21251 The World Bank February PREMnotes 1999 number 16 Economic Policy Reducing vulnerability to speculative attacks A speculative attack on domestic assets can occur irrespective of a country’s fiscal situation—and political economy considerations may be the reason. What are the sources and risk factors of speculative attacks? And how can countries reduce their vulnerability? In recent years Mexico and Thailand aban- Inconsistent macroeconomic policies doned fixed exchange rate regimes, re- The perils of inconsistent macroeconomic opening the debate on how to reduce policies are evident in the case of Argentina, Recent events have vulnerability to capital outflows in devel- where the Central Bank was financing the oping countries. In both countries—and in government’s budget deficit by creating reopened the contrast with the experiences of the 1980s— money while trying to keep the exchange speculative attacks did not occur in the con- rate fixed—not a viable strategy in an econ- debate on how to text of budget deficits. But recent empirical omy integrated with the rest of the world, work has identified other risk factors that, as Argentina was in the early 1980s (box 1). reduce vulnerability if minimized, can reduce vulnerability to Under a fixed exchange rate the cen- such attacks. tral bank commits to exchange foreign cur- to capital outflows rency for domestic money on demand at Sources of speculative attacks in developing A speculative attack on domestic liquid Box 1 Argentina, 1979–81 assets occurs when speculators believe that In 1977 Argentina liberalized its financial countries a devaluation is imminent. This belief leads sector, and in 1979 it opened its capital speculators to demand central bank for- account. Fixed exchange rates and high inter- eign exchange reserves in exchange for est rates attracted capital inflows that their domestic currency asset holdings. increased the supply of domestic high-pow- ered money, helping to finance a growing The speculators’ aim is to profit from buy- government budget deficit. But policy incon- ing reserves at the prevailing exchange rate sistencies soon became apparent. With expec- and selling them after the attack at a higher tations of devaluation on the rise, losing exchange rate. If the central bank has no reserves became the order of the day. To stem access to international credit or chooses the hemorrhage in reserves, the government offered incentives to borrow abroad and thus not to borrow abroad, it will devalue the replenish the Central Bank’s foreign currency the moment it runs out of exchange reserves. But this strategy led to reserves. a massive official debt that added an extra What leads to expectations of devalu- burden to government finances. Moreover, ation in developing countries? Empirical it did not restore credibility. In June 1981, studies have identified two broad sources: after several devaluations, the fixed exchange rate regime was abandoned. inconsistent macroeconomic policies and a sudden shift in perceptions about the Source: Calvo and Calvo 1992. sustainability of macroeconomic policies. f ro m the developm ent economics vice p res iden cy a nd pover t y re d u ct i o n a nd e co no mi c ma na ge me nt n e t w o r k a policy-determined rate. Domestic money is then determined solely by money demand. Box 2 Mexico, 1994 Money created by the central bank, if not In the early 1990s Mexico, a credible demanded by the public, typically results reformer, eliminated fiscal imbalances and in expectations of devaluation, leading to liberalized its financial sector. But large cap- a loss in reserves. ital inflows intermediated through the bank- ing sector widened the gap between liquid The dynamics of crises due to inconsis- financial sector debt (that is, M2) and inter- tent macroeconomic policies are captured national reserves (see figure), making Mex- in the popular Krugman model (Flood and ico vulnerable to speculative attacks. Marion 1997). In this model, and as observed In 1994 both shocks, an increase in U.S. A speculative attack in developing countries, speculators attack interest rates, and domestic political turmoil led to capital outflows. To prevent a credit the currency before the central bank runs crunch and a banking crisis, the Central on bonds—instead out of reserves. At a certain point compe- Bank injected liquidity—fulfilling investor tition leads speculators to suddenly purchase expectations that the government would not of currency—can all remaining reserves, which causes the gov- tolerate high interest rates. ernment to abandon the fixed exchange M2 grew much faster than also lead to a rate. Note that this discussion focuses on international reserves explicit fixed exchange rate regimes. Still, devaluation floating exchange rate regimes in which the Billions of U.S. dollars government intervenes—as happens in most 120 M2 developing countries with flexible exchange 100 rates—are de facto fixed exchange rate regimes, and the same argument applies. 