Can Currency Crises be Predicted?
The type of exchange rate regime is important for normal market trading conditions, but it is especially important for abnormal periods of market stress that may lead ultimately to a “currency crisis”.
In the wake of the emerging market crises in Mexico (1994–1995), Asia (1997–1998), Russia (1998), Brazil (1999) and Turkey (2001), considerable effort has been made by the academic and financial communities to create models that might be able to predict such crises in the future. As with long-term valuation models aimed at finding a currency’s “equilibrium” level, most of these are based on highly complex mathematical formulae and make certain key assumptions about human behaviour and psychology. Equally, like the equilibrium models, the results of these have been mixed at best to date. No-one has as yet come up with the definitive model capable of predicting currency crises ahead of time on a consistent basis. The best that has been achieved is some degree of success, albeit claimed after the fact.
For my part, I make no claim either as to a definitive breakthrough. What I would lay claim to however is having approached the issue of currency crisis from a different angle. Most of the existing models focus largely on the rationality of human behaviour. In a financial context, this implies rational investors investing where the best returns are to be found. If those returns diminish or if better returns are available elsewhere, it is assumed that they will leave. Such a rationally-dominated view does not allow for herd behaviour, that buying may continue long past the point at which yield returns have diminished significantly. There is an emotional hang-up, both within economic theory and within the official community, which labels buyers as investors and sellers as speculators. Yet, buyers can also be speculating. Indeed, some of the best examples of speculative excess gone mad have come from buying rather than selling, notably the internet bubble. Markets are ruled by such fundamental sentiments as greed and fear, and it is safe to say that in 1999–2000 greed was running rampant. Easy money was to be had — as it always is during such periods of market hysteria. The financial bubble got bigger and bigger and then burst spectacularly in mid-2000. We are still feeling the after-effects of the bursting of the economic bubble, that tidal wave of increasingly unprofitable investment. This is just one example of the “speculative” excess with which human history is littered. In trying to create a model to predict currency crises, my aim has not been to fit economic theory around the facts, but rather to start the other way around, examining patterns within those facts and then aligning the theory to fit. The effort has been that of a forensic detective, rather than a psychic. Thus, the rather simple — though hopefully not simplistic — model that I created in 19981 is based not on complex mathematical formulae, but instead on the sum of those patterns that have been seen in the emerging market currency crises of the past 10 years. For want of a more pithy title, I called it the Classic Emerging Market Currency Crisis (CEMC) model, a title that is long-winded but hopefully captures the repetitious nature of currency crisis patterns. Our detective did find if not a smoking gun, then at least enough forensic evidence to discover the “how” and the “why”.
The model focuses on emerging markets and more specifically the Asian currency crisis in large part because I witnessed the latter at first hand, having lived and been involved in the financial markets in Hong Kong during the second part of the 1990s. Because the model’s initial aim was to discover patterns that specifically reflected the Asian crisis, it was de facto a model that focused on fixed or pegged exchange rate regimes and how those broke down. This is not to say it is only reflective of the Asian crisis. CEMC should be viewed as a template for emerging market currency pegged regimes generally. Indeed, it works remarkably well in explaining the key dynamics behind the currency crises in Mexico, Russia, Brazil and Turkey. The model is based on five key phases that appeared to take place during the Asian crisis, and were also mirrored in subsequent emerging market crises in Russia, Brazil and Turkey. Throughout, I use Thailand, seen as the catalyst for the Asian currency crisis, as an example of the general phenomenon at work.
Tags: Crisis, Currency, Exchange rate, finance
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