INTERNATIONAL FINANCE PROJECT

Causes of Exchange Rate Crisis

Submitted By:

Group 6

Aakash Gupta

B. Sundar

Vinay Jain
 ACKNOWLEDGMENT

We express our gratitude to Professors N. Ganesh Kumar and A. Kanakaraj for giving us an
opportunity to undertake our term paper in “Causes of exchange rate crisis” which enabled us to
learn more on International Finance.

Group 6

2
 CONTENTS

Conceptual framework …4

Review of past studies …4

Research design and Empirical analysis…6

Chile … 6

Turkey … 10

Great Britain … 14

Conclusions and Findings … 16

3
1. CONCEPTUAL FRAMEWORK

The exchange rates (also known as the foreign-exchange rate, forex rate or FX rate) between two
currencies specifies how much one currency is worth in terms of the other. For example an exchange
rate of 102 Japanese yen (JPY, ¥) to the United States dollar(USD, $) means that JPY 102 is worth the
same as USD 1. The foreign exchange market is one of the largest markets in the world. By some
estimates, about 2 trillion USD worth of currency changes hands every day. The spot exchange rate
refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted
and traded today but for delivery and payment on a specific future date. 1 Exchange rate crisis have
occurred in the recent past in many Asian and Latin American countries. The causes have been unstable
macro economic fundamentals ( high inflation, growing current account deficits, high debt and high
domestic interest rates ), uncontrolled capital inflows and outflows and asset price bubbles. This crisis
spreads to other countries that are economically and geographically integrated (Mexican crisis in 1994
which spread in Latin American and the Thailand crisis (1997) in Asian countries ). At the other extreme,
we have the currency board regimes of Argentina and dollarization, as in Panama.

In this paper, we have attempted to explore the various causes for exchange rate crisis that occurs in
selected countries ( Turkey, Mexico, Brazil, Chile, Britain and Thailand ). Such an approach would tend
to reduce our attempt at mere documentation of past historic events. Further, the causes for such crisis
are country-specific. Essentially a backward – looking study, we have attempted to apply established
models ( for example the Logit model ) to validate a major exchange rate crisis that have occurred in the
recent past ( as we attempted for the Turkey crisis (2005-06)). Similarly, we have analyzed the capital
controls regime in Chile ( 1991-97), evaluated its advantages and disadvantages and through the Preto-
Soto model, have assessed implications if a similar regime were to be imposed by the policy makers in
our Country.

2. REVIEW OF PAST STUDIES

The 1994 Mexican peso crisis2

Mexico has historically been heavily leveraged towards foreign capital. Increase in interest rates therefore
increases the outflow of capital from the country. As such the country is very sensitive to external factors.
A contraction in the US monetary system of the in early 1990’s was one of the significant reasons behind
the collapse of the peso in 1994. According to one estimate, in 1994 Mexico had raised foreign debt to the
tune of $160 billion. Foreign investment in peso-denominated debt was around 70% while that in dollar-
denominated debt was 80%.3

The peso crisis is also attributed to a rigid financial framework, where policies were not implemented
leading to a delay in the devaluation of the peso. If the peso had been devalued the crisis may have been
averted. A high interest in the Mexican market coupled with an overvalued peso lead to a large capital
account deficit. The resulting flight in capital reduced the foreign exchange reserves and the government
did not have enough reserves to prop up the peso.
1
http://en.wikipedia.org/wiki/Exchange_rate accessed on 05.11.2008
2
Maskooki Kooros. 2002. “Mexico’s 1994 peso crisis and its aftermath”
3
Gruben C. Williams.Economic Review First Quarter. 1996. “Policy Priorities and the
Mexican Exchange Rate Crisis”

4
Post the crisis the government instituted financial sector reforms which led to higher mobility among the
domestic investors. They could now invest abroad. There were further more financial liberalization
followed by the adoption of a floating rate system.

Brazilian Crisis in 20024

By 2002 Brazil had institutionalized a number of financial reforms and had very strong fundamentals.
During the period July ‘02 – November ’02 sovereign interest rate spreads rose from 12.5% to 25%. The
country was also heavily dependent on foreign debt. A large share of the debt was also indexed debt.
37% of the public debt was a floating rate debt while around 42% was indexed to the exchange rate. A
rapid increase in the interest rates therefore could result in a reversal of capital from the country. A high
bond-spread and the depreciation in the currency led to a high debt-GDP ratio of 56% resulting in a crisis.

