Speculating Disaster

The Real Situation

Brazilian currency was the last thing on my mind when I made my first trade. After all, I had decided to start trading in stocks, not foreign currencies, in the hopes that eventually my experiences would give me more insight into the general subject of economics and make me some money in the process. After first getting my feet wet, I decided, I could then move to something more "international."

The particular stock I was interested in was that of an Internet stock broker I had been watching for several months, and as the U.S. markets opened that morning, the stock's price quickly jumped to $103/share, having closed at $88 the night before. I patiently waited and several minutes later the initial buying stopped and the stock started to drop back towards the previous day's closing price. I waited some more: $90/share. $88. Even lower to $85. At $82, the price stopped falling and started to come up again. I decided it was time to buy.

In the few seconds it took for me to place my order, the price was already rising again, up to $88 and still going. My order went through at $90, but the price kept climbing. By the end of the day, the markets closed with my stock sitting at over $100 per share. I had increased my capital by more than 11% in just one day, just by pressing a few buttons. Trading stocks is easy if you trade at the right time, I thought, and my timing seemed impeccable.

Impeccable timing, indeed. At the same time I was putting my feeble supply of capital into U.S. stocks, others were quickly removing their capital from Brazil, the eighth-largest economy on earth. The next morning, on January 13, 1999, U.S. stock markets plunged when Brazil effectively devalued its currency. "The other shoe just dropped," said Sherry Cooper, chief economist at Nesbitt Burns, as the amount of capital exiting Brazil reached $1.2 billion (Nutting) and Brazil promptly halted trading to prevent even more capital from leaving the country. Fearful that the Brazilian crisis might spread to its neighbors, stock markets around the world fell, and my carefully-chosen well-timed stock purchase reversed its course; in only a few days, my stock was worth less than I had originally paid.

What prompted the day's events is that Brazil had widened the band in which its currency, the real, could trade. Since the real immediately dropped to the bottom of this new, wider band, the decision was an effective devaluation of the currency. Investors continued to sell Brazilian stocks, however, and by the next day Brazil again suspended trading (Rohter). One day later, on Friday, January 15, 1999, Brazil floated its currency, abandoning currency bands and allowing the real to be traded at whatever price the market decides (Schemo).

Traders Help out

"Currency trading is unnecessary, unproductive, and immoral!" proclaimed Dr. Mahathir Mohammed, the Malaysian prime minister, at the Annual Meeting of the IMF and World Bank in Hong Kong in September 1997. "It should be stopped. It should be made illegal!" Malaysia had in the previous months experienced something similar to what Brazil would later endure: through the activities of traders, the Malaysian currency, the ringgit, had been significantly lowered, and Malaysia's stock and bond markets had followed along (Henderson, xi).

The "other shoe" of Brazil was after all just the next step in a series of dropping shoes around the globe. In 1997 several Asian countries, led by Thailand, went through similar crises in which their currency prices fell enormously. Only a few years before that, Mexico was having the same experience.

The root causes of these countries' economic problems are diverse. Mexico, for example, had experienced a large current account deficit for quite some time. Investor confidence, however, was high enough that capital still flowed into the country at a rate that the deficit could be maintained. The Chiapas rebellion in 1994 provided the catalyst needed to shake investor confidence; by December currency traders saw their chance and began putting pressure on Mexican currency, the peso, and on December 22, 1994, the Mexican authorities allowed the peso to float (Henderson, 67-69).

A currency crisis has at its heart one or more fundamental domestic economic problems. Once exogenous shocks provide the opportunity, however, the stage is set for currency traders to play their part in the developing problems. In the process, traders are reviled for "attacking" the currency and are blamed for the crisis in general.

The way a trader operates is quite simple: a commodity, whether it be diamonds or dollars, bought at a one price and sold at a higher price. Currency trading is no different. A currency trader speculates that the price of a currency in terms of other currencies will fall, so he/she sells that currency. If many speculators attempt to sell the same currency, this inevitably lowers the price of the currency. The more the currency falls, the more sellers and less buyers there are, which further lowers the price of the currency. Speculators, therefore, can exacerbate economic problems by creating a downward spiral in the price of a currency.

