4.3.7 Speculative Attacks | Balance of Payments (BOP) Adjustments

I. Theoretical Foundations of Speculative Attacks

Definition and Conceptualization

• Nature and Characteristics of Speculative Attacks
  • Speculative attack refers to a large-scale selling of a country’s currency assets, often leading to forced devaluation or drastic measures by monetary authorities.
  • Primarily occurs when market participants anticipate a currency’s depreciation and take advantage of arbitrage opportunities.
  • Involves actions like short-selling, capital flight, and large-scale withdrawal of deposits from banking institutions.
  • Speculative attacks can be either successful (leading to currency devaluation) or unsuccessful (when government intervention prevents devaluation).
  • Two main forms:
    • Currency-based speculative attacks – Target a nation’s foreign exchange reserves and fixed exchange rate system.
    • Debt-based speculative attacks – Involve speculation against sovereign bonds, leading to rising yields and credit rating downgrades.
  • Examples include the 1992 ERM Crisis, where Britain’s pound was targeted, forcing it out of the European Exchange Rate Mechanism (ERM).
• Distinction Between First-Generation, Second-Generation, and Third-Generation Crisis Models
  • First-Generation Models (Krugman, 1979)
    • Explain speculative attacks as a consequence of fundamental economic weaknesses, such as unsustainable fiscal deficits.
    • When governments monetize deficits, it leads to a depletion of foreign exchange reserves, making currency pegs unsustainable.
    • Example: Latin American debt crises (1980s) where fiscal mismanagement led to forced devaluations.
  • Second-Generation Models (Obstfeld, 1994)
    • Highlight the role of self-fulfilling expectations and government policy trade-offs in speculative attacks.
    • Governments face a dilemma between defending a fixed exchange rate and maintaining economic stability (e.g., controlling unemployment).
    • Example: 1992 European Currency Crisis, where speculative attacks were driven by doubts about central bank commitment.
  • Third-Generation Models (Post-1997)
    • Incorporate financial market imperfections, banking sector fragility, and corporate balance sheet mismatches into crisis dynamics.
    • Show that speculative attacks can originate from private-sector vulnerabilities, such as excessive foreign currency-denominated debt.
    • Example: 1997 Asian Financial Crisis, where currency depreciation led to a banking crisis and corporate bankruptcies.

Classical vs. Modern Views

Rational Expectations and Self-Fulfilling Prophecies

• Impact of Rational Expectations on Speculative Behavior
  • Rational expectations theory (developed by John Muth, 1961, and expanded by Robert Lucas, 1972) asserts that market participants use available information efficiently to form expectations about future policies.
  • When investors anticipate a policy shift (such as devaluation), they act preemptively, triggering the very event they predict.
  • Example: 1994 Mexican Peso Crisis, where investors expected the peso to devalue, leading to a self-reinforcing spiral of capital outflows.
• Coordination Problems and Sunspot Equilibria
  • Coordination failures occur when multiple equilibria exist, and investors must decide whether to speculate based on expectations of others’ behavior.
  • Sunspot equilibria (introduced by Cass and Shell, 1983) explain how extrinsic factors (such as political events or rumors) can trigger speculative attacks even without fundamental weaknesses.
  • Example: 1997 South Korean Crisis, where rumors of banking sector distress led to coordinated speculative attacks.
• Role of Belief Systems in Triggering Crises
  • Market participants often rely on heuristics, narratives, and global risk perceptions, amplifying speculative waves.
  • Belief shifts can be driven by political instability, sudden policy reversals, or shifts in international capital flows.
  • Example: 2023 Pakistan Rupee Crisis, where fears of IMF loan delays led to massive speculation against the currency.

Linkages with Balance of Payments (BOP)

• Speculative Attacks in the Broader Framework of BOP Disequilibria
  • The Balance of Payments (BOP) records all economic transactions between a country and the rest of the world.
  • Persistent current account deficits signal fundamental imbalances, making a currency more vulnerable to speculative attacks.
  • Example: 2013 Indian Rupee Crisis, triggered by widening trade deficits and concerns over external debt sustainability.
• BOP Sustainability and Speculative Pressures
  • A sustainable BOP position implies a country can meet its international obligations without external crises.
  • Indicators of BOP vulnerability:
    • Declining foreign exchange reserves
    • Rising short-term external debt
    • Unsustainable current account deficits (above 5% of GDP is often risky)
  • Example: Argentina’s 2018 Currency Crisis, where dwindling forex reserves triggered market panic.
• Twin Crises Phenomenon
  • Introduced by Kaminsky and Reinhart (1999), the twin crises hypothesis argues that banking crises and currency crises often occur together.
  • Financial sector vulnerabilities, when combined with speculative currency attacks, amplify economic downturns.
  • Example: Thailand’s 1997 Crisis, where currency depreciation triggered a banking sector meltdown.

II. Balance of Payments and Exchange Rate Regimes

Overview of BOP Dynamics

• Definition and Importance of BOP (Balance of Payments)
  • BOP is a systematic record of a country’s economic transactions with the rest of the world over a specific period.
  • It includes transactions in goods, services, capital, and financial transfers, influencing currency stability and economic growth.
  • A surplus in BOP strengthens a currency, while a deficit increases vulnerability to speculative attacks.
  • The Reserve Bank of India (RBI) monitors and manages India’s BOP to ensure macroeconomic stability.
• Components of the BOP and Their Interactions
  • Current Account
    • Records trade balance (exports minus imports), net income from abroad, and transfers such as remittances.
    • A current account deficit (CAD) implies more outflows than inflows, leading to external borrowing or reserve depletion.
    • India’s CAD peaked at 4.8% of GDP in 2012-13, leading to sharp rupee depreciation.
  • Capital Account
    • Records financial transactions like foreign direct investment (FDI), foreign portfolio investment (FPI), external commercial borrowings (ECB), and external assistance.
    • Large capital inflows can cover a CAD but may also lead to external debt accumulation.
  • Financial Account
    • Covers foreign exchange reserves, monetary flows, and financial derivatives.
    • Central banks manage financial accounts through forex interventions and sovereign debt adjustments.
  • Errors and Omissions
    • Adjustments made to balance discrepancies in BOP reporting due to statistical gaps.
• Relationship Between Current Account and Capital Account
  • A current account deficit (CAD) must be financed by capital account surplus, meaning inflows from foreign investment or debt compensate for trade deficits.
  • High reliance on volatile FPI (Foreign Portfolio Investment) inflows for financing CAD makes a country more vulnerable to external shocks.
  • Example: India’s 2013 currency depreciation was triggered by capital outflows after the US Federal Reserve signaled monetary tightening.
• Sustainability of Deficits
  • Persistent CAD above 3-4% of GDP leads to reserve depletion, foreign debt accumulation, and speculative pressures.
  • BOP sustainability depends on foreign exchange reserves, external debt levels, and the stability of capital inflows.
  • India’s forex reserves of over $600 billion (2023) provide a buffer against external shocks.

