By Andrés Velasco
With the currencies of Malaysia, Indonesia, South Africa, Turkey, Brazil, Colombia, Chile, and Mexico hitting record lows recently, currency traders around the world are asking: How much further can emerging-market currencies weaken?
The standard approach to answering this question takes a relatively normal base year and measures how much a country’s currency has depreciated since then. That number is then adjusted for the inflation differential between the country and its trading partners. If the resulting real exchange rate is not too far from that of the base year, the market is said to be in equilibrium, and little or no further depreciation should be expected.
Now consider an alternative method. Take the same country’s current-account deficit and ask how large a real depreciation is needed (making some assumptions about trade elasticities along the way) to close that external gap. If the recent real depreciation achieves that threshold, no further change in the exchange rate should be expected.
These are the right answers, but to the wrong question. Over the medium to long term, exchange rates are indeed driven by what happens in the real economy. Or, more precisely, they reflect the requirement that the real exchange rate be such that the economy attains both external balance (a small and manageable current-account deficit) and internal balance (no inflationary pressures at home).
But that need not happen until many months – perhaps years – after a shock. In the short run, exchange rates are driven by purely financial considerations. That is why they are prone to overshooting. Even small changes in fundamentals can have large effects on exchange rates, with up-front movements that far exceed what long-run adjustment requires. And the potential for volatility is particularly great if domestic corporations have large foreign-currency debts, which is true in all of the emerging economies under stress today.
Consider the case of a hypothetical Latin American retail company that borrowed abroad in dollars to build a shopping mall at home. Such borrowing calls for collateral – in this case, the land on which construction will take place. The larger the value of the collateral, typically measured in domestic currency (or in an inflation-indexed unit, such as Chile’s Unidad de Fomento), the larger the size of the dollar loan.
Next, suppose that the price of the natural resource that is the country’s largest export suddenly dips sharply (as has happened recently). The exchange rate (both nominal and real) will depreciate accordingly, thereby setting in motion the standard, textbook adjustment process.
But in this case, a second, non-standard factor comes into play. After the depreciation, the collateral, valued in dollars, is worth less. Loan covenants have likely been broken, and lenders begin demanding that the borrower either put up new collateral or deleverage and repay part of the loan.
To repay, the firm must purchase dollars. If there are large dollar debts outstanding, and many firms find themselves in the same position, the additional demand for dollars will cause the exchange rate to depreciate even further. And that, of course, causes the dollar value of the collateral to fall yet again.
You can see where this story is going. The process plays out until the domestic currency has lost a good deal of its value. After a few days or weeks, the exchange rate is likely to be weaker than is warranted by the need to adjust the current account. The overshooting is caused by the coexistence of sizeable foreign-currency debts and financial (collateral) constraints.
Notice that if in the long run the debt is reduced sufficiently, and the terms-of-trade shock abates somewhat, the real exchange rate need not depreciate that much, and may even end up appreciating a bit. This is overshooting on steroids: a very sharp initial loss of value for the domestic currency, followed by a gain that may leave the exchange rate, measured in inflation-adjusted terms, stronger than it was at the start.
For many emerging-market economies, this is, alas, a painfully realistic scenario. Since the subprime crisis, ultra-low interest rates in the rich world have caused emerging-market firms to borrow like never before. Some of the debt does not even appear in the official statistics of borrowing countries, because it was often taken on not by domestically-based firms, but by their offshore subsidiaries.
The Bank for International Settlements estimates outstanding dollar credit to non-bank borrowers outside the United States at $9 trillion. Big debtors include some of those countries whose currencies have come under downward pressure recently: China ($1 trillion), Brazil (more than $300 billion), India ($125 billion), plus Malaysia, South Africa, Turkey, and Latin America’s financially open economies: Colombia, Chile, Peru, and Mexico.
Central banks can intervene in the currency markets and sell reserves, thereby offsetting the withdrawal of financing by foreign lenders. But intervention requires that the authorities first have both the reserves and the will to abandon (at least temporarily) their hands-off commitment to a floating exchange rate. Not all emerging-market central banks are in a position to fulfill both of these requirements.
A sharp growth slowdown is the other component of this overshooting adjustment pattern. The initial export shock was likely to reduce growth. The sudden deleveraging imposed by foreign creditors requires the current-account balance to adjust further and faster.
The additional exports triggered by the depreciated currency can help, but they are often slow in coming. The fastest way to adjust is via reduced demand and imports, and that is what almost always ends up happening. Growth and job creation take the hit, as we are seeing today in emerging market economies around the world.
In these circumstances, currency traders suffer. But citizens of indebted middle-income countries are likely to suffer far more. Today’s emerging-market turmoil is here to stay, and they are the true victims.
Andrés Velasco, is a former presidential candidate and finance minister of Chile, and is Professor of Professional Practice in International Development at Columbia University’s School of International and Public Affairs.