Asian andRussian crises. A similar trend has been seen in bank lending, which also fell back in the wake
Exchange Rate Regimes: Fixed or Floating?
111
of these crises. The vulnerability of emerging markets to capital outflow and reversal has beena key focus for the emerging markets, and is likely to remain the case for some time to come.A key differentiation between the emerging markets and the industrial countries is the depth oftheir asset markets and their ability to absorb capital inflows and outflows without significantpolicy and economic distortion.5.2.2 Openness to TradeThe degree of openness to commercial trade of goods and services is also an important consideration with regard to the exchange rate system, both how it has developed and where it isgoing. As with capital flows, emerging market participation in global trade has risen exponentially in the last two decades. The average share of external trade (measured by exports plusimports, divided by two) in GDP for emerging market countries rose from about 30% in thelate 1960s to 40% in the late 1990s.Within this, the trend towards opening up to trade has beenparticularly marked in Asia. As trade makes up an increasingly large share of emerging marketGDP, so changes in the exchange rate and in output and prices are increasingly interrelated. Atthe same time, the type of trade has changed significantly, moving away from a dependence oncommodities towards manufacturing. This change appears to have helped stabilize the termsof trade of emerging market economies, as manufacturing prices change considerably moreslowly than do commodities. However, it has also made the economy as a whole more sensitive to exchange rate fluctuations. Commodities are priced in US dollars and fluctuate for themost part independently of fluctuations in exchange rates. Conversely, supply and demand ofmanufactured trade is very sensitive to exchange rate fluctuations.
5.3 FIXED AND PEGGED EXCHANGE RATE REGIMESThese four periods have been characterized by a general – although not universal – move fromfixed exchange rate systems to convertible pegs and finally to freely floating exchange rates.In the mid-1970s, almost 90% of emerging market countries had some form of fixed/peggedexchange rate. As of the end of 2001, this had fallen to 30%. It should be noted of course thatthis is still a high number and thus it remains important to examine the dynamics of fixed andpegged exchange rate systems, why they came about and their relevance in the modern world.Fixed or pegged exchange rate systems made sense for emerging markets during the 1970sand 1980s. For the most part, their involvement in the global economy was still relativelylimited, for both political and economic reasons. Their financial systems were still for the mostpart in their infancy and certainly not able to cope, at least early on, with the harsh disciplinesimposed by global financial markets. A credible anchor was needed for monetary policy and itwas found in the form of the US dollar. The pegged exchange rate value between the US dollarand the emerging market currency became the anchor of monetary credibility. Sometimes thesewere hard pegs to the US dollar, sometimes they were “crawling pegs”, meaning that the pegvalue changed to reflect a gradual depreciation of the emerging market currency in line withits higher inflation rate. Others were pegged not to a single currency, but instead to a basket ofcurrencies. In all cases, however, the exchange rate peg was the anchor of monetary credibility.What does this mean? A pegged exchange rate system implies a commitment by the financialauthorities of a country to limit exchange rate fluctuation within the limits of the peg. At themacroeconomic level, the aim of this is to provide both stability and credibility. At the microeconomic level, it is to provide an implicit guarantee to the private sector of exchange rate stability.
