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Fundamental rally was indeed the driving force for Asian currency strength in the second quarter of 1999. As the Asian economies showed increasing signs of recovery, so capital inflows resumed, more than offsetting renewed deterioration in their trade and current account balances. Asian currencies maintained their strength also for much of the third quarter before concerns over Y2K and specific microeconomic concerns in Korea and Thailand over Daewoo and Krung Thai Bank caused a retracement. In addition to these specific concerns, at the global level the US Federal Reserve changed the rules of the game. At its June 30 meeting of the Federal Open Market Committee, the US central bank raised interest rates for the first time since its March 25, 1997 meeting. The Fed hiked the Fed funds’ target rate by 25 basis points to 5.00% from 4.75%, however it was not so much the degree of the move as what that move itself signified — the end of monetary easing.
Candidly, the problem with any economic model is that it does not, indeed cannot, take account of what we call “event risk”. That is to say, it cannot by definition allow for events which occur unexpectedly and which can and often do cause temporary or even extended reversals in market sentiment. The CEMC model is no different in this. Its aim is to provide a framework for anticipating how emerging market currencies might perform, based on the phase in which they find themselves, all other factors being equal. Of course, in reality all factors are frequently not equal and event risk can play a part in distorting price action. A model aimed at targeting the various phases of emerging market currency crises cannot include external factors such as a change in Fed policy. That said, such external factors or event risk notwithstanding, CEMC is still a robust model in providing a predictive framework for emerging market pegged currencies.
This was not aimed at pegged currencies deliberately, but rather as a result of trying to provide an explanation for the Asian crisis and in turn link it to other emerging market currency crises — which also happened to involve currency pegs. The policy of pegging their currencies to the US dollar had provided substantial stability for the likes of Mexico, Asia, Brazil, Russia or Turkey. This had attracted significant capital inflows. In all cases however, those capital inflows caused real exchange rate appreciation and led to trade balance deterioration. The degree of that real exchange rate appreciation was much more significant in a fixed or pegged exchange rate regime. Equally, pegged currencies that experienced the greatest degree of real exchange rate appreciation also had the greatest degree of trade and current account deterioration. The one major exception was China, which in 1994–1995 experienced a real depreciation, thus cushioning the current account balance (a significant surplus) from the after- effects of the Asian crisis in 1997–1998. By early 1997, it was clear there were overvaluation concerns over several Asian currencies and that such overvaluation had been a major factor in current account deterioration. There were two possible macroeconomic responses. Either domestic prices collapsed to reduce the lost trade competitiveness as reflected by current account deterioration or the currency experienced a real depreciation to offset the previous appreciation. In the end, the currency took most of the burden of adjustment, and in spectacular fashion.
The lesson from this is that the type of exchange rate regime has a major influence on the real exchange rate performance and thus in turn on the trade balance. Indeed, the type of exchange rate regime coupled with an event — such as the US dollar’s real exchange rate appreciation — led to a series of events. While the degree of eventual market reaction (the Asian currency crisis) could not have been and generally was not predicted, the series of events itself was predictable. For this very reason, we can deduce two things:
The Asian currency crisis happened because of fundamental imbalances created by the exchange rate regime.
A model can be created to reflect this series of events for the purpose of looking at other emerging and developed market currencies.
Thus, CEMC was created and can be used to watch the progress of the likes of Turkey, Argentina and Venezuela going forward.
Floating exchange rate regimes behave differently as the transmission mechanism from the exchange rate regime through the real exchange rate to the trade balance is also different. As an example, let’s look again at the Polish zloty during 2001. During the flrst half of 2001, the zloty was one of the top performing currencies in the world against both the Euro and the dollar, supported by heavy capital inflows. Then, in early July 2001, it collapsed. What happened? In April 2000, the National Bank of Poland had made one of its smartest decisions, scrapping the zloty’s crawl and peg regime and making the currency fully floating. Since the zloty was a floating currency how could it collapse? Economic theory suggests a floating currency will reflect economic deterioration gradually, thus militating against the worst effects of that deterioration. Economic theory suggests that economic deterioration through a widening current account deflcit should lead to gradual real exchange rate depreciation in order to restore equilibrium. Yet, there is nothing gradual about a freely floating currency losing almost 10% of its value in a couple of days, as happened with the Polish zloty. Similarly, in the autumn of 1998 as noted earlier, the dollar–yen exchange rate collapsed from 135 to 114 in less than two days. So, what happened?
To answer this question, we have to refer back to the speculative cycle of exchange rates we first looked at in previous posts, which focuses specifically on speculative flow to explain moves and trends in freely floating exchange rates. To recap, the central idea behind this is that the longer an exchange rate trend develops, the inherently more speculative in nature it becomes. Eventually, speculative buying (selling) is overwhelmed by fundamental selling (buying) and the exchange rate trend reverses. Sometimes, this reversal is sudden and dramatic, as in the cases of the Polish zloty and the Japanese yen. Somewhat helpfully, ahead of that reversal, option volatility tends to start rising, which currency market practitioners should view as awarning of the reversal to come. This is indeed what happened with the zloty and the yen. We looked at this phenomenon briefly in a previous post. Here, in the context of a post devoted speciflcally to exchange rate models, we do so in considerably more detail. While this can be applied to developed market currencies, there are specific considerations with these such as “safe haven” and “reserve currency” status, which distort all models. This particular model is particularly effective with freely floating emerging market currencies, given how capital inflows influence nominal and real interest rates. In the case of the CEMC model, we used the example of Thailand to demonstrate it in practice. With the freely floating exchange rate model, specializing in emerging markets, we use the example of Poland.

