Impact of the Financial Crisis on the Exchange Rate

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International Economics and Business Department

“Impact of financial crisis on exchange rate”

Table of Contents
1.Comparison of three episodes5


Financial crises are often associated with significant movements in exchange rates, which reflect both increasing risk aversion and changes in the perceived risk of investing in certain currencies. The global financial crisis of 2007–09 was no exception. Previous work on exchange rate movements during the crisis has concentrated on the unusual (and unexpected) appreciation of the US dollar (McCauley and McGuire (2009), McGuire and von Peter (2009)). This feature investigates the flip side of this development and focuses on movements in the exchange rates of a number of emerging markets and small advanced economies against three major currencies: the Japanese yen, the Swiss franc and the US dollar. During the crisis, a large number of currencies that were not at the centre of the turmoil depreciated. These movements reversed within a year or so. Both these experiences stand out when compared with those seen during the Asian financial crisis of 1997–98 or the crisis that followed the Russian debt default in mid-1998. We concentrate on two factors that can explain part of these unusual developments. First, during the most recent episode safe haven flows went against the typical crisis-related pattern: instead of fleeing the country at the epicentre of the crisis, they moved into it. Second, interest rate differentials played a bigger role than in the past in explaining some of the crisis-related exchange rate movements. The increase in carry trade activity over the past 15 years could be one explanation for this finding. If so, the dynamics of exchange rate movements around crises may have changed more fundamentally. In the next section, we briefly review exchange rate movements during late 2008 and 2009 and compare them with those in the Asian financial crisis and the crisis following the Russian debt default. We then analyse measures from currency options, implied volatility and risk reversals, to gauge risk aversion and market perceptions of uncertainty and “safe haven” currencies during these episodes. Extending previous BIS work, we then investigate the role of interest rates for exchange rate movements during both the crisis and its immediate aftermath. The last section concludes.

1. Comparison of three episodes

Three recent financial crises were accompanied by substantial movements in exchange rates: the Asian financial crisis of 1997–98, the crisis that followed the Russian debt default in August 1998 and the global financial crisis of 2007–09. Of course, the first two crises differed from the most recent one in a number of ways, including their place of origin, whether they were accompanied by currency crises and the scale of contagion. The earlier two episodes centred on emerging market economies, while in the most recent crisis the epicentre of the turmoil was the US banking system. Both the Asian crisis and the crisis after the Russian default involved speculative attacks that forced a number of countries to abandon fixed exchange rate regimes.2 By 2008, however, many more countries had floating or managed exchange rates, limiting the pent-up need for abrupt and sizeable adjustments due to misaligned currencies in the most recent episode. And, while contagion was important in all three episodes, in the Asian crisis it was largely confined to the region and after the Russian default it concentrated on emerging market economies seen to be in a similar situation, such as Brazil. The latest crisis, by contrast, was truly global. Graph 1 shows the exchange rate movements of a range of countries against three major “safe haven” currencies: the US dollar, the Japanese yen...
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