Failing to spot the Asian currency crisis of 1997 would have been disastrous for an investor. In the case of Thailand, Malaysia and the Philippines, it took almost a decade for equity markets to reach January 1997 levels again in nominal terms. But, how can you see a currency crisis coming in real time?
The Asian Boom:
The Asian currency crisis was an example of a classic emerging market bubble. Funds cascaded into the emerging “Tiger” economies after the bubble burst in Japan in the late 1980s. The new inflows pushed up the value of Asian currencies or, if they were pegged, it forced them to accumulate FX reserves.
The Asian countries were seen as a new economic miracle, not subject to normal economic laws. The inflows not only inflated the currencies of the countries, they pushed up equity markets and drove down bond yields, making it exceedingly cheap for corporates and governments to borrow while flooding domestic markets with credit. This fueled property markets, through easy access to mortgage credit, and boosted consumption, as consumer loans became much easier to come by.
Currency pegs encouraged foreign lending, and gross external debt in many Asian EMs grew to alarming levels, as high as 72% in Thailand.
Signs of a Currency Crisis:
1. A large current account deficit:
Currency crises are usually an emerging market phenomenon where foreign capital flees after a bust. Countries with large and growing current account deficits are vulnerable. The surge in consumption and enthusiasm for domestic assets collapsed current account balances in Asia. Sizable current account deficits illustrated the excess of imports over exports and the outflow of dividends and coupons from equities and bonds now owned by foreigners.
We can see here the collapse in current account balances in Thailand and Indonesia in the mid to late 1990s.
Current accounts are the single best indicator of a future currency crisis. Thailand’s, we can see, reached almost 10%.
2. Low Foreign Direct Investment (FDI):
When countries have large current account deficits, these deficits have to be funded and there are only essentially two ways: potentially volatile hot money portfolio inflows (stocks and bonds), or more sticky FDI (factories, buildings, etc). Having low levels of foreign direct investment means that money can flow out of a country quickly.
In Asian currency crisis, much of the capital that flowed out of Japan and into Thailand, Malaysia, and so on was short-term in nature. This means it was invested in the equity market – hoping to benefit from the seeming irrepressible profitability of domestic firms, and a rising currency – or in debt, often with a short maturity. International capital flows were rarely invested in foreign direct investment and infrastructure.
As the chart below shows, short-term debt as a percentage of foreign reserves rose sharply in Asian countries in the mid-1990s (with an exceedingly rapid rise in Korea masking the still significant surges in Malaysia and Thailand).
3. Insufficient FX Reserves:
Having insufficient foreign exchange reserves to cover portfolio flows, imports and debt leaves a currency vulnerable to a currency crisis.
This is what we saw in Asia in the late 90s. In late 1996, consumer loans in Thailand started to deteriorate, causing large losses. Skittish foreign investors began to pull money from Thailand. The short-term nature of much of the inflows meant it very quickly left a big hole in Thailand’s finances. Compounding the problem was the currency peg. Again, what was useful on the way in, encouraging ‘investment’ in the domestic economy, became incendiary on the way out, as Thai authorities quickly depleted their FX reserves in a doomed attempt to maintain the peg and keep the illusion of an “economic miracle” going.
The Asian Currency Crisis
The following chart clearly illustrates the damage done to EM Asian currencies as the crisis in 1997 took hold.
The fleeting nature of capital flows meant contagion could easily and rapidly follow to other countries. Malaysia, Indonesia, Korea, Singapore all saw sharp falls in their currencies when the pegs were dropped as it became clear the game was up. The aftermath led to huge losses or defaults for companies that had borrowed in foreign currencies. Banking crises led to collapses in credit, and deep recessions ensued that lasted several years.
All the warning signals were there that not all was well in Asia: large and persistent current account deficits, short-term capital inflows, and insufficient FX reserves. These factors have repeatedly re-appeared in subsequent crises and tracking them can allow you to anticipate which countries are vulnerable to future crises. For example, here are current account deficits as a percentage of GDP, annual net inward FDI as a percentage of GDP and FX reserves/short-term external debt that we delivered to clients in September 2017.
On the flip side, EM currency crises can present exceptional investment opportunities as they bottom out. You can download our EM Crises white paper here to see how you can identify the next bottom, whether it’s in Turkey, Argentina, or elsewhere.