Predict Changes in the Euro–Dollar Exchange Rate
Establish Money Market Equilibrium
Combine the Money Market with the Foreign Exchange Market

Attract Foreign Investors with Soft Pegs

Some soft pegs are implemented for other reasons than international trade. The aim here isn’t to make exports or imports less expensive. Some soft pegs are introduced to attract foreign investors to the country. In this case, the idea isn’t to attract long-term foreign direct investment (FDI), but to attract foreign portfolio investment in the country.

Portfolio investment implies investing in financial papers such as debt securities or equities. Especially developing or emerging countries are interested in attracting incoming foreign portfolio investment.

These countries are in need of accumulating hard currency to finance their infrastructure investment. Among the usual sources of hard currency are export earnings and international borrowing. However, exports earnings are used to pay for imports.

As to international lending, commercial bank lending to developing countries has significantly declined since the debt crisis of 1982. Therefore, some developing countries liberalized capital movements into and out of the country (capital account convertibility) in an attempt to attract foreign portfolio investment.

Although intentions were good, allowing foreign capital inflows into a developing country turned out to be risky business. During the 1990s and early 2000s, a number of currency crises arose because of the soft pegs implemented to attract foreign portfolio investment.

Currency crises may take place in different countries, but their anatomy and timeline are very similar. Following are the steps toward a currency crisis:

  • Attempt to attract foreign portfolio investment: The government is in need of external financing and wants to make the country attractive for foreign portfolio investment.

  • Identify the reasons for foreign investors’ reservations: The government realizes that the country will not attract portfolio investment because of the exchange rate risk. Even though this country’s (nominal) returns may be higher, investors are aware of the risk that this country’s currency will depreciate over and above the returns and the risk that they will lose money.

  • Understand that the government is fiscally undisciplined and influences the central bank: One of the reasons investors expect depreciation of this currency in the future is that the government hasn’t shown any monetary and fiscal discipline in the past. Investors are concerned that the country will continue its path of expansionary macroeconomic policies.

    They also know that the central bank of the country isn’t independent from the fiscal authority and surrenders to the wishes of the government.

  • Peg the domestic currency to a hard currency: The government realizes the possibility of changing investors’ expectations without changing the country’s institutions. Why not peg the domestic currency to a hard currency such as the dollar? Suppose that this country’s currency is the krank (KR). The government announces that the pegged exchange rate is KR2 per dollar. In this case, the country uses the peg as a nominal anchor to signal stability.

  • Eliminate exchange rate risk: The government needs to make the exchange rate risk disappear for foreign investors. Therefore, the government announces that if foreign investors invest in krank-denominated assets, then when they feel like it, they can convert their kranks into dollars at the pegged rate and leave the country. Now foreign investors have virtually no exchange rate risk and can enjoy the higher returns on krank-denominated assets.

  • Watch to see if the peg will break: While the peg is credible, foreign investors have the best of both worlds: no exchange rate risk and higher returns on krank-denominated assets. But they are watching the country. Specifically, they are watching the country to figure out whether the current peg is credible.

    Note that they won’t wait until something happens to cash in their krank-denominated portfolio and get out of this country. If the peg is broken, the krank will depreciate so much that foreign investors will incur large losses, despite higher returns in this country. Therefore, foreign investors observe the country to understand whether conditions exist that will break the peg.

  • Causes for the peg to break: Over the years, views on what would break the peg have changed.

    • When the portfolio inflows to emerging markets were increasing starting in the late 1980s, investors were watching the fiscal and monetary policies of these countries. A credible peg indicates no expected changes in fiscal or monetary policy that will break the peg.

      Suppose that, while pegging the krank, the government increases its spending without raising taxes, which pressures the monetary authority to decrease its key interest rate; this situation is called monetizing the deficit. In this case, both monetary and fiscal authorities follow expansionary policies. Investors understand that the peg (KR2 per dollar) will not remain credible for long. They then expect that the peg will be broken and that the krank will substantially depreciate.

    • Some of the currency crises of the late 1990s, such as the Asian crisis of 1997–1998, belong to the group of second-generation currency crises. The second-generation currency crises implied that foreign investors learned about emerging markets and started looking at obvious but also not-so-obvious circumstances that would break the peg.

      One common characteristic of the Asian economies was a weak financial structure that wasn’t equipped to distribute the incoming portfolio investment efficiently. Investors thought that if anything went wrong in the financial systems of these countries, governments would provide large bailouts, which would break the peg.

  • Pay out with hard currency: When investors sell their portfolios for hard currency, the central bank must do what it promised foreign investors when the country introduced the peg: The central bank must exchange the domestic currency for hard currency at the pegged exchange rate.

    Because foreign investors are now leaving the country, soon the central bank will run out of its foreign currency reserves. This event, with foreign investors cashing in their portfolios and depleting the foreign currency reserves of the central bank, is called a speculative attack on the currency.

  • Allow currency to float: Now the peg is broken. The government lets the domestic currency float, which generally leads to a large depreciation. Additionally, because the country is out of foreign currency reserves, it must restore its short-run liquidity. The country goes to the IMF and receives a loan.

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