How did the Credit Crisis of 2008 Impact European Exchange Rates? Mark David Witte [email protected].

How did the Credit Crisis of 2008 Impact European

Exchange Rates?

Mark David Witte

[email protected]

European Currencies

& TED Spread

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EUR/CZK EUR/HUF

EUR/ISK EUR/NOK

EUR/PLN EUR/SEK

EUR/CHF EUR/GBP

TED Spread Avg. TED Spread (Jan.-June)

The BIG Questions• What drove exchange rate innovations during

the credit crisis? • What’s the impact of credit risk aversion (or

awareness) as measured by the TED spread? • What role for Macroeconomic Imbalances? Or

more Meese-Rogoff puzzle (fundamentals don’t impact ex. rates)?

• Carry trade and interest differentials?– Carry trade = borrow in low int. rate countries to

invest in high interest rate countries

Interest Rates during

Crisis

Methodology

tktkXtttttktk Xiiiiee ,,*

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tke ,

tt ii *

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Change in Exchange Rate k

Change in interest rate differential

Various Macro imbalances that literature says are important & TED spread for each country pair

DATA

36 country pairs

Sept. 2008 through January 2009

OLS with robust standard errors

Regression follows microstructure approach from Evans and Lyons (2002)

Results – Table 1  Reg. 1 Reg. 2

Lagged Exchange Rate Change 0.28** 0.28**

(0.03) (0.03)

Interest Rate Differential -0.218** -0.219**

(0.089) (0.088)

Change in Interest Rate Differential 0.22 0.20

(0.93) (0.92)

Lagged Change in Interest Rate Differential

-1.59 -1.62

(1.05) (1.03)

Constant -0.19 -0.19

  (0.27) (0.27)

Country Pair TED Spread? No Yes

R-squared 0.0855 0.0922

5.3% annual ex. rate change for 1% difference in interest rates

Insignificant Macroeconomic Imbalances – Table 1

• Current Account/GDP Differential• Current Account/GDP Differential X TED Spread• Growth of M/GDP Differential• Growth of M/Foreign Currency Assets Diff.• Real Effective Exchange Rate Diff.• External Debt Measures• GDP growth rate Diff. (-)* -- faster growing

countries depreciated = opposite of literature on currency crises

What about TED Spread?

• Hungarian Forint falls against 7 of 8 currencies as TED spread widens

• Hungarians borrowed EUR and CHF pre-crisis

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HUF Composite TED Spread Avg. TED Spread (Jan.-June)

Determinants of Int. Rate Diff. 

All Country Pairs (36 Total) 

  Reg. 1 Reg. 2 Reg. 3

Current Account/GDP Differential

-0.060** -0.088** -0.068**

(0.003) (0.003) (0.003)

Past Inflation Differential 1.274** 0.995** 1.021**

(0.019) (0.022) (0.023)

Gross External Debt (% of GDP) Differential - Government

  4.653** 4.110**

  (0.215) (0.201)

Gross External Debt (% of GDP) Differential – Banks

    0.201**

    (0.016)

R-squared 0.7577 0.7858 0.7961

If the interest rate differential is so important than what are it’s determinants?

Causation & Amplification by TED Spread

Reg. 1 Reg. 2

Lagged Exchange Rate Change 0.28** 0.28**

(0.03) (0.03)

Predicted Interest Rate Differential (Table 2, Reg. 3)

0.175*

(0.094)

Interest Rate Differential x TED Spread 0.144**

(0.041)

Change in Interest Rate Differential -0.91

(1.02)

Country Pair TED Spread? Yes No

R-squared 0.0885 0.0862

More significant estimate than previous coefficients

Foreign Currency Assets

Reg. 1 Reg. 2

Lagged Exchange Rate Change 0.28** 0.28**

(0.03) (0.03)

Interest Rate Differential 0.184** 0.184**

(0.090) (0.090)

Foreign Currency Assets Differential (In Trillions)

-0.159* -0.159*

(0.094) (0.094)

Country Pair TED Spread? No Yes

R-squared 0.0836 0.0902

Expensive: Additional $1 Billion = 1.6% Appreciation

Mean = $0.65 Billion Std.Dev. = $1.7 Billion

Conclusion

• Interest Rate Differential significantly impacted Exchange Rates = unwinding of carry trade– 1% higher int. rate = 5.3% - 4.2% annual depreciation – Magnified by TED Spread

• Foreign Currency Assets hedge depreciation but are very expensive

• Hungary especially hard hit by TED Spread• Macroeconomic Imbalances (current account

deficits, high inflation, high external debt) only indirectly are associated with exchange rate swings