Although a country's economic problems can simmer for some time, a currency crisis brings the issues to a boiling point, with speculators at the forefront of one of the visible side-effects—the falling price of the currency. Exactly how speculators become such scapegoats requires further investigation; the place to start is the very mechanism of the exchange rate system.

Money Bought and Sold

Most independent countries today produce their own currencies, each of which is guaranteed to be usable to make purchase within the borders of the respective country. Currency exchange becomes an issue whenever goods are purchased across borders or money is invested in another country, either through portfolio investment (buying stocks in another country) or Foreign Direct Investment (FDI—actually setting up a company in another country) (Brown, 623). In order to buy foreign goods, purchase foreign stocks, or open a bank account in another country, one must first exchange the domestic currency for the foreign currency—one must buy the foreign currency at the exchange rate.

The Gold Standard

Money was invented when barter was no longer an adequate means of trade, seeing that actual goods could quickly lose value, were subject to value discrepancies, and could many times not easily be divided (Morris, 4). Money, on the other hand, could function as a medium of exchange, a unit of accounting, and a store of value (Ethier, 402). The original form of money was typically something that had value in itself, such a precious metal. The metal itself, usually gold or silver (Eichengreen, 9), was valuable, both because of its scarcity and its inherent usefulness.

By the nineteenth century, both coins and paper money were in popular use. Under the famous "Gold Standard," currencies were not directly valued in terms of each other. Instead, each currency had a certain mint parity, the rate at which the currency could be exchanged for gold. This in turn produced an effective exchange rate between any two currencies. In 1900, for example, the mint parity for the U.S. dollar was $20.67, while that of the British pound was 3 pounds, 17 shillings, 10½ pence. To exchange U.S. dollars for British pounds, one would divide $20.67 by 3.17.10½, which produces $4.86 per pound after adjusting for the fact that U.S. gold coins had a somewhat greater gold content than did British coins (Aliber, 34).

Paper money could then be used in place of the precious metal. A citizen could carry paper money while the central bank would reserve the appropriate amount of gold. A simplified international flow of transactions under the Gold Standard might go like this: If someone in the U.S. wanted to make a large purchase from someone Great Britain, that person could purchase gold from the U.S. central bank's reserves at $20.67 an ounce. The gold reserves of the U.S. would go down, as would the supply of dollars in circulation. That person could then purchase the goods from someone in Britain by paying gold, which the seller could take to the British central bank and exchange for pounds. The British central bank would then print more money to give to the seller, and store the gold in its reserves (Aliber, 34).

It follows that if the U.S. were to buy more abroad than it exported, creating in turn a balance of payments deficit, in which more money left the country than came in, there would be less U.S. dollars in circulation. In simplest terms, as Hume explained and later the Cunliffe Committee clarified (Eichengreen, 26), this would lower prices in the U.S. because less money was available domestically. Lower prices locally would mean less goods purchased from abroad. It would also mean more foreigners would find domestic prices attractive, increasing foreign exports (and thereby domestic imports), which would reverse the entire process so that an equilibrium would be maintained.

Because central banks have large control over the interest rates, the rates at which banks borrow and lend money, they soon found that they did not have to passively wait for gold flows to be restored. In a trade deficit scenario, with gold supplies leaving the country, a central bank could raise interest rates which would make domestic savings more attractive. Therefore, if a central bank wanted to stop gold outflows quickly, it could, instead of waiting for falling prices, simply raise interest rates, attracting currency and gold reserves back into the country (Eichengreen, 28).

Floating Exchanges Systems

Under a floating exchange system, on the other hand, currencies are not valued in terms of gold—they are valued in terms of other currencies. Floating implies that a currency's price in terms of the price of another currency can change at any time as the market decides. A central bank keeps not only gold but foreign currencies in its reserves.

The purchase of a foreign good also functions quite differently: instead of changing the currency for gold and using gold as a currency, the domestic currency, somewhere along the line, is traded directly for the foreign currency at the market price. A balance of payments deficit, if caused by more goods bought from abroad than were sold, for example, would mean that the demand for foreign currencies would go up, increasing their prices. The demand for domestic currency would go down, lowering the domestic exchange rate, meaning that more domestic currency would be needed to purchase foreign currencies.

