Are Emerging Markets Close to Another Currency Crisis?

Historically, when the U.S. raises interest rates, emerging-market currencies suffer. Capital chasing a higher interest rate tends to repatriate to the U.S., or to USD-denominated assets, drawing capital out of emerging markets and emerging currencies. As theU.S. continues to raise interest rates, those currencies might face jeopardy again. Let’s see what several fundamental indicators can tell us about how emerging-market currencies are holding up.

First, a little history

In particular, rising U.S. interest rates are associated with the domino freefall of East Asian currencies during the Asian Financial Crisis of 1997-1998. Two years before the Crisis, the U.S. Fed had hiked the interest rate 7 times, doubling the benchmark rate from 3% to 6%.The U.S. interest rate remained roughly at that same high level until after the onset of the Asian Financial Crisis, and bears at least some of the blame for the capital outflow that triggered currency depreciations and banking crises in East Asian countries.

Since late 2015, the U.S. has hiked the benchmark interest rate  9 times, raising it from 0%-0.25% to 2.25%-2.5%. Taking a hint from those interest rate hikes, the USD index has risen from around 80 in the pre-hike period in mid-2014 to 95.79 as of 25 Jan 2019. The rally in the USD index means that capital is already heading back into the U.S. and USD-denominated assets. Capital outflow from emerging countries is indeed imminent, if it’s not already happening.

The fundamental indicators

Here are some fundamental indicators of the strengths of major emerging market currencies in 1996 (the year right before the Asian Financial Crisis) versus the latest data, followed by brief explanations:

Source: CEIC, World Bank

*Argentina’s 1996 current account balance figure is unavailable.

^Turkey ran a current account deficit of 7.38% in 2018Q2. The improvement in current account balance in 2018Q3 was due to the sharp depreciation of Turkish Lira in 2018Q3.

Current account balance measures a country’s tangible and intangible trade balance. A current account deficit represents downward pressure on the currency, because the country is dumping domestic currency in exchange for foreign currency to make up for an excess purchase of foreign goods and services.

Source: CEIC, World Bank

*Argentina’s and Malaysia’s 1996 short-term external debt figures are unavailable.

Short-term External debt measures the amount of foreign debt maturing in one year or less. The more it is, the greater downward pressure on the currency, because the country needs to convert domestic currency to foreign currency to repay the foreign debt in the near future.

Source: CEIC, World Bank

*South Africa’s 1996 FX reserve figure is unavailable.

Foreign reserves measure the amount of foreign currency in the country’s official account. The less it is, the greater downward pressure on the currency, because the country has fewer means to support the valuation of domestic currency with sale of foreign currency.

The Guidotti-Greenspan Rule

If the above indicators seem abstract and scattered, here is a simple rule for identifying countries with great currency crisis risk. The Guidotti-Greenspan Rule, derived by the former Argentine deputy minister of finance Pablo Guidotti and the great former U.S. Fed Chairman Alan Greenspan, simply states that a country runs a high currency-crisis risk if it holds an amount of foreign reserve less than its short-term external debt. The rationale is that countries should have enough foreign reserves to withstand a massive claim of immediate (maturing in less than one year) foreign debts.

Source: CEIC, World Bank

*Argentina’s and Malaysia’s 1996 short-term external debt figures and South Africa’s 1996 FX reserve figure are unavailable.

The Guidotti-Greenspan Rule has been strikingly powerful at predicting past currency crises. The four countries that failed to meet the rule at the end of 1996 suffered from currency crises in 1997-98. Indonesia, the Philippines, and Thailand were the hardest-hit countries in the 1997 Asian Financial Crisis, enduring sharp currency depreciations. In 1998, Russia also suffered a debt default (which infamously brought down the hedge fund Long-Term Capital Management) and sharp currency depreciation.

History repeats itself, but not in the exact same form

Source: CEIC, World Bank

Most of the crisis-hit countries in 1997-98 have learned their lessons and maintained a much higher foreign reserve or a much lower short-term external debt now. But the countries that were relatively unaffected in 1997-98 are most at risk now. Turkey and Argentina currently have short-term external debts roughly double their foreign reserves. It’s no accident that the currencies of these two countries fell off the cliff in 2018, and are likely to fall further in 2019. Malaysia also currently holds a foreign reserve slightly below its short-term external debt, and there have been rumors on the market that Malaysian Ringgit is the next emerging market currency to fall.


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