If history is any guide, governments can’t stop a run on their currency.  Back in the 1980’s, George Soros made his reputation when he brought down the pound, defeating the Bank of England.  Closer to home, in that same decade and then again, in the next, Mexican governments of very different political persuasions engaged in costly and unsuccessful attempts to defend the peso; in the first case, “like a dog” and in the second, by quietly depleting the reserves, then by a government-dictated devaluation, and finally, conceding to the market.  Readers should judge the wisdom of those defenses.

Since the financial crisis brought down Wall Street last fall, investors have fled to the dollar, pressuring currencies around the world.  (See the two graphs below.  The first chart is the euro-dollar exchange rate and the second, the peso-dollar rate.)  What was once the “flight to quality” is now “flight to safety,” but the deleterious effects on other currencies of investors’ preference for dollars are no less toxic, to use the word that’s become a standard of the financial lexicon. 

The Russian and Mexican governments’ actions to the moves away from their currencies are interesting studies in what happens when governments take on markets.  Once again, readers should be the judge.

The Russian government vowed to defend the ruble.  Between August and January, Russia has spent US$200 billion, more than a third of its reserves, doing that.  In January, the government tried a new tack, announcing a minimum exchange rate below which it would not let the ruble fall.  As the limit rapidly approaches, the question is how the Russian government will enforce it.  How much more is Russia willing — and able — to spend to defend the exchange rate?  Could the Russians take a page out of the Thai crisis management book written in 1998 and restrict capital redemptions?  Or, might they turn to the Chilean example?  The Chileans instituted a tax on short-term capital flows, which increased the cost of repatriating funds. Meanwhile, S&P reduced Russia’s credit rating in December for the first time in a decade.  Fitch followed, cutting Russia’s rating to BBB (just two grades away from a “junk” rating), citing the loss of reserves and growing capital outflows.

Mexico, too, has intervened in the exchange markets, committing US$16.7 billion between October and the end of January (an amount equal to a fifth of the level of its reserves at year end) to “smooth the movements in the exchange rate.”  The Exchange Commission sets exchange rate policy, including the decisions to intervene and the form of intervention.  It is comprised of representatives from the central bank (Banco de México or Banxico) and Hacienda, with the latter casting the deciding vote.  So, while Banxico has a voice in setting policy and is responsible for its execution, the administration has the final say over exchange rate policy.

Interventions have taken three forms, to date.  On October 8, when the peso’s precipitous fall began, Banxico sold dollars directly into the markets as a first step and then announced the creation of an auction mechanism to supply dollars to the markets: Banxico would offer US$400 million daily at a price 2% above the previous business day’s rate to those banks who wanted to buy dollars.  February 4 saw a new approach to controlling the peso’s drop: Banxico called commercial banks individually, offering to sell dollars at a “take it or leave it” price.

The introduction of a new intervention technique has complemented, not supplanted, existing forms of intervention.  For example, over five days in October (8th, 9th, 10th, 16th and 23rd), Banxico sold US$11.0 billion in addition to the normal daily auction of US$400 million.  The February 4 circular announcing the direct sale specifies that the US$400 million daily auctions remain in effect.

Dr. Deborah L. Riner is Chief Economist of American Chamber/Mexico.