In the early 20^th century, two world wars brought about social upheavals, rapid inflation, and the destruction of the setting which made the gold standard operable. Between the wars, many countries elected to temporarily abandon the gold standard and opt for floating exchange systems until their economies returned to the point at which pegging their currencies to gold was once again feasible. Ultimately, that period was never again reached.

The Bretton Woods System

In a new social setting, brought about through increased capital mobility and a greater willingness of countries to either manipulate interest rates or change gold parities, the gold standard as formulated could not survive. In July 1944, 44 Allied nations met at Bretton Woods, New Hampshire to determine the shape of the international monetary system after World War II (Ethier, 468). The so-called Bretton Woods System relied on the notion of adjustable pegs.

In recognition that the gold standard could no longer be maintained, yet seeing that the periods of free floating currencies had been chaotic, the Bretton Woods adjustable peg system was meant to be a compromise between the two systems. Currencies were allowed to float, as long as the exchange rate stayed within a certain band on either side of a currency peg. When the value of a particular currency would fall toward the floor of its band (due to a balance-of-payments deficit, for example), the respective country was expected to intervene—the central bank would buy the domestic currency in return for its reserves (be they gold or other foreign currencies), raising the price of the domestic currency. The pegs were adjustable in light of the fact that, if a currency drifted too far outside its band and could not be contained by central bank intervention, the country was allowed to adjust its peg by setting a new exchange price.

There were three aspects of the system that were in conflict: constant exchange rates, autonomous domestic economic policies, and increasing international capital mobility. The existence of Bretton Woods did not stop states from using domestic economic policy (manipulating interest rates, for example, as under the gold standard) for domestic reasons, whatever their long-term effects on the exchange rate. Capital mobility simply makes the effects of domestic economic policies on the exchange rate happen sooner than they otherwise would (Ethier, 478).

Foreign central banks during the 1960s bought dollars with their own currencies and used dollars for reserves instead of gold (Kenen, 497), and there began to be a dollar overhang, in which about 85% of the world reserve-currency holdings were in U.S. dollars (Ethier, 485). There began to be more dollars in central banks around the world than the U.S. could possibly back up by its gold reserves; other countries began to realize that they could not dispose of their huge dollar reserves without drastically upsetting the foreign exchange market.

With the instability brought about by the Vietnam War, central banks finally began to convert their dollars to gold. To halt the loss of gold, in 1971 Nixon "closed the gold window" by refusing to provide gold to foreign dollar holders (Eichengreen, 133). In 1974 the Bretton Woods System of adjustable pegs was officially abandoned and the Jamaica Agreement basically allowed the presence of any exchange system a country chooses (Aliber, 52).

Exchange Systems Today

There are several exchange systems a country can currently choose from. A free floating exchange system, as mentioned earlier, would simply allow the market to determine the price of a currency. Trade surpluses and deficits, domestic investments versus foreign investments, and domestic taxation policies, to name a few factors affecting the exchange rate, would all be allowed to occur whatever their effects on the currency.

A pegged exchange rate, on the other hand, would function exactly as the gold standard did a century beforehand, except that a country would peg its currency to the price of another currency, usually the U.S. dollar. If there is a balance of payments deficit, for example the central bank will buy the appropriate amount of the domestic currency in exchange for its foreign currency reserves, thereby returning the price of the currency to its peg but at the same time depleting the size of its reserves.

In real life, a free floating exchange rate is an animal usually found only in textbooks. Some countries practice dirty floating by, while remaining officially free-floating, sometimes intervening in their currency rates in order to suite domestic interests—increasing (revaluing) their exchange rate before an oil shipment, for example (Luca, 17). Other countries, for example Brazil before its turn to a free floating system, peg their currencies to the U.S. dollar or some other currency but allow the rate to float within a certain band similar to the Bretton Woods adjustable peg system.

Although most industrialized countries use more or less free floating systems, they still use interest rates and other methods to keep the exchange rate under control. Even the central bank of the U.S., the Federal Reserve Bank, sometimes intervenes to change the value of the U.S. dollar, although there is no set rate to which the currency is fixed (Luca, 15). Pegged systems and free-floating systems therefore differ solely in the amount the authorities intervene. As Aliber notes, "...the more frequently the exchange rate pegs are changed, the more nearly the pegged-rate system resembles a floating-rate system. Conversely, the more frequently authorities in countries with floating exchange rates intervene in the exchange market to dampen the movements in the foreign exchange prices of their currency, the more nearly the floating-rate system resembles the pegged-rate system" (Aliber, 21).