Exchange Rate Regimes and Vulnerability to Speculative Attacks

• Types of Exchange Rate Regimes
  • Fixed Exchange Rate
    • Currency value is pegged to another currency, basket of currencies, or a commodity like gold.
    • Requires large forex reserves to maintain stability.
    • Example: Bretton Woods System (1944-1971), where major currencies were pegged to the US dollar.
  • Flexible (Floating) Exchange Rate
    • Currency value is determined by market forces of demand and supply.
    • Reduces speculative attacks as exchange rates adjust naturally, preventing reserve depletion.
    • Example: India adopted a market-determined exchange rate in 1993 after abandoning a controlled regime.
  • Managed Float (Dirty Float)
    • A hybrid system where central banks intervene in forex markets to prevent excessive volatility.
    • India follows a managed float regime, where RBI intervenes to stabilize the rupee.
  • Crawling Peg
    • Exchange rate adjusts gradually in response to market trends instead of sharp devaluations.
    • Example: China’s Renminbi (RMB) policy, which follows a managed crawl to maintain trade competitiveness.
• Speculative Pressures Under Different Exchange Rate Regimes

BOP Crises vs. Speculative Attacks

• Distinguishing Between BOP Crises and Speculative Attacks
  • BOP Crisis
    • Results from persistent current account deficits, unsustainable debt, or sharp capital outflows.
    • Typically leads to forced devaluation, reserve depletion, and economic contraction.
  • Speculative Attack
    • Occurs when investors anticipate a currency depreciation and short-sell aggressively.
    • Can be triggered by policy misalignment, weak fundamentals, or self-fulfilling expectations.
• Role of Capital Flows in Precipitating Crises
  • Large capital outflows lead to reserve depletion, forcing central banks to intervene.
  • Sudden stop phenomenon occurs when investor sentiment shifts, causing massive FPI withdrawals.
  • Example: The 1997 Asian Financial Crisis saw massive capital flight from Thailand, Indonesia, and South Korea, triggering economic collapses.

Role of Central Banks in Exchange Rate Management

• Intervention Mechanisms
  • Direct Market Intervention
    • Central banks buy or sell foreign currencies to stabilize exchange rates.
    • RBI uses open market operations (OMOs) to regulate rupee liquidity.
  • Interest Rate Adjustments
    • Raising interest rates attracts capital inflows, strengthening the currency.
    • Example: India’s repo rate hikes in 2013 helped curb rupee depreciation.
• Sterilized vs. Unsterilized Intervention
  • Sterilized Intervention
    • Central bank offsets forex interventions through domestic monetary policy tools to prevent inflationary effects.
    • Example: RBI uses bond sales to absorb excess rupee liquidity when purchasing foreign exchange.
  • Unsterilized Intervention
    • Central bank intervenes in forex markets without offsetting measures, affecting money supply and inflation.
    • Example: Excessive intervention in currency markets can lead to liquidity imbalances and inflationary pressures.
• Forex Reserves as a Buffer Against Speculation
  • Foreign exchange reserves provide stability against currency crises.
  • Countries with higher reserves can defend their exchange rate by selling foreign assets.
  • India’s forex reserves stood at $600 billion in 2023, making it resilient against speculative pressures.

III. First-generation models of speculative attacks

The Krugman Model of Currency Crises

• Assumptions and Framework
  • Developed by Paul Krugman in 1979, the model explains speculative attacks under fixed exchange rate regimes.
  • Based on classical monetary models, it assumes that government fiscal mismanagement leads to reserve depletion.
  • Assumes perfect capital mobility, meaning investors can freely move capital across borders.
  • Speculators act rationally based on available economic information, anticipating the collapse of a currency peg.
  • The model relies on the idea that persistent fiscal deficits lead to money creation, increasing inflation and eroding confidence in the currency.
• Depletion of Reserves and Collapse of Fixed Exchange Rates
  • Central banks maintain a fixed exchange rate by selling foreign reserves to meet demand for foreign currency.
  • When government spending exceeds revenue, authorities print money, increasing domestic inflation and reducing the real value of reserves.
  • A point arrives where foreign exchange reserves fall below a critical threshold, making it impossible to defend the currency.
  • Speculators anticipate this moment and launch an attack, leading to a self-fulfilling crisis.
  • Example: The 1992 European Exchange Rate Mechanism (ERM) crisis, where George Soros led a speculative attack on the British pound, forcing its exit from the ERM.
  • India’s 1991 balance of payments crisis followed a similar pattern, where the RBI’s forex reserves fell to less than $1 billion, leading to a forced rupee devaluation.

Fiscal Deficits and Currency Attacks

• Unsustainable Government Policies and Market Reactions
  • Persistent fiscal deficits, financed by printing money, create inflationary pressures.
  • Governments running high fiscal deficits without sufficient revenues create uncertainty in financial markets.
  • Foreign investors demand higher interest rates on sovereign bonds, increasing the cost of borrowing.
  • Rising fiscal imbalances signal that currency depreciation is inevitable, prompting speculators to attack.
  • Example: Argentina’s 2001 crisis, where excessive government borrowing led to a speculative attack, forcing peso devaluation and default.
• Seigniorage and Inflationary Pressures
  • Seigniorage refers to revenue earned by a government from money printing, which is often used to finance deficits.
  • Excessive reliance on seigniorage erodes confidence in a currency, leading to hyperinflation.
  • Example: Zimbabwe’s hyperinflation in the 2000s, where continuous money printing led to a speculative attack on the Zimbabwean dollar.
  • India follows a strict monetary policy under RBI, avoiding seigniorage-driven inflation despite fiscal deficits.

