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Lessons from history from three generations of currency crises

The aftermath of the Covid-19 pandemic and the Russia-Ukraine war have put developing countries under significant stress. This column draws lessons from three generations of currency crises since the 1980s for the current period. The 1980s crisis in Latin America, 1990s crisis in Mexico, and late 1990s crisis in Asia were all characterised by significant capital inflows followed by sharp reversals in confidence, outflows of financial capital, and international assistance. These crises emphasise the importance of credible policymaking, as well as sustainable trade and budget deficits.

Due to the pandemic and the weak global economy impacted by the Russia-Ukraine war, developing countries are under strain (Trebesch et al. 2021, Kose et al. 2022, Rijkers et al. 2022, Chuku et al. 2023). The International Monetary Fund (IMF) estimates that around 60% of low-income countries are at risk of debt distress, meaning they may not be able to pay their debts and could require a rescue (IMF 2022). This proportion is three times higher than after the 2008 global crisis.

There have been three generations of currency crises that led to sovereign rescues since the early 1980s (Yueh 2023). They demonstrate the speed of capital movements affecting both developing and advanced economies (Rey 2013, Ostry et al. 2014, Ferroro et al. 2023). Although the crises in Latin America in the early 1980s, Europe and Mexico in the early and mid 1990s, and Asia in the late 1990s were different in numerous respects, they shared common traits which give rise to lessons for today. Key among these is the importance of credible institutions and policies.

Each generation of the emerging markets crises exhibited exuberant behaviour in the run-up to the crash, where short-term capital (‘hot money’) flowed into countries that had promised to keep their exchange rates fixed and stable. The currency crises were due to speculators and investors finding a lack of credibility on the part of governments in Latin America to defend their currency pegs. The same can be said for Asia, though their crisis stemmed from investors losing confidence in those countries’ overextended financial markets. Thus, all three generations shared traits, such as euphoria driving capital inflows and the importance of credible exchange rates.

The first-generation currency crisis, the Latin American crisis of 1981–82, centred on Chile, Brazil, Mexico, and Argentina, which operated a fixed exchange rate against the US dollar, collectively called the Tablita, known as a crawling peg.

Just as abruptly as the ‘hot money’ flowed into these economies, the flows reversed when the US, under new Fed Chairman Paul Volcker, raised interest rates in late 1979 to curb inflation in the aftermath of the second oil price shock of that decade. Higher interest rates made it tougher for these Latin American countries to finance their external indebtedness. Moreover, monies started to flow back into the US due to better returns from the higher interest rates on US securities. The Tablita exchange rate came under pressure, particularly as there was also a substantial inflation differential between these countries and the US. Inflation in these Latin American economies rose in excess of the currency depreciations, which eroded their competitiveness and put pressure on their balance of payments.

The crisis erupted when these commodity-exporting countries said that they could not pay the interest on their external loans, which had jumped from $125 billion in the late 1970s to a staggering $800 billion. The combination of high interest rates and commodity prices falling due to the global recession meant that they were at risk of defaulting on their debt. For the next seven years, Latin American countries negotiated with their creditors.

It wasn’t until March 1989 that the Brady Plan, named after then US Treasury Secretary Nicholas F. Brady, saw the crisis finally resolved. Over $160 billion of ‘Brady bonds’ were issued not only by Latin American emerging economies but by others as well. By 2006, most Brady bonds had been exchanged or bought back by the debtor nations. Brady bond trading had accounted for 61% of emerging market debt in 1994; it had dropped to just 2% by 2005 (EMTA).

Mexico experienced crisis yet again in the second-generation currency crisis. The collapse of the Mexican peso against the US dollar in 1994 was dramatic: the peso fell by more than 50%.

On 1 January of that year, Mexico joined NAFTA, the North American Free Trade Agreement between it, Canada, and the US. Mexico privatised several hundred state-owned firms and deregulated to promote competition. It was expecting to become a low-cost producer for its neighbours. The opportunities attracted foreign investors, so money flowed into this emerging market.

