Perils of a currency crisis

Most people have forgotten that this week is the 10th anniversary of the collapse of the Investment bank Lehman Brothers and the beginning of the global financial crisis. The effects of that financial meltdown is still being felt today.

In his book Crashed, Adam Tooze writes that “...the financial and economic crisis of 2007-2012 morphed between 2013 and 2017 into a comprehensive political and geopolitical crisis of the post cold war order.” As governments adopted austerity measures, wages and incomes stagnated giving rise to the election of populist leaders in many parts of the world.

The question now being asked is whether the world has successfully weathered the 2008 financial crisis. This question is most relevant in the so called emerging markets where there are signs of a currency crisis and runaway inflation.

While the dollar continues to gain strength, the currency in many countries are falling – Turkey, Argentina, Venezuela, Indonesia. The Philippine peso has already dropped by 7%. Although the Central Bank is committed to defend the peso, Franklin Templeton Investments has a more pessimistic view. It sees the peso falling past 55 to the dollar. However, Goldman Sachs has a more optimistic medium term view. It sees the peso returning to 53 or 52 to the dollar in 2019. The weakening of the peso has been attributed to rising oil prices, faster inflation, fiscal and current account deficits and worldwide outward investment flows from emerging markets.

One of the most extreme currency price shock ever witnessed in Asia happened in 1998 – 20 years ago. The Thai baht collapsed by 50% within a few months. The Thai economy was then one of the fastest growing in Asia. It literally ground to a halt. The unemployment rate tripled, property prices fell by half and the collapsing baht reduced the average income of Thais by more than a third in dollar terms.

According to Ruchir Sharma, one way of gauging a country’s economic prospect is to ask the question: Is money flowing in or out of the country? He says: “If the currency feels cheap and the economy is reasonably healthy, bargain hunters will pour money in. If the currency feels cheap, yet money is still fleeing the country, something is seriously wrong.”

The most important indicator is the current account which measures the flow of money in and out of the country. There is a current account deficit if a country is consuming more than it produces and has to borrow from abroad to finance its consumption habits. If a country runs a sizeable deficit in its current account for too long, it is going to amass obligations it cannot pay and run into a financial crisis at some point. In his research Ruchir Sharma found out that “...when the current account deficit runs persistently high , the normal outcome is an economic slowdown over the next five years.”

Because of the rapid expansion of global trade and investments, politicians normally blame any local financial crisis on foreigners. The perception is that large shifts in money flows ( hot money) that can cause currency crisis are dictated by global players. Sharma has a different conclusion:

“To spot the beginning or the end of currency trouble in emerging markets, follow the locals. They are the first to know when a nation is in crisis or recovery, and they will be the first to move. The big global players mostly follow.

Often crisis erupt in emerging countries when investors lose confidence in the economy and start pulling out their money, which undermines the value of local currency and leaves the country incapable of paying its foreign debts. The country then has to run to the IMF for a bailout...nationalist attacks on immoral foreign speculators imply that locals are loyal and patriotic, while outsiders are flighty and exploitative.

This narrative ignores the Lucas paradox, named after the Nobel Prize laureate Robert Lucas, which questions the assumption that money flows tend to move from rich countries to poor ones, driven by wealthy American or European investors seeking high returns in hot growth markets. Lucas pointed out that rich locals in emerging nations also have a strong incentive to move their money to richer countries with more trustworthy institutions and safer investment options , such as US Treasury bonds.

Capital flights begin with locals, I suspect because they have better access to intelligence about local conditions. They can pick up informal signs – struggling businesses, looming bankruptcies – long before these trends show up in the official numbers that most big foreign institutions rely on.“

The money that locals move to the Bahamas or other money laundering sites usually show up in the balance of payments as capital outflows. Rich locals and corporations can also bring out money through illicit channels that show up in the balance of payments as “errors and omissions.” Another way is by doctoring trade invoices or understating receipts for exports and leaving some of the money abroad.

A free fall in currency is not a good sign for any economy especially a country that has a substantial foreign debt and does not have a manufacturing base for exports that can benefit from a cheap exchange rate. Ruchir Sharma has this advice:

“The ideal mix is a market determined cheap currency in a stable financial environment underpinned by low inflationary expectations. That combination will give local businesses the confidence to build, banks the confidence to disburse loans at reasonable rates, and investors the confidence to make long term commitments to the rise of a nation.” Creative writing classes for kids and teens Young Writers’ Hangout on Sept. 15 (1:30pm-3pm; stand-alone sessions) fiction writing with Sarge Lacuesta on Sept. 22 (1:30-4:30 pm) at Fully Booked BGC. For details and registration, email writethingsph@gmail.com.

* * *