be viewed as a templatefor emerging market currency pegged regimes generally. Indeed, it works remarkably well inexplaining the key dynamics behind the currency crises in Mexico, Russia, Brazil and Turkey.The model is based on five key phases that appeared to take place during the Asian crisis,and were also mirrored in subsequent emerging market crises in Russia, Brazil and Turkey.Throughout, I use Thailand, seen as the catalyst for the Asian currency crisis, as an example ofthe general phenomenon at work. Outside of my work, I first expressed this model in publishedform in a previous book, Asian Dawn – Recovery, Reform and Investing in the New Asia. Here,I present the same CEMC model, albeit in a revised and expanded format.
6.1 A MODEL FOR PEGGED EXCHANGE RATES6.1.1 Phase I: Capital Inflows and Real Exchange Rate AppreciationTheoryThe very purpose of having a local currency pegged to a base currency (usually the US dollar)is to provide a foundation for economic and financial stability. A currency peg reduces or eveneliminates the issue of currency risk, and therefore attracts capital inflows. Those capital inflowsbecome a self-fulfilling prophecy, since they help generate ever-higher growth rates, which inturn attract further capital inflows. There are two monetary effects of these inflows. First, thelocal currency comes under mounting upward pressure. Second, interest rates paradoxically areforced lower. On the first of these, the currency is pegged so it cannot appreciate beyond a certainpoint. In order to maintain the peg, the central bank intervenes, selling its own currency for thebase currency. In the money market, the central bank also conducts open market operations,sterilizing the effect of these inflows by withdrawing excess liquidity. Relative to the size ofthe inflows coming in, the ability of an emerging market central bank to conduct both of thesemonetary operations indefinitely is clearly limited. Meanwhile, precisely because interest ratesare low and emerging market economies are not fully open, inflation rates are relatively high,higher that is than the inflation rate of the base currency. This should ordinarily mean that thelocal currency depreciates on a real basis in order to offset the higher inflation rate. The sheerweight of the capital inflows means this cannot happen. Indeed, the opposite happens. Thelocal currency continues to appreciate on a real, inflation-adjusted basis. In turn, this causeswidening external imbalances and loss of export competitiveness.PracticeAsian countries pegged their currencies to the US dollar in order to provide a foundation foreconomic stability, while they got on with the job of growing their economies. In a sense thesedollar pegs did their job too well. With Asian currencies pegged to the US dollar, it appeared
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that the idea of currency risk had been all but eliminated. Asia in the 1980s and early 1990shad been growing strongly in any case. Thus the Asian currency pegs together with strongdomestic growth rates provided the platform for a veritable tidal wave of capital inflows to theregion, both of the portfolio and foreign direct investment kind. The lack of currency volatilitylulled investors into a false sense of security – though that false sense of security in some caseslasted for more than a decade.Many Asian countries had relatively high inflation rates, higher than the US whose currencythey were pegged to. Ordinarily, this should mean that a currency depreciates to offset itshigher inflation rate, however in the case of Asia the sheer weight of massive capital inflows,combined with the currency pegs, meant that Asian currencies appreciated on a real (inflationadjusted) basis, which was greatly exacerbated by the 35% devaluation of the Chinese yuanin 1994 and the depreciation of the Japanese yen from 1995. The result was widening Asiantrade and current account deficits. Put simply, Asian countries were slowly but surely losingexport competitiveness. High inflation and currency pegs meant high interest rates, despite thefact that most Asian countries ran healthy fiscal surpluses. This was not a problem for Asiangovernments since most were not seeking to expand domestic borrowing, but it was a problemfor the private sector. Those currency pegs provided the illusion of exchange rate stability,encouraging corporations to borrow offshore at lower interest rates and swap back to domesticcurrency. As a result, significant external debt burdens were built up. Unlike in Latin Americain the 1980s, this was private not public debt and went largely unnoticed in the more transparentpublic accounts. Thus, Asian corporate and bank balance sheets became increasingly exposedto external, US dollar-priced debt. While Asian currencies