Leading up to the crisis, there were several underlying weaknesses in the Mexican economy which led speculators to question the sustainability of the peg, including a growing current account deficit just like in the early 1980s.

Faced with mounting external pressure, Mexico decided to devalue the peso in December 1994, but the small initial devaluation was quickly followed by a loss of investor confidence and the crisis ensued.

In early 1995, Mexico was rescued by the US alongside the IMF and Bank for International Settlements. If Mexico had defaulted, it would have jeopardised NAFTA and could have affected the region, a potential repeat of the 1981-1982 crisis.

The third-generation currency crisis rather surprisingly took place among the fast-growing economies of Asia. In late 1997 and early 1998, the Asian Five – Thailand, Malaysia, South Korea, Indonesia, and the Philippines – suffered a collapse in their currencies brought on by large outflows of financial capital, which then led to a currency crisis as their fixed exchange rates collapsed as a consequence. Unlike the Latin American crises, the Asian crash was part of a broader financial crisis. The crisis also spread infectiously across the world.

Although there were those who questioned the extent of Asia’s economic miracle, few expected the region to suffer the crisis that it did. It didn’t follow the pattern set by the first- and second-generation models. On the eve of the crisis, inflation was low and there were no large budget and current account deficits.

The 1990s was later dubbed a period of hyper-globalisation as investment surged into emerging markets, and nowhere did it surge more rapidly than in Asia (Rodrik 2019). Stock prices soared. In the first half of the 1990s, Thailand, Malaysia, and Indonesia saw share prices rise by 300% to 500%. Real estate boomed along with the economy. In many of these countries, the listed companies were substantial property owners, so the real estate boom contributed to the stock market rise.

In 1996, net flows into these economies totalled $93 billion, mostly from private creditors and portfolio investors who were encouraged by high rates of economic growth. Also, wide-ranging deregulation enabled banks and domestic corporations to tap into foreign finance for domestic investments. In addition, their exchange rates were pegged to the US dollar, which helped to encourage inward investment.

In 1997, the net inflows into the Asian Five reversed to an outflow of $12 billion, a swing of $105 billion, which was about 11% of their collective GDP. Foreign direct investment remained constant at about $7 billion, so most of the decline came from short-term ‘hot money’.

The reversal was triggered by fragilities in the Asian Five’s financial systems. Although there were no explicit government guarantees, most banks had political connections. Such a system of ‘crony capitalism’ is likely to lead to risky investments.

When investors lost confidence after defaults in Thailand, they pulled their money. Following the collapse of the Thai baht, creditors became wary of the region, and the Asian financial crisis ensued. The currencies of Malaysia, the Philippines, Indonesia, and Singapore fell in value by 30% or more within six months. The Indonesian rupiah declined by more than two-thirds. These economies witnessed dramatic real estate and stock market collapses; share prices fell by 30% to 60%.

The contagion led to investors moving monies out of other emerging markets, including Russia, Turkey, Brazil, and Argentina. The US was also affected. Long-Term Capital Management (LTCM), which was one of the largest hedge funds in the world, needed to be rescued due to its exposure to emerging markets.

The Asian crisis ended with Thailand, Indonesia, and South Korea receiving bailouts by the IMF. The Philippines drew more funds from an existing IMF package.

For policymakers, the three generation of currency crises offer numerous lessons.

They should be wary of running excessive trade and budget deficits. When economic fundamentals are weak, as in Latin America in the early 1980s, speculators could sell off a country’s currency in anticipation of a collapse. In the ‘Tequila Crisis’ of 1994, Mexico could not credibly maintain its exchange rate. Therefore, credible policies are important.

In the third-generation crisis, investors quickly pulled ‘hot money’ out of emerging markets, which caused the late 1990s Asian financial crisis to spread across the world. Since investors might treat emerging economies as a class, policymakers should aim to differentiate their country to avoid being part of indiscriminate selling that can trigger a crisis.

In all crises, policymakers should act in a credible manner, the need for which has been evident in decades of sovereign crises.


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