How to Speculate

Becoming a speculator in foreign currency exchange is at the outset straightforward. Anyone in the United States, for example, upon determining that the exchange rate of the U.S. dollar versus the British pound (USD/GBP) was likely to decrease, could exchange dollars for pounds at a bank. This small transaction, effective immediately, is called a cash transaction (Luca, 155). If the trader were to exchange $100 dollars at an exchange rate of .625, he/she would own 62.50 pounds. If the USD/GBP rate were to decrease to .600, the trader could perform the opposite transaction, exchanging pounds for dollars, in the end securing more dollars than he/she started with. That is, 62.50 turned into dollars at a rate of 1.666 (the GBP/USD equivalent of USD/GBP .600) would equal $104.13—a small profit but a profit nonetheless.

The kind of speculation that makes currency crises out of economic instability are made of up much larger amounts and do not usually involve cash transactions. Instead, currency traders deal directly in the foreign exchange markets, which function 24 hours a day. These markets are for the most part decentralized (Luca, 46). They allow many types of instruments other than cash transactions.

Spot Transactions

In all the foreign exchange markets, the most popular instrument for trading is the use of spot transactions, making up 48% of all trading (Luca, 156). The delivery of funds in spot transactions occur two business days after the deal is made (the "deal date"), except in the case of Canada where spot delivery occurs on the next business day (Luca, 155).

Spot trading involves relatively large amounts of money, the standard being USD 10,000,000 (Luca, 158). At this level, small exchange rate changes, which may occur more than 18,000 times a day (Luca, 157), can bring significant rewards. Currency traders may use spot transactions to make profits in the same way as equity or commodity traders, buying low and selling high.

Forward Transactions

The forward market makes up 46% of currency trading (Luca, 174). A small part (7%) is comprised of forward outright deals, the least complex forward transaction. A forward outright transaction occurs when one party agrees to purchase a currency at a particular price on a certain date later than that of a spot transaction, that is, some time after two days. The date on which the currency is paid is referred to as the maturity date (Luca, 176).

Forward currency prices consist of the spot exchange rate (the rate at which the currency could be purchased in a spot transaction) and the forward price, calculated from a forward spread, the difference between the spot exchange rate and the forward price (Luca, 176-177). Since forward prices are derived from spot prices, forward transactions are examples of derivative instruments.

Forward transactions can be used by speculators in a similar manner to spot transactions. If the thirty-day forward for the pound is $1.60 (that is, USD/GBP is 1.60) but a trader believes that in thirty days the rate will be $1.50 per pound, the trader can "sell pounds forward." This means that the trader will make a commitment to deliver a certain amount of pounds (say 1 million) in return for dollars ($1.6 million in this example). If the trader is correct, when he/she must actually deliver the pounds, they will only cost $1.5 million, giving the traders a profit of $100,000 (Ethier, 367). Of course, if the trader is incorrect, he/she could end up paying much more than the $1.6 million being received.

In either case, if a trader sells a currency he/she does not own, the trader is short that amount. The trader will have to settle his/her short position by buying the amount he/she has agreed to sell. The opposite condition, when a trader owns a certain currency, is referred to as a long position.

A forward swap is the same as a forward outright deal except that is actually composed of two deals, or legs (Luca, 176). A typical forward swap is made by simultaneously buying and selling the same amount of currency with the same party, but the two legs mature on different dates, one usually being a spot transaction (Luca, 191). The example above, then, if performed with the same party, is really a swap transaction, with the first leg being a forward outright deal and the second being a spot deal.

Futures and Options

Futures are simply forward outright deals that have standardized amounts and maturity dates. Although commodity futures trading has been around for some time, currency futures trading began just as the Bretton Woods System was breaking down, on May 16, 1972. Futures, as opposed to spots and forwards, are traded in centralized exchanges, one of the largest ones in America being the International Money Market® (IMM) division of the Chicago Mercantile Exchange (Luca, 213). While other currency trading instruments are exclusive to corporations and high net worth individuals, the futures market is open to all market participants (Luca, 216).

