Currency Crises in Emerging Markets

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Backgrounder: Currency Crises in Emerging Markets - Council on Foreign Relations

Introduction
As the global economy regains its footing after the 2007 recession and financial crises in Europe, the gradual reversal of loose monetary policy by the United States and other large economies is revealing cracks in some dynamic emerging markets that were considered the engines of growth during the downturn. Once-booming countries like Indonesia, South Africa, Brazil, India, and Turkey in mid-2013 were dubbed the "Fragile Five" due to the mounting pressure on their currencies. Souring sentiment on these and other emerging markets led to a selloff in a number of currencies in early 2014, raising concerns that a potential crisis in emerging markets could undermine the global economic recovery.

Origins of a Currency Crisis
Currency declines typically follow a series of political, economic, and market forces that combine to pressure the exchange rate. Countries that experience a crisis tend to run persistent current account deficits, importing more than they are exporting or borrowing capital from foreign lenders, often with short-term maturities, to finance public budget deficits and long-term projects. Capital flows can be fickle, and after years of inflows from foreign investors, sentiments can suddenly shift and dollars are sucked out of an emerging market, driving down exchange rates, depleting reserves, raising domestic interest rates, and sometimes triggering recessions.

Although it takes years for a shaky economic environment to develop, financial crises unfold rapidly. The Asian financial crisis in 1997–1998 was triggered by Thailand's decision to float its currency, the baht, on July 2, 1997, after abandoning its peg to the dollar. By December of that year, the dollar was worth more than 48 baht, a sharp appreciation from the 25 baht–per-dollar peg only six months earlier. Thailand's plummeting currency caused foreign investors to reassess other economies in the region, withdrawing their capital, and soon Indonesia, Malaysia, Taiwan, and South Korea were all mired in financial crises of differing degrees. In addition to IMF bailouts, the United States intervened directly to rescue these economies rather than risk further contagion or the quick transfer of a financial crisis across countries, both near and far, that could dampen its own prospects. Widespread currency and financial crises can also stall trade agreement negotiations, hindering global economic growth many years after countries are stabilized.

Economists identified some common characteristics that caused the crisis after the dust settled in Asia: The region's currencies were overvalued; economies were over reliant on short-term borrowing from foreign lenders; private banks and finance companies were fragile and weakly regulated; and governments lacked the necessary political consensus needed to take swift and painful measures to adjust and stabilize the economy.

Policymakers should make adjustments early and quickly, especially in smaller countries that aren't "anchors of the international system," says Stanley Fischer, distinguished fellow at the Council on Foreign Relations and the former first deputy managing director of the IMF. Important data on the real economy, such as GDP, are usually months out of date, so waiting rarely results in a much clearer picture of the economic situation. Furthermore, Fischer said, in an interview with CFR, that "economic medicine takes a while to work, and needs to be taken earlier rather than later. This means that policymakers generally need to move in anticipation of changes in the economic situation, about which inevitably they are uncertain."

Emerging Market Currency Risks
Emerging markets such as Brazil, Turkey, and Indonesia, among others, have become darlings of international investors over the past decade, attracting capital to their fast-growing industries and delivering a boost to the global economy. But unlike the United States, United Kingdom, Japan, and, increasingly, China, emerging markets have an inherent weakness: few investors are willing to stockpile their currencies. If cracks are detected in an economy, investors will dump the local currency and extract dollars, leaving behind devalued reais, rupees, and liras. This dynamic has caused crises in several regions over the past decades, and threatens to be repeated in some of the so-called "Fragile Five" countries.

Sometimes well-performing emerging markets can still suffer from capital flight, and this was the concern in the summer of 2013 after the U.S. Federal Reserve hinted that it would start "tapering" its $85 billion–a-month bond-buying program. Since the 2007 global recession, the Fed has kept interest rates near zero, prompting investors to seek higher returns in emerging markets. Private capital inflows to emerging markets surged to over one trillion dollars in 2010. Inflows to emerging markets were expected to decline by $153 billion to $1.06 trillion in 2013 and by a further $30 billion in 2014 according to the Institute of International Finance, representing the reversal of a trend of elevated outflows from developed economies since 2009. (There was a "flight to quality" in 2008–2009, when investors bought U.S. financial assets in the depth of the global recession).

"If you look at the long arc of past emerging market crises, a lot of them were triggered by a tightening of global monetary conditions," says CFR Senior Fellow Robert Kahn. But the reversal of capital flows doesn't affect all emerging markets equally, Kahn adds, and it's the "countries that were living off easy money and were not adjusting policies that have imbalances, and, as a result, when the party ends they have an extreme reaction. These countries also tend to have the most liquid markets and access to international capital markets, so capital reversals are more harshly felt."


When the U.S. Fed first floated the possibility of a taper in May 2013, many emerging markets were caught off-guard. The Indian rupee, Brazilian real, Turkish lira, South African rand, and Indonesian rupiah weakened against the dollar, and some of these governments quickly intervened in their foreign-exchange markets. Indonesia and Turkey tapped into their reserves and hiked interest rates, while Brazil introduced a $60 billion currency swap and repurchase program that provided access to dollars and reversed the slide of the real. Unlike the Asian financial crisis fifteen years earlier, none of these countries had to defend a pegged exchange rate, so their currencies were able to adjust, but the downward pressure raised fears of stoking domestic inflation.
Chinn says the Indian rupee may be vulnerable to a sudden stop or reversal of capital flows because the country didn't rebuild its reserves after the 2007 recession. Indian foreign exchange reserves were at $281 billion in late 2013, roughly $40 billion lower than their 2007 level.
 

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