Today I found some time to read the section The Speculator’s Ball in Paul Krugman’s The Accidental Theorist (1997). The section is about financial speculation with the example of the world copper market in 1995, the currency crises of the 1990s such as the run on the Mexican peso in December 1994, and poisoned Asian currency markets due to unsustainable government policies. In particular the essay Making the World Safe for George Soros was interesting because his name came up in last week’s Macroeconomics class on exchange rates and arbitrage. So I decided to dedicate today’s post to the concept of exchange rates and currency crises. Firstly, I want to briefly look at the concept of a currency crisis and then in the remainder of the post I want to discuss whether BREXIT triggered a speculative attack on the Pound Sterling by looking at the GBP/EUR exchange market and potential implications for the British economy in case of a currency crisis.
What are currency crises? These crises are normally associated with fixed exchange rate regimes and they can occur when there is the expectation that a country’s reserve bank does not have enough foreign exchange reserves to maintain its target exchange rate. This is of concern because if the reserve bank runs out of foreign reserves it is forced to devalue its currency.
This is the starting point for speculative attacks which trigger the devaluation even earlier. The central bank has to deplete its foreign reserves faster and faster to satisfy the skyrocketing demand for foreign currency once a speculative attack has started. This is because the expectation of a devaluation induces investors to borrow large sums of the vulnerable currency to invest the money abroad. The twist is the following: After the expected devaluation the investors’ debt in the vulnerable currency will be worth less but the matching assets in investments abroad will be as valuable as before. Due to this arbitrage investors can make large sums of money like George Soros if I get it right here. However, one should note that such opportunities are rare. In general, a good sign for the beginning of a currency crisis are large temporary capital outflows. These create a mismatch in the foreign exchange market and force this devaluation if the run on the currency is sufficiently large and if the foreign exchange reserves of the reserve bank are below a certain threshold (Krugman, 1998). In principle, currency crises should be more or less limited to fixed exchange rate regimes because floating exchange rates tend to be market determined. For this reason exchange rates come closer to reflecting the true value of the currency. However, this is only true if foreign exchange markets are reliable (e.g. herding and irrational investors). If a floating currency – for whatever reasons – is expected to be overvalued, it can likewise experience a currency crisis (Glick & Hutchison, 2011).
So what do currency crises have to do with BREXIT? Probably a lot. The UK’s exchange rate has plummeted since November 2015 from more than 1.40 GBP/EUR to levels below 1.25 GBP/EUR in April (XE.com, 2016). With the referendum becoming more and more serious investors seem to postpone foreign direct investment (FDI) and if the BREXIT goes ahead inward investment from emerging markets could recede dramatically threatening its status as one of the world’s top FDI destinations (Fingar, 2016). This effect can be shown in the diagram below:
Firstly, the supply of Pound Sterling shifts to the right as investors pull capital out of the UK in search for stability. This leads to an initial depreciation of the Pound against the Euro in this example. Second, foreign investors allocate investment to countries other than the UK. This results in a shift in the demand for Pound Sterling to the left so that there is a further depreciation of the Pound against the Euro. As explained earlier, this is exactly the setting for a major currency crisis. The UK’s currency is threatened by an explosive mix of foreign capital already in the country and the potential to loose out on future FDI if the exit goes ahead in sum reducing the demand for Pound Sterling. This might set off a vicious cycle of speculative attacks. In fact the run on the currency might already have started as indicated by the plummeting exchange rate making borrowing of large sums of GBP attractive to invest abroad in the expectation of further depreciation.
Let’s look at the potential implications for the UK economy. A depreciation of a currency is normally associated with an increase in net exports and inflationary pressure on the currency. However, in the case of a currency crisis the picture is somewhat different. This is because not only does the currency fall in its value but also investment spending plummets. The fall in investment spending (I) is shown by the leftward shift in the aggregate demand curve to AD’ in diagram (ii). This can be derived from the Income-Expenditure Model in diagram (iii). Also government spending could take a hit because the burden of the UK’s sovereign debt increases sharply with every depreciation of the Pound (FT.com, 2016). Intuitively depreciation pushes up the costs of repaying outstanding debt and as the UK runs a current account deficit this is of major concern (Tradingeconomics, 2016). Hence, government spending might also be crowded out because more of the government budget has to be allocated to ensure it is not defaulting on its sovereign debt. The overall result is a recessionary gap at least in the very short run. This new threat could turn out to be extremely harmful because the UK already needed until the second quarter of 2013 to recover from the Global Financial Crisis. BREXIT could defeat hopes for accelerated economic growth after finally having surpassed its pre-downturn peak (Ping Chan, 2015).
In the medium run, the depreciation of the Pound Sterling could push the aggregate demand curve back up. This is because of the standard effects of depreciation, i.e. exports are likely to increase while imports fall and more domestic demand falls on domestic goods as they become cheaper relative to foreign goods. This shifts aggregate expenditure, as shown in diagram (iii), back up. It likely cushions the investment shortfall inducing the economy to recover in the medium run. In the long run, once the referendum has gone through and business confidence increases, FDI could recover to its initial level shifting the AD curve back up if everything goes well.
In sum, the referendum seems to be a textbook case of financial speculation (and probably a lesson in the standard law of unintended consequences). It somehow looks like a self-made currency crisis as government’s policies and the announcement of the referendum date have induced uncertainty and scope for speculation over a depreciation of the Pound. If the plummeting exchange rate can be taken as an indicator for a beginning currency crisis the standard economic model would predict a fall in aggregate demand due to capital outflows and postponed FDI. This would threaten the economy’s regained strength after a sluggish recovery from the GFC. Hence – aside of whether one is pro or contra BREXIT – merely the refendum debate seems to have negative impacts on the UK economy. So there are interesting weeks to come until 23 June.
Please note that I blog to learn Economics. I do not intend to make predictions about BREXIT consequences with this post. Many thanks for reading!
Fingar, C. (2016). Is Brexit a threat to foreign direct investment? [online] Available at: http://www.ft.com/intl/cms/s/3/6df1db7a-e159-11e5-8d9b-e88a2a889797.html#axzz46G0dodNc [Accessed 20/04/2016].
FT.com (2016). How Brexit will put extra pressure on the pound. [online] http://www.ft.com/intl/cms/s/0/7ee78420-c5b6-11e5-b3b1-7b2481276e45.html#axzz46G0dodNc [Accessed 20/04/2016].
Glick, R., and Hutchison, M. (2011). Currency Crises (Working Paper 2011-22). Available from Federal Reserve Bank of San Francisco website: http://www.frbsf.org/economic-research/files/wp11-22bk.pdf [Accessed 20/04/2016].
Krugman, P. (1998). The Accidential Theorist: And other Dispatches from the Dismal Science. New York, N.Y.: W.W. Norton & Company.
Ping Chan, S. (2015). Britain on top: recovery from Great Recession was faster than thought. [online] Available at: http://www.telegraph.co.uk/finance/economics/11900934/UK-GDP-growth-stronger-previously-though-recovery-ONS.html [Accessed 20/04/2016].
Tradingeconomics, 2016. United Kingdom Current Account. [online] Available at: http://www.tradingeconomics.com/united-kingdom/current-account [Accessed 20/04/2016].
XE.com (2016). XE Currency Charts (GBP/EUR). [online] Available at: http://www.xe.com/currencycharts/?from=GBP&to=EUR&view=1Y [Accessed 20/04/2016].