Speculative Currency Attacks
Many small countries, and even large ones, such as China, where exports are an important part of their economy, peg their currency to a foreign currency, known as the reserve currency.
If a country wants to maintain a fixed exchange rate with another country, the following conditions are necessary:
- the pegging country must have sufficient foreign reserves of the reserve currency to exchange it for the domestic currency on demand;
- the pegging country must maintain inflation rates and interest rates that closely match those of the reserve country.
If these conditions are not true, then speculators will attempt to attack the pegged currency in the hope to profit from its devaluation.
The most important factor, however, is to have enough reserves of the reserve currency to satisfy any demand. If the reserve country has higher interest rates or lower inflation rates than the pegging country, then capital will continually flow from the pegging country to the reserve country until the pegging country is depleted of its reserves and forced to abandon the peg by letting the exchange rate float freely, resulting in the devaluation of the domestic currency.
If forex traders suspect that the central bank does not have enough of the reserve currency to meet demand, they will launch what is called a speculative attack to make big profits within a short time.
To profit from a speculative attack is simple:
- borrow the pegged currency from a domestic bank,
- convert it to the reserve currency,
- buy short-term interest-paying government bonds of the reserve country. If the traders anticipate correctly, and the central bank is forced to devalue the domestic currency,
- then the traders will sell their bonds in the reserve currency,
- convert them back into the domestic currency,
- then repay their domestic loans.
Their profits will be proportional to the amount of the devaluation. Although interest must be paid on the bank loans, the effect on profits will be minimal because the interest paid by the short-term bonds of the reserve country will help to offset the loan interest, and because the loan is short-term — days, weeks, or at most, months.
As an example, consider Mexico in 1994. Mexico was maintaining its domestic currency, the peso, at 3.4 pesos to the United States dollar. Because of political turmoil, investors started taking their money out of Mexico. Since many of these investors were Americans, that meant that Mexico must use its foreign reserves of dollars to pay the investors. As more investors took their money out of Mexico, currency speculators increasingly believed that Mexico could no longer maintain its peg to the dollar. On December 22, 1994, Mexico was forced to allow the peso to float. Thereafter, its value against the dollar decreased rapidly, until it lost 50% of its value by March, 1995.
In this case, for instance, an investor could have borrowed 3.4 million pesos at the beginning of December, converted the pesos to $1 million with which to buy 28-day T-bills, which can easily be reinvested after maturity. So the investor reinvests the money in T-bills 4 times, covering a period of almost 4 months. By then, the value of the peso against the dollar had declined by about 50%, so each dollar could buy about 6.8 pesos. So the investor would only have to pay $500,000 for 3.4 million pesos plus a little extra for the interest, leaving the investor with almost $500,000. The investor doubled his money in 4 months.
The profits of speculative attacks can be enormous. George Soros was reported to have made $1 billion from a speculative attack on the Bank of England. In 1992, before the Euro, Europe had what was called an Exchange Rate Mechanism (ERM) that was designed to contain inflation and to facilitate trading among the European countries. An agreement was reached to fix the exchange rate among European currencies, permitting only small fluctuations from the European Currency Unit (ECU), which was not issued as currency but used as an accounting unit that effectively pegged the currencies to each other. However, to contain inflation, Germany greatly increased its interest rates, but England refused to raise their interest rates. Since England failed to raise their interest rates, it became profitable to borrow pounds from English banks, exchange them for German deutsche marks, to buy German bonds, since they were paying a much higher rate of interest. Since the demand for the British pound was declining while the demand for the German mark was increasing, the fixed exchange rate simply could not be maintained. Hence, on what became known as Black Wednesday, the bank of England was forced to devalue the pound, allowing investors — and, presumably, George Soros — to pay off their British loans with the increased value of the German deutsche marks. Even without the speculative attack, investors could still make money earning higher interest on the German bonds while paying lower interest on their British loans.
In addition to the requirement that a country pegging its currency to a reserve currency must maintain the same inflation rates and interest rates as a reserve country, the central bank or currency board must be not only able to maintain the fixed exchange rate, but it must also be willing to maintain it. Hong Kong, for instance, which pegs its Hong Kong dollar to the United States dollar, always maintained at least several times the amount of United States dollars as there were Hong Kong dollars in circulation. Nonetheless, this currency was attacked several times, because speculators believed that even though Hong Kong had the foreign exchange reserves to maintain the peg, they believed that the Hong Kong currency board was unwilling to take actions to maintain the peg. However, the speculators lost because the currency board successfully defended the peg by raising interest rates on the Hong Kong dollar, which brought in more United States dollars. When the speculative attacks ceased, Hong Kong lowered its interest rates to closely match interest rates in the United States. Hong Kong has maintained its dollar peg since 1983 and has successfully varied the interest rate by up to 1.5% from the United States rate while still being able to maintain the peg. Hence, interest rates do not have to be exactly equal. The greater the reserves and the shorter the time period, the more that the interest rate can deviate from the reserve country to effect a limited form of monetary policy while maintaining the currency peg.