112
Currency Strategy
5.3.1 The Currency BoardAside from the complete adoption of another and more credible currency, such as the USdollar, the hardest form of currency peg is the currency board. Here, the central bank relinquishes theoretically all discretion over monetary policy. Capital inflows lead automatically toa proportional reduction in money supply by the “monetary authority”, which replaces the jobof the central bank, and vice versa. The monetary authority pledges to exchange the domesticcurrency for the peg currency, usually the US dollar, at the peg rate in any size. Needless to say,this means it has to have the foreign exchange reserves in order to be able to do so. This in turnhas real impact on the economy. For a start, there has to be a strong degree of domestic priceflexibility in order to ensure that domestic prices are able to adjust to changes in the economysince the external price – the exchange rate – cannot adjust because of its peg/currency boardconstraint.Currency boards are no panacea. They imply and impose a very harsh policy discipline. Acountry has to be willing – and be seen to be willing – whatever economic pain is required inorder to maintain the currency board. On the positive side, they should provide transparencyand monetary credibility in addition to stability, which in turn should provide a mediumterm foundation for growth, albeit at a cost. As the example of Argentina suggests, currencyboards do not imply a guarantee of stability. They have tended however to be considerablymore resistant to speculative attack than has been the case with the crawling peg, in large partbecause they have provided a greater degree of monetary credibility. Note that a currency boardrequires that the monetary authority’s foreign exchange reserves more than cover the monetarybase. They do not and are not able to cover the broad money definition, which means that theyremain vulnerable in theory, particularly if locals abandon their own currency.5.3.2 Fear and FloatingMany emerging market countries have chosen to float their currencies only as a last resort andonly when they have been forced so to do. Even those who have eventually floated have stillsought to manage or interfere in otherwise floating currency markets in some way. From this,we have the idea of “fear of floating”, which Calvo and Reinhart set out in a major researchpaper.1 While it is understandable that emerging economies fear – or at least are nervous about –the risks of allowing the market free rein, in my view this is like democracy – the worst optionapart from all the rest. Government intervention in the economy inevitably creates economicdistortions, which can have significant costs. Similarly, if intervention is anything other thanoccasional in order to smooth price action and correct market overshooting, it can create pricingdistortions, which in any case will eventually be reversed.This notwithstanding, the move from pegged to floating exchange rate regimes has frequentlybeen done with considerable reluctance within the emerging markets, that is to say in manyinstances it has been forced by the market. Countries such as Mexico, much of Asia, the CzechRepublic, Brazil and Turkey did not adopt floating exchange rates willingly. These were forcedon them as a result of the breaking of currency pegs and maxi-devaluations that in many casesresulted in catastrophic economic contractions. It should be no surprise therefore that therelationship between the emerging markets and the idea of freely floating exchange rates is anuneasy one. However, barring a major reversal in terms of trade or capital market deregulation1Guillermo A. Calvo and Carmen Reinhart, Fear of Floating, NBER Working Paper 7993, National Bureau of Economic Research,September 25, 2000.
Exchange Rate Regimes: Fixed or Floating?
113
and liberalization, there is no going back on this trend towards freely floating exchange rates.The question now is no longer whether emerging markets will choose freely floating exchangerates as one type of exchange rate regime, but when and how they will move to that.5.3.3 The Monetary Anchor of CredibilityThe discipline of floating exchange rates is quite different to that of a pegged exchange ratesystem. No longer is the exchange rate itself the anchor of monetary credibility. Instead, theconventional wisdom has moved towards inflation targeting through interest rate policy as theanchor of monetary credibility. As a result, the emphasis has shifted importantly away fromthe exchange rate regime and in favour of central banks in seeking to maintain both internaland external price stability. This move from the certainty of an exchange rate as the monetaryanchor of credibility to the uncertainty of a central bank’s monetary discipline is very mucha leap of faith, and it can take a considerable period of time for a central bank to gain therespect needed of the global financial markets to pursue that discipline with the minimum ofmarket instability. This is as true for the developed economies as it is for the emerging markets.For instance, it took the German central bank, the Bundesbank, over 30 years to achieve therevered status it had during the 1990s when German bond yields finally fell below those of theUS for a sustained period of time. Further, a central bank’s monetary credibility is hard wonbut easily lost.In the emerging markets also, as with the broader trend, there has been a general move awayfrom