It is suggested that to maintain a stable exchange rate the company should follow an expansionary
monetary policy with a high degree of liberalization. In the ideal condition there should be a constant
inflow of capital at low interest rates. This is possible with a favorable economic climate and a strong
financial structural. The Brazilian crisis of 2002 is believed to be a case of self-fulfilling hypothesis, where
the belief that the conditions were ripe for a currency crisis led to a flight of capital and a subsequent
depreciation in the Brazilian currency.

British “Black Wednesday”5

The “Black Wednesday” precipitated the British pound’s withdrawal from the European Exchange Rate
Mechanism (ERM). The Sterling had been set at 2.95 DM/GBP with a 6% band. The UK Central
bank had promised to keep the exchange rate above the lower band by active intervention. High interest
rates in Germany forced higher interest rates in the British market. The Germans had kept their interest
rates high to rein in the higher inflation and to facilitate the unification of Germany following the collapse of
the Berlin Wall. At the same time depreciation in the US dollar severely affected the country’s trade
account. The country was also facing a current account deficit along with a fiscal deficit. This made it
difficult for it to prop up the exchange rate. On 16th September the treasury announced a increase in
interest rates after sustained efforts by the central bank to buy out the pounds from the market failed to
give any results. But this did not stop the speculators from going short the pound and finally the
government announced its intention to exit the ERM.

The event had its political implications with the Conservative losing the general elections. The realization
that a stable currency is a result of efficient economic management led to the formation of the stable
Euro.

The Thai Baht crisis after the collapse of the Housing Market in 19976

4
Goretti Manuela. International Journal of Finance and Economics. 2005. “The Brazilian
Currency Turmoil of 2002: A Non Linear Analysis”

5
“Black Wednesday”. http://en.wikipedia.org/wiki/Black_Wednesday

5
The crisis in Thailand was preceded by years of prosperity and growth. It is suggested that these
continuous years of growth led to a complacency in the system. Irregularities in the housing sector were
overlooked which eventually led to the collapse of the Thai Baht. Most of the South East Asian countries
are interlinked economically with each other making them very likely to suffer from contagion. The crisis
that started in Thailand soon spread to the other countries in SE Asia.

Years of growth had led to an optimism of the real-estate developers. The growth in the housing market
was fueled by higher level of debt which was used to construct more units of housing and office space.
However in 1995 there was a liquidity squeeze which created a cash shortage in the market. This created
problems for the developers who defaulted on their interest payments. This snowballed into the closing
down of a number of financial institutions. Lower off take of office space also created cash problems for
the developers and there was an eventual flight of capital from the market. In anticipation of devaluation,
domestic investors had also started converting their holdings into foreign currency. This created a drain
on the central bank and it could no longer support the baht. A contagion followed which resulted in the
crisis spreading to the neighboring countries.

3. RESEARCH DESIGN AND EMPIRICAL ANALYSIS

A. CHILE

A fixed exchange rate regime puts fetters on monetary independence while a free floating exchange rate
regime necessitates a National monetary policy. It has been postulated that it is impossible to
simultaneously have free capital mobility, a fixed exchange rate and an independent monetary policy. But
free capital mobility is not an absolute must for emerging economies. Empirical results have revealed that
currency crisis stemming from exchange rate volatility is invariably a result of capital flow reversals and a
curb on capital inflows will reduce the risk of a currency crisis.

As an example, Chile had introduced capital restrictions in inflows in the form of an unremunerated
reserve requirement (URR), in June 1991 on a permanent basis, in a setting of predetermined exchange
rates, which lasted till 1998. Chile-style URR has been hailed by many academicians as a reasonably
good method to avoid exchange rate crisis. We have endeavored to analyze the policy followed by Chile
and examine its implications in applicability to India.