A currency option is similar to a future in that it involves the transaction of a currency at some point in the future. An option, however, simply gives the buyer a right, not an obligation, to trade a specific amount of currency at a specific price withing a specific period of time (Luca, 233). For a contrived example, a buyer might pay 20 pounds for the right to buy 1000 pounds at USD 1.40 within one months. By the end of the month, if the GBP/USD rate is lower than 1.30, the buyer would have no reason to actually trade the currency and could opt to simply let it expire. One reason that makes options attractive is that the risks are finite. The trader knows at the outset the most he/she could lose, in this case 20 pounds.

Another instrument involves a combination of these: futures on options. A trader can pay a price for the option to purchase or sell futures at a certain price within a certain time. As futures, options, and futures on options all are derived from the spot price, they are derivative instruments (Luca, 213). These three derivatives are not used as much as the other instruments, making up only about 6% of the entire foreign exchange market (Luca, 156).

Speculation and Currency Crises

The more something is sold (that is, its supply is increased), the lower its price becomes; currencies are no different. By selling forward contracts for currencies, traders can realize profits if the currency price has decreased by the time the forward contract matures. By pooling large amounts of money, hedge funds can be created. By their very size, the selling of a currency by a hedge fund can cause the price of a currency to decrease.

The most aggressive speculator cannot cause a currency's price to lower permanently if a country is economically sound. If that country is producing quality, competitive products, its exports will rise. Foreigners will want to buy products from that country. They will want to buy stock in that country's industry. They will want to deposit money in that country's banks. For all of these things, one needs to first have the domestic currency of the country. With a high demand for the currency, the currency's price cannot be held permanently held down, however large the hedge fund.

Problems with a country's economic fundamentals therefore lie at the bottom of the Mexican crisis, the Asian crisis, and most recently the Brazil crisis. Having prolonged balance-of-payment deficits which cannot be sustained by growth is a sure lure for speculators. The presence of a pegged exchange regime, present in all three of these examples, compounds the problem. A country can use interest rates and currency interventions to artificially keep the currency at a high exchange rate, hiding the underlying problems from view in the short run, delaying and worsening the eventual corrections. According to Milton Friedman, "the combination of a pegged exchange rate, a central bank and an independent monetary policy is almost invariably a disaster" (Friedman, 50).

The currency crisis of Thailand, which provided the catalyst for the entire Asian meltdown in 1997, provides an example of how currency speculation can successfully bring economic problems into view. Thailand land under cultivation tripled and crop exports rose at a cumulative rate of 12% a year from the 1950s through the 1980s. During the Vietnam War in the 1960s and 1970s, U.S. economic aid further boosted the Thai economy. By 1984 inflation was rising and exports were diminishing, and the Thai currency, the baht, was devalued and repegged to the dollar at a lower rate. A boom in Japan, however, brought more Japanese investmentto Thailand, and from 1985 to 1996 Thailand GDP averaged almost 8% a year (Henderson, 83-84).

During the boom, infrastructure improvements abounded while the educational system was ignored. Although growth started heading downhill in 1991 and 1992, building projects continued and government corruption increased. Thailand became downgraded by investors services and the Stock Exchange of Thailand (SET) Index fell. Exports continued to retract (Henderson, 86-91). Just like Mexico, Thai developed a large current account deficit, an increasing dependence on foreign capital, and rising debt (Henderson, 95).

Speculators saw trouble ahead, and wanted to profit from it. On March 8, 1996 a hedge fund in New York sold the baht in the forward market (i.e. sold baht short) in the hopes that its exchange rate would decrease (Henderson, 98). It did not, and the hedge fund lost money. Economic conditions grew worse, however, and to keep the baht within its pegged band to the dollar, the Bank of Thailand was forced to use its U.S. dollar reserves to buy the baht to bring up its price. It also raised interest rates hoping to attract capital into the country (Henderson, 100). Economic problems continued, as did speculative "attacks."