80 Sudden shift in perceptions 60 Mexico’s 1994 crisis shows what happens when there is a sudden shift in perceptions 40 about the sustainability of macroeconomic policies. The expectation that during a pres- 20 idential campaign the government would Reserves not tolerate high interest rates associated 0 1985 1988 1991 1994 with a currency defense led to a loss in Source: Calvo and Mendoza 1996. reserves (box 2) and to a sudden shift in investor perceptions about the country’s sol- vency. At that point Mexico’s short-term pub- debt in countries other than the crisis coun- lic debt was about three times larger than try, an effect known as contagion. Conta- its reserves. This vulnerability led investors gion was evident in many developing to refuse to roll over the debt and to a deval- countries after Russia devalued the ruble in uation. Thus Mexico also shows how a spec- August 1998. ulative attack on bonds—instead of currency In all these situations a devaluation was as in Argentina—can lead to a devaluation. the result of self-fulfilling prophecies about Similarly, in Sweden a sudden shift in the sustainability of the exchange rate. expectations about the government’s will- Models of speculative attacks resulting from ingness to borrow abroad to defend the cur- sudden changes in perceptions are char- rency led to a run on the Swedish krona and acterized by multiple equilibria in which an ensuing devaluation (box 3). economy can suddenly jump from a no- Other sources of a sudden shift in per- attack to an attack equilibrium. In these ceptions include the expectation of realized models—so-called second generation mod- contingent liabilities, a drop in tax revenues els of balance of payment crises, in con- associated with business cycles driven by cap- trast to the first generation models ital inflows, and investor refusal to roll over pioneered by Krugman—an event, no mat- P R E Mn ote 16 exposure to profitable but risky sectors. In Box 3 Sweden, 1992 addition, under explicit or implicit exchange In mid-1992 international events led to rate risk insurance, such as a fixed exchange attacks on the Finish markka, Norwegian rate, financial institutions may not worry krone, and Swedish krona. At the height about loan risk and the maturity mismatch of the attack Sweden’s Riksbank defended the krona by borrowing reserves from of (short-term) deposits and (long-term) abroad. But this defense was extremely loans. This situation makes the banking sys- unpopular: it increased (already high) unem- tem vulnerable to a crisis due to a sudden ployment and raised (high) interest rates, drop in deposits (for example, due to a sud- putting considerable strain on government den stop in or reversal of capital inflows). accounts, borrowers, and a weak financial sector. Three months later, however, another This vulnerability leads investors to expect Each country must attack occurred. This time market expec- devaluation in economies where they per- tations were fulfilled that the government ceive the government will bail out the bank- decide on the would not risk political support by again ing system if banking problems arise. defending the currency. Similarly, an increasing ratio of short-term relevant measure of Source: Obstfeld 1994. debt to international reserves indicates that international reserves are insufficient to its liquid debt help cushion the effects of short-term debt ter how minor, can trigger a speculative refinancing difficulties. As noted, in Mex- attack on liquid debt. ico investor refusal to roll over debt led to devaluation because of a large gap between Monitoring risk factors short-term debt and international reserves. Given the discussion above, identifying spe- In calculating the short-term debt financ- cific triggers of speculative attacks could ing gap, both domestic and external pub- prove impossible. Risk factors, however, have lic debt must be taken into account. It is been identified and monitored. Increas- particularly important to include domes- ing budget deficits and credit to govern- tic debt in countries where the debt is ment, real exchange rate appreciation, and indexed to the exchange rate or there is large conventional solvency measures—such an explicit or implicit exchange rate guar- as the ratio of debt to exports—are risk fac- antee. Each country, however, must decide tors of crises attributable to inconsistent on the relevant measure of its liquid debt. macroeconomic policies. Not all the vulnerability indicators Crises such as Mexico’s in 1994 have led described above have proven reliable. Sev- to the monitoring of variables on which eral studies on