URR and Chile. URR imposition collected revenue for the Government indicating its relevance. The
objectives of the Government were to reduce the exchange rate appreciation and maintenance of
interest differential to control inflation. Studies also indicate that URR did not discourage net short-term
credit to the private sector. URR resulted in creating a stark differential between domestic and foreign
interest rates, reduced capital inflows, encouraged and obtained long term maturities without taking a hit
on its exchange rate and increased Chile’s control over monetary policy. URR saved Chile in the Global
financial turmoil by limiting its exposure in 1997-98. The domestic interest rates were tranquil from 1994
– 97(October ) and was not affected by the Mexican crisis (December 1994), when most of the Latin
American countries were severely affected by the “tequila” effect of the Mexican crisis. Paradoxically,
when capital inflows were tightened by hiking the URR in Chile, the domestic interest rates spiked

6
Wong Kar-Yiu. The Japanese Economic Review. December 2001. “Housing Market Bubble and the
Currency Crisis: The Case of Thailand”

6
between October 1997-September 1998, mainly due to the Russian default ( August 1998). Stability
returned in Q499, when the URR was scrapped7.

Conclusion. A valid conclusion from the above analysis is that Chile-style URR capital controls, though
useful in the short run, tends to magnify the negative effects of externally-originated shocks. The macro
economic benefits have been temporary which stunts the economy’s growth by increasing the costs
relating to implementation of the policy. The cost of capital increases, especially for small and mid sized
firms. The policy-makers, as it happened in Chile, tend to make this policy permanent and neglect key
and fundamental macro economic reform.

Application to India through econometric model. Chile’s URR can be viewed as a tax on capital
inflows. A quantification of the tax effects of controls over capital inflow is given by the model developed
by Valdes Preto and Soto (1996 ), “Preto- Soto model “ ( and subsequently by De Gregorio, Valdes and
Edwards (2000), which is defined as follows ( Reference – 6) :

Te (k) = [(R * α ) /( 1-α)] *(Ω) / k, where

Te(k) = tax equivalent rate for funds that stay in the country for k months

R = International interest rate that captures the opportunity cost of require requirement

α = proportion of funds that has to be deposited in the Central Bank ( Reserve Bank of India )

Ω = period of time, in months, that has to be kept in the Central Bank.

The above model is used to assess the tax equivalent of a capital control in the Indian context.

Capturing R.

a) Implied R. We began our analysis for determining R, the opportunity cost for reserve requirement,
from reference (6) quoted above. The paper used the Preto soto model to determine the tax equivalent of
URR during the period 1991-97. The result is depicted below in the form of a graph ( figure 2) extracted
from the above reference:

7
Exchange rate regimes, capital flows and crisis prevention by Sebastian Edwards, NBER( September
2001)

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It is known that for Chile, as of July 1992, α = 30%, Ω = 12 months and k = 1 year ( assumed by the
author of the paper ), for which Te ( k = 1 year ) = 1.5 % = (R * 0.3)*12 / (0.7 *12), using the “preto-soto”
model, which yields R = 3.5%.

b) Assessment through world averages. It should be noted here that we have viewed reserves as a
stock concept and not as a flow concept. Thus reserves is a monetary asset and as such, is treated as
stock. Consequently, the cost of holding reserves is seen as income foregone by not employing the
reserve asset in an alternative use.8 An estimate for assessing the International cost of capital ( ICC) for
the G7 countries was obtained as follows : 9

8
“Assessing State reserve requirements, An opportunity cost approach”, by R. Stafford
Johnson and Merlin M. Hackbart , Southern Illinois University ( undated paper )
9
Cross section of International Cost of Capital ( May 2003 ) by Charles Lee and Bhaskar
Swaminathan

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 • The ICC for the G-7 countries for the period 1990-2000 was estimated in the range of 2% - 4%
( mean = 2.9%)

• Real estate, food, health care in G7 : Range is 1.5% to 2.3 %

• Entertainment, finance, construction, transport, construction : Range is 3.2% to 5%

• Overall industry average in G7 is 3.43%

• Proposed weight for country : industry = 65:35 ( as proposed by us )

• R = 0.65 * 2.9 + 0.35* 3.43 = 3.0855 %

• An assumption is that we are assuming the present state of growth in India (2008) is
equivalent to the growth and status of G7 in 2000.

c) Studies in India.10 The cost for holding reserves in India, in terms of physical investment foregone,
excess ECB, public sector borrowing and balance sheet risks, is estimated as 2% of GDP. That is, India
is foregoing 2% of GDP by accumulating reserves instead of employing these resources in alternative
use. Thus, R can be captured as this cost, equivalent to 2 %.

