A Currency Peg Abandoned: PPP, UIP and Group Solvency
A UK insurer writes specialist commercial property cover through a subsidiary in the Republic of Marland, whose currency (the MAR) has been pegged to the US dollar at 7.80, with a ±2% band, for nine years. Marland inflation is 9.0% a year against 2.5% in the UK, and local government bonds yield 11.0% against 4.0% on US Treasuries. The subsidiary writes MAR 480m of premium, incurs MAR 310m of claims and MAR 90m of local expenses, and holds reserves in local government bonds. Sixty per cent of its reinsurance is placed in US dollars. The group holds capital in sterling. In the first quarter the central bank abandons the peg; the MAR depreciates 12% against the dollar within a month, local bond yields rise to 18%, and local inflation reaches 15%. The group CFO asks whether the original business plan's exchange rate and inflation assumptions were reasonable and what the loss means for group solvency.
1. Using purchasing power parity and uncovered interest parity, assess whether the peg was sustainable at the start of the year and what the business plan should have assumed.
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PPP: the inflation differential is 9.0% − 2.5% = 6.5% a year. Relative PPP implies the MAR should depreciate by roughly 6.5% a year against the dollar, other things equal. Over nine years the cumulative effect is large (1.065^9 ≈ 1.76), so a peg held at 7.80 implies a substantial real appreciation and loss of competitiveness. PPP does not time a devaluation, but it says the peg was not a sustainable long-run equilibrium.
UIP: the local bond yield is 11.0% against 4.0% on US Treasuries, a 7.0% differential. UIP implies expected depreciation of about 7% a year, so forward rates should have priced the MAR at a discount. The apparent 7% carry was compensation for devaluation risk, not a free return.
The business plan should not have used a constant 7.80 rate. It should have used probability-weighted scenarios - for example a 70% probability of the peg holding and a 30% probability of a 20% devaluation - with the devaluation scenario including higher local inflation, higher bond yields and wider credit spreads.
2. Estimate the main channels through which the devaluation affects the subsidiary's results and recommend mitigations.
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Channels:
- Translation: the subsidiary's MAR net assets are translated into sterling at the new rate, producing an immediate loss of roughly 12% of their sterling value.
- Transaction: 60% of reinsurance is in US dollars, so the MAR cost of reinsurance rises 12% immediately while premium is fixed for the policy period.
- Claims inflation: local inflation at 15% raises repair and rebuild costs, making reserves set before the devaluation look inadequate.
- Asset values: local bonds yielding 18% fall in price. Discounting reserves at the local curve offsets part of the reserve increase, but the asset side still suffers.
- Capital: local solvency requirements may rise with FX and inflation volatility while group capital is in sterling.
Mitigations: hold US dollar or hard-currency assets against US dollar reinsurance liabilities (a natural hedge); use forwards or non-deliverable forwards where available, accepting cost and counterparty risk; shorten local asset duration or use inflation-linked assets; reprice and include FX clauses where legally possible; set group limits on local-currency exposure; and include a devaluation scenario (for example 30%) with fat-tailed FX distributions in the capital model.
3. Discuss the data and model risk in setting the subsidiary's assumptions after the devaluation.
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Model risk is high:
- Data: the subsidiary has a short history, and the pre-devaluation period was distorted by the peg. Inflation and yield data may be unreliable or infrequent.
- Structural break: the devaluation changes the relationship between inflation, yields and the exchange rate, so historical correlations are not a guide.
- Proxies: there may be no long-dated local yield curve, forcing the actuary to use proxies from other emerging markets, which introduces judgement.
- Anchoring: there is a risk of anchoring on the old 7.80 rate or on central bank statements.
Good practice: use scenario analysis and ranges rather than single point assumptions; document expert judgement; use a stochastic FX model with jumps or fat tails; backtest against other pegged regimes; obtain independent review; and set triggers for revisiting assumptions if inflation or reserves move outside an agreed band.