Currency bomb is still ticking

News Analysis: A year after Thailand was forced to devalue, emerging markets remain in turmoil
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The Independent Online
ON 2 JULY 1997, the Thai government devalued the baht in the face of intense pressure from currency speculators. By the end of the year, the Indonesian rupiah, the Korean won, the Malaysian ringgit and the Philippine peso had all depreciated by at least 40 per cent. The world at large was forced to face facts - the once-vaunted "tiger" economies of the East were on decidedly shaky ground.

Almost exactly a year on, currency speculators are in the news again - the Russian rouble is faltering, the Pakistan government devalued the rupee by 4.2 per cent at the weekend, and the South African rand yesterday hit an all-time low, at 6.155 to the dollar. Are we about to see a second, perhaps more widespread, round of devaluations? And what, if anything, can the authorities do to stave off the speculators?

The amount of money traded on the world's foreign exchange markets is nothing short of phenomenal. Harry Shutt, in his newly-published book The Trouble with Capitalism, estimates that the daily volume of business on the world's currency markets stood at around $1,500bn in 1995, a figure which exceeds the annual gross domestic product of all but three of the world's economies.

As a result, currency speculators have immense power. When the markets become convinced that a country's currency is fundamentally overvalued, as recently has been the case in South Africa, there is little the authorities can do to avert a currency collapse.

Notwithstanding the Malaysian Prime Minister's view that the markets' attack on the ringgit was a Jewish conspiracy aimed at the Far East, most experts are now convinced that last year's Asian devaluations were inevitable, given the fundamentals. In its recently published 1997 annual report, the Asian Development Bank argues that globalisation, and the consequent rapid inflow of capital into the tiger economies merely "heightened the risks associated with failing to address inappropriate policies, weaknesses in financial sector institutions and problems in corporate and public governance".

Globalisation, and the free movement of capital, may have been a spur to the heady economic growth enjoyed by the region in the early 1990s, but it also opened up the economies to an unprecedented degree of public scrutiny and evaluation. When the bubble burst in Asia, and when investor confidence began to falter, capital flowed out of the region as fast as it had flowed in just a few months before, and devaluations became inevitable.

A combination of increased globalisation - with the accompanying increase in global scrutiny - and weak economic fundamentals also lies behind the latest round of currency speculation in the emerging markets.

In Russia, the rouble yesterday steadied at around 6.22 to the dollar after the government raised interest rates on Friday to 80 per cent from 60 per cent, but analysts were gloomy about the country's long-term prospects. Paul McNamara, emerging markets economist at Julius Baer Investments, commented: "Policy is king and neither in Asia nor Russia are we seeing any positive steps."

In South Africa, meanwhile, the rand pulled itself off its earlier lows after the central bank raised its repo rate by almost 2 per cent but, as with Russia, experts say the outlook for the economy is negative. The central bank's use of interest rates is predicted to slow economic growth in an already fragile economy, while the fall in the exchange rate is likely to fuel inflation.

There has also been pressure on the Australian dollar, where economists are predicting that the Asian crisis will continue to hit growth. In Pakistan, meanwhile, the reasons for the currency slide are also economic in nature, albeit of a slightly different variety. Most experts have been attributing the weakness in the rupee to the economic sanctions imposed on Pakistan in the wake of its nuclear tests.

But although economic fundamentals would seem to provide the reasons for the latest bout of speculative attacks, they do not fully explain the timing. The markets have known about the weaknesses in certain of the emerging markets for some time. So why has the speculation started now? The answer here lies in the Japanese economy, and in particular in the recent bout of weakness in the Japanese yen.

David Brickman, international economist at PaineWebber, explained: "The weakness in the yen has changed the attitude to risk in the global currency markets. There has been a flight to quality, and the markets have begun to reassess the weaker economies." Ask the experts which of the emerging markets economies are the weakest, and the names South Africa and Russia are on almost everybody's lips.

As it is Japan that lies behind the renewed attacks by the currency speculators, so it is Japan that will determine how far the latest slump in emerging market currencies will go.

If the yen depreciates rapidly, the signs are that China will devalue the yuan. And if China devalues, this is likely to spark not only another round of devaluations in the East, but also sharp falls in global stock markets. Further emerging market gloom will also hit export demand in the developed countries, re-awakening fears of a world-wide slowdown.

It is this spectre of Chinese devaluation that prompted the US Federal Reserve to intervene in the world currency markets 10 days ago in an attempt to stem the rapid fall in the yen. The apparent success of the US intervention - the yen has not rallied but neither has it gone into free-fall - seems surprising, given the funds the currency speculators have at their disposal.

Most analysts attribute this to a mixture of nervousness in the markets, which believe that there may be no ceiling on the Fed's willingness to intervene and buy up the yen, and, perhaps more significantly, to the signals the intervention sent to the speculators. Some believe the West is now committed to rescuing the Japanese economy - and that Japan is committed to making the necessary reforms.

In sum, depreciation in the South African rand and the Russian rouble may be inevitable, given the power of the currency speculators, the renewed risk-averseness in the markets and the weak economic fundamentals.

What is less clear is whether a devaluation in the yuan is inevitable, at least in the near-term. Policymakers the world over hope that co-ordinated central bank intervention combined with rapid and wide-ranging structural reforms in Japan will be sufficient to stave off the speculators. If it is not, the economic consequences may be nothing short of disastrous.