Speculative Attacks on Fixed Exchange Rates: An Empirical Exploration with Special Reference to the Russian Economy

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Speculative attacks on fixed exchange rate regimes

In my essay I will focus on the problem of speculative attacks on the countries with fixed exchange rate regimes. By definition a speculative attack on a fixed exchange rate is the attempt of currency market participants to force Central Bank to abandon the support of fixed exchange rate regime, thus getting profit from the jump in exchange rate of foreign currency. Obviously, appreciation of domestic currency as the result from speculative attack can not be achieved (Central Bank will only increase its reserves), that's why any speculative attack is aimed at depreciation of domestic currency. For the attack to be successful speculators must create substantial short term demand for foreign currency, which can not be satisfied by Central Bank at current fixed exchange rate because of the lack of foreign reserves. Speculative attacks are a very widespread phenomenon: they were in tens of countries in the world, including Russia on October 11, 1994. In a short term these attacks harm the economy: the stock market goes down, domestic currency depreciates, inflation pressure grows. But on the other hand, we may look at this process as on inevitable clearing the world from weak and inappropriate monetary and currency policies. In this work I will cover the conditions, which are to be satisfied for the attack to be successful, will briefly talk about various models for speculative attacks (first and second generation, etc.), will discuss the strategies of the players in this game. I will also refer to and investigate Russia's experience in 1998. And I will finish with a discussion on possible Central Bank's policies to avoid speculative attacks. Theoretical Coverage First Generation Models The easiest understanding of first speculative attacks was reflected in the so-called models of first generation. The description can be found in works of Krugman , Flood and Garber , Blanco and Garber and others. The main reason for currency crises becomes rapid growth of internal credit in comparison with demand for money in the economy, which under fixed exchange rate leads to purchases by investors of foreign currency from central bank with the purpose of investing in foreign assets. When the accumulated reserves come close to depletion a speculative attack may be undertaken, which would lead to abandonment of fixed exchange rate regime. Models of a given type allow: •to calculate shadow exchange rate, based on which it becomes possible to judge about under- or overvaluation of the foreign currency. The attack can be successful only if foreign currency would appear undervalued and the shift to floating regime would lead to its appreciation. •to illustrate a well known empirical fact that speculative attack very often takes place even before the central bank runs out of reserves. So the key place in the model is occupied by the dynamics of foreign reserves. If the exchange rate is fixed and internal credit is constantly growing under PPP and UIP it means that foreign reserves should decrease. As the internal credit grows agents will use excess money, issued by CB, to by foreign assets and, consequently, it will result in foreign reserves depletion. When CB's position in foreign reserves go down, it loses its power in defending the fixed exchange rate regime. The main engine of speculative attack here becomes the relation of fixed and shadow exchange rates. Speculative attack will take place only when a shadow rate of foreign currency would be higher than current fixed exchange rate. Such models might be somehow useful in forecasting when speculative attack will take place. They say that: •the more international reserves CB has now, the later collapse of fixed exchange rate would be •the faster internal credit is growing (the faster international reserves are sold out), the closer speculative attack is •the lower is the reaction of demand on interest rate, the...
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