Currency attacks on weak economies have become more frequent. Even strengthening economies in Asia continue to experience currency attacks and devaluation after the economic reforms prescribed by the IMF during the Asian Financial Crisis.
Failure to understand currency attacks and devaluations can render an investment program completely ineffective. Recent Private Equity Investments in Asia have seen 50% to 100% of investment performance being wiped out by significant currency devaluations. The ability to identify and react to the symptoms of a weak economy is hence crucial to fund performance.
This study provides a systematic approach to help portfolio managers identify weak economies in Asia and assess whether their governments are likely to be able to prevent currency attacks in the 3-year horizon.
Case Study: Asian Financial Crisis
The Asian Financial Crisis occurred as a result of (i) Incentives forcing managers in corporations to pursue growth regardless of risk by borrowing to fund projects (ii) continuous investments into the region in pursuit of yield, and (iii) lax supervision and weak regulation of domestic banking sectors.
The conditions surrounding the Crisis were in place years before it began. At that time, Southeast Asia was a roaring economic region with most countries growing at 5%-10% per annum. Thailand, the country at the center of the crisis, embarked on a loose credit policy and encouraged local banks to lend money for private real estate and other capital projects despite failing Returns on Capital. Consequently, Thai companies started borrowing from abroad to get cheaper interest rates to continue investments into these projects.
Non-productive sectors, such as over-leveraged Thai real estate companies, began exhibiting financial stress around February 1997. The trigger was the sudden depreciation of the Thai Baht by 20% on 2 July 1997. This had a financial and information contagion effect on its neighbours, resulting in a region-wide currency crisis that led to a financial crisis.
The ability of market participants to attack a currency depends on environmental factors. Supporting the proposition of Obtsfeld (1994), we posit that since FX markets have multiple equilibria, there is no single indicator that appropriately signals country weakness, the first phase that precedes a currency attack.
The next phase involves the actions of market participants that cause sharp depreciation of the currency. The term “currency attack” is in fact, a misnomer – in practice, they are merely actions by market participants who act on perceived irrationality in FX markets.
The last phase is the intervention of governments to prevent the exacerbation of current attacks. Evidence from previous crises shows that the magnitude and timing of the intervention are critical to avoid further deterioration in a crisis. Intervention needs to be adequate and timely to break the vicious cycle of crisis.
Identifying Weak Economies
FX price movements can be explained by transitions between states of equilibrium. We believe that currency attacks happen to countries that are “weak economies”, or economies with macroeconomic conditions that make their currency vulnerable to speculative attacks. The environment plays a critical role in a currency attack. Combining insights from literature review and survey results, we applied a PESTEL analysis to identify indicators that would be effective in revealing the various types of economic weakness that might suggest an impending currency attack:
- Financial Weakness – We suggest the use of rate of credit expansion, and the short-term credit to GDP ratio to measure the strength of the country. This reflects the country’s vulnerability to a shock arising from the financial sector, as well as the financial sector’s resilience to a currency attack.
- Trade Weakness – This refers to the strength of a country’s trade position vis-à-vis the rest of the world. We suggest using the current account deficit to GDP ratio. A current account deficit might indicate that the country’s currency is not at its long-term equilibrium value, or the value that would allow imports and exports to be balanced – hence, a current account deficit may be predictive of an impending correction.
- Intervention Weakness – This refers to the ability of governments to react during a currency attack. We suggest Public Debt to GDP, the M2 to Foreign Reserves ratio, inflation and interest rates. Countries with low interest rates would be able to raise rates to prevent the outflow of capital in times of currency attacks. Countries with high M2 to Foreign Reserves ratio will be better able to directly intervene in FX markets and defend its currency. These, together with the public debt burden, provides a strong signal of the ability to use government policy levers to counteract triggers.
- Market Weakness – This refers to the ability of markets to generate returns. We suggest the use of appreciation of asset prices and Return on Capital. Rapid appreciation of asset prices may translate to deteriorating returns if the increase is not based on growth in the real economy. Similarly, a decreasing return on capital is a sign of country weakness. If expected future returns are weak, the demand for the currency from investors will be correspondingly weak.
Implications for Fund Managers
Based on our analysis, we have identified important implications for fund managers.
Fund managers should pay close attention to macroeconomic conditions in the core countries they invest in and assess the weakness of those economies. Unfavourable macroeconomic conditions always precede severe currency attacks and provide vital warning signs for fund managers. In the event that fund managers assess that the country is weak, they can optimise their investment strategies and strategically select their targets to capitalise on the opportunities that may arise from a future attack – for example, they should invest in export clusters, which will benefit from sharp depreciations in exchange rates.
Fund managers should also pay close attention to the attempts of governments to intervene and correct structural weaknesses in their economy following an attack. By assessing the credibility and effectiveness of intervention efforts, fund managers can assess the future strengths of economies. This is especially useful for fund managers who make investments over the medium term and for whom intelligence on long-term economic prospects are crucial for investment decisions.
Weak economies create conditions for currency attacks to emerge. These weaknesses accumulate over time and are therefore often observable from measured macroeconomic variables. Currency attacks usually occur when thresholds in these triggers are breached, offering strong arbitrage incentives for market participants to alter their behaviour. Using this analysis, fund managers can position themselves to minimise the losses and maximise the opportunities arising from weak economies and the currency attacks experienced by these economies.
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