The value of R from (a) above cannot be directly applied to the present Indian context, but enabled us to
get a hold of the range of R. Results from (b) and (c) give us close approximation, and we decided to
adopt a weighted value of R as under :

R= 0.3 * 3.0855 + 0.7 * 2 = 2.32%.

With the above value of R, we propose to calculate the tax equivalent of capital control, which is indicated
in the excel sheet.

B. TURKEY

Using a logit model to predict factors affecting currency crisis

In order to find out the major variables that can reflect the occurrence of a currency crisis we had to
choose a country that had experienced a major financial crisis recently. We eventually chose Turkey as
the country of study and decided to apply a logit regression on the variables we thought would make a
significant difference to whether a currency crisis occurred or not.

Turkey experienced two major crises in the last decade. The first one occurred at the beginning of 1994
when there was a managed float. The second crisis preceded by a financial turmoil which hit the country
sometime in November 2000. According to most researchers the reason for the 2000 crisis was the
fragility of the banking sector in Turkey. The root cause of the fragility of the banking system was
supposed to be the high public sector borrowing and the methodology in which that was funded. The
sustainability of this financing mechanism was conditional on the continuation of demand for government
securities. In the absence of a program that reduced borrowing requirement, the upward trend in
government debt instruments portfolios of the banks and their mode of financing in bank balance sheets
increased the vulnerability of the banking system. To reflect this fragility we have included some variables
in our model which do reflect that one of the reasons for the crisis could have been the banking sector
fragility.

The usage of logit regression (binomial logit) has been quite prevalent in previous studies of currency
crises. Logit regression is a model used for prediction of the probability of occurrence of an event by fitting
10
“Cost of holding reserves : The Indian experience” by Abhijit Sen Gupta ( March 2008)

9
data to a logistic curve. It makes use of several predictor variables that may be either numerical or
categorical. Given the aforementioned indicators, the model estimates the probability for financial crises.
The estimated model takes the form:

Prob (yit= 1 | x , b ) = F(xt , bt ) (1) 11

Where xt corresponds to our set of indicators and is a vector of unknown parameters. The observed
variable y receives a value of 0 or 1 depending on whether a crisis has occurred or not. With a logit
model, the right-hand side of the model is constrained between 0 and 1, and is compared to the observed
value y.

Data and Methodology

A binomial logit mode was built based on monthly observations spanning the period, 1988:1 to 2007:12.
Most of the data has been gathered from IMF website. In all thirteen variables were selected on the basis
of previous currency crisis theories and previous empirical literature. In order to test the vulnerability of
domestic banks we used another indicator bank reserves/bank assets which would signify the liquidity of
the banking system. We have employed variables that indicate the vulnerability to a sudden stop in capital
inflows. These variables are M2/Foreign Exchange reserves and foreign exchange reserves themselves.
To study the foreign influence on the crisis we have included the US interest rate. From the study of these
fourteen variables we try to distinguish the factors which significantly affect the likelihood of a currency
crisis. For some variables like GDP, current account and population we could not obtain the monthly
figures. In these cases we have annualized the data through interpolation.

Listed below is the explanation of the reason we have chosen some of the variables and the expected
sign in the model. Another variable called the crisis variable was input to reflect whether a currency crisis
had occurred or not. In order to reflect the fact that a crisis would have occurred quite before the actual
knowledge of the crisis we have assumed that a crisis in one month implies a crisis in another eleven
months, either before or after the crisis. For the purpose of the crisis in 2000 we have chosen six months
before the month of November 2000 and five months after that. For 1994 we have chosen the whole year
as when the crisis occurred implying that in these 24 months the crisis variable takes the value of 1, while
in the rest its value is zero.

