In the early 1990s, many global fund managers invested in countries like Thailand, Mexico, and Russia to “catch the wave” in emerging market development. Toward the latter half of the decade, there were currency crises in emerging markets. As a result, fund managers had to pull out their funds because of the losses incurred. Many investors have researched the reasons for the currency crises in the 1990s and have come up with two schools of thought:
- Economic fundamentals can to predict currency crises.
- Currency crises cannot be anticipated and because of sudden, unpredictable adverse shifts in the market.
If the latter were true, then investing in emerging markets would be too risky because investors are unable to anticipate when there will be a currency crisis. However, if currency crises can be anticipated by economic fundamentals, then it is possible for traders and investors to be on the lookout for such economic indicators.
So, what is a currency crisis?
Currency crises are brought on by a diverse and complex set of variables. They are, however, linked together by common factors. One commonality countries undergoing currency crises have is that their central bank has heavily borrowed from its citizens or internationally. A country’s central bank heavily borrows in attempt to increase the country’s currency value. However, what can happen is that a country’s central bank will borrow too much, causing its investors to be skeptical of its ability to pay back their debt. One by one, investors will pull out their investments, which may result in some households and firms going bankrupt. A snowball effect may occur as a currency crisis develops. This is what happened on a high level in the currency crises in Mexico, Southeast Asia (Thailand, Indonesia, South Korea, Hong Kong, Laos, Malaysia, and the Philippines), as well as Russia in the late 1990s and early 2000s.
How can an investor anticipate a currency crisis in an emerging market?
One way is to determine if a country has a current-account imbalance. A current-account is the difference between a country’s savings and investment. Therefore, a current-account imbalance means the value of goods and services a country imports exceeds the value of the goods and services it exports. In this scenario, a country might run a large and persistent deficit, which in time will give rise to a large and growing external debt. If this external debt burden becomes large, it might raise questions about the solvency of the indebted nation. Research done by the IMF has shown even though current-account imbalances are unable to predict currency crises, current account deficit/GDP ratios, on average, have been significantly larger in periods leading up to a crisis than during tranquil periods. Thus, there could be some sort of correlation between current-account deficit/GDP ratios and currency crises.
Along with current-account imbalances, another potential indicator for currency crises is if a country’s central bank is pursuing an overly expansionary monetary policy. Because the monetary authority of a country controls the supply of money, it can influence an inflation rate or interest rate. An overly expansionary monetary policy is inconsistent with the maintenance of stable nominal exchange rates in the long run. As a result of the inconsistency, a country’s currency could be vulnerable to a speculation attack.
Next, if the M2/FX reserve ratio is too high, a currency crisis could be imminent. M2 is a way of measuring money supply. This measurement includes both M0 and M1 money supply along with any savings deposits. Keep in mind, M0 is a measure of money supply which combines any liquid or cash assets held within a central bank and M1 refers to the money supply of the country which includes physical money as well as checking accounts and demand deposits. The M2/FX reserve ratio measures the ratio of the M2 money supply to the central bank’s holdings of foreign exchange reserves. Countries with relatively high M2/reserve ratios tended to be more vulnerable to the contagion affects for a speculative attack. Knowing the M2/reserve ratios is imperative for investors if they want to attempt to anticipate a currency crisis. The final indicators investors can use to anticipate currency crises are to monitor unemployment levels as well debt and banking crises.
To recap, currency crises are brought on by a diverse set of variables, but they do have some commonalities. The first is that a country will have heavily borrowed from either its citizens or internationally. Eventually, investors will be skeptical about the country’s central bank’s ability to pay back their loans. A subsequent currency crisis may ensue. Luckily, there are some ways to anticipate a currency crisis. It is imperative for investors to monitor two ratios: the M2/FX reserve as well as the current-account balance/GDP ratios. These two ratios are leading indicators to whether or not a currency crisis will emerge. Other important figures to monitor are a country’s unemployment and debt levels. After the currency crises of the 90’s, some economists were able to develop ways to anticipate a currency crisis. Hopefully, investors can learn their lessons from the late 1990’s currency crash and be able to anticipate the risk.