency is already overvalued; (2) the current account balance of payments is rather large; (3) the forex reserve is at a very low level; (4) the currency is tied to a single international currency (say, greenback); and (5) the currency is soon going to be devalued. Speculative Attack is not the real cause but rather a trigger for currency crisis. Thus, speculation did not work in the cases of Singapore, Hong Kong and Brunei.

  There are various models of Speculative Attacks. These are explained in the following section of the discussion.

  Speculative Attack: which model to apply?

  Speculative Attack on a currency has been regarded by some economists and politicians as the main reason behind the currency crisis in the MIT countries. The received mainsteam models of Speculative Attacks are briefly discussed below.

  First generation models

  The first generation model of Speculative Attack was popularized first by Paul Krugman (1979). The model suggests that domestic policy of monetary and fiscal expansion leads to a series of persistent balance of payments deficits under a regime of fixed exchange rate. In such a situation, there is a run on the country’s international reserve, and a Speculative Attack on the currency. The attack is engineered because in the face of declining stock of reserve, the speculators know for sure that the fixed exchange rate regime will ultimately collapse and the devaluation of the currency is going to take place. The speculators will sell off the domestic currency because if they do not do so, they will soon suffer huge capital loss. The domestic currency is converted to foreign assets/currency, and in the process, the central bank has to lose foreign exchange reserve in spite of its limited stock; and when the danger point comes, the currency collapses. The Speculative Attack cannot be supported by the authorities for long. A few macroeconomic indicators, such as huge budget deficit, high interest rate, growing inflation, overvaluation of real exchange rate, balance of payments deficit and dwindling foreign exchange reserve, become taletelling before any Speculative Attack.

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  Exchange Rate Economics

  Theories and Evidence

  • Ronald MacDonald(Author)
  • 2007(Publication Date)
  • Routledge

    (Publisher)

  B and speculators were subsumed into a representative agent then an attack would be successful in this range since the economy would move to the new shadow line, there would be a run on the currency and the currency would depreciate. Here the authorities validate the attack ex post by engaging in the higher monetary creation, and this gives an outcome which is observationally equivalent to the kind of attack considered in the first generation model. Here though the crucial difference is that the outcome is being driven by the exogenous ‘sunspot’ expectations of the representative speculator.

  In reality, however, speculators are a group who often have heterogenous beliefs and the coordination of their expectations on the sunpsot variable may not be straightforward. For example, if speculators are individually small and uncoordinated then they will have little market power to individually change the rate and multiple equilibria may still arise. For example, a speculator who believes the currency is overvalued will not attack the currency unless he believes there is a chance the rest of the market has the same expectation and will actually follow suit. In this case the economy could stay indefinitely on the lower shadow line. Alternatively, if all speculators believe the currency should be attacked the attack will, as in the case of the representative agent outcome, force the currency to devalue. In a heterogenous market one way this could occur is if there is one large player – for example, a Soros type figure – who leads the market to its new equilibrium (the coordination issue is discussed later).

  Jeanne (2000a) provides a nice critique of the first and second generation Speculative Attack models. In particular, what is to stop the central bank engaging in unsterilised changes in domestic credit to keep the interest rate at a level which offsets the devaluation expectations and sustains reserves above the minimum level?The Speculative Attack models therefore dodge the issue of why monetary authorities who have the power in the run-up to an attack, or at the time of an attack, to raise interest rate do not always do so. By failing to answer this question Jeanne (2000a) argues that the Speculative Attack model misses an important link in the logic of currency crises. Of course, raising interest rates in this way is costly and it is a comparison of the costs and benefits of raising interest rates which will influence the policy-maker in deciding to maintain a fixed peg. However, in order to address this kind of issue in the context of a Speculative Attack model, th policy-maker’s objective function has to be explicitly modelled (i.e. the policy-maker’s actions have to be endogenised). The so-called escape clause model of Obstfeld (1994) attempts to do this.

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  The Economics of Exchange Rates

  • Lucio Sarno, Mark P. Taylor(Authors)
  • 2003(Publication Date)
  • Cambridge University Press

    (Publisher)

