Gauging the crisis potential
In the two years preceding the adoption of the common currency, the exchange rate will be linked to the euro and the band of fluctuations will be reduced to ±15 percent within the determined parity. This could bring about some dangers, especially those of speculative attacks on the złoty that could lead to a currency crisis. But how real are the dangers?
The roots of past currency crises have been twofold: planned attacks from investing profiteers, and exchange-rate breakdowns resulting from macro- and micro-economic problems. It seems the real danger comes from the latter group.
Poland will enter the new exchange rate mechanism (ERM2) as a still emerging market. This combination creates the potential for a currency crisis. But speculative attacks on participating currencies are currently improbable, so at least this factor should not enter into the equation.
The ERM history does, however, show that uncertainty in the markets increases the risk of a crisis, as in 1992. When Germany's Bundesbank increased interest rates, other countries followed suit in fear of a steep depreciation of their national currencies. As individual economic systems varied, as did approaches to economic policy, problems predictably followed.
The British pound, the chief target of speculative attacks, is a case in point. It collapsed under the weight of unfavorable circumstances: very high short-term interest rates (15 percent), large amounts of company debt at variable interest, an unfavorable social atmosphere, and general knowledge about the amount held by the central bank reserve to keep the pound within the permitted fluctuation band, which amounted to only around $14 billion (zł.53.1 billion). Compare this to the $30 billion (zł.113.8 million) reserves held by the Polish National Bank (NBP).
But the UK's economic structure alone was not the cause of speculative attacks. Investors were in a comfortable situation. They knew in advance the levels at which the central bank would start to intervene. They also knew, approximately at least, the resources at the bank's disposal. Furthermore, they had on their side surprise and uncertainty on the market. The later widening of the permitted fluctuations band to ±15 percent confirmed that the system was imperfect to start with. The situation of the złoty after entering ERM2 should be seen in this light.
Speculative attacks require preparation with particular attention to the time factor. For example, the George Soros Quantum fund is purported to have prepared a L15 billion (zł.104.4 billion) credit line prior to their attack on the pound. Such an attack must induce panic in order to have the intended effect, as large amounts of money alone are not enough. Other factors, mostly macroeconomic, are also required to increase, or at least sustain, panic. Market expectations also play a vital role.
The next two factors to consider are foreign debt and problems with public finance reform. According to the NBP, the current foreign debt of the economy, excluding the banking sector, amounts to approximately E39 billion (zł.178.4 billion), while the public sector foreign debt amounts to more than E35 billion (zł.160.1 billion). It should be remembered that fears about foreign debt by banks and companies were among the main reasons for the crisis in South and East Asia.
It should also be highlighted that the relatively wide 30 percent fluctuation band can also be used to produce high fluctuations in exchange rates. The situation of Hungary's forint market is a good example. When the central bank widened the permitted fluctuation band, the market "tested" at the low line for a few months.
The 30 percent band also allows the central bank more time for preparations. Costs of speculative attacks are also higher in such situations. It can be assumed that possible attacks on Polish currency will not be aimed at breaking the adopted band, thus forcing an NBP intervention, but rather will focus on shaking the market and generating high profits for speculative investors. The wider fluctuation band seems too ideal for such action.
As past złoty fluctuations show, the currency has so far resisted strong speculative attacks, despite circumstances that could favor such attacks. This can be largely credited to central bank policy. The floating exchange rate as well as the firm commitment to refrain from intervening on the market act as deterrents to large-scale speculative attacks. The potential high costs and highly uncertain success, not high levels of currency reserves, discourage profiteers. This is crucial, as enthusiasts for NBP intervention have long argued against leaving the exchange rate to market forces alone.
ERM2 membership will certainly make such a policy difficult to sustain, and the moment of Eurozone accession, which some analysts set as early as 2005/6, will be the time to observe the effects of the policy. Therefore, a more realistic date might be two years later.
In conclusion, the main dangers will not be linked with entering the ERM2, which can be expected to happen within the next four years. And the danger from speculative investors is moderate or even small. Rather the main worry is a currency crisis sparked by a public finances crisis, especially as the increasing public debt threatens a constitutional crisis.
If no public finance reform is in place by the time the country enters into the ERM2, then the event could coincide with a major budgetary crisis. This would have disastrous consequences for the currency, which will be even more severe as Poland would not be able to fall on the "credit" pillow used in the 1990s. It is also worth remembering that the system will not change the situation of Polish companies, as it will not eliminate the exchange rate risk they are exposed to. Under unfavorable circumstances, the risk could be even greater.
