Emerging market currencies have been under considerable stress this spring and summer. Many policymakers in affected countries have been blaming the U.S. Federal Reserve’s exit plans for its asset purchases, known as quantitative easing, for their currency’s woes.
Brazil, for example, has even announced a large, $60 billion, foreign exchange intervention program to try to dampen the slide of the real. Unfortunately, our analysis suggests, first, that the Fed’s potential exit from QE is only a small part of emerging market currency problems, and second, that intervention activities are unlikely to work although they will certainly drain the resources of the central bank.
With any currency decline, it is critical to understand that proximate causes. And, when the currency decline of one country is associated with similar declines of varying degrees in other countries, then the reasons for contagion need to be assessed as well. In this case, there are at least two critical factors to consider.
First, emerging market currencies are considered relatively risky investments by many. Thus, when global events, such as the Fed’s potential exit from QE raise risks generally, all assets deemed to be in the higher risk categories are vulnerable to price drops as a wide swath of market participants trim their overall risk positions.
Second, simultaneous to the market debate over the Fed’s potential exit from QE, the world has witnessed some turmoil in many emerging market countries. For example, there have been huge demonstrations in Brazil about economic policies. There has been turbulence in the streets of Turkey about development plans. There is the violence in Egypt and the civil war in Syria.
While there is no causal relationship among these events, the mere fact that political risk in many parts of the emerging market world appear to be rising simultaneously can send a very large chill through global markets. And veteran market participants have learned from past episodes, such as the Asian contagion in the fall of 1997, once contagion starts in the currency markets it is often better to step aside temporarily than focus on local fundamentals.
Will Brazil’s $60 billion intervention work?
This analysis brings us to the question of whether foreign exchange intervention can work. Often, on the day of the intervention or its announcement, a currency will get a small bounce upward. For the longer-term, however, market participants often return to a focus on the basic issues of rising risks and contagion potential. The intervention activities address none of these issues, and so none of the critical market dynamics that matter have been altered. Hence, our conclusion is that currency intervention will not work.
What can work are aggressive short-term interest rate increases that dramatically raise the costs of going short a currency and incent investors to take long positions. Unfortunately, baby step rate increases do not work. And, the large increases in rates that might work to halt the currency slide are all too often politically unpalatable, or the high-rate medicine is deemed worse than currency-weakness disease.
New programs of political and economic reforms can work, too, as these can change the long-term fundamental landscape for investors. Such reforms can rarely be enacted or implemented quickly, so the only dependable short-term medicine is large rate rises.
Then there is another alternative; the country can just wait it out. As the currency depreciates, the risk for market participants declines. Indeed, allowing a more rapid decline in the currency is a very effective way of allowing the market to solve the currency problem quickly by making the currency look like a much better investment at the lower prices.
Regardless of what path is chosen, though, we would argue that until the longer-term fundamental landscape has been changed, foreign exchange intervention will not work. The fundamental landscape changes either with a much less expensive currency, higher rates to increase the cost of short positions and reward long positions, or the enactment and implementation of economic and political reforms.