Role of Speculators

• Arbitrage and Profit Motives
  • Speculators engage in currency arbitrage, taking advantage of price differentials between domestic and foreign currencies.
  • They short-sell the domestic currency if they anticipate devaluation, profiting when the exchange rate collapses.
  • Example: Black Wednesday (1992), where speculators profited by betting against the British pound.
• Impact of Forward Markets on Speculative Dynamics
  • Forward contracts allow traders to bet on future exchange rates, amplifying speculative attacks.
  • If forward market prices indicate a higher probability of devaluation, more traders engage in short-selling.
  • Governments often increase interest rates or impose capital controls to counteract speculative forces.
  • Example: India’s 2008 rupee defense, where the RBI raised interest rates to curb currency speculation.

Extensions and Criticisms

• Incorporation of Real Economy Effects
  • First-generation models do not consider private sector debt, banking stability, or global contagion effects.
  • Real-world crises often involve financial sector instability, leading to deeper recessions.
  • Example: The 1997 Asian Financial Crisis, where currency depreciation triggered corporate bankruptcies and banking collapses.
• Limitations in Explaining All Crisis Episodes
  • The model assumes government policy is the sole driver of speculative attacks, ignoring investor sentiment and self-fulfilling expectations.
  • Modern speculative attacks can occur without large fiscal deficits, driven instead by financial market distortions and panic behavior.
  • Example: The 2008 Global Financial Crisis saw capital flight despite no fundamental fiscal crisis in many economies.
  • India’s 2013 rupee depreciation was influenced by external factors like US Federal Reserve policy changes, rather than domestic fiscal mismanagement.

IV. Second-generation models of speculative attacks

Self-Fulfilling Crisis Theories

• Concept of Self-Fulfilling Speculative Attacks
  • Unlike first-generation models, which emphasize macroeconomic fundamentals as the cause of speculative attacks, second-generation models focus on investor expectations and government responses.
  • A self-fulfilling crisis occurs when investors believe a currency will collapse, leading them to sell off assets, which in turn triggers the very collapse they anticipated.
  • Governments often face a dilemma between defending the currency and preserving economic stability, which can worsen the crisis.
  • Example: The 1992 European Exchange Rate Mechanism (ERM) crisis, where investors expected the British pound to devalue, leading to speculative selling and its forced exit from the ERM.
• Multiple Equilibria and Policy Credibility
  • Second-generation models introduce the idea of multiple equilibria, where a country’s economic state can move between different stable outcomes based on investor perceptions rather than just economic fundamentals.
  • If investors believe the government will defend the currency, they may continue holding it, avoiding a crisis. However, if they doubt the government’s commitment, speculative attacks become inevitable.
  • Policy credibility plays a crucial role. If a government has a history of breaking currency pegs or devaluing, investors will be more likely to speculate against its currency.
  • Example: The 1998 Russian ruble crisis, where a lack of policy credibility led to mass capital flight and a sharp devaluation of the ruble.
• Role of Investor Expectations in Crisis Propagation
  • Market sentiment and herd behavior amplify currency crises, even in countries with relatively stable macroeconomic conditions.
  • Financial contagion effects occur when a speculative attack in one country spills over into others, triggering regional or global currency crises.
  • Example: The 1997 Asian Financial Crisis started in Thailand but quickly spread to Indonesia, Malaysia, South Korea, and the Philippines, as investors feared similar currency collapses.

Obstfeld’s Model of Currency Crises

• Interplay Between Policy Decisions and Market Confidence
  • Maurice Obstfeld (1994) developed a second-generation model explaining how currency crises arise due to the interaction between government policies and market confidence.
  • Governments often face a trade-off between maintaining a fixed exchange rate and supporting domestic economic conditions.
  • If authorities choose to defend a currency peg, they may need to increase interest rates, which can lead to economic contraction, higher unemployment, and social unrest.
  • If they devalue the currency, they can prevent recessionary pressures but at the cost of higher inflation and loss of investor trust.
• Trade-Offs Between Inflation Control and Exchange Rate Stability
  • Inflation control and currency stability are conflicting policy goals in fixed exchange rate regimes.
  • A government trying to defend its currency peg may raise interest rates to attract foreign capital, but this can reduce investment and growth.
  • On the other hand, abandoning the peg allows monetary expansion and inflation control, but it also triggers capital outflows and investor panic.
  • Example: The 1994 Mexican peso crisis, where the government initially defended the peg but eventually allowed a steep devaluation, causing inflation and economic turmoil.

Policy Dilemmas and Political Economy Considerations

• Cost of Defending a Peg vs. Cost of Devaluation
  • Governments must weigh the economic and political costs of maintaining a currency peg versus the costs of devaluation.
  • Defending a currency peg
    • Requires selling foreign reserves to meet rising demand for foreign currency.
    • Raises interest rates, which can cause economic contraction and recession.
    • Drains forex reserves, making long-term sustainability difficult.
  • Cost of devaluation
    • Reduces external debt burden, as local currency depreciates relative to foreign debt.
    • Increases inflation, as import prices rise significantly.
    • Can lead to social unrest if living costs surge.
  • Example: The 2018 Turkish lira crisis, where the government’s reluctance to raise interest rates led to severe devaluation, high inflation, and capital flight.
• Domestic Political Pressures and Speculative Attacks
  • Political factors play a critical role in government decisions during a speculative attack.
  • Governments facing elections may hesitate to raise interest rates, as this can hurt economic growth and employment.
  • Political instability reduces market confidence, making speculative attacks more likely.
  • Example: The 2011 Eurozone crisis, where uncertainty over Greece’s debt restructuring worsened the European financial turmoil.

Empirical Evidence and Policy Failures

• Historical Cases Illustrating Second-Generation Dynamics

• Lessons from Policy Failures
  • Delaying devaluation often worsens the crisis, leading to higher economic costs.
  • Maintaining strong forex reserves provides a buffer against speculative attacks.
  • Political credibility and consistent policies reduce the risk of investor panic.
  • Example: India’s 2013 currency crisis was managed effectively through foreign exchange interventions, interest rate hikes, and macroeconomic adjustments, preventing a full-scale speculative attack.