11
Pezo and Analizi,1995. An econometric analysis of the Mexican Peso crisis of 1994-95

10
Table1:Explanatoryvariables

Indicator Expectedsign Explanation

Inflation + Inflationisassociatedwithhighnominal interest ratesandmayproxy
macroeconomicmismanagement that adverselyaffectstheeconomy
andthebankingsystem
ExportGrowth - Weakexportsmayleadtodeteriorationsinthecurrent account and
haveoftenbeenassociatedwithcurrencycrises

Importgrowth - Excessiveimportgrowthcouldleadtoworseninginthecurrent
account andhavebeenrelatedwithcurrencycrises
M1 + Growthof M1indicatesexcessliquidity, whichmayinvoke
speculativeattacksonthecurrencythusleadingtoacurrencycrisis
Domesticcedit/GDP + Highlevelsof domesticcredit indicatethefragilityof abanking
system
FDI/GDP + Showsnet inflowsinthereportingeconomy. East Asiancountrieshad
beendependent onnet capital inflowsoverthedecadeprecedingthe
crisis
USinterest rates + International interest rateincreasesareoftenassociatedwithcapital
outflows
BankReserves/BankAssets - Showstheliquidityof thebankingsystem.Adversemacroeconomic
shocksarelesslikelytoleadtocrisesincountrieswherethebanking
systemisliquid
ForeignExchangeReserves - Most currencycollapsesareprecededbyaperiodof increasedefforts
todefendtheexchangerate, whicharemarket bydecliningforeign
exchangereserves
CurrentAccount/GDP - Anincreaseinthecurrent account isassociatedwithlargecapital
inflowswhichindicateadiminishedprobabilitytodevalueandthusto
lowertheprobabilityof acrisis
M2/ForeignExchangereserves + Indicatestowhat extent theliabilitiesof thebankingsystemare
backedbyforeignreserves. It alsocapturestheabilityof thecentral
banktomeet suddendomesticforeignexchangedemands
GDPpercapita - Deteriorationof thedomesticeconomicactivityisexpectedto
increasethelikelihoodof crises
TurkeyInterbankrate + Usedasaproxyof financial liberalization. Liberalizationprocess
itself tendstoleadtohighreal rates. Highreal interestrateshavebeen
increasedtorepel aspeculativeattack

Empirical Results

As the table below indicates the signs of the variables are mostly in line with our expectations with the
exception of inflation, import growth, Domestic credit/GDP and foreign exchange reserves. The most
significant variable as was expected is the ratio of Bank Reserves to Bank assets. The other significant
variables are current accounts/GDP, M2/Foreign exchange reserves ratio, Domestic credit/GDP and US
interest rates.

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Table 2: ExpectedversusActual signs

Indicator Expectedsign Actual Sign

Inflation + -
Export Growth - -
Import growth - +
M1 + +
Domestic credit/GDP + -
FDI/GDP + +
USinterest rates + +
Bank Reserves/Bank Assets - -
Foreign Exchange Reserves - +
Current Account/GDP - -
M2/Foreign Exchange reserves + +
GDP per capita - -
Turkey Interbank rate + +

Table 3: SPSS output for the logit model

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 C. GREAT BRITAIN

“Black Wednesday”

The “Black Wednesday” incident precipitated the

British pound’s withdrawal from the European
Exchange Rate Mechanism (ERM). The Sterling
had been set at 2.95 DM/GBP with a 6% band. The
UK Central bank had promised to keep the
exchange rate above the lower band by active
intervention. The Germans had kept their interest
rates high to rein in the higher inflation and to
facilitate the unification of Germany following the
collapse of the Berlin Wall. The higher interest rates
in Germany forced higher interest rates in the British
inter bank market. At the same time depreciation in
the US dollar severely affected the country’s trade account.

Fig 1: DEM/GBP exchange rates Sept-Oct ‘92

This made it difficult for the Bank of England to prop up the exchange rate. On 16th September 1992 the
treasury announced an increase in interest rates after sustained efforts by the central bank to buy out the
pounds from the market failed to give any results. But this did not stop the speculators from going short
the pound and the government had to announce its intention to exit the ERM.

The event had its political implications with the Conservative losing the general elections. The
realization that a stable currency is a result of efficient economic management led to the formation of a
stable Euro.

Fig 2: BoE announcing an increase in call money rates to tempt speculators in taking a long position in the pound. 15th
September 1992

“The Unholy Trinity”

There is an intrinsic incompatibility between exchange rate stability, capital mobility and national
policy autonomy. A central bank that is following a fixed rate system cannot pursue expansionary policies.
The government has to choose between price and exchange rate stability or a monetary expansionary
policy. Paul-Krugmen suggests that policies should be consistent with fixed exchange rate systems.

13
Following an overtly expansionary monetary policy along with a fixed exchange rate system can expose a
country to speculative attacks.

