Published August 9, 2019
This week’s shocking currency move by China brought currencies and their management into the spotlight. The Chinese lowered their currency “peg” to a surprisingly low number as a retaliatory move in the trade skirmish with the Trump Administration.
That pushed a panic button for investors sending them into the safety of U.S. Treasury bonds, which in turn sent bond yields hurtling lower (see chart below).
As a bit of a primer on currency moves, we reprint below an article from Investopedia written by Brent Radcliffe that includes a couple of example of historical currency crises. We hope you will find it informative.
Here is Mr. Radcliffe’s article:
“Since the early 1990s, there have been many cases of currency crises precipitated by investors whose outlooks cause wide-scale retreats and loss of capital. In this article, we’ll explore the historical drivers of currency crises and uncover their causes.
What Is a Currency Crisis?
A currency crisis is brought on by a decline in the value of a country’s currency. This decline in value negatively affects an economy by creating instabilities in exchange rates, meaning that one unit of a certain currency no longer buys as much as it used to in another currency. To simplify the matter, we can say that from a historical perspective, crises have developed when investor expectations cause significant shifts in the value of currencies.
The Role of Governments, Central Banks and Investors in a Currency Crisis
Central banks in a fixed exchange rate economy can try to maintain the current fixed exchange rate by eating into the country’s foreign reserves, or letting the exchange rate fluctuate when faced with the prospect of a currency crisis.
First, let’s explain why tapping into foreign reserves is a potential solution. When the market expects devaluation, downward pressure placed on the currency can really only be offset by an increase in the interest rate. In order to increase the rate, the central bank has to lower the money supply, which in turn increases demand for the currency. The bank can do this by selling off foreign reserves to create a capital outflow. When the bank sells a portion of its foreign reserves, it receives payment in the form of the domestic currency, which it holds out of circulation as an asset.
Central banks cannot prop up the exchange rate for long periods due to the resulting decline in foreign reserves as well as political and economic factors, such as rising unemployment. Devaluing the currency by increasing the fixed exchange rate also results in domestic goods being cheaper than foreign goods, which boosts demand for workers and increases output. In the short run, devaluation also increases interest rates, which must be offset by the central bank through an increase in the money supply and an increase in foreign reserves. As mentioned earlier, propping up a fixed exchange rate can eat through a country’s reserves quickly, and devaluing the currency can add back reserves.
Investors are well aware that a devaluation strategy can be used and can build this into their expectations, to the chagrin of central banks. If the market expects the central bank to devalue the currency (and thus increase the exchange rate), the possibility of boosting foreign reserves through an increase in aggregate demand is not realized. Instead, the central bank must use its reserves to shrink the money supply, which increases the domestic interest rate.
What Causes a Currency Crisis?
Anatomy of a Currency Crisis
Investors will often attempt to withdraw their money en masse if there is an overall erosion in confidence of an economy’s stability. This is referred to as capital flight. Once investors have sold their domestic-currency denominated investments, they convert those investments into foreign currency. This causes the exchange rate to get even worse, resulting in a run on the currency, which can then make it nearly impossible for the country to finance its capital spending.
Currency crisis predictions involve the analysis of a diverse and complex set of variables. There are a couple of common factors linking recent crises:
- The countries borrowed heavily (current account deficits)
- Currency values increased rapidly
- Uncertainty over the government’s actions unsettled investors
Let’s take a look at a few crises to see how they played out for investors:
Example 1: Latin American Crisis of 1994
On December 20, 1994, the Mexican peso was devalued. The Mexican economy had improved greatly since 1982, when it last experienced upheaval, and interest rates on Mexican securities were at positive levels.
Several factors contributed to the subsequent crisis:
- Economic reforms from the late 1980s, which were designed to limit the country’s oft-rampant inflation, began to crack as the economy weakened.
- The assassination of a Mexican presidential candidate in March of 1994 sparked fears of a currency sell off.
- The central bank was sitting on an estimated $28 billion in foreign reserves, which were expected to keep the peso stable. In less than a year, the reserves were gone.
- The central bank began converting short-term debt, denominated in pesos, into dollar-denominated bonds. The conversion resulted in a decrease in foreign reserves and an increase in debt.
- A self-fulfilling crisis resulted when investors feared a default on debt by the government.