V. Third-generation models and contagion effects

Financial market imperfections and speculative attacks

• Role of Banking Sector Fragilities
  • Third-generation models of speculative attacks emphasize the role of financial sector weaknesses in currency crises, unlike earlier models that focused on macroeconomic fundamentals or investor expectations.
  • Banking sector fragility arises due to weak regulatory frameworks, excessive risk-taking, and poor credit quality, making financial institutions vulnerable to crises.
  • A banking crisis increases a country’s exposure to speculative attacks as foreign investors withdraw funds due to concerns over financial stability.
  • Example: The 1997 Thai financial crisis began with the collapse of Bangkok Bank of Commerce, which triggered a loss of investor confidence in the Thai economy.
  • India has strengthened banking regulations under the Reserve Bank of India (RBI), particularly after the 2008 global financial crisis, reducing the likelihood of a bank-driven speculative attack.
• Balance Sheet Effects and Currency Mismatches
  • Balance sheet effects refer to the impact of currency depreciation on domestic firms and banks that have foreign-denominated liabilities.
  • If a country borrows heavily in foreign currency, a sharp depreciation increases the burden of repaying foreign debt, leading to insolvencies.
  • Currency mismatches occur when financial institutions have assets in domestic currency but liabilities in foreign currency, making them highly vulnerable to exchange rate fluctuations.
  • Example: The 1998 Russian financial crisis saw Russian banks suffer massive losses due to foreign debt exposure, leading to a sovereign default.
  • India has implemented External Commercial Borrowing (ECB) regulations to prevent excessive foreign-currency debt, ensuring stability against balance sheet effects.

Asian Financial Crisis and Third-Generation Models

• Interconnected Banking Crises and Currency Collapses
  • The 1997 Asian Financial Crisis demonstrated how banking fragility, currency devaluations, and capital flight could reinforce each other, leading to deeper economic crises.
  • Countries such as Thailand, Indonesia, South Korea, and Malaysia faced a dual crisis where both the banking sector and the currency market collapsed simultaneously.
  • Excessive short-term foreign borrowing by banks and corporations increased vulnerability, and when foreign investors pulled out, currencies collapsed.
  • Example: The Thai baht collapse in July 1997 triggered a crisis that spread across Asia, with Indonesia’s rupiah and South Korea’s won depreciating significantly.
• International Financial Flows and Liquidity Constraints
  • Short-term capital inflows such as foreign portfolio investments (FPI) and short-term bank loans created instability in Asian economies, leading to sudden capital outflows.
  • Foreign investors quickly withdrew funds due to concerns over banking sector health, triggering currency collapses.
  • Liquidity constraints meant that central banks had insufficient reserves to stabilize the currency, exacerbating the crisis.
  • The International Monetary Fund (IMF) intervened in several Asian economies, offering financial assistance in exchange for economic reforms.
  • India avoided a full-fledged financial crisis in 1997 due to its relatively closed capital account and cautious approach towards foreign borrowing.

Speculative attacks and emerging market vulnerabilities

• Role of Moral Hazard and Financial Liberalization
  • Moral hazard arises when financial institutions take excessive risks, assuming that the government or international organizations will bail them out.
  • Many Asian economies before 1997 had implicit government guarantees for banks, encouraging reckless lending and speculative investments.
  • Financial liberalization without proper regulation increased speculative borrowing in emerging markets, making them vulnerable to crises.
  • Example: South Korea’s financial sector liberalization in the 1990s led to excessive borrowing from foreign banks, making it highly susceptible to capital outflows.
• Impact of Global Capital Mobility
  • Unrestricted capital flows expose emerging markets to speculative attacks, as investors can move funds rapidly based on global sentiment.
  • Carry trade strategies, where investors borrow in low-interest currencies (like the Japanese yen) and invest in high-yielding emerging market assets, amplify vulnerabilities.
  • A sudden increase in global interest rates or financial instability can lead to large-scale capital flight, triggering currency crises.
  • Example: India’s 2013 rupee depreciation was triggered by the US Federal Reserve’s decision to taper quantitative easing, leading to capital outflows from emerging markets.

Contagion vs. Independent Crises

• Cross-Country Crisis Transmission Mechanisms
  • Financial contagion occurs when a crisis in one country spreads to others due to investor panic and interconnected financial systems.
  • Trade linkages contribute to contagion, as countries heavily dependent on exports to crisis-hit nations suffer economic downturns.
  • Financial spillovers occur when global banks and hedge funds reduce exposure to multiple emerging markets following a crisis in one country.
  • Example: The 2008 Global Financial Crisis, which began in the United States, led to massive capital outflows from emerging markets, affecting India, Brazil, and South Africa.
• Distinction Between Trade Linkages, Financial Spillovers, and Investor Panic
  • Trade linkages affect countries dependent on exports, causing economic distress when key trading partners face a crisis.
  • Financial spillovers occur when global investment firms withdraw funds from multiple markets due to rising global risks.
  • Investor panic leads to self-fulfilling currency crises, where speculation causes sudden capital flight.
  • Example: The 2011 Eurozone debt crisis, where panic over Greece’s default risk spread to Spain, Italy, and Portugal, worsening their debt problems.

VI. Speculative attacks in floating vs. pegged exchange rate systems

Fixed exchange rates and the risk of speculative attacks

• Credibility Issues
  • A fixed exchange rate regime requires a government to maintain a predetermined exchange rate against another currency or a basket of currencies.
  • The success of a fixed exchange rate depends on investor confidence in the government’s ability to maintain the peg.
  • If investors doubt the credibility of the central bank’s commitment, they may engage in speculative attacks, forcing devaluation.
  • Example: The 1992 European Exchange Rate Mechanism (ERM) crisis, where investors lost confidence in the British pound, leading to massive short-selling and its forced exit from the ERM.
  • India abandoned its fixed exchange rate system in 1993, moving to a market-determined exchange rate to reduce vulnerability.
• Reserves and Interest Rate Defenses
  • To defend a fixed exchange rate, a central bank must hold sufficient foreign exchange reserves to intervene in currency markets.
  • If reserves are insufficient, raising interest rates is another defense mechanism to attract capital inflows and prevent depreciation.
  • High interest rates, however, can slow economic growth and increase debt servicing costs.
  • Example: The 1997 Thai baht crisis, where Thailand spent over $23 billion in reserves defending its peg before devaluation became inevitable.
• Real vs. Nominal Pegs
  • Nominal pegs fix the exchange rate at a constant level against another currency but do not adjust for inflation.
  • Real pegs adjust for inflation differentials, ensuring price competitiveness in international trade.
  • Countries with nominal pegs often struggle with overvaluation, making their exports less competitive and leading to balance of payments crises.
  • Example: Argentina’s 2001 crisis, where the Argentine peso was nominally pegged to the US dollar but became overvalued, leading to a severe recession and sovereign debt default.