Krzysztof Dziura Analyst for Capital Management Poland www.forex.pl
The roots of past currency crises have been twofold: planned attacks from investing profiteers, and exchange-rate breakdowns resulting from macro- and micro-economic problems. It seems the real danger comes from the latter group.
Poland will enter the new exchange rate mechanism (ERM2) as a still emerging market. This combination creates the potential for a currency crisis. But speculative attacks on participating currencies are currently improbable, so at least this factor should not enter into the equation.
The ERM history does, however, show that uncertainty in the markets increases the risk of a crisis, as in 1992. When Germany's Bundesbank increased interest rates, other countries followed suit in fear of a steep depreciation of their national currencies. As individual economic systems varied, as did approaches to economic policy, problems predictably followed.
The British pound, the chief target of speculative attacks, is a case in point. It collapsed under the weight of unfavorable circumstances: very high short-term interest rates (15 percent), large amounts of company debt at variable interest, an unfavorable social atmosphere, and general knowledge about the amount held by the central bank reserve to keep the pound within the permitted fluctuation band, which amounted to only around $14 billion (zł.53.1 billion). Compare this to the $30 billion (zł.113.8 million) reserves held by the Polish National Bank (NBP).
But the UK's economic structure alone was not the cause of speculative attacks. Investors were in a comfortable situation. They knew in advance the levels at which the central bank would start to intervene. They also knew, approximately at least, the resources at the bank's disposal. Furthermore, they had on their side surprise and uncertainty on the market. The later widening of the permitted fluctuations band to ±15 percent confirmed that the system was imperfect to start with. The situation of the złoty after entering ERM2 should be seen in this light.
Speculative attacks require preparation with particular attention to the time factor. For example, the George Soros Quantum fund is purported to have prepared a L15 billion (zł.104.4 billion) credit line prior to their attack on the pound. Such an attack must induce panic in order to have the intended effect, as large amounts of money alone are not enough. Other factors, mostly macroeconomic, are also required to increase, or at least sustain, panic. Market expectations also play a vital role.
The next two factors to consider are foreign debt and problems with public finance reform. According to the NBP, the current foreign debt of the economy, excluding the banking sector, amounts to approximately E39 billion (zł.178.4 billion), while the public sector foreign debt amounts to more than E35 billion (zł.160.1 billion). It should be remembered that fears about foreign debt by banks and companies were among the main reasons for the crisis in South and East Asia.
It should also be highlighted that the relatively wide 30 percent fluctuation band can also be used to produce high fluctuations in exchange rates. The situation of Hungary's forint market is a good example. When the central bank widened the permitted fluctuation band, the market "tested" at the low line for a few months.
The 30 percent band also allows the central bank more time for preparations. Costs of speculative attacks are also higher in such situations. It can be assumed that possible attacks on Polish currency will not be aimed at breaking the adopted band, thus forcing an NBP intervention, but rather will focus on shaking the market and generating high profits for speculative investors. The wider fluctuation band seems too ideal for such action.
As past złoty fluctuations show, the currency has so far resisted strong speculative attacks, despite circumstances that could favor such attacks. This can be largely credited to central bank policy. The floating exchange rate as well as the firm commitment to refrain from intervening on the market act as deterrents to large-scale speculative attacks. The potential high costs and highly uncertain success, not high levels of currency reserves, discourage profiteers. This is crucial, as enthusiasts for NBP intervention have long argued against leaving the exchange rate to market forces alone.
ERM2 membership will certainly make such a policy difficult to sustain, and the moment of Eurozone accession, which some analysts set as early as 2005/6, will be the time to observe the effects of the policy. Therefore, a more realistic date might be two years later.
In conclusion, the main dangers will not be linked with entering the ERM2, which can be expected to happen within the next four years. And the danger from speculative investors is moderate or even small. Rather the main worry is a currency crisis sparked by a public finances crisis, especially as the increasing public debt threatens a constitutional crisis.
If no public finance reform is in place by the time the country enters into the ERM2, then the event could coincide with a major budgetary crisis. This would have disastrous consequences for the currency, which will be even more severe as Poland would not be able to fall on the "credit" pillow used in the 1990s. It is also worth remembering that the system will not change the situation of Polish companies, as it will not eliminate the exchange rate risk they are exposed to. Under unfavorable circumstances, the risk could be even greater.
Krzysztof Dziura Analyst for Capital Management Poland www.forex.pl
