Even an ant can bring an elephant to its knees. All it takes for the ant is to get get inside the elephant’s trunk. In the foreign exchange market, negative expectations of investors work like ants. They can bring even a sound currency to its knees. Last week, Jinny talked about how weak economic fundamentals, coupled with greed and fear, can generate negative expectations, which could lead to speculative attacks.
Johnny: Hi Jinny! I hope today you will clarify how exactly speculative attacks take place.
Jinny: Last week, I told you about some of the factors that influence investors’ thinking. Speculative attacks, like any other financial crisis, survive on the negative expectations of investors. If investors think that the present exchange rate is overvalued, they will expect a devaluation in the near future. This expectation is enough to turn the market upside down. Suppose, you have eggs to sell. You come to know that the price of eggs is going to fall. What would you do?
Johnny: I will try to sell the eggs before the chickens come home to roost. But, how is this related to our discussion?
Illustration: Jayachandran/ Mint
Jinny: Devaluation decreases the value of the domestic currency, and at the same time increases the value of the foreign currency. In other words, if you are holding domestic currency, you are going to lose the value of your money in terms of foreign currency. After devaluation, more units of domestic currency would be required to purchase a single unit of a foreign currency. Suppose, today, you can exchange Rs40 for $1, but after devaluation you would be required to pay more Indian rupees for purchasing the same dollar. You can look at the whole scenario in another way, too.
If you’re able to purchase the foreign currency before devaluation, then you may earn a profit. A single unit of foreign currency can be exchanged for more units of domestic currency after devaluation. This possibility of earning a profit or suffering a loss is what sets the wheels of speculative attack in motion. If the price of eggs is falling, but the price of chicken is on the rise, it makes sense to let the eggs hatch. Likewise, you may see investors converting their domestic currency into foreign currency en masse during spells of speculative attacks. Everybody wants to cross the bridge before it collapses. But, the commotion to cross the bridge, more than anything else, is what may in fact lead to the bridge collapse.
Johnny: But, what can be done to protect the bridge? I mean, how can we fight speculative attacks?
Jinny: Well, in a fixed exchange rate system, the central bank acts as a guardian of the exchange rate. It starts selling the foreign currency at the fixed rate by using the money lying in its reserves. The central bank has to act before the herd mentality sets in. If the attack has been engineered by misguided speculators, then timely intervention by the central bank may help stem the problem.
But, if the problem is due to fundamental economic weaknesses, making the foreign currency readily available may not in itself solve the problem. The selling pressure on the domestic currency would sooner or later deplete the reserves of the central bank. You can’t cure a patient of blood cancer by providing blood transfusion. The central bank may, therefore, simultaneously use another instrument of defence in its arsenal—interest rates. The central bank may raise domestic interest rates, which makes investment in domestic currency more lucrative.
High interest rates also make it difficult to obtain domestic currency on credit for speculating in the forex market. This may help in controlling the tides. But, sharply rising interest rates may hurt the domestic economy. An overdose of medicine instead of curing the disease may kill the patient.
Some experts suggest the use of “capital fasting” as an effective tool. Fasting in the forex market comes in the form of capital controls. The central bank may severely restrict the limit up to which residents can purchase foreign currency. It can even put restrictions on repatriation of money by foreigners. Thailand used selective capital controls to reduce foreign speculators’ access to domestic currency. Capital controls can be an effective means of limiting short-term speculative pressure if the attack is not warranted by underlying fundamentals, but like any other remedy, it may cause side effects.
Use of capital controls during a crisis can seriously affect capital inflows in the future. Nobody would like to go to a theatre that shuts all the doors during a fire to prevent a stampede. Ultimately, the central bank also has to take note of all costs and benefits. If the costs outweigh benefits, then the central bank may let the currency devalue.
Johnny: Yeah, Jinny. Sometimes financial problems have to take care of themselves.
What: Speculative attacks, if successful, can lead to devaluation of the domestic currency.
How: Central banks use different instruments, such as direct market intervention or high interest rates or capital control, to fight speculative attacks.
Why: If the costs of using different instruments outweigh benefits, then the central bank may let the currency devalue.
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 both of them at email@example.com