Analyzing Currency Crises: A Case Study of the UK and Hong Kong

This case study analyzes the 1992 UK and 1998 Hong Kong currency crises, examining the causes of exchange rate fluctuations and their impact on firms. It defines currency risk, discussing factors influencing exchange rates like interest rates, demand, and supply, and how they affect firms through transaction, translation, and economic exposures. The study explores the effects on balance sheets, income statements, and cash flow statements. It compares the economic performance of Germany and the UK, explaining the Exchange Rate Mechanism (ERM) and analyzing the Hong Kong dollar attack, including the mechanics of a speculative attack and the "double play" process. The analysis evaluates the Hong Kong government's actions, considering the Mundell-Fleming model, and identifies the crisis as a third-generation crisis. The study uses sources like Krugman, Majaski, and Mundell to support the analysis.

WEEK 6 CASE STUDY
Executive Summary
This case study analysis focuses on the past two currency crises the 1992 United Kingdom and
the 1998 Hong Kong crises. The causes and what contributes to the changes in the currency
exchange rate and the firm's exposure to the exchange rate will be reviewed. The case study will
explain the possible ways in which the two countries did to deal with their crises.
1. Define Currency Risk
There is a drastic effect of foreign rates change on a firm’s profitability, cash flows and market
value. So, it is important to measure the foreign exchange exposure and manage it and try to
reduce it to the acceptable level. Accounting exposures are described as transaction exposure and
translation exposure, and economic exposure is described as operating exposure.
Currency risk refers to the risk which arises due to fluctuation in the value of currency. It is the
variance in forecasted cash flows which occurs from unexpected exchange rate fluctuations.
Since, these fluctuations result in unexpected gains or losses, it is needed to manage and reduce
this risk. Investors try to reduce their currency risk by entering forward hedge, money market
hedge, future derivative contracts, and options derivative contracts.
Currency risk is a one form of financial risk that arises from the change in price of one currency
against another. Whenever the business investors or companies have an assets or business
operations across the national boundaries or one or more countries, they face a currency risks in
foreign market. For example: If the United Kingdom investor has stocks in Hong Kong, the
return that you will realize is affected by both the changes in the price of the stocks and the
changes in the value of the Hong Kong currency against the UK currency. So, if you realize a

10% return in your Hong Kong stocks but the Hong Kong currency depreciates at 10% against
the UK currency, this will cause no gain at all.
2. Discuss factors that cause and contribute to changes in currency exchange rates and a
firm’s exposure to exchange rate fluctuations.
The following are the reasons that cause and contribute the changes in the currency exchange
rates:
While there are various economic, political, and regulatory factors that affect the changes in the
currency exchange rate. The factors are interest rate, demand and supply, political stability,
economic strength, inflation, trade balance etc. For example, when we look at demand and
supply factor, as we know the basics of it, if there is a huge demand for a particular currency, the
prices of that currency, the prices of that currency will tend to rise as compared to the other
currencies. For example, US dollar is the largest traded currency in the world. As all the
countries require USD to trade in the international markets, the demand for USD will rise if there
is limited or minimum supply of USD in the currency market. When we look at interest rates
factor, we see that interest rates and currency rates are connected to each other in some way. If
the interest rates of domestic currency are high, then they will require less of foreign currency
pushing the value of the foreign currency down and if the interest rates of the foreign currency
are high, the demand for the foreign currency will be higher making it expensive.
Factors affecting the firm exposure to currency fluctuations are as follows:
a) Transaction Risk: A firm may be affected by currency exchange rate fluctuations if the
payables and receivables are in foreign currency. A minimum upside or downside in the
value of the currency exchange can cause the firm to a greater amount of loss or gain

because of the transactions. For example, if a company in India imports iphones from Usa
at $1000 per phone with a current exchange rate of Rs. 70/dollar and if the rate increases
to Rs. 73/dollar the importer will have to shell out Rs. 73,000 i.e. Rs 3,000 extra than the
previous exchange rate.
b) Translation Risk: The Value of assets and liabilities that a firm has on its books which are
in foreign land also causes the amount to revalue at the current rate and absorb the
difference in the equity. For example, if the assets invested in USA are valued at $100 in
the balance sheet and if the exchange rate increase from Rs. 70/dollar to Rs. 73/dollar.
The assets will be revalued at Rs. 7300 as per the current exchange rate as compared to
Rs. 7000 in the previous exchange rate.
3. Discuss how currency rate fluctuations and currency risks apply to a firm’s:
Discuss the effect on Balance Sheet
Discuss the effect on Income Statement
Discuss the effect on Cash Flow Statement
Balance Sheet: The gains and losses from the currency exchange affect the balance sheet only
through the other comprehensive income which comes in the equity section of the balance sheet.
Assets revalued also affect the other comprehensive income, which adds up to equity.
Income Statements: The Foreign Exchange translation Losses or Gains are recorded in the Other
Comprehensive Income. This amount is later added to Equity Section of the Balance Sheet in the
form of retained earnings.

