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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.