On Tuesday, May 14, 1997 speculators were increasingly selling the baht forward, putting downward pressure on the baht's price. The Bank of Thailand, however, after allowing the price of the baht to fall, formed an agreement with the Hong Kong Monetary Authority and the Monetary Authority of Singapore to purchase baht in exchange for dollars, bringing up the price overnight. On Thursday, Thai banks were cautioned not to lend baht.. Speculators found that baht prices had rose by the time their forward deals matured, but they still had to cover their short positions. This meant that the speculators themselves, by buying the now more expensive baht to cover their forward deals, raised the price of the baht even more (Henderson, 104-105).

Tricking speculators and spending reserves can only go on for so long until the economic problems surface again. As with Mexico before and with Brazil later, speculators eventually succeed in lowering the price of a currency that was not backed up by a sound domestic economy. On Wednesday, July 2, 1997, after repeated speculative attacks, the Thai authorities declared it would no longer defend its peg—the baht was allowed to float (Henderson, 108).

Not Just Speculation

Dr. Mahathir Mohammed knew that the effects of speculation can cause problems; after all, his outcry against speculation was made against the backdrop of Malaysian currency problems that followed in the wake of the Thai devaluation, several months before. The currency crisis soon spread to other Asian countries, some of which had a much more sound underlying economy than did Thailand. And as I'm now very much aware, even a currency crisis in Brazil can have economic repercussions countries away.

The price of a currency, since it reflects how much goods can be bought in the international market, can cause problems for a country's neighbors that rely on it for trade if the currency is devalued. A devaluation has the same effect as immediately taking money away from domestic citizens, if they purchase any goods which were created abroad. Loan repayments to other countries are immediately magnified. An interruption of trade and the complication of debt servicing through currency changes can therefore have severe repercussions not only domestically but in neighboring countries.

Not all the blame should be placed on currency traders, though. Speculators attempt to realize profits through trading currencies similar to the way one would trade commodities. While currency traders can certainly cause temporary currency fluctuations, a country with a strong economy and underlying fundamentals will send speculators looking elsewhere. Economic prosperity has caused many a country to become relaxed and leave creeping problems undetected and unaddressed. It would be prudent if economic authorities, politicians, and indeed the business people themselves would, instead of being rocked to sleep by the good times, take an active role in ensuring the books are accurate and the economic boat is ship-shape—leaving no room for speculation.

Works Cited

• Aliber, Robert Z. The International Money Game: How It Works and Who Sets the Rules, Fifth Edition. London: MacMillan, 1988.
• Brown, Wilson B. and Jan S. Hogendorn. International Economics: Theory and Context. Reading: Addison-Wesley Publishing Company, 1994.
• Eichengreen, Barry. Globalizing Capital: A History of the International Monetary System. Princeton: Princeton University Press, 1996.
• Ethier, Wilfred J. Modern International Economics. London: W. W. Norton & Company, 1995.
• Friedman, Milton. "Confirmed Convictions: An Interview with Milton Friedman." World Economic Affairs. 2.3 (Winter 1999).
• Henderson, Callum. Asia Falling: Making Sense of the Asian Crisis and its Aftermath. New York: McGraw-Hill, 1998.
• Kenen, Peter B. The International Economy, Third Edition. Cambridge: Cambridge University Press, 1996.
• Luca, Cornelius. Trading in the Global Currency Markets. New Jersey: Prentice-Hall, 1995.
• Morris, Kenneth M. and Alan M. Siegal. The Wall Street Journal Guide to Understanding Money and Investing. Lightbulb Press, 1993.
• Nutting, Rex. "Brazil Crisis Sends Shares Tumbling." CBS MarketWatch, January 13, 1999 4:33 PM ET. WWW: http://cbs.marketwatch.com/archive/19990113/news/current/brazil.htx
• Rohter, Larry. "Crisis Is Deepening in Brazilian Financial Markets." New York: New York Times, Internet Edition, January 15, 1999. WWW: http://www.nytimes.com/library/world/americas/011599brazil-econ.html
• Schemo, Diana Jean. "Brazil Devalues Further, and Stocks Soar by 33%." New York: New York Times, Internet Edition, January 16, 1999. WWW: http://www.nytimes.com/library/world/americas/011699brazil-rdp.html