Floating exchange rates and speculative volatility

• Managed Floats and Speculative Interventions
  • A floating exchange rate regime allows currency values to be determined by market forces of demand and supply.
  • However, most governments adopt a managed float system, where the central bank intervenes periodically to prevent excessive volatility.
  • Speculative attacks in floating exchange rate systems often target interest rate-sensitive capital flows rather than currency pegs.
  • Example: India follows a managed float system, where the Reserve Bank of India (RBI) intervenes in forex markets to curb excessive volatility in the rupee’s value.
  • Speculators often engage in carry trade strategies, borrowing in low-interest-rate currencies and investing in high-yielding assets, creating instability.
• Case of Free-Floating Currencies
  • A fully free-floating currency experiences greater short-term volatility but is less prone to speculative attacks since its value adjusts automatically to market conditions.
  • Advantages:
    • Eliminates the need for large foreign exchange reserves.
    • Reduces the risk of reserve depletion due to speculative attacks.
    • Provides greater monetary policy independence.
  • Disadvantages:
    • Increases exchange rate volatility, affecting trade and investment decisions.
    • Requires strong macroeconomic policies to prevent excessive fluctuations.
  • Example: The US dollar, euro, and Japanese yen are fully floating currencies, but central banks occasionally intervene to stabilize them.

Currency boards and dollarization as defenses

• Impact on Crisis Vulnerability
  • A currency board system is a strict form of a fixed exchange rate regime where the central bank backs the domestic currency fully with foreign reserves.
  • Unlike conventional pegs, currency boards do not allow discretionary monetary policy, making them highly rigid.
  • Advantages:
    • Ensures stronger exchange rate stability.
    • Prevents excessive money printing, reducing inflation risks.
  • Disadvantages:
    • Limits monetary policy flexibility in responding to economic shocks.
    • Makes economies highly dependent on external capital flows.
  • Example: Hong Kong maintains a currency board linking the Hong Kong dollar to the US dollar, making it resistant to speculative attacks.
• Examples from Hong Kong and Argentina
  • Hong Kong (1998 Crisis):
    • Maintained its currency board despite heavy speculative pressures during the Asian Financial Crisis.
    • Interest rates were raised sharply, increasing borrowing costs but successfully defending the peg.
  • Argentina (2001 Crisis):
    • Adopted a currency board in 1991, linking the Argentine peso to the US dollar.
    • Faced severe economic stagnation and loss of competitiveness due to overvaluation.
    • Eventually abandoned the currency board, leading to devaluation and a debt default.

Role of international institutions

• IMF’s Role in Preventing and Mitigating Speculative Attacks
  • The International Monetary Fund (IMF), founded in 1944, plays a key role in providing financial assistance to countries facing speculative attacks and currency crises.
  • Primary roles include:
    • Offering short-term financial assistance through bailout packages to stabilize currency markets.
    • Imposing structural adjustment programs (SAPs) requiring fiscal and monetary reforms.
    • Providing technical assistance on exchange rate policies and financial regulations.
  • Example: The IMF played a crucial role in managing the 1997 Asian Financial Crisis, offering bailout packages to Thailand, Indonesia, and South Korea.
• Coordination of Global Liquidity Support
  • The IMF, World Bank (founded in 1944), and central banks coordinate liquidity measures to prevent global financial contagion.
  • Swap agreements between central banks help stabilize currency markets during speculative attacks.
  • Example: The US Federal Reserve’s dollar swap arrangements during the 2008 Global Financial Crisis helped stabilize global liquidity.
  • India’s foreign exchange reserves of over $600 billion in 2023 provide a strong buffer against speculative pressures, reducing reliance on external liquidity support.

VII. Role of capital mobility and financial liberalization

Capital account liberalization and crisis vulnerability

• Impact of Capital Inflows and Sudden Stops
  • Capital account liberalization refers to the removal of restrictions on cross-border financial transactions, allowing free movement of capital.
  • Increased capital inflows lead to higher foreign investments, improved liquidity, and economic expansion, but also create risks of sudden reversals.
  • Sudden stops occur when foreign investors withdraw capital rapidly, leading to currency depreciation, financial instability, and economic slowdowns.
  • Example: The 1997 Asian Financial Crisis saw massive capital outflows from Thailand, Indonesia, and South Korea, resulting in currency collapses and banking sector crises.
  • India follows a partial capital account convertibility framework under the RBI, allowing controlled foreign investment while limiting short-term speculative flows.
• Financial Deregulation and Instability Risks
  • Deregulation of financial markets increases access to capital but also raises systemic risk, asset price bubbles, and financial volatility.
  • Unregulated financial markets encourage excessive foreign borrowing, creating exposure to currency mismatches and financial crises.
  • Example: The 2008 Global Financial Crisis originated due to unregulated financial instruments like subprime mortgage-backed securities, leading to global liquidity shocks.
  • India follows stringent financial sector regulations under the Securities and Exchange Board of India (SEBI) and RBI, reducing risks from excessive financial deregulation.

Short-term capital flows and speculative attacks

• Role of Carry Trades and Herd Behavior
  • Carry trade strategy involves borrowing in low-interest-rate currencies and investing in high-yielding assets in emerging markets.
  • Carry trades increase short-term capital inflows, making economies vulnerable to sudden reversals if global interest rates change.
  • Example: The 2013 Indian Rupee crisis was triggered by capital outflows following the US Federal Reserve’s decision to taper quantitative easing, leading to rapid rupee depreciation.
  • Herd behavior amplifies financial instability, where investors follow market trends rather than fundamental analysis, leading to mass capital movements.
  • Speculative attacks often coincide with herd behavior, as investors panic and exit markets simultaneously.
• Implications of Hot Money Flows
  • Hot money flows refer to volatile capital movements that enter and exit economies quickly, primarily through foreign portfolio investments (FPI).
  • While hot money inflows boost stock markets and currency values, sudden outflows cause sharp devaluations and financial instability.
  • Example: The 1998 Russian crisis saw hot money outflows after confidence in the ruble collapsed, leading to currency devaluation and debt default.
  • India imposes sectoral restrictions on FPI investments to control the impact of hot money flows on financial stability.

Benefits vs. risks of financial globalization

Capital flight and policy responses

• Macroprudential Tools and Capital Controls
  • Macroprudential tools are financial regulations designed to prevent excessive risk-taking and systemic financial instability.
  • Key macroprudential measures include:
    • Limits on foreign-currency borrowing to reduce currency mismatch risks.
    • Capital reserve requirements for banks to ensure liquidity buffers.
    • Flexible exchange rate policies to absorb external shocks.
  • Capital controls involve restrictions on cross-border financial transactions to prevent excessive capital flight.
  • India implements selective capital controls under RBI, such as limits on FPI withdrawals during market volatility to prevent financial instability.
• Empirical Cases of Successful and Failed Restrictions
  • Successful Case: Chile (1990s)
    • Imposed unremunerated reserve requirements (URR) on short-term foreign investments to discourage speculative inflows.
    • Maintained macroeconomic stability while attracting long-term investments.
  • Failed Case: Argentina (2001)
    • Imposed strict capital controls following a currency crisis and banking sector collapse.
    • Led to investor panic and prolonged economic contraction.
  • India follows a balanced approach to capital controls, allowing long-term foreign investment while restricting speculative short-term flows.