The annual inflation rate in 1992 was 4.3% and the Bank of England had announced its intention
to follow a fixed exchange rate. Thus the country had price and exchange rate stability. Paul Krugmen
suggests that in such a scenario a consistent policy will be to follow a contractionary fiscal and monetary
policy. However in 1992 with high levels of unemployment the government was making larger
expenditures, the total expenditure for the financial year had risen by 11.14%.

Model for predicting speculative attacks on the currency

The probability of a speculative attack can be a defined as a function of the following variables

ƒ ≈ { F; Un; B; GovtExp; I; GDP; TB }

F: whether the country follows a system of fixed rate or flexible exchange rate system

Un: Unemployment rate

B: Budgetary Deficit/Surplus as percentage of GDP

GovtExp: Government Expenditure

I: Inflation rate

GDP: Real rate of GDP growth

TB: Trade Balances

Fig 2: Call Rates spike in October ‘08 before appreciation in the US dollar with respect to the INR

In the Indian context, the country is following a loose system based on a crawling peg policy
towards exchange rate management. Inflation has been high in the past couple of months. The historical
trend also indicates inflationary forces at work. This is a characteristic of any high growth developing
economy. So unlike the British case, there is no price and exchange rate stability. Budgetary deficit has
risen considerably in 2007 to around $22.3 billion. Government expenditure rose by 15.60% in the FY07.
Inflation is also at a 12-year high. However unemployment has reduced in 2007. Similarly Real GDP
growth at 9.3% is an indication of a healthy economy. In the same manner the presence of a negative
trade balance in the function may not be an indication of vulnerability. As a negative trade balance is quite
common in a developing economy. These trends are quite unlike the British case in Sept 1992.

Therefore a speculative attack on the Indian currency can be ruled out.

14
The objective of the model is to sketch out a “vulnerability- scenario”, which reduces the credibility of the
central bank in defending the exchange rate. With foreign exchange reserves at $ 266.5 billion the
Reserve Bank of India can successfully defend a speculative attack. The devaluation in the INR with
respect to the US dollar is evidently the result of externalities like the bailout of financial institutions in the
US. This has sucked up the liquidity from the market. As governments buy dollars to fend of the crisis, it
creates a shortage of USD in the currency market, leading to an appreciation of the dollar.

In 1992 the British government was facing a condition known as the “double deficit”. The current account
balance was negative at $22.7 billion. The budgetary deficit had also risen significantly to $29.2 billion
which was a 314% hike from the previous year. The second generation of models on speculative attacks
suggests that the government can protect a currency peg as long as the interest costs of defense are less
than the benefits from defending the peg. This leads to a condition known as a self-fulfilling currency
crisis model. If investors believe that the country’s commitments to defending a currency peg are credible
then it will deter them from making a speculative attack. However if the claims are unsubstantiated then it
tempts speculators to attack the currency. Credibility leads to a good equilibrium position among investors
which causes capital flows in a more stabilizing direction.

Real GDP growth was at 0.1%. This was favorable as compared to a -1.4% deflation in the previous year.
But with unemployment at a high of 9.2% and a budgetary deficit at an all-time high the British
exchequer’s statement that they will defend the currency peg was simply not credible.

Leading indicators like high level of unemployment

make it difficult for governments to raise interest
rates which can squeeze the job-market Sharp
interest rate hikes are difficult to sustain with a large
budget deficit. High levels of debt are another
indicator of government vulnerability

High levels of unemployment can lead to political

uncertainty. This puts pressures on the government
to finance social protection programs and increase
its non-productive expenditure. Such an
expansionary policy leads the country into a
vulnerable zone.

Fig 3:1-year yields dropping with increasing liquidity in the market

Dombusch has suggested that an exchange rate strategy that is viable with only good news in a bad
strategy similarly Jeffrey Frankel says that if volatility is somehow suppressed in the foreign exchange
market, it would simply appear somewhere else. Dis equilibrium view suggests that speculative attacks
are a case of “herd-like behavior”. Speculative attacks can be initiated by a small group of speculators.
The emphasis is on market inefficiencies rather than on policy blunders.