could not move, this was not anissue. Implicitly however, it meant if Asian currencies were ever allowed to depreciate, thecapital base of those same corporate and banking sectors would be severely depleted if noteliminated. Asian currency devaluation would mean the cost of repaying that external debtwould be multiplied by the extent of that devaluation.By late 1996, real exchange rate appreciation had resulted in significant trade and current account balance deterioration. Thailand was running a current account deficit of some 8% of GDP.Assuming the balance of payments must indeed balance, the other side of a current accountdeficit must be a capital account surplus. This is indeed what happened in Asia. Massive capitalinflows helped cause real currency appreciation, which in turn led to a rising current accountdeficit. To fund its widening current account deficit, Thailand had to attract an ever-increasingamount of capital inflows. It did not get them. Instead, “fundamental” investors became increasingly wary and started if anything to reduce their exposure to Thailand in early 1997 dueto a combination of increasing political and economic concerns and diminishing returns ontheir investments. As that capital fled – selling Thai baht in order to do so – so Thai domesticinterest rates edged higher while the Thai baht itself came under increasing downward pressure.
6.1.2 Phase II: The Irresistible Force and the Moveable ObjectTheoryAs the capital account surplus is reduced while the current account deficit remains high, thepressure through the balance of payments is expressed through rising local interest rates andincreasing downward pressure on the local currency. In order to maintain the peg, the centralbank again intervenes, this time buying local currency (when capital was flowing in, it wasforced to sell its own currency) and selling the base currency. In order to do so, it has to sell
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its foreign exchange reserves, which are denominated in that base currency. As local currencyis bought from the market so supply is reduced and the interest rates attached to that localcurrency forced higher. The central bank has the unpalatable choice of sterilizing this effect byinjecting liquidity back into the money market and thus effectively nullifying the effect of itsforeign exchange intervention or allowing interest rates to rise and hurting the economy andasset markets in turn. As interest rates rise, so asset markets fall, forcing those investors whohave stayed to cut their losses – and their positions – thus putting yet more pressure and so onand so forth. A vicious cycle develops, the length of which is decided only by the ability orthe willingness of the central bank to expend its foreign exchange reserves. Eventually, one oftwo things happen, either the central bank runs out of reserves or the economic and financialcost of maintaining the currency peg becomes too great and the central bank scraps the pegand allows the currency to “float” (i.e. free-fall).PracticeAs Thailand’s capital account came under increasing pressure so did the Thai baht as increasingnumbers of foreign asset managers tried to get out while they could. Financial market volatilitybegan to rise alarmingly. From the local perspective, Thai corporations and banks had up untilthen largely dismissed the idea of currency risk on the view the currency peg eliminated theneed to hedge. Some not only borrowed in US dollars via the Bangkok International BankingFacility (BIBF) to reduce the corporation’s interest rate bill but also to make what seemeda risk-free profit, borrowing those dollars, swapping back into Thai baht and then lendingthose baht onshore, making a very nice interest rate spread. The market volatility seen in thefirst quarter of 1997 made some of these Thai corporations re-think the issue of currencyand interest rate risk (though clearly too few went through this re-thinking process given whattranspired!). Perhaps currency risk should be a consideration after all. Thai corporations startedto hedge, albeit selectively and cautiously, and certainly in small amounts compared to the sizeof their external debt exposure. Finally, some speculators arrived on the scene, attracted bythe market volatility as a shark is attracted by the thrashing motion of a fish, and started tobuild up positions against several Asian currencies, including the Thai baht. Readers familiarwith my work on the Asian crisis, Asia Falling – Making Sense of the Asian Currency Crisis,will be familiar with my view that if speculators can be accused of anything it is tardiness.Frankly, they were late on the scene. The situation had already deteriorated to the point of noreturn before they showed up. They were certainly not responsible for the