  Models of currency crisis and Speculative Attack 251 The first-generation Speculative Attack models combine linearity in behaviour – a log-linear money demand function – with perfect foresight, to produce a unique timing of the Speculative Attack when the stance of domestic monetary and fiscal policy is inconsistent with the exchange rate peg. In second-generation models (Obstfeld, 1994, 1996), however, the emphasis is generally on policy rule nonlinearities, such as a shift in domestic monetary policy conditional on whether or not there is a Speculative Attack. 5 If the timing and intensity of the attack depend upon whether or not there is a shift in monetary policy and vice versa, then the possibility of multiple equilibria (i.e. the non-uniqueness of the timing of the attack), together with the possibility that the attack may be self-fulfilling by leading to a shift in policy, becomes intuitively clear. The possibility of multiple equilibria in such circumstances may be viewed in some ways as a co-ordination problem: if there were one large trader able to undertake massive speculation and lead the attack 6 then the multiple equilibria may collapse to a unique equilibrium. If speculators are dispersed, with heterogeneous expectations and liquidity constraints, however, then the possibility of multiple equilibria seems greater. Consider the following version of the model analysed by Obstfeld (1996). We assume that the government conducts its exchange rate policy according to a loss function of the form: L = θ (˙ p ) 2 + ( y − y ) 2 , (8.16) where θ is the relative weight given to inflation, ˙ p , in the loss function, and y is the target level of real output, y . Real output, in turn, is assumed to be determined according to a ‘surprise supply curve’ relationship of the form: y = y + ( ˙ p − ˙ p e ) − v , (8.17) where y denotes the natural level of output, ˙ p e denotes expected inflation, and v represents a stochastic output shock.

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  Coping with Globalization

  Cross-National Patterns in Domestic Governance and Policy Performance

  • Steve Chan, James R. Scarritt(Authors)
  • 2013(Publication Date)
  • Routledge

    (Publisher)

  Table 7.2 the sample is restricted to those countries which adopt a fixed/pegged exchange rate. In this more limited sample, there are only 51 instances of Speculative Attacks out of a possible 7,392 observations. Most first-generation models were explicitly concerned with the vulnerability of fixed-rate regimes to Speculative Attacks. In line with these expectations, the results show that countries with pegs are vulnerable to Speculative Attacks when (1) their exchange rate is overvalued and (2) their banks have increased lending. Surprisingly, the ratio of foreign-exchange reserves to imports is not statistically significant for this sub-sample regardless of the model specification. In addition, changes in foreign interest rates now have a statistically significant effect on the probability of a Speculative Attack, a finding which is in line with the prior research.

  In column six, both measures of political uncertainty are statistically significant and positive. The variable for non-constitutional leadership exit is not included in models seven and eight because it predicts perfectly the outcome of no Speculative Attack. Electoral periods do not have a statistically significant effect on Speculative Attacks and democracy does (albeit seemingly sensitive to variations in specification). These results indicate that political uncertainty matters insofar as currency crises are concerned. As economic actors become uncertain about a country’s future economic policy, they become more reluctant to hold its currency. Even more important, the results of this study show that not only political uncertainty changes over time, but also increases in uncertainty have profound effects on currency markets.

   

  THE IMPORTANCE OF INTERNATIONAL INFLUENCES

  Recently, policy-makers from the IMF and some academics have developed a ‘third generation’ of models on Speculative Attacks. The motivation behind this effort is the fact that the ‘usual suspects’ leading to a currency crisis were not evident in the East Asian crises during 1990–97. These analysts focus on the moral hazard faced by international lending institutions, the composition of external debt, the current account, and capital controls (e.g. Frankel and Rose, 1996; Corsetti et al.

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  International Financial Operations

  Arbitrage, Hedging, Speculation, Financing and Investment

  • I. Moosa(Author)
  • 2003(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  CHAPTER 7 Speculation in the Spot and Currency Derivative Markets 7.1 DEFINITION OF SPECULATION Speculation in the foreign exchange market is a subject that has been dealt with in the early writings on exchange rate economics. Early contributors to the post-war literature on exchange rate economics were to a large extent concerned with the role of speculation in the foreign exchange market. Nurkse (1945) warned against the dangers of “bandwagon effect” as a source of market instability. In his seminal work on the choice between fixed and flex- ible exchange rates, Friedman (1953) argued for flexible exchange rates by suggesting that speculation would be stabilising under flexible exchange rates because profit-making requires buying low and selling high, which is the action that makes speculation stabilising. A proof of this proposition will be presented later. Tirole (1993) argues that the concept of speculation has always fascinated academics and practitioners alike, attributing this fascination to “inconsistent definitions, occasional misunderstanding and genuine economic importance”. Speculation may be defined as the assumption of risk for the sake of making profit. Speculators act on the basis of certain beliefs or expectations, making profit if their expectations are realised (or if their forecasts turn out to be accu- rate). Another definition that can be found in the Oxford Universal Dictionary is that it is “the action or practice of buying and selling goods, stocks and shares, etc. in order to profit by the rise or fall in the market value, as distinct from regular trading or investment”. Keynes (1930) and Hicks (1939) viewed speculation as a substitute for missing insurance markets, in that gains from trading are linked to differences in the trader’s willingness to take risk on an initial position. This is the so-called insurance motive for speculation, whereby speculation is viewed to be used to shift price risk from more to less risk-averse traders.

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