Richard Olsen’s Reactions on Critics (Part 2)

Currency attacks are becoming a depressingly common feature of the global economy. But the exact timing of the onset of an attack is notoriously difficult to predict. Richard Olsen has developed a global financial early-warning system, which tries to do the same thing as a gadget that tells someone when they are getting their next heart attack.

Olsen comments:
We have been looking at the data now for many years and we have learned a lot about what really makes a market function successfully. And, most importantly, how the components within the market that is, the market makers, the medium and long-term investors interact, and what is required to build a healthy market or, in reverse, what leads to a negative market with large-scale shocks.
For obvious reasons, such a system would be of immense interest to regulators and speculators.
The core determining factor of a currency's value is the health of the real national economy, especially the balance-of-payments. current account. If there is a surplus in the current account, that is, a country sells more goods than it buys, then buyers have to acquire that currency to purchase goods. This adds to foreign reserves and bids up the price of that currency. Conversely, a current account deficit implies the need to sell the local currency in order to acquire foreign goods. Persistent current account deficits, particularly if allied with relatively low foreign reserves, indicate a problem.

A currency's value is also affected by levels of inflation and the domestic rate of interest. High rates of interest and low inflation make a currency attractive for those holding assets denominated in it. So typically one country raising interest rates while others remain the same will raise the value of its currency as money flows into the country. This will have a limited effect if the fundamentals are wrong.

Comparative inflation rates, interest rates and balances of payments will all give clues to likely medium-term movements of a currency. But a key factor determining short-term currency values is market sentiment. There can be a self-fueling process in which enthusiasm for a currency, or the lack of it, drives the exchange rate. Speculators might decide, as they did during the European Monetary System debacle of 19923 and the Asian and Russian crises of 19978, that a currency is overvalued or simply that there are speculative gains to be made by selling it.

Currency attacks are triggered when a small shock to the fundamentals of the economy is combined with systemic weaknesses in the corporate and banking sectors. One facet of such systemic weaknesses is the effect of belated hedging activity by some economic actors in the economy whose currency is under attack. The more these actors try to hedge, the greater is the incentive for others to follow suit. This unleashes a whiplash effect, which turns a potentially orderly depreciation into a collapse of the currency. In other words, if speculators believe a currency will come under attack, their actions will precipitate the crisis; while if they believe the currency is not in danger, their inaction will spare it from attack attacks are self-fulfilling. The magnitude of the shock necessary to trigger an attack need not be large, which makes predictions very difficult. Nevertheless, it is possible to draw some broad conclusions on the vulnerability of currencies to attack. In particular, there must be a pre-existing weakness, which will prevent the authorities from conducting a fullfledged defense of the currency by raising interest rates. The weakness may not be lethal in itself (though it can become lethal once the situation deteriorates) so it is a necessary condition but not a sufficient condition for a speculative attack.

Self-fulfilling attacks may affect any country with a fixed exchange rate and high capital mobility that is in the gray area between fully safe and sure to be attacked. Recent research suggests that countries with strong trade links with a country that has recently experienced a currency crisis is highly likely to face an attack itself the growing phenomenon of contagion in foreign exchange markets.