Why a speculative attack might succeed

By: Eurointelligence

Some of us have lived through the 1992 speculative attack that almost sunk the European exchange-rate mechanism. This is why we are so obsessed with the possibility that a similar event could sink the euro area. We believe there are some disturbing parallels.

 

Let’s briefly recall the events in 1992. This was after the conclusion of the Maastricht Treaty, after the first Danish referendum – a No vote - at a time when the euro was still far away. Many investors regarded the exchange-rate mechanism first and foremost as a not very good currency regime, rather than as an antechamber to a monetary union. When the markets successfully attacked the pound that year, they effectively sealed the UK fate as a semi-permanent EMU-outsider. The speculative attack became a self-fulfilling prophecy. Following expulsion of sterling, the Bank of England devised its own monetary policy strategy. The UK went its own way, and never looked back.

 

What are the parallels to today’s situation? Surely, the ERM was by its nature vulnerable to a speculative attack, as the system tested the commitment by governments to support a central parity. Such an attack is impossible now.

 

Obviously, the markets cannot attack the euro area in exactly the same way as they attacked the ERM. But two types of speculative attacks are possible, and some investors are already betting. The first one concerns speculation on the devaluation of CEE currencies (all of them, those speculator do not get about the difference between the Czech Republic and Bulgaria).

 

But how could such a speculative attack become a self-fulfilling prophecy? As EU leaders have limited the financial aid to CEE countries, and have also ruled out fast-track euro membership, they have given a clear signal to speculators that it might. Imagine a situation of a speculative attack that would result in currency devaluations of 50% against the euro. With the exposure to foreign currency loans, Hungary, for example, would be in acute difficulty. Many Polish borrowers would also be in trouble.

 

Another important implication would be on intra-EU trade. A 50% devaluation of the Czech koruna would make the Czech Republic so massively competitive that the euro area countries might retaliate by trade sanctions. Remember that President Sarkozy famously complained about Czech imports, but if the Czech koruna were to devalue, he might have reason to complain and to act.

 

Imagine too, that such events would coincide with a Czech No to the Lisbon, and it is not that difficult to see several countries calling for the expulsion of the Czech Republic from the EU. The currency attack would be self-fulfilling. If the Czechs get pushed to the fringes of the EU, the currency will sink and sink, as investors are pulling out.

 

Let us describe another self-fulfilling vicious circle. The markets attack a peripheral currency, which devalues as a result, and inflation rises beyond the no-go threshold for euro accession. As euro accession moves further into the distance, the currency depreciates further.

 

From the point of view of currency speculators, betting against the CEE currencies is not a certain gamble. But given those self-fulfilling mechanisms, those bets are not entirely implausible either. We are therefore not surprised that serious investors are putting serious money on CEE/euro exchange rate bets.

 

The second form of speculative attack occurs via credit default swaps, those much hated instruments through which an investor can insure against, and speculate on, default. The important thing to remember about CDS purchases is that you can actually make money not only if default occurs, but already when default perception are rising. This is why buying Greek or Irish CDS were, and possibly still are, a very good bet for anyone who believes that the situation will get worse before it will get better.

 

We have written about the euro area’s No Bailout clause last week, and argued that this clause loses its bite in times of crisis. But beyond vague commitments, we have not seen any test of the euro area’s readiness to spring to a member state’s aid. We doubt that Germany is going to relax its tough-mindedness on this issue, especially not before the September elections, so this a period of acute danger.

 

Buying Irish CDS is perhaps not the smartest choice because if there is one country the EU could bail out quite easily, it is tiny Ireland. Greece could be bailed out too, but since the country has flouted EU fiscal rules more than anybody else, any bailout will invariably lead to a de facto loss of fiscal sovereignty. We can see danger in respect of Italy or Spain, both of which are too large to be bailed out.

 

These bets can also becoming self-fulfilling in that higher CDS spreads lead to higher bonds spreads, greater roll-over costs for governments, and ultimately default if things get out of hand. Any investor who believes that the situation in Spain could get dramatically worse – a scenario we consider plausible – could stand to make a killing on Spanish CDS, even if Spain is not actually defaulting.

 

So we are saying that the probability of a speculative attack is much higher than EU leaders are currently prepared to admit. Given this lack of preparedness, we cannot see how they can defend themselves successfully against such attacks for as long as they keep agreeing on the minimal set of policy choices – minimal coordination on stimulus and on bank rescues (last autumn), on bank supervision (the de Larosiere report), and on east Europe (Sunday’s summit). We believe that the probability of a speculative attack of one sort or another is very high, and that the probability of a successful speculative attack is non-trivial. The weaker the policy response, the stronger will be the latter probability. This is why we believe the outcome of the March 1 informal EU is extremely disappointing, potentially leading to great danger.

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