Does Speculative Currency Attack Leads To Financial Crisis?

Does Speculative Currency Attack Leads To Financial Crisis?

26 Dec 2019 05:01 PM

Ever wondered how the currency jumps on certain days even though there aren’t any significant events or data released? The foreign exchange market has huge volumes thanks to the currency traders rather than the exporters or importers who want to convert their payables or receivables.

Most traders believe a particular trend in which a currency pair will move and take positions accordingly. Assuming these are well informed and forex educated traders, there are bound to be stop loss levels in place. But ever so often, we see traders who believe the value of one currency is over-valued against the other and thus sell that currency expecting a fall in it. Simultaneously they also buy another currency. Thus making profit by seeing upward potential in the currency they purchase.

When the currency of a country is fixed or pegged, then the speculators who attempt to manipulate the market may succeed if the respective central bank doesn’t have enough forex reserves to purchase its domestic currency. Thus the pegged currency may not hold all together.

Black Wednesday in 1992

Most of us have heard of the Black Wednesday in UK when there was a speculative currency attack by George Soros on September 16, 1992 on Bank of England. That was the time when Pound was semi-pegged as it was under the European Exchange Rate Mechanism (ERM) wherein the currency could move within a 6% in either direction – thus central bank intervened to keep a check on its movements with counter trades. George Soros short sold more than $10 million worth of Pound which prompted Bank of England to buy ‎£1 billion worth of its own currency within two hours of the market opening on Wednesday. This prompted the Bank to raise interest rates from 2% to 5% in one day in order to resolve the currency attack attracting the pound, but that too didn’t work and finally the Bank of England withdrew from the ERM to let the market revalue the pound to lower levels which were more appropriate.

Black Thursday in 1997

A similar attack happened on October 23, 1997 with Hong Kong Dollar wherein the interbank interest rate rose to triple digits and monthly interest rate rose to 50%. Though it settled the currency initially, but later in 1998 further attacks with high interest rates took a toll on the Hong Kong Dollar. This was along with the devaluation of Thai Baht as Thai government was unable to support the pegged currency to the dollar due to lack of forex reserves. After Hong Kong sourced large amounts of money from China, the central bank successfully defended the attack. These currency attacks led to the 1997 Asian financial crisis.

Learning from Speculative Currency attacks

The central bank cannot always manage the currency attack through interest rates by increasing them to a great extent which becomes an expensive endeavor – often futile. Since governments have chosen to stay with a pegged/semi pegged policy, they may not always be right. Loopholes prevail which are awaited by many currency attackers. But at the same time, the government stepped in at the right time (even though temporarily) shows the potential to resolve the issue at their end.

Thus central banks can understand such issues and avoid future crisis caused due to regulatory constraints.

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