targeting the exchange rate towards targeting inflation. This is of course particularlyevident within the EU accession candidates such as the Czech Republic, Poland and Hungary,which in any case have to adopt some form of inflation targeting to ensure that their inflationrates do not exceed EU/Euro entry rules. However, inflation targeting is also now present inLatin America and Asia.The presumed premise behind this is that as the emerging markets continue to participateto an increasing degree in the global economy and in the global financial markets, so theywill be increasingly judged by the most efficient economy of that global economy, the UnitedStates, and have to adopt its economic policies, such as inflation targeting. This is richlyironic since in fact the US has no formal inflation target. Indeed, it is not too much to suggestthat the official community in Washington, led by the IMF, is in many cases demandingeconomic policies (as quid pro quos for new loans) that would simply not be acceptable in theindustrial countries. Granted, this picture is not entirely negative. Inflation targeting frameworksare usually characterized also by a greater degree of policy transparency and accountability.Inflation targeting also allows some degree of discretion in the setting of the inflation target, butthereafter little latitude in missing it. Broadly put, financial markets “reward” administrations –through lower bond yields – that meet their inflation targets and punish those that do not. Anystudent of international economics knows the classical argument by Milton Friedman for priceflexibility: if there is a change in economic conditions, the fastest and most efficient way ofexpressing this necessary adjustment is through the external price – the exchange rate – ratherthan through a large number of domestic prices. The analogy that Friedman used in 1953 toexplain this was daylight saving time; that is, it is easier to move to daylight saving time thanto coordinate a large number of people and move all activities one hour.The basic argument in favour of flexible exchange rates is that it makes it easier for aneconomy to adjust to external shocks, such as a dramatic change in commodity prices, whichin turn triggers a change in the trade balance. A flexible exchange rate also allows the central
114
Currency Strategy
bank to devote its energies to seeking to maintain domestic monetary stability rather thanfocusing on the external price. Of course, this is the theory. In practice, many central banksstill try to focus on the exchange rate and not just to the extent that it affects domestic inflation.In principle, however, the central bank’s focus on internal price stability frees it from theobligation of targeting the exchange rate.Freely floating exchange rates also have a downside, most notably in that they can be volatileand also on occasion can significantly overshoot anything approximating fundamental value.This in turn can hurt the real economy. To return to Churchill’s description of democracy,freely floating exchange rates are far from perfect, but they have so far proved better and moreresilient than anything else on offer. That said, although a freely floating exchange rate systemis probably the best and most flexible system on offer over the long term, there are specificeconomic factors that can determine which type of exchange rate system may be appropriatein the short to medium term:
r Size/openness of the economy – If an economy is very open to external trade, the economiccosts of currency instability are likely to be a lot higher than if this is not the case. Forinstance, in the wake of the Asian crisis, the structural damage to the likes of India wasfar less than to Korea or Thailand, not least because trade is a far smaller proportion ofthe Indian economy. In turn, this may suggest that it may be appropriate over the short tomedium term for small open economies, such as Hong Kong or Singapore, to have eitherfixed or managed exchange rate regimes.r Inflation – If a country has a higher inflation rate than its trading partners, its exchange rateneeds to be flexible (i.e. floating) in order to maintain trade competitiveness. Indeed, the lawof PPP requires that its exchange rate depreciates to offset this higher inflation rate.r Labour market flexibility – The more rigid the wage structure within the economy, thegreater the need for exchange rate flexibility to act as a buffer against real economic shocks.r Capital mobility – The general rule is that the more open an economy is to capital flow, theharder it is to sustain a fixed exchange rate system. The only exception to this is if a countryadopts a currency board and relinquishes monetary independence.r Monetary credibility – The stronger the credibility of a central bank, the less the need to pegor fix the exchange rate, and vice versa. The relationship between the monetary credibilityof a central bank and the trust of the financial markets is very much a confidence game. Aswe saw earlier, it usually takes a considerable period of time for central banks to build thatrelationship and that trust with financial markets.r Financial development – The degree of financial development, particularly with regard tothe domestic financial system, may be a consideration when choosing a type of exchange rateregime. For instance, immature financial systems may not be able to withstand the volatilityinherent in freely floating exchange rates.
