Currency crises: Apocalypse-in-waiting or pressure relief and rebalancing?

The term “currency crisis’’ has not only become the new flavor of the season, but has repeatedly been used to describe the economic crisis that has engulfed many emerging or developing economies. The season started with the Turkish Lira, moved to the Argentinian Peso, and then to the Indian and Indonesian Rupee.

The sharp devaluation of these currencies, was justified by the media in terms of “economic imbalances” which resulted in the further weakening of the currencies like a self-fulfilling prophecy.

But is currency devaluation such a bad thing as everybody makes it out to be?

Not necessarily.

Fever is often just a symptom of a more serious and substantial disease or an imbalance of the physiology of the organism, and it is organism’s own way of combating it. Currency devaluations should also be treated as fever. For instance, Turkey was growing at a 5.2% average during 2015-2017, with inflation averaging around 8.8% during the same period. Moreover, the inflation rate was projected to touch 13.5% by FY 18 and the current account deficit jumping from 3.7% in 2015 to an estimated 6.5% in 2018 (EIU, ABN AMRO).

A similar story was unfolding in Argentina too, where the current account deficit (CAD) shot up to 5% of GDP by the end of 2017. India's current account in the balance of payments ended in a deficit of $ 13.5 billion, or 2% of GDP in the quarter ending December 2017, up from $ 8.0 billion or 1.4% of GDP in the same quarter.

From this a pattern clearly emerges. Rapidly growing economies that relied more on debt to finance their growth had taken advantage of low interest rates in foreign currencies. Meanwhile, the US Federal Reserve or the US central bank had started raising interest rates as the economy returned to the growth trajectory. Moreover, when US President Donald Trump makes statements about imposing a variety of tariffs on China and other countries, it results in a stronger US dollar in expectation of future interest rate hike, to cool off a rapidly overheating American economy.

The confluence of these factors is the perfect recipe for the so called “emerging” currency crises. In reality, the rapid devaluation in the currency of the affected country, is the remedy that countries to use to resolve various imbalances in the economy. It also provided time to the highly inflationary internal prices to cool off and readjust to the existing global prices.

It is as simple and unglamorous as that. There is a physiological level at which an economy can grow, depending on the depth of internal capital markets and rates of savings. Attempts to artificially jump start an economy by using foreign currencies, and widening CAD has to be kept in check by rapidly exporting more goods and services. Or else, foreign backers will start to doubt of the capacity to keep servicing the debt, resulting in their exit from these currencies.

Traditionally, banks manage currency risks through a measure called Value-at-Risk (VaR). However, foreign exchange (Fx) VaR for emerging currencies is rather difficult because of the unusually high volatility of their currencies. However, as per the regulatory norms, most of the banks are required to preserve appropriate assets in line with the riskiness of their portfolio.

To this end, emerging market regulators (i.e, Reserve Bank of India) issued a circular on Prudential Guidelines on Capital Adequacy— Implementation of Internal Models Approach (IMA) for Market Risk to select appropriate methods which must be developed correctly for the banks to determine the regulatory capital requirement under the market risk exposures.

Value-at-Risk has been estimated for foreign exchange rate risk by using parametric variance–covariance method and non-parametric historical simulation (HS) method. Backtesting results for various VaR models have been done based on Kupiec’s proportion of failures (KPoF) test and regulatory ‘traffic light’ test.

In our opinion, banks and financial institutions could avoid blackbox risks and a correct approach is required to quantify appropriately market risk through their own Value-at-Risk (VaR) model under stress scenarios. In conclusion, for non-normal returns, VaR models based on the assumption of normality significantly underestimates the risk. Therefore one needs to look at Expected Shortfall, Stress VaR, Stress Testing, and other metrics, in addition to traditional VaR.

Currency risk and its measurement needs to be looked at seriously for emerging markets. A devaluation is not a drama. It is a rebalancing of a disequilibrium which implies a cooling off of hot growth which cannot be financed internally by financial surpluses, savings, and capital markets.

Majumdar is founder, RsRL and co-founder of a start-up on AI Ethics and Piglia is the adviser of RsRL & director of The Guardian Multi Family Office.