Ask Mint | Speculative attacks thrive on perception

Ask Mint | Speculative attacks thrive on perception
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First Published: Mon, Apr 14 2008. 01 42 AM IST

Illustration: Jayachandran / Mint
Illustration: Jayachandran / Mint
Updated: Mon, Apr 14 2008. 01 42 AM IST
Some currencies, like a loaded buffet table, attract hungry speculators from all sides. If not stopped in time, speculators can rip the currency apart and bring the whole financial market to its knees. The central bank must step in quickly to ward off the predators. Today, our friends Jinny and Johnny are chatting about what is known as speculative attack in the currency market.
Illustration: Jayachandran / Mint
Jinny: Hi, Johnny! It looks as if you are in a foul mood today. What’s the matter?
Johnny: Yes, I am. A few months back, you had told me how the fixed exchange rate system works. One of my friends pointed out that the fixed exchange rate system is most vulnerable to what is called speculative attack. I was taken by surprise because you didn’t tell me about that.
Jinny: That day, I had just scratched the surface.
Johnny: Tell me how speculative attacks take place.
Jinny: Speculative attacks on currencies have a long, notorious history. Any currency can fall prey to these attacks but currencies with a fixed exchange rate system are the most vulnerable. The attack on the British pound in 1992-93 was so severe that Britain had to embarrassingly opt out of the European Monetary System to carry out a devaluation of its currency. In the age of interconnected financial markets, speculative attacks, like a contagious virus, can spread from one country to another. The attack on the Thai baht in 1997 quickly took other East Asian countries in its grip. A crisis in the currency market of one country soon became a problem of the world economy. This makes the working of speculative attacks one of the most serious areas of academic research.
Johnny: Tell me in simple terms — what makes countries with a fixed exchange rate system vulnerable?
Jinny: As you are aware, in a fixed exchange rate system, a country under the guidance of its central bank decides the rate at which the domestic currency can be exchanged with a foreign currency. If a country follows the fixed exchange rate system and allows free capital movement at the same time, you can exchange the domestic currency with the foreign currency and vice versa at the fixed exchange rate without any restrictions. But, a fixed exchange rate amid free capital flow can’t be maintained merely by sweet words or coercion. A fixed exchange rate system can work only if sellers are able to find buyers at the fixed rate.
If I want to buy 100 US dollars at the fixed rate, I must be able to find a seller willing to exchange $100 with my domestic currency at the fixed rate. So, the central bank needs to be omnipresent in the foreign exchange market to fill the gap between demand and supply. For this, the central bank needs to be equipped with adequate reserves. This gap in demand and supply sometimes may purely be temporary, requiring the central bank to merely iron out the creases. But, sometimes, the gap may be due to fundamental problems. No amount of reserves can be considered adequate for maintaining a fixed exchange rate if the economy is facing fundamental problems.
Johnny: Fundamental problems? Such as?
Jinny: Well, some countries squarely blame the greed of hungry speculators, coupled with the herd mentality of investors, for untimely speculative attacks. To some extent, this could be true. But, speculative attacks cannot thrive on greed alone. Like any other economic disease, speculative attacks thrive on the perception of investors. Sometimes, speculation may add fuel to the fire but it really requires weak economic fundamentals to start the fire in the first place. Economic indicators like high current account deficits and adverse balance of payments, weak fiscal position, high inflation, high short-term external debts, low foreign exchange reserves, weak financial institutions, among others, may start the thinking that the currency is highly overvalued at its fixed exchange rate. Once this perception sets in, investors start expecting the currency to be devalued sooner or later. This sets the ground for a speculative attack. At this moment, the hurried actions of some may start a stampede in the foreign exchange market. Devaluation, a remote possibility yesterday, might become a reality today due to speculative attacks. This makes speculative attacks a kind of self-fulfilling prophecy.
Johnny: That’s true. I’ll ask a few more questions on speculative attack next week.
What: A speculative attack on any currency occurs when speculators start selling it under the belief that devaluation of the currency is imminent.
Why: Speculative attacks could occur due to the herd mentality of investors, coupled with weak economic fundamentals.
How: Speculative attacks can be put to an end by the timely intervention of the central bank in the currency market.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to them at realsimple@livemint.com
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First Published: Mon, Apr 14 2008. 01 42 AM IST