5.4 EXCHANGE RATE REGIMESUSTAINABILITY – A BI-POLAR WORLD?Within the emerging markets, there has been a gradual realization, particularly as barriers totrade and capital have come down, that fixed or pegged exchange rate regimes may no longerbe appropriate in an economic world dominated by high capital mobility. Furthermore, therehas been an equal realization that exchange rate pegs of one type or another inevitably increase“moral hazard”, in that they are seen as an official guarantee of exchange rate stability and
Exchange Rate Regimes: Fixed or Floating?
115
therefore serve to encourage the taking on of unnecessary and dangerous exchange rate risk.Pegging to an international currency such as the US dollar can provide substantial monetarycredibility on the one hand, but on the other the fact that US dollar interest rates are likely tobe substantially lower than those in the domestic market can encourage domestic corporationsand finance companies to borrow in the pegged currency without hedging out the currency riskembedded in those liabilities. The Asian crisis was greatly exacerbated by the fact that Thai,Korean and Indonesian corporations borrowed heavily in US dollars, swapped back to domesticcurrency and lent that out at much higher rates or used it for investment purposes. Yet, the USdollar liability remained unhedged from a currency perspective. Consequently, when domesticcurrencies such as the Thai baht, Indonesian rupiah and Korean won devalued, the cost of payingthose US dollar loans was multiplied proportionally in terms of the domestic currency. In practice, many corporations were bankrupted as a direct result, while others defaulted in such debts.Gradually, emerging market countries have abandoned pegged exchange rates in favour offreely floating exchange rates, either willingly or otherwise, with this process being greatlyaccelerated in the wake of the emerging market crises of 1994–1999. With this process hascome the realization that “soft” or “crawling” currency pegs are no longer sustainable in a worldof high capital mobility. Either exchange rates should float freely or they should be constrainedby the hardest of currency pegs. The middle ground of “intermediate” exchange rate regimesis no longer seen as tenable. This view of a “bi-polar” world of exchange rates was put mostclearly and eloquently by the former IMF First Deputy Managing Director Stanley Fischer,reflecting a general move in favour of this view by the Washington official community. Inseveral research pieces and speeches, Fischer noted that the currency pegs have been involvedin just about every emerging market crisis during the 1990s, from Mexico in 1994 throughto Turkey in 2001. Whether coincidence or not, emerging market countries that have not hadpegged exchange rates have generally been able to avoid experiencing currency crises. Of the33 leading countries classified as emerging market economies, the proportion with intermediateexchange rate regimes fell from 64% at the start of the 1990s to 42% at the end. By 1999, 16of these countries had freely floating exchange rates, while three had hard currency pegs in theform of a currency board or dollarization. The remainder still had intermediate exchange rateregimes. Since then, the hollowing out of intermediate exchange rate regimes has continued,with Greece moving out of both emerging market status and a horizontal currency band intothe Euro, while Turkey was forced off its crawling peg, floating its currency in the process.This hollowing out process of intermediate exchange rate regimes has also happened with theso-called developed economies, a process dominated by the drive towards EMU and the creationof the Euro. The ERM crises of 1992 and 1993 were initially thought to have endangered ifnot ended the dream of EMU. Conversely, it appears they actually served to accelerate themomentum away from such an intermediate exchange rate regime to the hardest of pegs, thesingle currency. By the end of 1999, all but one developed economy had either hard pegs orfreely floating exchange rates, with that one exception being Denmark.As countries move from targeting the exchange rate, through intermediate exchange rateregimes, towards