Cash Flow Statements: The gains and losses that arise due to currency rate fluctuations is not a
cash flows, but they can be recorded in the cash flow statement separately from the cash flows
from operating, financing, and investing activity, which is later added to the other comprehensive
income.
4. Discuss the economic performance of Germany and the United Kingdom from 1988 to
1992.
Discuss the effect of differences in economic performance affect exchange rates
How does the Exchange Rate Mechanism (ERM) work?
Slow growth in domestic demand, construction investment and private consumption are the main
reasons for the weakness of GDP growth in Germany. However, the difference between growth
rate of Germany to UK can be attributed to shrinking German construction sector. During this
period, the tax burden in Germany was more than other European countries. This has resulted in
adverse growth rates in Germany during 1988-1992. Macroeconomic policies implemented in
the country are mainly blamed for this situation. In 1992 economic forecasters were looking for a
longer lasting recovery in Germany. UK as well experienced slow growth during this period.
However, the situation improved quickly due to job creation accelerated above the trend.
Germany lost its purchasing power due to a fall in the euro exchange rate and rising oil prices.
Unfavorable exchange rate developments were seen during this period. The tightening of
monetary conditions due to this, created tensions.
Exchange rate mechanism is based on the concept of fixed currency exchange rate margins. The
goal of European exchange rate mechanism was to achieve monetary stability in Europe. ERM
removes the risk of decline in value of the currency and improve credit rating.

Succession of crisis has led to the transmission of shocks across national borders. Problems
occur in many of the emerging markets on the periphery because a shock in one of them first
influences the financial center. The transmission of shocks passes from one periphery country to
another through a center country. A crisis in Russia creates liquidity problems in European
countries.
5. Discuss the attack on the Hong Kong dollar.
Discuss the mechanics of a speculative attack and the “double play” process.
This happened in 1998 when the economy of Hong Kong was experiencing a slowdown. The
hedge funds started taking positions against Hong Kong dollar. The hedge funds expected that if
the countries competing with Hong Kong devalued their currency by 30 percent, then Hong
Kong dollar will get devalued as well. Due to this reason, hedge funds borrowed in Hong Kong
dollars and sold back the borrowed Hong Kong dollars to Hong Kong Monetary Authority at
fixed rate. They expected that at the time of repayment, Hong Kong dollars would be weaker,
and the repayment amount would reduce accordingly. At the same time, hedge funds expected
that the stock market might fall if the regulators decide to increase domestic interest rate. Hence,
they borrowed the stocks from investment banks and sold it. Since, at a later point of time, stocks
would go down and so would be the repayment. This came to be known as ‘double play’.
The Hedge funds were secured by taking such position. If the regulators decide to devalue the
currency, the borrowed Hong Kong dollar would become cheaper, and repayment of the
borrowed fund would be lesser and hedge fund will make money. Otherwise, if the regulators

increase the domestic interest rate, the stock market would fall, and hedge funds will pay back
lesser for their borrowed stocks.
6. Provide an evaluation of the actions taken by the Hong Kong government compared with
alternatives it might have taken.
How does Mundell’s Trinity factor into your analysis?
Was this a first-, second-, or third-generation crisis?
Various calculations of real effective exchange rates in Hong Kong clearly demonstrate that
despite a rising nominal effective exchange rate due to higher domestic inflation, the real
effective exchange rate index, as deflated by prices of tradeable goods, adjust very quickly so
that in the trade account, the Hong Kong dollar is not overvalued. The Mundell-Fleming model
portrays the short-run relationships between an economy’s nominal exchange rate, interest rate
and output. The Mundell- Fleming model has been used to argue that an economy cannot
simultaneously maintain a fixed exchange rate, free capital movement, and an independent
monetary policy. This principle is frequently called the “impossible trinity”, “unholy trinity”,
“irreconcilable trinity”, “inconsistent trinity” or the “Mundell-Fleming trilemma.”
The Mundell- Fleming model also provides a handy device for evaluating the relative efficacy of
monetary and fiscal policies. It is well known that under a fixed exchange rate regime with
perfect capital mobility, monetary policy is totally ineffective.

In the diagrams, an expansionary monetary policy to stimulate the economy is represented by a
rightward shift. Should it interest at a point below, a massive capital flight would ensue, shifting
the back to its original position. In the context of the Asian currency crisis, an expansionary
monetary policy can be ruled out of court anyway since it will surely be seen as an open
invitation to attack the domestic currency.
By contrast, an expansionary fiscal policy is in theory and practice much more effective in fine-
tuning the real economy. A rightward shift will produce a higher interest rate, which under
normal circumstances will induce capital inflow. The original model is, however, not designed to
deal with a situation where the domestic currency is under threat. Our modified model can
handle this situation.
Basic assumptions of the model are as follows:
· Spot and forward exchange rates are identical, and the existing exchange rates are
expected to persist indefinitely.

· Fixed money wage rate, unemployed resources and constant returns to scale are assumed.
Thus, domestic price level is kept constant, and the supply of domestic output is elastic.
· Taxes and saving increase with income.
· The balance of trade depends only on income and the exchange rate
· Capital mobility is perfect, and all securities are perfect substitutes. Only risk neutral
investors are in the system. The demand for money therefore depends only on income and the
interest rate, and investment depends on the interest rate.
The country under consideration is so small that the country cannot affect foreign incomes or the
world level of interest rates.
The Hong Kong government was third generation crisis.
SOURCES:
Krugman, Paul (April 12, 2021) The Mundell Difference. retrieved from
https://voxeu.org/article/mundell-difference
Majaski, Christina (November 22, 2020) Trilemma Definition. Retrieved from
https://www.investopedia.com/terms/t/trilemma.asp
Mundell, Robert A. (1963). "Capital mobility and stabilization policy under fixed and flexible
exchange rates". Canadian Journal of Economics and Political Science. 29 (4): 475–485
Donovan, P. (2015). The Truth About Inflation. Abingdon: Routledge

Paula, L.F. (2012). Financial Liberalization and Economic Performance: Brazil at the
Crossroads. Abingdon: Routledge.