subsequent currencydevaluations. They may have added to the selling pressure, but they certainly did not cause it.Whatever the case, the Bank of Thailand tried to respond vigorously to the rising sellingpressure on the baht, intervening in the currency market and hiking official interest rates. Stillthe selling pressure increased, if anything it accelerated. In May 1997, the Bank of Thailandtried to ambush the market, stopping Thai banks from lending baht to the offshore market,hiking interest rates dramatically and intervening aggressively. The dollar collapsed against thebaht and the Thai overnight borrowing rate skyrocketed to 3000%. It was a brave but ultimatelyunsuccessful attempt to defend the currency. Undoubtedly, many speculators were burned inthe process, but so too were local market participants. Furthermore, it did nothing to stop thecapital flight. The selling pressure on the Thai baht continued to intensify and the Bank ofThailand’s foreign exchange reserves continued to fall. Eventually, it proved too much. If theBank of Thailand did not scrap the peg and allow the currency to float freely it would simplyrun out of reserves with which to defend it within a matter of days. On July 2, 1997, the baht peg
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to the US dollar was scrapped and the currency allowed to float freely. It promptly collapsedin value, falling by some 10% on that day alone.6.1.3 Phase III: The Liquidity RallyTheoryA pegged currency that is allowed to float freely usually falls sharply for at least the first sixmonths after the free float is put in place, overshooting any idea of fair value. The rule is thelonger a central bank tries to defend it, the further the currency falls in the end. Currencymarket participants who earlier dismissed the idea of currency risk have to chase the marketto put belated hedges in place. In addition, at the macroeconomic level inflation rises as thepass-through effect to the real economy of maxi-devaluation. The signal that the devaluation isat an end is when that inflation rate peaks. At that time, portfolio money starts to flow back intothe country, attracted by high nominal interest rates. This in turn allows the local currency torecover potentially significant ground. In line with this, the trade account improves significantlyas import demand collapses in the wake of economic contraction. Thus a liquidity-based rallyin local asset markets and the local currency is created through lower interest rates and renewedportfolio inflows. This is different from Phase IV, which sees a fundamentally-based rally, asdemand-side indicators continue to deteriorate during this period.PracticeThe collapse of the Thai baht extended well beyond levels seen on the first day of “flotation”.Having been around THB25 to the US dollar before the “flotation” (devaluation), it subsequently fell to a low of 56.3 in the coming months, a decline in value of over 40%. In thecase of the Indonesian rupiah, the fall was even more spectacular, plunging from IDR2,300to the dollar to a low of 17,000, a devaluation of 85%! Asian countries generally tightenedmonetary policy in order to temper the threat of imported inflation from currency devaluationsand in line with the IMF’s initial call for tightening of both fiscal and monetary policy. Policy tightening in the face of maxi-devaluation of the currency tends to cause a slowdown inthe economy to become a recession (if not a depression!), and in the cases of Thailand andIndonesia that is indeed what happened. In 1998, the Thai economy contracted 9.5%, while thatof Indonesia contracted 13.2%. Whatever the merits of these policies, which were ostensiblyaimed at providing long-term economic stability, there is no question that in the short term theyseverely exacerbated the regional economic slowdown. At street level, millions were forcedinto poverty. The World Bank estimated that half of Indonesia was living in a state of absolutepoverty in 1998, defined as earning less than USD1 a day. Unemployment levels skyrocketed. Retail prices rose sharply to offset the free-falling currency in the likes of Indonesia, thePhilippines and Thailand. Interest rates were tightened to offset this, compounding the misery.In the wake of this, several leading commentators were heavily critical of the IMF policyresponse to the Asian crisis, saying the combination of tight fiscal and monetary policy represented a worse cure than the disease itself. While I have some sympathy with this view,particularly as public policy adjustment is not necessarily the appropriate policy response toprivate sector imbalance (too many Asian companies borrowing too much in dollars and speculating too much in their own stock and property markets), this still does not answer the questionof how one stops a currency from free falling. This is a key consideration bearing in mind that