4. CONCLUSIONS AND FINDINGS

A. CHILE STUDY

Conclusions

15
 • The implied tax as calculated from the Chile modelis inversely proportional to the length of stay of
capital in the country. The longer the capital stays in India, the lesser the implied tax rate. For k =
12 months, the implied tax is calculated at 25 to 152 bps for “URR-like” rates of 10%, 12%, 15%
and 18%. For the same “URR-like” rates, for k = 36 months, the implied tax is as low as 8 – 50
bps. This result should be seen in the light of the Tarapore committee which was contemplating
the imposition of a capital control by insisting that 10 % of the foreign capital inflow be deposited
in RBI for a period of one year. For this scenario, the results as calculated above indicate that the
implied tax rate is as follows:

k= 12 24 36 k=12 months k=24 months k=36 months

R α R*α 1-α Ω ( months) T(e) T(e) T(e)
2.32% 0.1 0.00232 0.9 12 0.002577778 0.001288889 0.000859259

• The tax rate is 25.8, 12.89 and 8.6 bps depending on whether the capital stays for 1, 2 or 3 years
in India respectively. India ‘s foreign exchange reserves, as on 29.08.2008, stood at 13.40.417
crores INR. If capital controls in the form of Chile –style URR is imposed now, India stands to
earn 0.15 %( average implied tax as calculated above ) of 13,40,417 crores INR = 2010.62 crores
INR12. However this scenario is applicable only when the rupee appreciated accompanied by a
strong rising market, as in the first three quarters of 2007. Under such a scenario, there is bound
to be a speculative attack on the rupee with massive capital inflows, but will also exit as easily.
This will also widen the current account deficit.

• The situation today is different where the Indian economy has slowed down. The sensex is
trading at 10120 suffering a decline of 511 points since yesterday.13 Inflation is at 10.25% There
is no gain in imposing capital control in the present low growth stage.

B. TURKEY STUDY

Conclusion
The logit model was used to analyze the factors responsible for the crisis in Turkey both in 1994 and 2000
using data from 1988:1 to 2007:12. The results indicate that the significant variables are bank reserves to
bank assets, current account to GDP, domestic credit/GDP and US interest rates. Evidence further
indicates that the signs of the variables are mostly in line with expectations.
Explanation of the significant variables
Bank Reserves to bank assets
This shows the liquidity of the banking system. Adverse macroeconomic shocks are less likely to lead to
crises in countries which have liquid banking systems.
Current account deficit to GDP
A high current account deficit to GDP ratio implies that the host country, Turkey, seems to be expending
more than earning from foreign transactions. In order to pay off the deficit it must borrow large amounts of
capital from the foreign world. This implies a greater reliance on foreign portfolio investment, or rather
capital inflows. Most currency crises as we know have been a direct result of the volatility in capital flows.
Thus, the significance of this variable in explaining the currency crisis can be understood.
Domestic credit to GDP

12
www.rbi.in accessed on 05.11.2008
13
http://economictimes.indiatimes.com/ accessed on 05.11.2008

16
Domestic credit is generally thought of as an indicator of the fragility of the banking system. 14 Domestic
credit rises in the early phase of the banking crisis. As the crisis unfolds the central bank injects money
into banks to improve their liquidity position as is also evident in the crisis that US is facing nowadays.
Thus the importance of this indicator in predicting a currency crisis cannot be ignored.
M2 to foreign exchange reserves
The ratio of M2 to foreign exchange reserves implies to what extent the liabilities of the banking system
are backed by foreign exchange reserves. If the foreign exchange reserves are not enough to cover the
liabilities of the banking system (broad money liabilities) the possibility of a crisis increases.
US interest rates

US interest rates are also shown to be significant by the model. This could be because of the fact that a
lower US interest rate implies higher capital inflows into another country (the source for “hot” money). This
again increases the likelihood of a major crisis.

Reference for Part C:

14
Mete Feridun and Orhan Korhan,2005. Turkish and Argentine Financial crises: A Univariate
Event Study Analysis

17
Harmes Adam.2001.Review of International Political Economy.”Institutional Investors and Polanyi’s
double movement: A model of contemporary currency crisis”

Greenaway David.July 1997.The Economic Journal. Royal Economic Society.”UK Macroeconomic Policy
after Black Wednesday”

Cobham David.July 1997. The Economic Journal. Royal Economic Society. ”The Post-Era Framework for
Monetary Policy in the United Kingdom: Bounded Credibility”

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