different types of speculative changing perceptions about the sustain- attacks suggest that only the real exchange ability of the exchange rate system could be rate level, domestic credit growth, and the predicated. These variables include pri- ratio of M2 to international reserves can vate and public credit growth and the liq- consistently signal an increased probabil- uid debt financing gap—that is, the gap ity of a speculative attack (IMF 1998; Berg between a country’s stock of liquid debt (M2, and Pattillo 1998). a central bank liability) and international reserves (see box 2). The liquid debt financ- What should countries do? ing gap complements the conventional ratio The best way for countries to reduce their of international reserves to monthly imports, vulnerability to speculative attacks is to elim- which provides information about an econ- inate sources of fiscal imbalances and pre- omy’s ability to finance its imports in the vent large variations in capital flows. More absence of external financing. Why are these specifically, countries should: vulnerability indicators important? • Adopt consistent macroeconomic policies. The Rapid growth of credit (say, because of consistency of policies should be assessed surges in capital inflows) typically leads to using a cyclically adjusted budget deficit poorly supervised lending and bank over- to avoid inconsistencies during the down- Fe br u ar y 1 9 9 9 turn of the business cycle. Making pro- ually opening the financial sector and visions for contingent fiscal risks is also the capital account has also reduced vul- important (see PREMnote 9 on contin- nerability in highly distorted developing gent liabilities). countries. • Keep large international reserves relative to Not all economies are alike, however. financial sector liquid liabilities. Thus the measures needed to achieve these • Reduce debt rollover risks . Debt rollover goals will vary by country. risks due to a sudden shift in perceptions can be eased by reducing short-term Further reading debt, lengthening the maturity of debt, Berg, Andrew, and Catherine Pattillo. 1998. and preventing the bunching of matur- “Are Currency Crises Predictable? A Test.” Reducing ing debt obligations (see PREMnote 17 IMF Working Paper 98/154. International on debt management). Note that short- Monetary Fund, Washington, D.C. incentives for term debt resulting from open market Calvo, Guillermo, and Sara Calvo. 1992. operations to contain banking credit “Argentina: Monetary and Financial Sys- short-term capital increases vulnerability, as in Mexico in tem.” In John Eatwell, Murray Milgate, 1994. and Peter Newman, eds., The New Palgrave inflows can • Strengthen financial sector regulation and Dictionary of Money and Finance. London: supervision and establish contingent sources McMillan. also reduce of liquidity. The goal here is to eliminate Calvo, Guillermo, and Enrique Mendoza. sources of expectations of bank bailouts. 1996. “Mexico’s Balance of Payments Cri- vulnerability to Contingent sources of bank liquidity sis: A Chronicle of a Death Foretold.” Jour- include remunerated liquidity require- nal of International Economics 41: 235–64. capital outflows ments and international credit lines that Flood, Robert, and Nancy Marion. “Per- are activated only if deposits drop (see spectives on Recent Currency Crisis Lit- box 1 in PREMnote 17). Financial sector erature.” IMF Working Paper 98/130. regulation should also cover nonbank fi- International Monetary Fund, Washing- nancial institutions—so-called financieras, ton, D.C. such as credit unions and mortgage com- IMF (International Monetary Fund). 1998 panies, whose lending activities can be “Financial Crises: Characteristics and Indi- significant during periods of negative cators of Vulnerability.” World Economic interest rates. These institutions have Outlook (May). Washington, D.C. proven to be a source of vulnerability Obstfeld, Maurice. 1994. “The Logic of in many developing countries and have Currency Crises.” http://elsa.Berkeley.edu/ not contributed to effective monetary users/obstfeld/ftp/currency_crises/cc.html policy. • Regulate capital flows. Reducing incentives This note was written by Sara Calvo (Senior Econ- for short-term capital inflows—as with omist, Economic Policy, PREM Network, and Chile’s reserve requirements on exter- facilitator of the Managing Volatility Thematic nal borrowing or taxes—can also reduce Groups). vulnerability to capital outflows. The chal- If you are interested in similar topics, consider lenge then becomes identifying the right joining the Managing Capital Flow Volatility environment for applying these mea- Thematic Group. Contact Sara Calvo, x36337, sures, given their costs and risks. Grad- or click on Thematic Groups on PREMnet. 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