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the collapse of the rupiah resulted in the bankruptcy of almost every company in Indonesia.Whether you favoured the argument of the IMF’s Herbert Neiss or Harvard’s Jeffrey Sachs, itis pretty irrelevant. By then, the damage was already done; the battle had already been lost.By then, it was a question only of damage limitation.The example of the Brazilian crisis, however, suggests some refinements to the standard IMFpolicy response have been considered – not least at the IMF – in the wake of the Asian crisis.When the Brazilian real devalued in January 1999 and subsequently fell to a low of 2.2200to the dollar from its 1.20 band level, many forecast 2.50 or even 3.00 and a similar type ofrecession to that Asia had experienced. In reality, neither of those two possibilities happened.Clearly, the appointment of Arminio Fraga as the new head of the Brazilian central bank was animportant stabilizing measure, as Fraga was a widely respected figure in the financial markets.The maintenance of trade finance for Brazil was also a crucial difference.Whatever the differences, the similarities between the crises in Asia and Brazil – and alsowith Mexico, Russia and Turkey – are clear. Most notably within this was the fact that onceinflation peaked so too did local interest rates, allowing for a substantial rally in asset marketsand the currencies themselves. In Indonesia, for example, this meant interest rates comingdown from around 75–80% and the dollar–rupiah exchange rate falling back from around17,000 to around 6500. Equally, in Thailand, the dollar–Thai baht exchange rate fell back from56 to around 35. In the case of Brazil, the dollar–Brazilian real exchange rate fell back from2.22 to 1.63. Fundamentally, during this period, the trade accounts in many Asian countriesswung from significant deficits to massive trade and current account surpluses.
6.1.4 Phase IV: The Economy Hits BottomTheoryWhile Phase III remains ongoing, the economic patient is still showing no major sign ofrecovery. Inflation peaks, which in turn allows domestic interest rates to peak. The tradeaccount swings hugely, in many cases from a deficit to a surplus as import demand collapses.This accelerates the recovery in liquidity, helping to force down interest rates and thus causingthe liquidity-based rally, which we talked about earlier. Eventually, the trade surplus, lowinterest rates and basing effects help support the economy. Put bluntly, the economy hitsbottom and a period of stabilization ensues.Readers should note that economic stabilization does not mean the same as recovery, in thesame way that hitting the ground after a fall from some height does not entail recovery (indeed,if the height is sufficient there is unlikely to be any recovery!). Both processes usually entaila prolongation of pain, but at least the pain is not getting worse. Thankfully, economies arenot as frail as the human body. They can indeed fall from great heights, smack down hard onthe concrete with a sickening thud and yet still recover; the timing of that recovery dependingcrucially on the extent of the fall.At the microeconomic level, companies are still continuing the process of de-stocking ofinventory. Consumers remain very cautious and retail prices continue to decline to levels aimedat causing them to buy. That said, the fall in interest rates eventually provides crucial supportfor cash-strapped companies and banks. These hastily complete their inventory de-stockingprocess, switching most of that supply to export markets unaffected by the crisis, and start theprocess of re-stocking. At the international level, the reality of the economy hitting bottom, asevidenced by declining contractions in economic indicators, leads to the expectation of Phase V,
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economic recovery. Phase IV is not plain sailing for local currencies however. As domesticeconomies stabilize, so do imports. Indeed, year-on-year basing effects accelerate that process.Thus, what we usually see in Phase IV is those trade and current account surpluses peaking ona monthly basis. During Phase III and the initial part of Phase IV, trade flows are actually moreimportant than capital flows – as most offshore investors have already left by then, taking theircapital with them. Reduced trade surpluses thus have a greater effect on market movementsthan would otherwise be the case, serving to weaken the local currencies.PracticeDuring Phase III, Asian currencies appreciated on the back of the liquidity-based rally. However, during Phase IV, trade and current account surpluses peak as import demand hits bottom.This is of course good news for the domestic