When the government finally decided to devalue the currency in December 1994, it made major mistakes. It did not devalue the currency by a large enough amount, which showed that while still following the pegging policy, it was unwilling to take the necessary painful steps. This led foreign investors to push the peso exchange rate drastically lower, which ultimately forced the government to increase domestic interest rates to nearly 80%. This took a major toll on the country’s economic growth which also fell. The crisis was finally alleviated by an emergency loan from the U.S.
Example 2: Asian Crisis of 1997
Southeast Asia was home to the “tiger” economies, and the Southeast Asian crisis. Foreign investments had poured in for years. Underdeveloped economies were experiencing rapid rates of growth and high levels of exports. The rapid growth was attributed to capital investment projects, but the overall productivity did not meet expectations. While the exact cause of the crisis is disputed, Thailand was the first to run into trouble.
Much like Mexico, Thailand relied heavily on foreign debt, causing it to teeter on the brink of illiquidity. Primarily, real estate dominated investment was inefficiently managed. Huge current account deficits were maintained by the private sector, which increasingly relied on foreign investment to stay afloat. This exposed the country to a significant amount of foreign exchange risk.
This risk came to a head when the U.S. increased domestic interest rates, which ultimately lowered the amount of foreign investment going into Southeast Asian economies. Suddenly, the current account deficits became a huge problem, and a financial contagion quickly developed. The Southeast Asian crisis stemmed from several key points:
- As fixed exchange rates became exceedingly difficult to maintain, many Southeast Asian currencies dropped in value.
- Southeast Asian economies saw a rapid increase in privately-held debt, which was bolstered in several countries by overinflated asset values. Defaults increased as foreign capital inflows dropped off.
- Foreign investment may have been at least partially speculative, and investors may not have been paying close enough attention to the risks involved.
Lessons Learned from Currency Crises
There several key lessons from these crises:
- An economy can be initially solvent and still succumb to a crisis. Having a low amount of debt is not enough to keep policies functioning or quell negative investor sentiment.
- Trade surpluses and low inflation rates can diminish the extent at which a crisis impacts an economy, but in case of financial contagion, speculation limits options in the short run.
- Governments will often be forced to provide liquidity to private banks, which can invest in short-term debt that will require near-term payments. If the government also invests in short-term debt, it can run through foreign reserves very quickly.
- Maintaining the fixed exchange rate does not make a central bank’s policy work simply on face value. While announcing intentions to retain the peg can help, investors will ultimately look at the central bank’s ability to maintain the policy. The central bank will have to devalue in a sufficient manner in order to be credible.
The Bottom Line
Currency crises can come in multiple forms but are largely formed when investor sentiment and expectations do not match the economic outlooks of a country. While growth in developing countries is generally positive for the global economy, history has shown us that growth rates that are too rapid can cause instability and a higher chance of capital flight and runs on the domestic currency. Although efficient central bank management can help, predicting the route an economy will ultimately take is difficult to anticipate, thus contributing to a sustained currency crisis.”
Markets endured further volatility this week in the wake of last week’s announcement of additional tariffs imposed on Chinese goods by the U.S. Fears around the worsening of the trade battle sent stocks to their worst day of the year in Monday’s trade. The -3% slide came as China retaliated against the tariffs by lowering their currency target, a move that nominally makes Chinese goods cheaper to import. China also suspended new agricultural purchases from the U.S. The heightened moves fanned investor fears. Those fears drove market futures down another -2% in overnight trading before Tuesday’s market open. However, China responded to allegations of currency manipulation by raising the target for the currency. This move calmed investors allowing stocks to recover once trading began and sending indexes higher by +1.3% on the day. Once again Wednesday morning stocks slid -2% as investors poured into the safety of U.S. Treasury bonds. But as the day wore on the selling abated. Investors bought back into stocks, reversing the early drop to bring stock indexes back to unchanged on the day. U.S. Treasury yields also came back to little change after their initial plunge. A strong report on Chinese exports overnight encouraged investors to take more risk and wade back into stocks Thursday. Markets rose +2% in a broad-based rebound. Friday brought a smaller dose of trade-related angst as President Trump indicated that upcoming trade talks with China might be cancelled. However, the closely-watched U.S. Treasury bond market signaled little new concerns with yields largely holding firm. Stocks slipped -0.7% Friday to cap a turbulent week of trading.
Wild swings in markets this week culminated with the S&P 500 down only -0.34% and still above the 2900 level; and more than 3% above its low point earlier in the week. The Nasdaq 100 (QQQ) dipped -0.46%. Small-cap stocks tumbled -1.28% but closed within the tight 6% trading range they’ve been in for over six months now.
Warm wishes and until next week.