freely floating exchange rates, the monetary emphasis shifts towards targetinginflation as the monetary anchor of credibility. Whether a country chooses a hard currency pegor allows its currency to float freely may depend at least in part on its inflationary history. Intheory, a hard currency peg makes sense for countries with long histories of high inflation andmonetary instability. The peg imposes a harsh policy discipline, but it also acts as a straightjacket on inflationary pressure. Even if a currency has a hard peg regime, it is also important tohave an exit strategy in case of a major change (deterioration) in economic conditions, which
116
Currency Strategy
requires a similar change in the exchange rate regime. A hard currency peg should not be seenas permanent. If a country chooses to de-peg, this is best done when the currency is underpressure to appreciate.While this idea of a “bi-polar” world of exchange rates appeared to provide an answer to thevexing question of how countries could cope with increasingly mobile capital flow, the exampleof Argentina would appear to challenge this view. Not only was it the first currency board inhistory to be “defeated,” but also this example appears to prove that even the hardest pegs couldbe forced to de-peg. Certainly, the idea that a currency board cannot be defeated, once prevalentin the financial markets, has now gone. Going forward, it seems likely therefore that marketswill charge a higher risk premium on currency board regimes than was previously the case asa result of this precedent. Not only is a hard currency peg no panacea, it can also be defeated.Countries are therefore left with the question of the most appropriate exchange rate regime inthe face of a global market economy consisting of high capital mobility and instant informationavailability. For both developed and emerging market economies the choices left are:
r Freely floating exchange ratesr Adopt a base currency (US dollar or Euro)r Adopt a regional currencyWhile some such as John Williamson of the Institute for International Economics havelong argued that intermediate exchange rates are unjustly neglected and “corner solutions”are not immune to crisis – as the case of Argentina indeed proves – it remains to be seenwhether financial markets will tolerate anything other than freely floating exchange rates oralternatively adopting a base or regional currency.
5.5 THE REALWORLD RELEVANCE OF THE EXCHANGERATE REGIMEUp to now, this chapter has largely focused on exchange rate regime theory. This section dealswith how the choice of exchange rate regime actually affects currency market practitionersin practice. As the exchange rate regimes of both developed and emerging markets are stillevolving, it is difficult to find definitive answers. That said, based on what we have alreadylooked at we can draw some useful conclusions. For a start, “fixed” currency pegs are notnecessarily fixed forever – if you get caught long a currency that has just devalued it can killyour balance sheet or portfolio. For instance, on February 19, 1982, the Mexican peso lostsome 29% of its value. Some 15 years later, on July 2, 1997, the Thai baht lost 10% of its valuein a single day. How do we avoid the kind of portfolio or balance sheet losses such disastrousevents imply? Currency market practitioners within fixed or pegged exchange rate regimesneed to consider the following points:
r Does the currency peg contribute to economic stability or instability? Currency pegscan provide monetary credibility by using the exchange rate to force inflation lower, but theycan also attract substantial and potentially destabilizing capital flows.r To what extent is a country open to global capital flows? If a country allows high capitalmobility, a currency peg may not be appropriate unless it abandons monetary independenceand adopts the hardest of pegs, such as a currency board. Capital flows are less easilyanticipated than trade flows, but much more quickly reversed.r Is the currency pegged at the correct level? This has been an important question not justfor emerging but also for developed economies, notably with the ERM. Currency market
Exchange Rate Regimes: Fixed or Floating?
