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Know When to Hold 'em
How to detect an upcoming foreign currency devaluation in an emerging market.
Arvind Singh, CFO Magazine
November 1, 1997
On November 1994, near the town of No-gales, a post-NAFTA (North American Free Trade Agreement) beneficiary located on the border between Mexico and the United States, local entrepre-neurs gladly exchang-ed U.S. dollars for Mexican pesos at below-market rates. Ignoring government statistics and official declarations of support for the embattled peso, these border-town currency traders saw first-hand the peso's shrinking purchasing power and sought a more durable store of value. Events soon proved them right. In December of that year, a serious devaluation caused the peso to lose more than half of its value versus the U.S. dollar within six months.
As global corporations crowd emerging markets in search of growth, there's no avoiding volatile currencies. Just ask anyone who got caught this past summer with Thai bahts or Malaysian ringgits, or with Czech korunas last spring. This hazardous economic climate tends to defeat reactive measures. Instead, companies must learn to read the signs of impending devaluation.
A few traders in Nogales notwithstanding, anticipating foreign currency devaluations requires more than street smarts (usually acquired by painful past experiences). Here are the 10 clues currency experts watch for:
- Current account deficits. The three recent significant currency devaluations, of Mexico (1994), the Czech Republic (1997), and Thailand (1997), were all triggered when cash flowing out for imports outstripped cash received for exports. This shortfall was a major component of the current account deficit that approached 9 percent of the gross national product. Even narrower deficits caused devaluations in Indonesia and Malaysia, when current account deficits were 4 percent and 6 percent, respectively. These deficits stemmed from a combination of declining exports and a growing economy sucking in imports, especially in the high-tech and electronics sectors.
- Level of foreign exchange (FX) reserves. Where absolute levels of FX reserves are substantial, speculators fear to tread. It's no coincidence that China, with U.S. $120 billion, and Hong Kong, with U.S. $82 billion, have so far escaped the devaluations that swept away several of their Far Eastern neighbors.
- Alert Mexico watchers saw FX reserves depleted prior to the devaluation, from U.S. $28 billion to U.S. $7 billion during the period from February 1994 to December 1994.There's a hitch, though: periods of economic stress can hamper access to timely macroeconomic information.
- Condition of the home currency versus currencies of trading partners. Stable exchange rates encourage capital inflows, reduce uncertainty, and promote domestic growth. Thus, pegging local Southeast Asian currencies to U.S. dollars proved effective in the earliest stages of economic development in that region. Since early 1995, however, the U.S. dollar has gained 46 percent versus the Japanese yen and 37 percent versus the deutsche mark, erasing the export-pricing edge that Southeast Asian producers used to enjoy. As the region's currencies became less competitive, moreover, a combination of increased manufacturing capacity and an undervalued Chinese yuan intensified the competitive pressures on the region.
- The nature of foreign capital inflows and outflows. Shrewd market observers segregate short-term investments in bond and equity markets from direct foreign investment in bricks and mortar, which are destined to reside longer. Long-term, direct investments generally offer more stability. That is, of course, unless those investments are directed toward grandiose, ego-linked, showcase products instead of toward boosting broad export capabilities.
- Money-supply growth. Typically, the monetary spigot is open wide during a country's rapid-growth phase. In Malaysia, bank credit is currently growing at the rate of 30 percent a year. That puts lots of cash into circulation, and banks awash in liquidity tend to adopt lax credit standards.
- Local condition of real estate markets. In developing countries, traditional faith in commercial and residential real estate as the safest form of wealth accumulation is well entrenched. It becomes a self-fulfilling prophesy; asset inflation encourages further construction and crane-dotted skylines--until in-evitable gluts develop. The Philippines, Thailand, and Malaysia today show the effects of overheated real estate booms. Ensuing write- offs of bad real estate loans can sap currency strength.
- ency of banking and financial institutions. Currency traders know that the ability of the central bank to sharply raise interest rates to defend the currency effectively is severely curtailed when banks are weak. Lax lending practices and ill- advised expansion of credit cost Mexico 10 percent of its gross national product from 1994 to early 1997, according to some estimates. Currency watchers should (1) monitor the effectiveness of banks in efficiently recycling capital inflows; (2) check the political independence of banking supervisors; and (3) review the stringency of bank supervision.
- Dissent on financial policy. Thailand's economy has grown rapidly despite six coups or attempted coups since 1973. The average life of a reigning government in recent times has been only 2.5 years. This dark cloud notwithstanding, experts treat the mere suggestion in global financial circles that the central bank and the ministry of finance are at loggerheads on policy issues as an even more serious matter. Political pressures influence policy-setting, as expediency rules. Market observers know that frequently opting for a currency devaluation is the easier path to take.
- Forward FX market. FX market veterans closely monitor bid-offer spreads and any visible widening of forward discounts in the currency markets. These patterns frequently predict impending devaluations.
These transactions are synonymous with offshore borrowing and subsequent sale of the currency. How do U.S. corporations with local currency sales in emerging markets deal with this future FX risk? Oracle Corp. international treasurer Mark Mohler says, "Oracle has substantial exposure in emerging markets. Given the high cost to hedge, it becomes impractical to hedge all currencies. Hence, we selectively hedge where, in our view, the risk exceeds the cost of hedging."
- Sophistication of technocrats and central bankers. The reputation of the central bank and the results of its past encounters with currency traders influence the extent of future attention paid to the currency by the ever-watchful eyes of market opportunists. Compare the reputations of Malaysia's Bank Negara and Singapore's Monetary Authority. During 1992 and 1993, the former engaged in formidable speculation and proceeded to lose an estimated Malaysian $15 billion (U.S. $5.8 billion). Meanwhile, the latter's skill is feared and respected by currency traders, as Singapore has become the world's fourth- largest FX center by skillfully managing its currency. The adeptness with which the authorities play the cat-and-mouse zero-sum game is definitely a factor that influences potential speculators.
Clearly, the presence of some of these conditions indicates that a currency is on thin ice. But when will it crack? No crystal ball exists. However, we can be armed with the knowledge that on previous occasions, the indicators listed above played a key role.
Which currency will catch the Asian flu next? The three-year-old Brazilian real is a likely candidate, thanks to a 4.5 percent uptick in the country's current account and a fiscal deficit approaching 5 percent. Meanwhile, currency appreciation has dampened Brazil's export market. Although expected privatizations should raise U.S. $85 billion and stabilize the restructured financial system, thereby giving cause for optimism, a cliff-hanger awaits the outcome of the 1998 Presidential election. If political expediency prevails in the wrangle between competent technocrats and politicians, current account and fiscal deficits could balloon. Once this process starts to gain momentum, taking protective action can be prohibitively expensive, similar to seeking flood insurance during a hurricane.