How to spot the signs of the next currency crisis

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Investing in Currencies - September 2014

In the past two decades or so the global financial markets have been rocked by a series of currency crises and devaluations – from the European Exchange Rate Mechanism (ERM) crisis of 1992 to Argentina’s ongoing currency issues and, more recently, the 2008 euro crisis.

Ugo Lancioni, head of currency management at Neuberger Berman, points to the causes of these currency devaluations.

“Currency depreciations or crises are caused by substantial misalignments between the real value of the currency and the fundamentals of the country,” he explains.

Mr Lancioni emphasises that while the triggers for a crisis are never the same, the affected countries may have common “symptoms”, including excessive borrowing, with too much capital in the hands of foreign investors or lenders; a current account deficit; a deterioration in growth prospects; and high or “out of control” inflation.

He adds: “Those common signs are often magnified during periods of uncertainty and as a result you may get contagion, as well as substantial capital outflows as investors tend to take their money out of risky assets and out of countries that have those signs or show that weakness.”

Frances Hudson, global thematic strategist at Standard Life Investments, agrees that one of the characteristics of a currency crisis is rapid contagion.

She observes: “You get speculative waves spreading out from the point of origin, either regionally or to other places that are perceived as having similar characteristics.

“The other thing you could say they all have in common is that the solution requires an awful lot more cooperation on policy than we generally see. So one suspects that things would work out more smoothly or more quickly if there were more cooperation, but that isn’t the way most countries behave; they are more likely to compete.”

Most investors recall the euro crisis, which followed the global financial crisis.

Insight Investment’s head of currency, Paul Lambert, recalls that the global crisis saw a flight to dollars and yen.

“The currencies that tend to do well in currency crises are those that are running current account surpluses, and the dollar has tended to do well because a lot of speculative positions in higher-yielding currencies would tend to be created out of the dollar and as those positions got taken off it would result in dollar buying,” he says.

Mr Lambert believes emerging market currencies have either fully or largely recovered from that crisis.

“Currencies like the South African rand didn’t but I think that’s more to do with the domestic economic situation in South Africa than it is to do with any continued hangover from the financial crisis,” he suggests.

“In fact the pickup in cross-border flows into emerging markets since the financial crisis has been very large indeed, as some of the enormous amounts of liquidity pumped into the system by central banks in the core countries have found their way into investment capital flowing into emerging markets seeking yield.”

So where are any currency devaluations likely to come from in the future?