VIII. Policy responses and crisis management

Interest rate defense strategies

• Effectiveness of High Interest Rates in Deterring Speculative Attacks
  • Central banks use interest rate hikes to attract foreign capital inflows and strengthen currency value.
  • Higher interest rates increase the returns on domestic assets, making them more attractive to investors.
  • A strong interest rate defense signals monetary discipline, discouraging speculators from attacking the currency.
  • Example: During the 1997 Asian Financial Crisis, Indonesia, Thailand, and South Korea sharply increased interest rates to defend their currencies against speculative attacks.
  • India’s RBI raised interest rates in 2013 to stabilize the rupee amid capital outflows triggered by the US Federal Reserve’s policy changes.
• Trade-offs Between Growth and Stability
  • Higher interest rates reduce inflationary pressures but slow down economic growth.
  • Cost of borrowing rises, discouraging businesses from taking loans for investment and expansion.
  • Households face higher loan repayment costs, reducing consumption and demand.
  • Prolonged high interest rates can push economies into recession, worsening unemployment and reducing tax revenues.
  • Example: Brazil in 1998 adopted aggressive interest rate hikes to counter a speculative attack, leading to a sharp economic slowdown.
  • India follows a balanced interest rate policy under the RBI’s Monetary Policy Committee (MPC), adjusting rates based on inflation and growth needs.

Capital controls and macroeconomic stability

• Tobin Tax and Transaction Taxes
  • Tobin tax, introduced by economist James Tobin, is a levy on short-term foreign exchange transactions to curb speculative currency trading.
  • It discourages high-frequency trading and rapid capital movements, reducing exchange rate volatility.
  • Example: France imposed a financial transaction tax in 2012 to limit speculative trading.
  • India applies securities transaction taxes (STT) on equity trading to regulate market speculation and volatility.
• Case Studies of Capital Account Restrictions

Currency devaluation vs. defending the peg

• Conditions Favoring Each Approach
  • Currency devaluation is preferred when reserves are insufficient to defend the exchange rate.
  • Defending the peg is suitable if the country has adequate foreign exchange reserves and strong investor confidence.
  • Countries with high external debt may avoid devaluation, as it increases the domestic burden of foreign loans.
  • Export-driven economies often prefer devaluation, as it makes exports more competitive.
  • Example: China has periodically adjusted the renminbi’s value to maintain trade competitiveness.
• Consequences of Delayed Devaluations
  • Delaying devaluation can lead to prolonged speculative attacks, forcing a sharper and more painful correction later.
  • Forex reserves can be depleted rapidly if the central bank intervenes excessively to maintain an artificial exchange rate.
  • Sharp devaluations can cause inflation surges, increasing import costs and reducing purchasing power.
  • Example: Argentina’s delayed devaluation in 2001 worsened its economic collapse, leading to a severe recession and debt default.

IMF and international financial institutions’ role

• Conditional Lending and Structural Reforms
  • The International Monetary Fund (IMF), founded in 1944, provides emergency financial assistance to countries facing currency crises.
  • IMF loans come with policy conditions, requiring structural adjustments such as fiscal austerity, deregulation, and trade liberalization.
  • Example: The IMF’s bailout of South Korea in 1997 required banking sector reforms, trade liberalization, and monetary tightening.
  • India has sought IMF assistance in the past, notably in 1991, when it implemented economic liberalization measures as part of an IMF-backed reform package.
• Criticisms of IMF-Led Stabilization Programs
  • IMF-imposed austerity measures often lead to economic contractions, increasing unemployment and social unrest.
  • Structural reforms may benefit foreign investors while burdening domestic industries and workers.
  • Example: Greece’s 2010 debt crisis bailout resulted in severe public sector cuts, triggering widespread protests.
  • Many countries, including India, prefer self-reliant crisis management using foreign exchange reserves rather than relying on IMF assistance.

IX. Case studies of speculative attacks

The 1992 ERM crisis

• George Soros and the Bank of England
  • The 1992 European Exchange Rate Mechanism (ERM) crisis exposed weaknesses in the United Kingdom’s monetary policy and its ability to maintain a fixed exchange rate.
  • George Soros, a hedge fund manager, led one of the largest speculative attacks in history, short-selling the British pound heavily.
  • The Bank of England attempted to defend the pound by raising interest rates from 10% to 15% in a single day and using foreign exchange reserves to buy sterling.
  • Despite intervention, market confidence collapsed, forcing the UK government to withdraw the pound from the ERM on September 16, 1992, known as Black Wednesday.
  • Soros reportedly profited over $1 billion from the attack, demonstrating the power of speculative forces in currency markets.
• Weaknesses in European Monetary Coordination
  • The ERM was designed to maintain exchange rate stability among European nations in preparation for the euro.
  • However, economic conditions across member countries varied significantly, making it difficult to sustain a single exchange rate policy.
  • The UK had high inflation and weak economic growth, while Germany, led by the Bundesbank, maintained strict monetary policies.
  • Speculators targeted the pound, betting that the Bank of England lacked the reserves and economic strength to maintain its peg.
  • The crisis exposed flaws in the ERM’s rigidity and lack of fiscal harmonization, eventually leading to the establishment of the Eurozone in 1999.

