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Liliana Schumacher is an Assistant Professor of International Finance at George Washington University. The authors are grateful to Rudiger Dornbusch, Edward Frydl, May Khamis, Paul Masson, Judit Nemenyi, Charles Siegman, Angel Ubide, and Charles Wyplosz for their suggestions and comments. The views expressed are solely those of the authors.
The initial work in this type of model can be attributed to Salant and Henderson (1978) and the classical references are Krugman (1979) and Flood and Garber (1984). For a useful survey of models focussed on Krugman’s approach see Garber and Svensson (1994).
Buiter, Corsetti, and Pesenti (1997) label the first and second generation models as “exogenous-policy” and “endogenous-policy” models, respectively.
The 1992 ERM crisis has been characterized as a classic example of the type of models belonging to the second generation. See Eichengreen, Rose, and Wyplosz (1995).
Readers familiar with Value-at-Risk models could safely skip this section without losing continuity.
For simplicity we net domestic-currency debt from the gross rediscount position of the financial sector. Also for simplicity we assume that central bank reserves and central bank foreign debt represent the total foreign assets and liabilities of the sovereign, i.e., the country’s foreign assets and the public sector (or publically guaranteed) foreign debt. These assumptions can be relaxed without affecting the nature of the results.
These operations are widespread among emerging-market central banks and are designed to provide hedges to operators when financial markets are incomplete. They have been also utilized, however, to strengthen the credibility of exchange-rate pegs and, as in the recent case in Thailand, have been kept as off-balance-sheet operations.
Strictly, the analysis is applied to the portfolio of the country’s monetary authorities, that is, to the consolidation of the central bank with the relevant treasury accounts.
This assumption could be relaxed in order to allow for changes in value that result from maturity mismatches (see Section IV below).
There is an ongoing debate in the literature regarding the concept of “central bank capital” and the need for a central bank to hold net tangible assets that could be realized on short notice to independently finance its operations. See Stella (1997). The concept embodied in (9), i.e., the net economic value of central bank equity, could be regarded as akin to the concept of capital but it encompasses the complete array of central bank current and contingent assets and liabilities, regardless of their liquidity and disponibility, and revalue them continuously using market prices.
This is most likely when the central bank holds a net foreign asset position, since a devaluation, when the value of international reserves is higher than the value of external debt plus the value of the short forward leads to an increase in solvency, that is, in equity, denominated in domestic currency. Of course, as we discuss below, a sudden devaluation may increase also the Value-at-Risk, among other reasons, by increasing the volatility of expectations and of country risk.
This is different from the more traditional VaR approach that largely focuses on changes in prices. See, for example, J.P. Morgan (1996).
Notice that, to avoid overcomplicating the presentation, we do not introduce further behavioral macroeconomic relationships. However, monetary equilibria conditions could be superimposed on equation (11) and the central bank VaR would then also reflect velocity behavior. Balance of payments and inflation equations could also be added without changing the nature of the model. However, these extensions are avoided in this paper in order to confine the analysis to its basic concepts.
This assumption can be easily changed in the, uncommon but possible, cases where the government makes budgetary allowances to reduce its debt with the central bank. There have been, indeed, cases of governments utilizing fiscal surpluses, capital gains and, particularly, privatization revenues to repay its debt to the central bank.
As discussed in Section II, under the assumption of normality, we evaluate VaRCB at the chosen desired confidence level by using the corresponding factor k.
Note again that we have defined volatility as kσ where σ is the standard deviation of the variable discussed and k is the multiplicative factor that depends on the chosen confidence interval.
These considerations apply to both floating rates and to exchange regimes that allow fluctuation within given parameters. When the central bank does not hedge its position and holds, say, a net positive exposure—that is, if the economic value of its international reserves, net of the short leg of its forward position, is higher than the economic value of the foreign debt, a negative change in the spot exchange rate (an appreciation of the domestic currency) leads to a portfolio loss.
As Dornbush (1998) points out, a large VaR may be signaling this mismatching that, under extreme circumstances, could turn into a funding crisis (for example, the case of Korea in late 1997).
Sterilized intervention reduces this exposure since, as sterilized intervention accelerates, D in equation (22) becomes negative. Another possible way in which the central bank could hedge its domestic positions is by increasing compulsory reserve requirements, a liability on the central bank portfolio, that will fall in value if interest rates go up. These types of interventions give rise, of course, to other distortions.
Clearly, if forward transactions can indeed convince speculators about the central bank commitment to defend the exchange rate, this will translate in a lower variance for expected devaluation, thus decreasing VaR.