Financial Instability: A Guide to Exchange Rate Instability

Since the exchange rate is the one price that affects all of the prices in a country (to foreign buyers) it is very important that the FX rate be stable in the short run and be able to adjust smoothly to changing economic and political conditions. It is significant, therefore, that many of the world's most important currencies have experienced great instability in the past 10 years. Unstable FX rates have caused significant economic and political tensions within and between nations. Unstable exchange rates sometimes force governments to choose between domestic needs and their responsibilities to the international trade and monetary systems.

This page looks at six sources of exchange rate instability: domestic inflation, domestic economic policy, asset price bubbles, central bank actions, speculation, and speculative attacks.

The currency crises associated with the Asian Crisis were due to a combination of asset price bubbles, speculation, and speculative attacks.

Inflation and PPP
Exchange rate instability is not due to any one single factor but results from a number of factors that build up to create an unstable pattern of FX movements. For simplicity, let us think about these forces as layers. The first layer is based on international price and inflation differences. Over the long run, the purchasing power parity rule tends to apply. If nation A has lower inflation than nation B, then people will prefer A's goods over B's and so buy those goods, along with A's currency. So, in the long run, we expect A's currency to appreciate and B's currency to depreciate. This is a necessary and useful exchange rate movement. But inflation is not the only factor that will affect the exchange rate.

Economic Policy
Changing interest rates and economic policy will be a second independent factor influencing the exchange rate between A and B. If, for example, B's central bank raises interests rates in the short run (perhaps be reduce its inflation rate), this causes investment funds to flow into B, appreciating its currency. Thus the long term depreciation of B's currencies is interrupted by a short term appreciation. (Central banks are the national monetary authorities that represent nation-states in the international arena. The Federal Reserve System, for example, is the U.S. central bank. If you look at U.S. currency, you will see that dollars are actually Federal Reserve notes, issued by the Federal Reserve. The Federal Reserve regulates the availability of money and credit within the United States, plays a role in regulating the banking system, and works with other countries' central banks.)

Asset Price Bubble
Under certain circumstances, B's economic policies may trigger an investment bubble. This occurs when international investors begin to pour funds into the country, encouraged by good economic news or expectations of improved performance. As a wave of foreign funds enters the country, it can drive up the prices of stocks and other investments in the country and, simultaneously, also push up the value of the currency. This creates very large "paper profits," as investors calculate how much they have made from the combination of asset and exchange rate changes.

The profits from the first investment wave encourages further investment, and wave after wave floods the economy, pushing both up the currency and asset prices. The problem, especially in a less developed country, is that there may not be enough prudent investment opportunities to absorb all these foreign funds. At some point, foreign investors become concerned that their investments are not as secure as they seem. The bubble can burst, with dramatic effect. As investors sell out and take their funds home, both asset prices and exchange rates crash. This affects the investors, of course, but even more it affects the other parts of the economy that are affected by trade and finance, and creates political and social problem as well.

The collapse of Mexico's peso in 1994-95 was due to an investment bubble like the one just described. Although you would think that international investors would learn from this experience, apparetly their memories are very short-term, because another investment bubble, this time in Asia, caused the crash of the Thai Bhat in 1997 and the contributed to Asian economic crisis that followed, which many Asian countries directly and had global economic ripple effects.
More information about financial bubbles >>

Central Bank Intervention
Perhaps, at this point, A's central bank is concerned about the fact that the long term appreciation of its currency is making is export businesses less competitive with those in A. If so, it could take some currency from its stockpile of reserve and intervene in the exchange market, selling its currency to drive down the exchange rate and appreciate B's currency instead. If this takes place, then we might see a very large shift in the exchange rates in the opposite direction of the long term PPP movement. This could be a good and useful thing if it addresses legitimate short term economic and political problems. But it might set the exchange rate to vibrating or oscillating, inviting speculation.

Speculators are individual and firms that bet on what direction the exchange rate will move next. If they think that A's currency will depreciate tomorrow, they will sell it today, hoping to be able to buy it back tomorrow at a lower price, profiting from the difference in the exchange rate. (If they guess wrong, of course, they lose). Such speculation is often actually constructive, helping the market move more efficiently to the market equilibrium. At other times, however, speculation is tremendously damaging and disrupting, especially when it takes the form of a speculative attack.

Speculative Attack
A speculative attack is essentially a confrontation between a central bank, which pledges to maintain its country's exchanger rate at a certain level, and international currency speculators, are willing to wager that the central bank is not committed to its exchanger rate goal. The speculators attack the currency by borrowing huge sums of it and then selling them on the currency market. The central bank can keeps its pledge by using its currency reserves to buy up the currency that the speculators are selling. If the central bank keeps its pledge, the speculators have little to lose because they can buy back the currency to repay their loans at about the same rate at which they sold it. If, however, the central bank is not willing to intervene to keep its currency stable, or if it runs low on the reserves it needs to do this, then the currency will fall. The speculators will be able to buy back their currency at a lower price and have great profits left even after they've paid back their loans.

Speculative attacks were responsible for the collapse of the Indonesian Rupiah and the Malaysian Ringgit in 1997-98 as well as the British pound and the Italian lira in 1992-93. So long as investment capital is freely mobile between countries, the sorts of currency crises that are caused by speculative attacks and investment bubbles are likely to occur. Exchange rates, therefore, can be expected to display a variety of patterns over time, including stability, cycles, booms, and crashes. The problem of the international monetary system is to provide ways for nations to deal with this complex financial environment.