The 1997 Asian financial crisis

• Speculative Attacks on Thai Baht
  • The 1997 Asian financial crisis began in Thailand when speculators targeted the Thai baht, leading to a sharp devaluation and financial contagion across Asia.
  • Thailand had a fixed exchange rate system and relied heavily on short-term foreign debt, making it vulnerable to external shocks.
  • In May 1997, hedge funds and institutional investors began short-selling the baht, anticipating that Thailand lacked sufficient foreign reserves to defend the currency peg.
  • The Thai government exhausted over $27 billion in reserves, but speculative pressure continued, forcing Thailand to abandon the peg and float the baht on July 2, 1997.
  • The baht lost more than 50% of its value, triggering financial distress in Indonesia, Malaysia, South Korea, and the Philippines.
• Regional Contagion and IMF Responses
  • The crisis spread across Asia as investors lost confidence in emerging market currencies, leading to capital flight and financial sector collapses.
  • Indonesia’s rupiah, South Korea’s won, and Malaysia’s ringgit faced severe depreciation, worsening banking crises in these economies.
  • The International Monetary Fund (IMF) intervened, providing bailout packages to Thailand ($17.2 billion), Indonesia ($43 billion), and South Korea ($57 billion).
  • IMF programs required strict austerity measures, including government spending cuts, higher interest rates, and financial sector reforms.
  • Critics argued that IMF-imposed austerity deepened the economic downturn, worsening unemployment and social unrest.

The 1998 Russian crisis

• Ruble Collapse and Sovereign Default
  • The 1998 Russian financial crisis was triggered by a combination of declining oil prices, fiscal deficits, and speculative attacks on the ruble.
  • Russia maintained a quasi-fixed exchange rate system, making it vulnerable to capital flight.
  • By mid-1998, investors doubted the government’s ability to sustain the ruble peg, leading to speculative selling and capital outflows.
  • In August 1998, Russia devalued the ruble, defaulted on $40 billion of domestic debt, and declared a moratorium on foreign debt repayments.
  • The crisis led to inflation surges, banking collapses, and a sharp decline in investor confidence.
• Role of External Debt
  • Russia’s dependence on short-term external borrowing created financial instability.
  • As global oil prices collapsed in 1998, government revenues declined, limiting Russia’s ability to service its external debt.
  • Foreign investors, fearing default, dumped Russian government bonds (GKOs), triggering capital flight.
  • The International Monetary Fund (IMF) provided emergency loans, but policy mismanagement worsened the crisis.
  • The ruble’s collapse led to sharp inflation, eroding savings and pushing millions into poverty.

The 2018 Turkish lira crisis

• Capital Flow Reversals and Political Risk
  • The 2018 Turkish lira crisis resulted from excessive foreign borrowing, rising inflation, and deteriorating investor confidence.
  • The Turkish government, led by President Recep Tayyip Erdoğan, pursued expansionary fiscal policies and resisted interest rate hikes.
  • Foreign investors, concerned about Turkey’s large current account deficit and external debt, began withdrawing capital.
  • The Turkish lira lost nearly 40% of its value in 2018, increasing the cost of servicing foreign debt.
  • A diplomatic standoff between Turkey and the United States, along with U.S. sanctions, further worsened investor sentiment.
• Lessons for Emerging Markets
  • Turkey’s reliance on external debt made it highly vulnerable to capital flight, highlighting the risks of financial liberalization without strong regulatory frameworks.
  • Delayed monetary policy responses exacerbated inflation, eroded real incomes, and weakened financial stability.
  • Example: The RBI’s timely intervention in 2013 helped India avoid a similar currency crisis by raising interest rates and stabilizing capital flows.
  • The crisis underscored the importance of maintaining strong foreign exchange reserves and adopting sound macroeconomic policies to prevent speculative attacks.

X. Speculative attacks on asset markets and cryptocurrencies

Stock market speculation and bubbles

• Rational vs. Irrational Exuberance
  • Stock market speculation occurs when investors buy assets based on expected price increases rather than intrinsic value.
  • Rational speculation is driven by economic fundamentals, such as earnings growth, macroeconomic stability, and monetary policies.
  • Irrational exuberance, a term popularized by Alan Greenspan in 1996, describes excessive investor optimism that inflates asset prices beyond sustainable levels.
  • Example: The dot-com bubble (1995-2000) saw tech stocks soar due to speculative buying, despite weak financials, leading to a major market crash in 2000.
  • In India, the 1992 Harshad Mehta scam artificially inflated stock prices through fraudulent financial activities, causing market instability when uncovered.
• Linkages Between Stock Crashes and Currency Attacks
  • A stock market crash can trigger capital outflows, leading to currency depreciation and potential speculative attacks.
  • Foreign investors often liquidate assets in developing economies during financial crises, causing sharp exchange rate fluctuations.
  • Example: The 2008 Global Financial Crisis led to massive capital outflows from emerging markets, including India, causing the rupee to depreciate sharply.
  • Central banks intervene through monetary policies, interest rate hikes, or forex interventions to stabilize markets and prevent currency collapses.

Real estate market and speculative booms

• Housing Price Bubbles
  • A real estate bubble occurs when housing prices rise significantly due to speculation, easy credit, and high demand rather than actual supply constraints.
  • Speculative investors enter the market expecting continuous price appreciation, inflating asset values.
  • Example: The 2008 US housing bubble, fueled by subprime mortgage lending, collapsed, triggering the global financial crisis.
  • India’s real estate market saw rapid appreciation between 2005 and 2010, driven by low-interest home loans and foreign direct investment (FDI) inflows.
• Debt-Fueled Speculation
  • Excessive borrowing to finance real estate purchases increases systemic risk, as rising interest rates or economic downturns lead to loan defaults.
  • Banks and non-banking financial companies (NBFCs) are exposed to mortgage defaults, amplifying financial instability.
  • Example: The 2018 Infrastructure Leasing & Financial Services (IL&FS) crisis in India highlighted risks associated with overleveraged real estate investments.

Cryptocurrencies and digital currency attacks

• Speculative Price Swings
  • Cryptocurrencies like Bitcoin, Ethereum, and Dogecoin are highly speculative assets with extreme price volatility.
  • Speculative trading, fueled by social media trends and institutional investments, leads to sudden price fluctuations.
  • Example: The 2021 Bitcoin crash saw prices drop from $64,000 to $30,000 within weeks due to regulatory crackdowns and speculative liquidations.
  • Lack of government backing makes cryptocurrencies vulnerable to speculative bubbles and market panics.
• Risk of Stablecoin Depegging
  • Stablecoins like Tether (USDT) and USD Coin (USDC) are pegged to fiat currencies but remain vulnerable to speculative attacks.
  • Depegging occurs when investors lose confidence in a stablecoin’s reserves, triggering mass withdrawals and liquidity crises.
  • Example: The 2022 TerraUSD (UST) crash saw the stablecoin lose its dollar peg, wiping out over $40 billion in market value.
  • Regulators worldwide, including the Reserve Bank of India (RBI), have raised concerns over the financial stability risks posed by unregulated stablecoins.

