Foreign exchange speculations

The crisis of Southeast Asia

In 1997, the currencies of several Southeast Asian and Eastern European countries experienced severe pressure due to speculative attacks. The emerged tensions on money and foreign exchange markets exerted significant influence on the economic environment and in many cases entailed changes in foreign exchange conditions.

Speculations in Estonia

Also in Estonia, the short-spanned activity increase on the spot and forward market between the German mark and Estonian kroon in May and especially October 1997 has been viewed as speculations regarding the reliability of the Estonian kroon. Although confidence in the kroon had indeed dropped slightly, the direct speculative pressure abated relatively fast after the self-regulation ability of the monetary system had manifest itself and a positive affirmation regarding the resistance of the financial sector and economy had arrived.

For instance, a speculative attack may manifest itself in the fact that foreign investors massively start concluding forward contracts with banks, by which foreign investors assume short positions in the local currency (i.e. positions where their liabilities in the local currency exceed the assets in the local currency). The task of the bank participating in such a transaction is, from the one hand, to seek opportunities to finance this transaction, and to cover its own risks on the other.

The mechanism of foreign exchange speculation

The essence of a speculative foreign exchange attack mainly characteristic of an environment with a fixed exchange rate system may be described by the sudden and extensive formation of investment portfolios so as to yield direct financial profit to market participants after the potential change in foreign exchange conditions.

The basis for speculative activity is a firm belief that the foundations of the country's economy are weak and that the local currency is overpriced. The reactions of financial markets following foreign exchange attacks performed with high concentration may make the economic environment too tense, as a result of which the country does not want to or is not able to resist the attacks with the monetary policy measures at its disposal and prefers to abandon the current exchange rate.

Most generally, a foreign exchange attack is characterised by the aggressive sales of the local currency in spot and derivative markets, with which the speculative investors cause a sudden rise in the demand for foreign currencies and exert devaluation pressure on the local currency after the deterioration of monetary and economic policy conditions.

Counteractive measures of the central bank

The central bank may react to a speculative attack with various monetary policy measures, their usage efficiency depending largely on the harmony of the country's economic policy so far, and also on the strength and resistance of financial markets./p>

With interventions on the foreign exchange spot and derivative markets the central bank can change the demand for base money immediately or at a given moment in future. The scope of interventions is restricted by the volume of the central bank's foreign exchange reserve and the amount of resources that the country is able to obtain from other institutions or borrow from international markets.

Raising interest rates limits the conditions of financial markets and makes borrowing the local currency, being the subject of a speculative attack, more expensive. The increase of short-term money market interest rates, however, rapidly transfers to other economic sectors, and in case of a weak economy the country may have difficulties with applying such a strategy in the long-term. If high short-term interest rates become too burdening for the development of the local economy, the central bank may temporarily apply also administrative, incl selective restrictions on investors (i.e. different interest rates for lending to local and foreign investors).

Abandoning the fixed exchange rate is usually considered the last resort, after being convinced that the resistance of the monetary system and the economy as a whole has been broken.

In case of the currency board system some speculation-reducing mechanisms are implemented automatically and do not require making separate decisions. This guarantees a greater reliability of the currency system.