With Pegged Currencies Under Attack, How Do Countries React?
The market is currently on full alert about pegged or highly controlled currency markets depreciating past levels seen as acceptable to local governments. This has been led by China, which has allowed its currency to depreciate at a much quicker pace since August 2015, but has led to uncertainty across the globe from Argentina to Saudi Arabia. Even Hong Kong, one of the most stable currencies in the world which had successfully maintained a 7.75/7.85 fixed range since 2005 without much threat, saw some large bets enter the market this week to play the end of the peg:
Many emerging and frontier market countries have long faced problems managing their currencies. The currency market is global and tied to real economic flows in and out of a country, so it is much harder to control than a local stock market. Currencies are also unique in that if it is bought, it must be sold against another – you cannot just buy US dollars, you have to sell another currency first and convert it into that. This combination of a global market and relative value to other currencies means that EM and FM currencies usually have nowhere to hide, necessitating government action if they want to stem drastic moves.
How Do Countries Intervene or Defend Their Currency?
There are multiple ways a country can intervene (or manipulate, for the cynical) in their own currency market.
1. Set Official Currency Rates
Countries can set an official exchange rate that is conducted for all official business, even if it does not represent reality. This is the ultimate option for governments worried about their currencies depreciating past the point of no return. Current examples include Argentina, but have included almost any country that used to be on a fixed currency system. While some countries are able to maintain a currency peg, countries that institute an official rate as a policy response to existing depreciation pressure (eg. Argentina or Kazakhstan) only exacerbate the problem as investors and citizens alike try to get out. It results in a black market where the real exchange rate prevails.
2. Capital Controls
Countries can also attempt to control their currency market by using restrictive policies that prevent people from moving money out of a country. The most focused on example of this is in China, where the central bank and regulators have long had capital controls to keep their currency market relatively closed off. Despite being added to the IMF’s SDR currency basket and being one of the most used currencies in the world, the Chinese Yuan onshore currency market is still heavily controlled with people needing to use shadow banks or other loopholes to get money out of the country. While these controls protect a currency to a certain degree, people still find a way to get money out and a country loses important monetary policy tools to help manage their economy.
3. Verbal Intervention
Currency traders in emerging and frontier markets will know this type of story well. A call will go out to every major bank’s trading desk from the central bank or regulator, telling them to stop selling the local currency with a severe penalty (potentially getting their trading license revoked) for non-compliance. The central bank then sets its own rates or no rates are published in the market at all, and the general public is none the wiser. If none of the large market-makers in a country can sell the currency, and foreigners are barred access to the onshore market, a currency’s fall can be temporarily stalled. The move is unsustainable of course, since the market comes to a complete standstill.
4. Trading Restrictions
Another method of defending a local currency is by setting severe trading restrictions aimed at preventing large amounts of currency selling. Restrictions can include maximum transaction sizes, quotas on the size of short positions a bank is allowed to carry, strict documentation requirements for all transactions, and even reserve charges on all wrong-way trades. An extreme example would be a Tobin tax, a tax on all currency transactions, on all sell orders of a local currency. China is a country that has many of these restrictions (except the Tobin tax, at least not in its entirety) in order to stem the depreciation flows of the yuan at the moment.
5. Buying Their Own Currency In The Market
This is the most straight-forward method of controlling a currency – simply buy as much of it as possible in order to prop it up in the market. This is done to maintain pegs, but also in freer floating currencies that are in free-fall. The central bank will go out and buy a currency in size, either using their own accounts or through agency banks, setting up a fight against speculators. They may also buy foreign currency bonds which accomplishes the same thing.
The Swiss franc was a famous example of the ramifications of this strategy in 2015, as is the even more famous Soros trade vs the British pound. It is very hard for a central bank to hold off the market, especially as the market senses blood. This is because while central banks can print their own currency, they need foreign currencies to sell in order to fund purchases of their existing currency. The amount of firepower a central bank has is directly tied to the size of its liquid foreign currency reserves as well as its current and capital account surpluses/deficits.
6. Increase Interest Rates
Currency markets have always been dominated by carry trades – trades where investors sell a low yielding currency and buy a high yielding currency in order to profit on the difference, called the “carry”. So in order to make its currency more attractive to investors and harder to sell by speculators, a central bank can try to ensure that its currency is high-yielding through official rates or manipulating the liquidity in forwards markets. After all, if you are expecting a currency to depreciate by 5% over the next year, it makes sense to sell it if you need to pay 1% interest on it to hold the position, but much less so if you need to pay 10% interest on the same position.
Once again the best example of this type of intervention was by China last week, when the offshore yuan overnight rate spiked. Usually, the central bank cannot just ramp up an interest rate due to the negative impact on growth, liquidity, and other capital markets (ie. stocks would tank). However, we’ve seen these moves in Brazil (through official rates) and in China (through cash liquidity in the market).
Stay Vigilant When Investing In Markets With Heavy Currency Intervention
Frontier and emerging markets remain extremely susceptible to large currency moves – the currency returns on the local currency can easily overwhelm overall investment returns. We would advise caution to investors in markets where any of these intervention methods are used by the local authorities, as it opens up the currency to gap risk. Tail risks increase exponentially since these currency defense methods usually release a lot of pent-up selling when taken away. When developed market currencies like the Swiss Franc and Japanese Yen are experiencing such large moves, emerging and frontier market investors have to be even more on their toes.