Financial derivatives and speculation

• Role of Options and Futures in Market Volatility
  • Financial derivatives such as options and futures allow investors to speculate on asset price movements with leverage.
  • High derivative trading volumes increase market volatility, as leveraged positions amplify gains and losses.
  • Example: The 2008 financial crisis was exacerbated by excessive speculation in mortgage-backed securities (MBS) and credit default swaps (CDS).
  • India’s National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) regulate derivatives trading to prevent excessive speculation.

XI. Preventing and mitigating speculative attacks

Strengthening forex reserves and liquidity buffers

• Adequacy Measures and Global Best Practices
  • Foreign exchange reserves act as a financial shield against speculative attacks, capital outflows, and currency volatility.
  • The Reserve Bank of India (RBI) maintains over $600 billion in forex reserves as of 2023, ensuring macroeconomic stability.
  • The IMF recommends countries hold reserves sufficient to cover at least three months of imports to mitigate balance of payments crises.
  • Global best practices for reserve adequacy include:
    • Diversifying reserve holdings across multiple currencies, including the US dollar, euro, and gold.
    • Maintaining a high proportion of reserves in liquid assets to enable rapid intervention in forex markets.
    • Using swap agreements with other central banks to strengthen liquidity buffers.
  • Example: The People’s Bank of China holds the world’s largest forex reserves, exceeding $3.2 trillion, helping defend the yuan from speculative pressures.

Policy coordination and crisis prevention

• Role of G20 and Global Financial Safety Nets
  • The G20, established in 1999, coordinates global economic policies to enhance financial stability and mitigate speculative crises.
  • Key roles of the G20 in crisis prevention include:
    • Promoting policy consistency among major economies to prevent speculative spillovers.
    • Developing financial safety nets, such as central bank swap lines, to support liquidity in times of distress.
    • Encouraging prudential macroeconomic policies to prevent excessive debt accumulation.
  • The International Monetary Fund (IMF), founded in 1944, plays a crucial role in providing short-term liquidity assistance to crisis-hit economies.
  • Example: The IMF’s Flexible Credit Line (FCL) and Precautionary Liquidity Line (PLL) provide preemptive financial support to economies vulnerable to speculative attacks.

Macroprudential regulation and early warning systems

• Indicators of Crisis Vulnerability
  • Early detection of macroeconomic imbalances helps prevent full-scale speculative attacks and financial crises.
  • Common indicators of crisis vulnerability include:
    • Widening current account deficits, signaling external sector weaknesses.
    • Rapid foreign debt accumulation, increasing repayment risks.
    • Excessive exchange rate volatility, indicating market instability.
    • Sharp declines in forex reserves, reflecting unsustainable intervention policies.
  • Example: The 2013 Indian rupee crisis was triggered by widening current account deficits and capital flight following US Federal Reserve policy changes.
• Stress-Testing Financial Systems
  • Regulators conduct stress tests to assess the resilience of banks and financial institutions against economic shocks.
  • Stress-testing involves simulating adverse scenarios, such as:
    • Sharp currency depreciation and its impact on external debt repayments.
    • Sudden interest rate hikes and their effect on banking liquidity.
    • Massive capital outflows and their consequences for market stability.
  • The RBI regularly conducts macroeconomic stress tests to ensure financial sector resilience and mitigate crisis risks.

Proactive vs. reactive policy approaches

XII. Future of speculative attacks in a digital economy

Algorithmic trading and market speculation

• High-Frequency Trading and Flash Crashes
  • Algorithmic trading refers to automated trading strategies executed at high speeds using pre-programmed rules and real-time market data.
  • High-frequency trading (HFT) involves executing thousands of trades per second to capitalize on minuscule price differences.
  • HFT strategies create extreme market volatility, as seen in “flash crashes,” where asset prices collapse within minutes before recovering.
  • Example: The 2010 Flash Crash saw the Dow Jones Industrial Average lose nearly 1,000 points within minutes due to algorithm-driven trading.
  • Regulators, including the Securities and Exchange Board of India (SEBI), monitor HFT to prevent excessive speculation and systemic risks.
• Implications for Financial Stability
  • Algorithmic trading increases market liquidity but also amplifies price distortions during crises.
  • Flash crashes can trigger panic selling, leading to unintended speculative attacks on assets and currencies.
  • Central banks may struggle to respond to digital speculative pressures, as interventions require speed beyond human capability.
  • Example: The 2021 meme stock frenzy, led by retail traders using online platforms, showed how digital speculation can disrupt traditional financial markets.

Central bank digital currencies (CBDCs) and crisis management

• Potential Role in Preventing Speculative Attacks
  • Central Bank Digital Currencies (CBDCs) are state-backed digital currencies designed to modernize monetary systems and enhance financial inclusion.
  • CBDCs offer real-time transaction monitoring, allowing central banks to detect speculative activities before they escalate.
  • Digital currencies can be programmed to prevent excessive capital outflows during speculative attacks.
  • Example: The People’s Bank of China launched the digital yuan in 2020, aiming to counteract private cryptocurrency speculation and stabilize the financial system.
• Risks of Digital Runs on Currency
  • Digital bank runs can accelerate during financial crises, as depositors move funds instantly from banks to safer digital assets.
  • CBDCs may reduce traditional bank deposits, weakening banks’ ability to lend and affecting financial stability.
  • Example: India’s pilot project for the digital rupee under the Reserve Bank of India aims to assess the impact of CBDCs on banking sector liquidity.

Impact of geopolitical tensions on financial speculation

• Trade Wars, Sanctions, and Their Effects on Currency Markets
  • Geopolitical conflicts, economic sanctions, and trade wars influence currency markets by altering capital flows and investment risks.
  • Sanctions against countries reduce investor confidence, leading to speculative short-selling of affected currencies.
  • Example: The 2014 Russian ruble crisis was exacerbated by Western sanctions following geopolitical conflicts, leading to massive currency depreciation.
  • Trade wars, such as the US-China tariff dispute, create uncertainty, prompting currency fluctuations and capital flight.

Evolution of speculative attacks

1. Examine the role of investor expectations in triggering speculative attacks and discuss how self-fulfilling prophecies contribute to currency crises in emerging markets. (250 words)
2. Compare and contrast first-generation and second-generation models of speculative attacks, highlighting their assumptions, mechanisms, and limitations in explaining real-world currency crises. (250 words)
3. Assess the effectiveness of interest rate defenses and capital controls in preventing speculative attacks. Discuss their advantages, limitations, and unintended consequences in crisis management. (250 words)