Speculative Attack: Understanding Currency Attacks & Profits

[bitrex]

I don't have a lot of knowledge about economics, and I'm trying to understand the concept of a "speculative attack" on a currency. I've read the Wikipedia article and I'm still not understanding the concept - can anyone provide an example of how such an attack works and how investors profit from it? Thank you!

 

[ninar]

As far as I know, when there's buzz about a devaluation, uncertainty, a bad economic situation in the country, etc. the attacker -speculator- sells the national money and buys reserves (trades national currency for central bank bonds). Basically, you create a positive feedback to further devaluate the currency and to have higher profits:

So, the attacker trades its national currency money for reserves at the current rate. Then, the national currency devaluates. After the attack, they sell it at a higher rate.

Fixed echange rate economies suffer a lot with these attacks, because if the rate is fixed you need even MORE reserves to leave your money price stable.

And then you have a balance of payments or "currency" crisis. Basically investors which where holding the reserve fixed flee when they presume the rate is going dooooown so it's even worse for that economy.

Examples:

Mexico economic crisis december '94: capitals flee, Central Bank wants the peso stable so reserves go down down. Zedillo had to stop supporting the peso, it widened its flotation band and let it float to combat the especulative attack. It actually even affected other currencies (tequila effect). Another example is Argentina 1999-2002

 

[trv]

After the attack, they sell it at a higher rate.

I'm a bit confused about this point. Are you saying the attacker sells the reserve at a higher price then he bought it? If so, does that mean reserve price necessarily goes up as a currency devalues? What's to say investors won't instead buy a different currency or commodities using the currency under attack.

I would assume the point of such an attack is to buy back the currency at a lower value. So you can have the currency you originally had but you also made a profit through the trade.

 

[ninar]

I would assume the point of such an attack is to buy back the currency at a lower value. So you can have the currency you originally had but you also made a profit through the trade.

Yes. Consider an exogenous, asymmetric shock that causes a trade deficit. The agent (speculator) will try to buy out the bank's foreign reserves. A currency crisis occurs when the government can't bring up their currency (they can't prevent the devaluation/depreciation) by means of increasing interest rates or expanding their reserves. Economies with fixed exchange rates are usually target of speculation.

The speculator makes a bet, or rather, pressures the economy for a devaluation of its currency. In general, devaluation=fixed vs. depreciation=floating rates, but the idea is that the money loses value relative to another (nominal or real). So let's say the economy has a fixed exchange rate (relative to another currency).

Depending on the conditions of that particular economy... the devaluation will either: improve the trade balance (positive effect) or... have a negative effect such as lowering the real income (Laure-Metzler effect), a pass-through effect (in economies in high levels of dollarization), etc.

Since you can't apply monetary policy, then the stabilization occurs by means of capital control.

A lot this effects within different economic conditions are predicted by the Mundell-Fleming model.

EDIT:

What's to say investors won't instead buy a different currency or commodities using the currency under attack.

I'm not sure I understand the question, but I think the idea in general is to provoke a devaluation and to profit from this. The reserves the speculator traded (bought) in exchange for domestic assets will be worth more relative to the domestic currency, since a devaluation/depreciation is necessarily relative to another currency. Basically, the gain is made off this transaction, while the economy is suffering from it.

 

[trv]

Hey, thanks for your response although it is a little too technical for me as its something I interested but don't really have much knowledge of. I will have a think on what you said later though.

About the bit of my response you quoted, what I meant was...

Firstly, when you mentioned selling "it" at a higher rate, I wasn't sure whether you were referring to the currency or the reserves/central bank bonds that the attacker bought. I assumed you were talking about central bonds as that made more sense.

Assuming that is indeed the case, my question was, why should central bond prices rise above what the attacker pays for them. I understand a lot of investors (other then the attacker) would worry about the devaluation of their currency holdings and would thus follow the attacker in selling them off. That bit is clear. What i do not understand is why central bond prices rise? After all it is not necessary that those who follow the attackers in selling off the currency should neccesarily use it to buy central bonds like the attackers. What stops them from exchanging the attacked currency for some other currency or perhaps even a commodity such as gold?

Hope that clarifies the question.

 

[ninar]

Firstly, when you mentioned selling "it" at a higher rate, I wasn't sure whether you were referring to the currency or the reserves/central bank bonds that the attacker bought. I assumed you were talking about central bonds as that made more sense.

Ah, ok, sorry. I meant to refer to the currency reserves. Heheee. In the case of sterilisation operations, the domestic authorities would actually trade the bonds in the same direction of the trading of the currency reserves.

 

[trv]

Ok that makes some sense. Thanks for clarifying.