economy, however it temporarily reduces thebeneficial liquidity effect on local assets and local currencies. For this very reason, just as Asianeconomies bottomed around the turn of 1998/99, so Asian currencies started to weaken again,giving back some of the ground they had gained during the second half of 1998. More specifically, the Thai baht, which had risen to a high against the US dollar of THB35.65, fell back toaround 38–39. The same kind of thing happened to the Indonesian rupiah, the Philippine pesoand the Singapore dollar. The Malaysian ringgit was pegged to the dollar on September 1, 1998at 3.80, hence it did not experience this renewed setback, nor for that matter did it experienceThe fundamental recovery which most Asian currencies subsequently enjoyed. In the caseof Brazil, Phases III and IV happened much more quickly, partly because Brazil, unlike inAsia, was alone in its devaluation and not affected by region-wide devaluation. In addition, itcontinued to benefit from strong demand for its exports. Finally, at the corporate level, therewas not nearly the same degree of structural dislocation, as Brazilian corporates were by thenwell aware of what had happened to their Thai and Indonesian counterparts and had alreadybegun to hedge external liabilities long before the real’s final devaluation in January 1999.The case of Russia is special for many reasons, not least because several key elements of theRussian government were not informed of the decision to devalue the rouble and default onthe domestic debt market until the actual announcement was made. In addition, the size ofthe black market economy relative to the real economy, and the seemingly persistent state ofchaos in the Russian government, has somewhat distorted price and economic development asanticipated by the model. Nonetheless, the key aspects of the model – the turnaround in thetrade account, the defeat of inflation, the liquidity-based rally, still held true. So Phase IV seesa decidedly bumpier ride for emerging market currencies than Phase III. Yet, economic stabilization, all else being equal, gradually becomes economic recovery – the person eventuallypicks him/herself off the floor after lying there in pain after the fall.6.1.5 Phase V: The Fundamental RallyTheoryWhat does economic recovery mean and how is it different from mere “stabilization”? It is theequivalent of the patient on the one hand getting back his/her vital signs but still remainingessentially horizontal, and on the other hand wandering around the ward. There is a cleardifference! In economic terms, recovery means real economic indicators such as retail sales,industrial output and imports are no longer contracting, but actually rising. In particular, as
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imports start rising, first on a year-on-year basis due to basing effects and then on a month-onmonth basis, this is the first real sign of fundamental recovery. At street level, more practically,the first sign of recovery is people back in the shops and retail prices making a bottom.During Phases III and IV, prices fall until such time as consumers are tempted back by bargainbasement prices. Phase V is when that temptation produces results. The elimination of corporatede-stocking which had hitherto been a drag on growth, coupled with lower interest rates andlooser fiscal policy, which provide support for weak domestic demand, help boost economicgrowth. Corporate re-stocking of inventories gives a further lift to that growth take off. Interms of the trade balance, inventory re-stocking accelerates the recovery in imports, in turnaccelerating the pullback in monthly recorded trade surpluses. However, by this time, capitalflows have begun to offset and then exceed trade flows as investment returns to the region.Rising real economic indicators attract rising capital inflows, helping once again to produce arally in the local currency. However, unlike in Phase III, this time the rally is fundamentallybased rather than just liquidity-based.PracticeFundamental rally was indeed the driving force for Asian currency strength in the secondquarter of 1999. As the Asian economies showed increasing signs of recovery, so capitalinflows resumed, more than offsetting renewed deterioration in their trade and current accountbalances. Asian currencies maintained their strength also for much of the third quarter beforeconcerns over Y2K and specific microeconomic concerns in Korea and Thailand over Daewooand Krung Thai Bank caused a retracement. In addition to these specific concerns, at the globallevel the US Federal Reserve changed the rules of the game. At its June 30 meeting of theFederal Open Market Committee, the US central bank raised interest rates for the first timesince its March 25, 1997 meeting. The