What does economic recovery mean and how is it different from mere “stabilization”? It is the equivalent of the patient on the one hand getting back his/her vital signs but still remaining essentially horizontal, and on the other hand wandering around the ward. There is a clear difference! In economic terms, recovery means real economic indicators such as retail sales, industrial output and imports are no longer contracting, but actually rising. In particular, as imports start rising, first on a year-on-year basis due to basing effects and then on a month-on-month basis, this is the first real sign of fundamental recovery. At street level, more practically, the first sign of recovery is people back in the shops and retail prices making a bottom.
During Phases III and IV, prices fall until such time as consumers are tempted back by bargain basement prices. Phase V is when that temptation produces results. The elimination of corporate de-stocking which had hitherto been a drag on growth, coupled with lower interest rates and looser fiscal policy which provide support for weak domestic demand, help boost economic growth. Corporate re-stocking of inventories gives a further lift to that growth take off. In terms of the trade balance, inventory re-stocking accelerates the recovery in imports, in turn accelerating the pullback in monthly recorded trade surpluses. However, by this time, capital flows have begun to offset and then exceed trade flows as investment returns to the region. Rising real economic indicators attract rising capital inflows, helping once again to produce a rally in the local currency. However, unlike in Phase III, this time the rally is fundamentally- based rather than just liquidity-based.

During Phase III, Asian currencies appreciated on the back of the liquidity-based rally. However, during Phase IV, trade and current account surpluses peak as import demand hits bottom. This is of course good news for the domestic economy, however it temporarily reduces the beneficial liquidity effect on local assets and local currencies. For this very reason, just as Asian economies bottomed around the turn of 1998/99, so Asian currencies started to weaken again, giving back some of the ground they had gained during the second half of 1998. More specifically, the Thai baht, which had risen to a high against the US dollar of THB35.65, fell back to around 38–39. The same kind of thing happened to the Indonesian rupiah, the Philippine peso and the Singapore dollar. The Malaysian ringgit was pegged to the dollar on September 1, 1998 at 3.80, hence it did not experience this renewed setback, nor for that matter did it experience the fundamental recovery which most Asian currencies subsequently enjoyed. In the case of Brazil, Phases III and IV happened much more quickly, partly because Brazil, unlike in Asia, was alone in its devaluation and not affected by region-wide devaluation. In addition, it continued to benefit from strong demand for its exports. Finally, at the corporate level, there was not nearly the same degree of structural dislocation, as Brazilian corporates were by then well aware of what had happened to their Thai and Indonesian counterparts and had already begun to hedge external liabilities long before the real’s final devaluation in January 1999. The case of Russia is special for many reasons, not least because several key elements of the Russian government were not informed of the decision to devalue the rouble and default on the domestic debt market until the actual announcement was made. In addition, the size of the black market economy relative to the real economy, and the seemingly persistent state of chaos in the Russian government, has somewhat distorted price and economic development as anticipated by the model. Nonetheless, the key aspects of the model — the turnaround in the trade account, the defeat of inflation, the liquidity-based rally, still held true. So Phase IV sees a decidedly more bumpy ride for emerging market currencies than Phase III. Yet, economic stabilization, all else being equal, gradually becomes economic recovery — the person eventually picks him/herself off the floor after lying there in pain after the fall.

While Phase III remains ongoing, the economic patient is still showing no major sign of recovery. Inflation peaks, which in turn allows domestic interest rates to peak. The trade account swings hugely, in many cases from a deficit to a surplus as import demand collapses. This accelerates the recovery in liquidity, helping to force down interest rates and thus causing the liquidity-based rally which we talked about earlier. Eventually, the trade surplus, low interest rates and basing effects help support the economy. Put bluntly, the economy hits bottom and a period of stabilization ensues.
Readers should note that economic stabilization does not mean the same as recovery, in the same way that hitting the ground after a fall from some height does not entail recovery (indeed, if the height is sufficient there is unlikely to be any recovery!). Both processes usually entail a prolongation of pain, but at least the pain is not getting worse. Thankfully, economies are not as frail as the human body. They can indeed fall from great heights, smack down hard on the concrete with a sickening thud and yet still recover; the timing of that recovery depending crucially on the extent of the fall.
At the microeconomic level, companies are still continuing the process of de-stocking of inventory. Consumers remain very cautious and retail prices continue to decline to levels aimed at causing them to buy. That said, the fall in interest rates eventually provides crucial support for cash-strapped companies and banks. These hastily complete their inventory de-stocking process, switching most of that supply to export markets unaffected by the crisis, and start the process of re-stocking. At the international level, the reality of the economy hitting bottom, as evidenced by declining contractions in economic indicators, leads to the expectation of Phase V, economic recovery. Phase IV is not plain sailing for local currencies however. As domestic economies stabilize, so do imports. Indeed, year-on-year basing effects accelerate that process. Thus, what we usually see in Phase IV is those trade and current account surpluses peaking on a monthly basis. During Phase III and the initial part of Phase IV, trade flows are actually more important than capital flows — as most offshore investors have already left by then, taking their capital with them. Reduced trade surpluses thus have a greater effect on market movements than would otherwise be the case, serving to weaken the local currencies.

