Most of the currency crises of the 1990s happened against soft currency pegs. In the wake of the Asian currency crisis, I made a stab at creating a model which focused on how exchange rates typically performed in the run to and after the break down of a pegged exchange rate regime. For good or ill, the Classic Emerging Market Currency Crisis (CEMC) model was the result. To be sure, the title is a mouthful, but for the most part it tells the story of most emerging market currency crises during the 1990s and thus may serve as a useful barometer should any such crises be experienced going forward. This can be broken down into five phases during which the currency crisis takes place:
1. Capital inflows and real currency appreciation
2. Fundamental deterioration and inevitable currency collapse
3. A positive current account swing and a liquidity-based rally
4. The economy hits bottom; a period of consolidation
5. The fundamental rally
A key aspect of these crises was the relationship between the real exchange rate and the external balance. In floating exchange rate regimes, economic imbalances are usually smoothed out over time. In pegged exchange rate regimes, they can build up to unsustainable levels, thus forcing the collapse of the exchange rate peg, if not checked by changes in macroeconomic policy.
The signal grid and the risk appetite indicator should be the two main tools of the currency strategist. There are however other aspects of the currency markets that still have to be considered. For instance, the type of exchange rate regime is an important consideration as it can have a significantly different impact on the economy depending on what type of regime is being used. The latest fashion within the official community in Washington DC is to advocate the so-called “bi-polar” world of exchange rates, supporting the idea that in a world of free capital markets only the hardest currency peg or a completely free-floating currency are appropriate, and that anything else is unsustainable. It seems likely that this will ultimately give way to a new trend, whereby there are significantly less currencies, all of which are freely floating. As far as currency market practitioners are concerned, key questions that a corporate executive or an investor must ask if they are exposed to a currency peg regime are:
Does the currency peg itself contribute to macroeconomic stability?
What is the degree of participation in global capital flows of the country concerned?
Is the currency peg at the right value?
Most soft or semi-pegged exchange rate regimes have gone, voluntarily or otherwise. If you have currency exposure to a pegged exchange rate regime and you are concerned about currency risk, the rule to remember is that you should hedge when the market has no interest in hedging and thus when risk premiums are low. By the time the market is keen to hedge currency risk, liquidity and price conditions will have deteriorated and it will be too late to obtain anything but the most expensive of currency protection.
The beauty of freely floating exchange rates is that they act as a self-adjusting mechanism, transmitting changes in fundamental dynamics across the economy. In that sense, a freely floating exchange rate regime cannot be defeated, unlike a pegged exchange rate regime. That said, they can still be highly volatile at times.
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Risk by admin
When there is no clear, unequivocal signal from the signal grid, that is when not all four signals are pointing in the same direction, currency traders and investors can still boost their total return by using a risk appetite indicator to gauge overall market sentiment in terms of “risky” or “safe” assets, both in terms of putting on new positions and in terms of measuring their existing positions. Risk sentiment can be divided up into three levels:
Risk-seeking/stable
Risk-neutral
Risk-aversion/unstable
When the indicator is in risk-seeking or risk-neutral mode, be long a basket of higher carry currencies, either in the developed or emerging markets. Conversely, when it is in risk-aversion mode, obviously having moved there from risk-neutral, cut and reverse the position, going short the carry basket of currencies. Risk appetite has become an increasingly important concept not just because of the need to create more accurate models for forecasting short-term currency moves, but also because the last few years have shown a marked pick-up in cross-asset market volatility. There are several risk appetite indicators created by the private sector for this purpose. Not just currency traders or speculators can use this. A risk appetite indicator can be a crucial tool for corporate Treasurers and institutional investors, not least in providing them with an informed context within which their exposure exists.
The four analytical disciplines of currency economics, flow analysis, technical analysis and long-term valuation which come together to make a currency strategy decision can be expressed in the form of a signal grid. To be sure, this is a very simple model. However, what is important here is having the discipline to create it. Only when all four analytical indicators are reading buy or sell together should one put out an official currency strategy recommendation. Granted, this is still no guarantee of success. It should however have a number of positive effects on one’s trading or analytical performance:
It should eliminate the bias created by relying only on one analytical type
By nature, four buy signals make up a more powerful buy signal than just one
The bottom line — it should improve one’s performance and total returns
The dividing line between currency economics and long-term valuation analysis is somewhat blurred. There is a difference however and it concerns the time span involved in one’s analysis. The aim of currency economics is to look at the parts of the economy that affect and are affected by the exchange rate, such as the balance of payments and infkation differentials, in order to give an idea about that exchange rate’s current valuation and direction. Long-term valuation models, such as those that focus on REER or FEER, are trying to give a multi-month or more likely a multi-year view of exchange rate valuation. In line with this, the main exchange rate models that focus on long-term valuation are the following:
- Purchasing Power Parity
- The Monetary Approach
- The Interest Rate Approach
- The Balance of Payments Approach
- The Portfolio Balance Approach
Most of these models focus on the relative price of an asset or good which should over time cause an exchange rate adjustment to restore “equilibrium”.