Fed hiked the Fed funds’ target rate by 25 basis pointsto 5.00% from 4.75%, however it was not so much the degree of the move as what that moveitself signified – the end of monetary easing.Candidly, the problem with any economic model is that it does not, indeed cannot, takeaccount of what we call “event risk”. That is to say, it cannot by definition allow for eventswhich occur unexpectedly and which can and often do cause temporary or even extendedreversals in market sentiment. The CEMC model is no different in this. Its aim is to provide aframework for anticipating how emerging market currencies might perform, based on the phasein which they find themselves, all other factors being equal. Of course, in reality all factors arefrequently not equal and event risk can play a part in distorting price action. A model aimed attargeting the various phases of emerging market currency crises cannot include external factorssuch as a change in Fed policy. That said, such external factors or event risk notwithstanding,CEMC is still a robust model in providing a predictive framework for emerging market peggedcurrencies.This was not aimed at pegged currencies deliberately, but rather as a result of trying to provide an explanation for the Asian crisis and in turn link it to other emerging market currencycrises – which also happened to involve currency pegs. The policy of pegging their currenciesto the US dollar had provided substantial stability for the likes of Mexico, Asia, Brazil, Russiaor Turkey. This had attracted significant capital inflows. In all cases however, those capitalinflows caused real exchange rate appreciation and led to trade balance deterioration. Thedegree of that real exchange rate appreciation was much more significant in a fixed or peggedexchange rate regime. Equally, pegged currencies that experienced the greatest degree of real
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exchange rate appreciation also had the greatest degree of trade and current account deterioration. The one major exception was China, which in 1994–1995 experienced a real depreciation,thus cushioning the current account balance (a significant surplus) from the aftereffects of theAsian crisis in 1997–1998. By early 1997, it was clear there were overvaluation concerns overseveral Asian currencies and that such overvaluation had been a major factor in current accountdeterioration. There were two possible macroeconomic responses. Either domestic prices collapsed to reduce the lost trade competitiveness as reflected by current account deterioration orthe currency experienced a real depreciation to offset the previous appreciation. In the end, thecurrency took most of the burden of adjustment, and in spectacular fashion.The lesson from this is that the type of exchange rate regime has a major influence on the realexchange rate performance and thus in turn on the trade balance. Indeed, the type of exchangerate regime coupled with an event – such as the US dollar’s real exchange rate appreciation –led to a series of events. While the degree of eventual market reaction (the Asian currencycrisis) could not have been and generally was not predicted, the series of events itself waspredictable. For this very reason, we can deduce two things:
r The Asian currency crisis happened because of fundamental imbalances created by theexchange rate regime.
r A model can be created to reflect this series of events for the purpose of looking at otheremerging and developed market currencies.Thus, CEMC was created and can be used to watch the progress of the likes of Turkey,Argentina and Venezuela going forward.Floating exchange rate regimes behave differently as the transmission mechanism from theexchange rate regime through the real exchange rate to the trade balance is also different. Asan example, let’s look again at the Polish zloty during 2001. During the first half of 2001,the zloty was one of the top performing currencies in the world against both the Euro andthe dollar, supported by heavy capital inflows. Then, in early July 2001, it collapsed. Whathappened? In April 2000, the National Bank of Poland had made one of its smartest decisions,scrapping the zloty’s crawl and peg regime and making the currency fully floating. Since thezloty was a floating currency how could it collapse? Economic theory suggests a floatingcurrency will reflect economic deterioration gradually, thus militating against the worst effectsof that deterioration. Economic theory suggests that economic deterioration through a wideningcurrent account deficit should lead to gradual real exchange rate depreciation in order to restoreequilibrium. Yet, there is nothing gradual about a freely floating currency losing almost 10%of its value in a couple of days, as happened with the Polish