How Did the Credit Crisis of 2008 Impact European Exchange Rates?

The collapse of the housing market in the United States and the ensuing credit crisis in the United States was contagious.  Credit constraints during the recent crisis are exemplified by the TED spread.  The TED spread is the difference between three month Eurodollar contracts represented by the London Interbank Offer Rate (LIBOR) and the interest rate on three month U.S. Treasury Bills.   According to Bloomberg’s Financial Glossary, the TED spread is used as a measure of “investor/trader anxiety or credit quality”.  The TED spread makes an excellent measure of externally imposed credit constraints for European currencies – the cause of the credit crisis and its measure are both external to European economies.  With the TED spread we can measure when the credit crisis, and not necessarily uncertainty over the ensuing macroeconomic recession, began and ended as well as judge the impact on European currencies. 

The data suggests that European countries with relatively high interest rates experienced intense depreciation – overshooting a simple model of uncovered interest rate parity.  The interest rate differential, or “carry”, may make it profitable to borrow in currencies with low interest rates in order to invest in currencies with high interest rates. As the carry trade unwinds countries with higher interest rates may be more susceptible to depreciation. The estimated depreciation is 2.2%-1.7% for a 1% difference in long term interest rates over only the five months of the investigation period (implying a 5.3%-4.2% annual depreciation).  The absolute difference in interest rates, not changes in the interest rate differential, drove exchange rate movements. Further, the severity of the credit crisis, as exemplified by the TED spread, amplified the overshooting phenomenon which suggests that unwinding of the carry trade significantly drove Intra-European exchange rates during the most recent crisis.  Using Two Stage Least Squares, there is a causal relationship between the interest rate differential and exchange rate movements.  The results imply that current account deficits, high inflation and large levels of external debt held by central governments and banks contributed to greater interest rate differentials and only indirectly impacted European currencies. 

Additionally, evidence suggests that the Hungarian forint was especially susceptible to the heightened risk attitudes associated with the credit crisis as the forint tended to depreciate relative to other European currencies as the TED spread widened (and appreciate as the TED spread narrowed). 

Lastly, countries with large levels of official reserves had more robust currencies.  Fratzscher (2009) argues that reserves of foreign currency insulate a country’s currency from capital flight.  However, the results imply that foreign currency asset accumulation is a particularly expensive method of avoiding currency depreciation as an additional $1 billion in foreign currency assets is associated with only a 1.6% currency appreciation during the five month investigation period.  To put this in perspective the average accumulation of foreign currency assets by the countries (and the European Central Bank) studied herein is only $0.65 billion.