117
practitioners should use the lessons learned in Chapters 1 and 2 to judge whether the currencypeg level is appropriate. Corporations with subsidiaries in the countries concerned are wellplaced to do this given local pricing and demand knowledge.r Are there clear patterns of distress ahead of a peg’s collapse? Currency market practitioners can use the CEMC model (see Chapter 6) as a test of market conditions.r What do you do if a currency peg collapse appears imminent? The trick of course is totry to anticipate this before the rest of the financial market does. Remember the lessons ofthe Asian crisis, where the preceding depreciations of the yen and yuan helped make Asiancurrencies uncompetitive. Remember also that PPP and REER may not be useful over theshort term, but they are useful over a long-term horizon in suggesting currency over- orundervaluation. Also, don’t ignore common sense! Did it make sense in 1998 for Russia, acountry that was going cap in hand to the IMF for more money, to have some of the mostexpensive residential property in the world in Moscow? Every boom is characterized byincidents and anecdotes, which after the bubble bursts seem acts not of folly but of sheerlunacy. Look for signs of these.r Currency risk may not be the only consideration. Within the emerging markets in particular, there may be other important considerations as well, such as convertibility and liquidityrisk. Is a currency convertible on the capital account? Also, emerging market currencies areby nature much less liquid than those of developed economies. While USD200–300 billionmay go through the Euro–dollar exchange rate every day (spot, forward, swaps and options),only USD10 billion goes through the South African rand, the second most liquid emergingmarket currency in the world behind the Singapore dollar. Finally, there is also political risk,which is a more important consideration in emerging markets.r Hedge when the market doesn’t want to (and neither do you!). When market conditionsare benign is clearly when liquidity is best and pricing potentially most favourable. This isalso the best time to hedge currency risk, particularly if one is potentially concerned aboutthe sustainability of the currency regime. However, precisely because market conditions arebenign this is not the time when markets are looking to hedge currency risk. The temptationto stay with the pack (or rather the flock!) should be strenuously avoided. If valuationconsiderations suggest a currency peg may be overvalued, hedging should be seriouslyconsidered. It is a question of cost vs. risk rather than risk vs. reward. For the cost of anoption of around 1–2%, you hedge yourself against the potential risk of a devaluation ofaround 30–40%. Granted, options are not available in some markets, but in all markets thereare benign and also malign market conditions and seasoned currency market practitionersshould be able to tell the difference and take the opportunity when it is at hand.r When the market wants to hedge currency risk it is too late! There is no use complainingabout adverse pricing and liquidity developments when the market is scrambling to hedgecurrency risk. By that time, forwards have screamed higher and option risk reversals haveblown out. Take the opportunity of favourable pricing and market conditions when it presentsitself, based on valuation considerations.Most of the ideas presented in the bullet points above focus largely on pegged or fixedexchange rate regimes. A different set of considerations may be required when looking atfreely floating exchange rates:
r Freely floating exchange rates imply high capital mobility. The two tend to go together.The combination should mean in theory that capital flow reversals are transmitted throughthe exchange rate more efficiently and with less volatility.
118
Currency Strategy
r Freely floating exchange rates can however still see major bouts of volatility. While theytend to be rarer these days, particularly if there are no major economic imbalances involved,freely floating exchange rates can also see significant bouts of volatility. This is not justthe case within the emerging but also within the developed markets. A case in point is thecollapse in the dollar–yen exchange rate in the autumn of 1998 from around 135 to 114 inthe space of 36 hours. Speculative trends always reverse and when they reverse they tend todo so violently.r As pegged exchange rates may be temporary, so freely floating rates are no panacea.Freely floating exchange rates also exact costs and involve risks on the part of the currencymarket practitioner in seeking to manage currency risk.
5.6 SUMMARYTo sum up this chapter, we have looked at the various types of exchange rate regime, howthey developed in the wake of the collapse of the Bretton Woods system, how they developedfrom fixed to pegged to floating, and in line with this looked at some of the major factors –such as capital and trade deregulation – that helped bring this transition about. The aim hasbeen to acquaint currency market practitioners with the various issues involved with differentexchange rate regimes and how they might deal with these in their business and investmentdecisions. In the wake of the emerging market crises of the 1990s, a conventional wisdom hasdeveloped suggesting only a “bi-polar” world of exchange rates, involving either freely floatingexchange rates or the hardest of currency pegs, may be appropriate. If the history of economicsor finance teaches us anything, it is that the conventional wisdom is frequently debunked. Inthis, exchange rates are no different. The Bretton Woods exchange rate system itself representedthe conventional wisdom for almost 30 years, only to collapse under the weight of its owncontradictions. Intermediate exchange rate regimes, in the form of soft or crawling pegs, wereat one time the conventional wisdom only to be blown away by the irresistible force of capitalflows. For centuries, the medium of exchange was not coloured paper but hard metal, in theform of either gold or silver. Who is to say this might not return? Granted, it seems extremelyunlikely, but currency market practitioners should take nothing for granted. In this regard, theprice not of democracy but of financial security is eternal vigilance. Equally, the price of a lackof vigilance is a balance sheet or a portfolio in tatters. The type of exchange rate regime is anextremely important consideration for currency market practitioners.In this chapter, the focus has been on the type of regime rather than the extent of marketconditions. The ultimate expression of market volatility however is the currency crisis, which aswe have seen can occur frequently. To many these may seem chaotic and utterly unpredictable.This is however not necessarily the case. In the next chapter, we seek to build models to predictthe exchange rate equivalent of the storm or the hurricane, the currency crisis.