zloty. Similarly, in the autumn of1998 as noted earlier, the dollar–yen exchange rate collapsed from 135 to 114 in less than twodays. So, what happened?To answer this question, we have to refer back to the speculative cycle of exchange rateswe first looked at in Chapter 2, which focuses specifically on speculative flow to explain movesand trends in freely floating exchange rates. To recap, the central idea behind this is that thelonger an exchange rate trend develops, the inherently more speculative in nature it becomes.Eventually, speculative buying (selling) is overwhelmed by fundamental selling (buying) andthe exchange rate trend reverses. Sometimes, this reversal is sudden and dramatic, as in thecases of the Polish zloty and the Japanese yen. Somewhat helpfully, ahead of that reversal,option volatility tends to start rising, which currency market practitioners should view as awarning of the reversal to come. This is indeed what happened with the zloty and the yen.We looked at this phenomenon briefly in Chapter 2. Here, in the context of a chapter devoted
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specifically to exchange rate models, we do so in considerably more detail. While this can beapplied to developed market currencies, there are specific considerations with these such as“safe haven” and “reserve currency” status, which distort all models. This particular modelis particularly effective with freely floating emerging market currencies, given how capitalinflows influence nominal and real interest rates. In the case of the CEMC model, we usedthe example of Thailand to demonstrate it in practice. With the freely floating exchange ratemodel, specializing in emerging markets, we use the example of Poland.
6.2 A MODEL FOR FREELY FLOATING EXCHANGE RATES6.2.1 Phase I: Capital Inflows and Real Exchange Rate AppreciationTheoryUnder a pegged exchange rate, capital flows are attracted by the perception of exchangerate stability created by the peg itself. Conversely, under freely floating exchange rates, suchcapital flows are attracted by the prospect of high returns, either of income or capital gain.Fundamental flows are attracted to a currency, attracted both by currency and underlying assetmarket-related valuation considerations. Such capital inflows force the currency to appreciateand simultaneously force nominal interest rates lower. As a result, during this period, thecorrelation between the asset markets and the currency increases. Capital flows lead to bothnominal and real exchange rate appreciation.PracticeDuring much of 2000, the National Bank of Poland tightened monetary policy by hiking interestrates to squash inflation. Towards the end of that year, with the NBP’s 28-day intervention ratehaving peaked at around 19%, nominal and real interest rates peaked, as did inflation. The resultwas irresistible to fixed income investors, attracted both by extremely high interest yields andthe prospect of capital gains. As the NBP began cautiously to relax its monetary policy, thistriggered an increasing tide of capital inflows. Asset managers reduced or even eliminated theircurrency hedges. Dedicated emerging market investors raised their asset allocation in Polishbonds, while crossover investors increased their exposure to what was an off-index investment.6.2.2 Phase II: Speculators Join the Crowd – The Local Currency Continues to RallyTheoryMost speculators, though admittedly not all, are trend-followers. Thus, the longer the fundamental trend continues, the more trend-following speculators are attracted to what seemsrisk-free profit and thus ultimately the more speculative the trend becomes. As the exchangerate continues to appreciate, nominal interest rates to decline and capital inflows to continue,so the other side of the balance of payments starts to deteriorate. The balance of payments mustbalance and therefore including errors and omissions, a rising capital account surplus mustbe offset by a widening current account deficit. Equally, real exchange rate appreciationmust lead to external balance deterioration. For now, the deterioration is not sufficient tocause concern among fundamental investors and is more than offset by speculative inflows,thus the trend becomes self-fulfilling as more and more speculators join the trend.
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PracticeFrom October 2000 through March 2001, Polish bonds roared higher, benefiting from cuts inofficial policy interest rates in response to clear signs of slowing economic activity within thePolish economy. The dollar–Polish zloty exchange rate, which at one time had been as highas 4.75 extended its downward trend, at one point breaking through the 4.00 barrier. Moreand more leveraged money funds sold US dollars or Euro and bought zloty on the