The collapse of the Thai baht extended well beyond levels seen on the first day of “flotation”. Having been around THB25 to the US dollar before the “flotation” (devaluation), it subsequently fell to a low of 56.3 in the coming months, a decline in value of over 40%. In the case of the Indonesian rupiah, the fall was even more spectacular, plunging from IDR2,300 to the dollar to a low of 17,000, a devaluation of 85%! Asian countries generally tightened monetary policy in order to temper the threat of imported inflation from currency devaluations and in line with the IMF’s initial call for tightening of both fiscal and monetary policy. Policy tightening in the face of maxi-devaluation of the currency tends to cause a slowdown in the economy to become a recession (if not a depression!), and in the cases of Thailand and Indonesia that is indeed what happened. In 1998, the Thai economy contracted 9.5%, while that of Indonesia contracted 13.2%. Whatever the merits of these policies, which were ostensibly aimed at providing long-term economic stability, there is no question that in the short term they severely exacerbated the regional economic slowdown. At street level, millions were forced into poverty. The World Bank estimated that half of Indonesia was living in a state of absolute poverty in 1998, defined as earning less than USD1 a day. Unemployment levels skyrocketed. Retail prices rose sharply to offset the free-falling currency in the likes of Indonesia, the Philippines and Thailand. Interest rates were tightened to offset this, compounding the misery.
In the wake of this, several leading commentators were heavily critical of the IMF policy response to the Asian crisis, saying the combination of tight fiscal and monetary policy represented a worse cure than the disease itself. While I have some sympathy with this view, particularly as public policy adjustment is not necessarily the appropriate policy response to private sector imbalance (too many Asian companies borrowing too much in dollars and speculating too much in their own stock and property markets), this still does not answer the question of how one stops a currency from free-falling. This is a key consideration bearing in mind that the collapse of the rupiah resulted in the bankruptcy of almost every company in Indonesia. Whether you favoured the argument of the IMF’s Herbert Neiss or Harvard’s Jeffrey Sachs, it is pretty irrelevant. By then, the damage was already done; the battle had already been lost. By then, it was a question only of damage limitation.
The example of the Brazilian crisis, however, suggests some refinements to the standard IMF policy response have been considered — not least at the IMF — in the wake of the Asian crisis. When the Brazilian real devalued in January 1999 and subsequently fell to a low of 2.2200 to the dollar from its 1.20 band level, many forecast 2.50 or even 3.00 and a similar type of recession to that Asia had experienced. In reality, neither of those two possibilities happened. Clearly, the appointment of Arminio Fraga as the new head of the Brazilian central bank was an important stabilizing measure, as Fraga was a widely respected figure in the financial markets. The maintenance of trade finance for Brazil was also a crucial difference.
Whatever the differences, the similarities between the crises in Asia and Brazil — and also with Mexico, Russia and Turkey — are clear. Most notably within this was the fact that once inflation peaked so too did local interest rates, allowing for a substantial rally in asset markets and the currencies themselves. In Indonesia, for example, this meant interest rates coming down from around 75–80% and the dollar–rupiah exchange rate falling back from around 17,000 to around 6500. Equally, in Thailand, the dollar–Thai baht exchange rate fell back from 56 to around 35. In the case of Brazil, the dollar–Brazilian real exchange rate fell back from 2.22 to 1.63. Fundamentally, during this period, the trade accounts in many Asian countries swung from significant deficits to massive trade and current account surpluses.

A pegged currency that is allowed to float freely usually falls sharply for at least the first six months after the free float is put in place, overshooting any idea of fair value. The rule is the longer a central bank tries to defend it, the further the currency falls in the end. Currency market participants who earlier dismissed the idea of currency risk have to chase the market to put belated hedges in place. In addition, at the macroeconomic level inflation rises as the pass-through effect to the real economy of maxi-devaluation. The signal that the devaluation is at an end is when that inflation rate peaks. At that time, portfolio money starts to flow back into the country, attracted by high nominal interest rates. This in turn allows the local currency to recover potentially significant ground. In line with this, the trade account improves significantly as import demand collapses in the wake of economic contraction. Thus a liquidity-based rally in local asset markets and the local currency is created through lower interest rates and renewed portfolio inflows. This is different from Phase IV, which sees a fundamentally-based rally, as demand-side indicators continue to deteriorate during this period.