6Model Analysis: Can Currency Crisesbe Predicted?The type of exchange rate regime is important for normal market trading conditions, but itis especially important for abnormal periods of market stress that may lead ultimately to a“currency crisis”. In this chapter, we look specifically at the phenomenon of currency crisesand whether or not they can be predicted.In the wake of the emerging market crises in Mexico (1994–1995), Asia (1997–1998),Russia (1998), Brazil (1999) and Turkey (2001), considerable effort has been made by theacademic and financial communities to create models that might be able to predict such crisesin the future. As with long-term valuation models aimed at finding a currency’s “equilibrium”level, most of these are based on highly complex mathematical formulae and make certain keyassumptions about human behaviour and psychology. Equally, like the equilibrium models, theresults of these have been mixed at best to date. No-one has as yet come up with the definitivemodel capable of predicting currency crises ahead of time on a consistent basis. The best thathas been achieved is some degree of success, albeit claimed after the fact.For my part, I make no claim either as to a definitive breakthrough. What I would lay claimto however is having approached the issue of currency crisis from a different angle. Most ofthe existing models focus largely on the rationality of human behaviour. In a financial context,this implies rational investors investing where the best returns are to be found. If those returnsdiminish or if better returns are available elsewhere, it is assumed that they will leave. Sucha rationally-dominated view does not allow for herd behaviour, that buying may continuelong past the point at which yield returns have diminished significantly. There is an emotionalhang-up, both within economic theory and within the official community, which labels buyersas investors and sellers as speculators. Yet, buyers can also be speculating. Indeed, some ofthe best examples of speculative excess gone mad have come from buying rather than selling,notably the internet bubble. Markets are ruled by such fundamental sentiments as greed andfear, and it is safe to say that in 1999–2000 greed was running rampant. Easy money was to behad – as it always is during such periods of market hysteria. The financial bubble got biggerand bigger and then burst spectacularly in mid-2000. We are still feeling the after-effects ofthe bursting of the economic bubble, that tidal wave of increasingly unprofitable investment.This is just one example of the “speculative” excess with which human history is littered.In trying to create a model to predict currency crises, my aim has not been to fit economictheory around the facts, but rather to start the other way around, examining patterns withinthose facts and then aligning the theory to fit. The effort has been that of a forensic detective,rather than a psychic. Thus, the rather simple – though hopefully not simplistic – model thatI created in 19981 is based not on complex mathematical formulae, but instead on the sum ofthose patterns that have been seen in the emerging market currency crises of the past 10 years.For want of a more pithy title, I called it the Classic Emerging Market Currency Crisis (CEMC)1Callum Henderson, The Classic Emerging Market Currency Crisis model, 1998, as in Asian Dawn: Recovery, Reform andInvesting in the New Asia, McGraw-Hill, 2000.
120
Currency Strategy
model, a title that is long-winded but hopefully captures the repetitious nature of currency crisispatterns. Our detective did find if not a smoking gun, then at least enough forensic evidenceto discover the “how” and the “why”.The model focuses on emerging markets and more specifically the Asian currency crisis inlarge part because I witnessed the latter at first hand, having lived and been involved in thefinancial markets in Hong Kong during the second part of the 1990s. Because the model’sinitial aim was to discover patterns that specifically reflected the Asian crisis, it was de facto amodel that focused on fixed or pegged exchange rate regimes and how those broke down. Thisis not to say it is only reflective of the Asian crisis. CEMC should