Broad Currency Weakness Does Not Equal Financial Contagion

Anatomy of a Crisis

Many countries’ exchange rates depreciate continuously because their inflation rate is persistently higher than those of their trading partners. This gradual deterioration is very different to a situation in which the fall in the U.S. dollar value of a currency is part of a major economic crisis where depreciations exceed 20 percent. Such a large decline in the currency’s value invariably leads to much higher interest rates, a significant reduction in consumer and business spending, a contraction in imports and much slower GDP growth. A contagious crisis spreads between trading partners and then spills over to countries with seemingly few direct economic ties. Once participants in foreign exchange markets recognize vulnerability in one country, investors become jittery and begin to doubt the sustainability of other borrowers. This “risk-off” sentiment occurs even if the circumstances among countries are dissimilar, because investor exposure is often spread across emerging markets, as a class of investment, rather than limited to just one.

The Asia Crisis of 1997 Provides a Valuable History Lesson

The most recent contagious emerging market depreciation crisis was the Asian crisis that exploded in July 1997. Indonesia, South Korea, Malaysia, Philippines and Thailand experienced depreciations of between 20 and 30 percent. By 1998, the Indonesian rupiah was more than 70 percent below its value in 1997. Following the currency realignments, the GDP levels of Philippines, South Korea, Malaysia, Thailand and Indonesia shrank by 1 percent, 5 percent, 7 percent, 8 percent and 13 percent, respectively. As these fast-growing economies ground to a halt, commodity prices felt the effects, along with commodity exporters. The oil price fell to $12/bbl from $19/bbl, triggering a ruble depreciation of 60 percent and a fall in Russian Federation GDP of 5 percent. The Colombian peso depreciated by 20 percent and its GDP fell by 4 percent in the next year, with higher international risk premia exposing domestic banking and external borrowing liabilities. Base metal prices were hit the hardest, with copper prices falling by 30 percent in 1998 to $1,654/tonne.

Will History Repeat Itself?

Concerns over sizeable currency depreciations in both Argentina and Turkey have spilled over into other emerging markets. As evidence, we point to 13 September — Turkey significantly raised interest rates to stem the fall in the TRY and, immediately, there was a rebound in currencies where little risk exists, such as the Mexican peso. We would argue that currency events in several important economies have arisen because of country-specific factors and may not turn into contagion; for example:

• A perception that economic reforms in Argentina are too slow and that the central bank is not independent. IMF assistance may help reset sentiment towards the country and its plan for recovery.
• Turkey has a long-running political feud with the U.S. and has been singled out by President Trump for punishment with extra tariffs. Turkey does have some economic weaknesses and its political system is becoming less democratic. Still, a reduction in hostilities with the U.S. president could make some of the problem disappear.
• Tightening U.S. economic sanctions against Russia. Strong energy market fundamentals have helped to offset the impact so far.
• However, the EM currency recovery following the Turkish rate increase indicates that there are linked conditions in place which are making it difficult for emerging economies in general to sustain their economic growth levels:
• U.S. interest rates are rising and there is a distinct “risk-off” environment which is supporting the U.S. dollar and working against EM currencies.
• Trade, as a driver of global growth, is under siege from U.S. protectionist policies. U.S. trade actions are hitting important export sectors unevenly and are laser focused on China.
• China’s policymakers are engineering a managed deceleration in the economy to produce sustainable growth and financial stability in the future. Put another way, demand from one of the world’s largest economies is set to fall, by design. Whilst any roadblocks to economic growth are a challenge for emerging markets, 2018 is not 1997. One key distinction is that today, most emerging economies have a degree of float to their currencies, whereas the Asia crisis was partly a result of pressure building up within several fixed exchange rate regimes as “hot money” flowed in.

EM Contagion Possible, But Not Yet Likely

Crises are difficult to predict. The memory of the GFC is still very real and the interconnectedness of global supply chains and financial markets is probably greater today than in 2007, and certainly than in 1997. The persistence of a stronger U.S. dollar over the next year will continue to present risk for additional EM currency depreciation, particularly as Chinese and European growth is slowing and the trade environment is very uncertain. The most likely event to break the U.S. dollar strength will be the ECB’s decision to raise interest rates, which we expect in the summer of 2019.

Commodity prices may experience downward pressure from the stronger U.S. dollar, but the bigger risk to EMs is weaker global economic growth, which reduces demand and keeps prices from rising. A widespread crisis requires both vulnerability and trigger. The triggers have been pulled – strong U.S. dollar, slowing China, rising trade protectionism and tit-for-tat retaliation. The vulnerabilities are now being exposed – inadequate political institutions, shrinking export potential and financial shakiness. Although a contagious crisis has not yet emerged, we remain watchful for any shift in sentiment or circumstances which would signal its onset.