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Emerging-market investors ponder those pesky J-curves

A cashier counts rupees inside a bank in Mumbai.


Baseball, it is said, is an analogy for life's vagaries. Rarely has it served the ends of an economist so well as these past few days, as the Yankees swept the Jays in four closely contested matches and hope of playoffs on Canadian soil quickly faded to near-nothingness.

But there is a different group of J's at risk for Canadians just now: Those pesky J-curves that are lately affecting emerging-market (EM) currencies. What Canadian fans, er investors, do not yet realize is that if the 1997-98 currency crises are any guide, Canadian currency markets could also have their hopes dashed in the not-too-distant future.

The currency depreciations in India, Malaysia, Brazil and Indonesia have been sharp enough to prompt government intervention of one form or another in the past week, with Brazil and India policy makers announcing massive outright currency intervention. Though sufficient in size to make headlines, for now the events in currency markets seem at a distance to Canada.

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Currency depreciation is not necessarily a bad thing for an economy, since exporters gain a competitive edge over other countries as the prices of their exported goods drop. Since all of these countries have significant exporting sectors of either manufactured goods or commodities, these sectors stand to benefit from the much-weakened local currencies. While certainly true, this argument shows the tendency of many economists to consider only the long-run impact of currency moves.

Policy makers are no doubt aware of this long-run outcome, but it is the short-run implications that have them, well, on the run. What they are concerned about is the J-curve effect, an observed tendency for a trade balance to initially weaken as the currency depreciates because the prices of imported goods rise but the country continues to import the same volume of goods. India is especially likely to experience a deterioration in its current account deficit since so many commodities, particularly energy and food, are imported.

Recent currency moves could be merely a one-time reaction to the prospect of reduced Federal Reserve stimulus and capital flowing back into less-risky U.S. assets. But there is also a possibility that capital is fleeing these regions because of weak emerging-market growth prospects, which imply more capital flight and further rounds of depreciation. There is also the concern that low prospective returns will prompt capital flight from other EM countries, putting downward pressure on their currencies. In other words, the crisis could spread.

Although the players involved are different, there are some similarities to the events leading up to the Asian currency crisis in 1997, which eventually morphed into the Russian and Argentine debt defaults in 1998 and culminated in the collapse of the Long Term Capital Management hedge fund. To be sure, there are factors arguing against a replay of 1997-98. EM currencies are less managed than they were in the 1990s, when many EM currencies were firmly pegged to the U.S. dollar. EM countries owe less foreign-currency-denominated debt and hold larger foreign exchange reserves (although India's six-month supply of such reserves can hardly be considered plentiful).

Nonetheless, all of the countries experiencing currency depreciation have seen large capital inflows in the past five years, as investors sought higher-yielding markets, and now those flows are at least partly reversing. In tandem are notable current account and net-foreign-asset deficits – factors that played a role in starting the 1997-98 crises.

The Asian crisis at first had little impact on the Canadian dollar. The currency crisis started in mid-1997 with the 50-per-cent devaluation of the Thai baht. Yet the loonie saw a modest 5-per-cent depreciation that was consistent with the dip in commodity prices, which is well inside a one-standard-deviation move in a single year. But by the apex of the crisis in October, 1998, the loonie was down 13 per cent and would not see any significant turnaround until 2002, when the commodity cycle finally began its upswing.

Although commodity prices plummeted and pressured commodity producers, Canadian manufacturers benefited greatly through 1997-98 because the U.S. economy barely skipped a beat as it basked in the tech boom. The annual pace of U.S. economic growth averaged 4.5 per cent over 1997-98 and Canada fared likewise, save for one brief dip below 1 per cent in the particularly bad days of the summer of 1998.

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Over the next several quarters, the outlook for Canada is decidedly more tenuous if a currency crisis does, indeed, play out. The positive impact of easy monetary policy since 2008 has largely run its course in Canada. The U.S. economy remains limp and mainly supported by ultra-low interest rates (interest-rate-sensitive sectors of the economy accounted for 90 per cent of gross domestic product growth in the past year), and yet the Fed seems determined to reduce its monetary stimulus. If commodity prices continue to retreat in sympathy with the fortunes of emerging-market countries and Canada's manufacturing sector cannot offset the impact, the prospects for the loonie seem poor indeed.

As such, the Canadian economy may also experience a J-curve effect alongside further currency depreciation, adding to the woes of the Jays fans this autumn. (And no, it was not a trapped ball; Rajai Davis caught it fair and square.)

Sheryl King is an independent macroeconomic strategist with more than 20 years experience in the international financial industry and central banking.

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About the Author

Sheryl is an independent macroeconomic strategist with over 20-years experience in the international financial industry and central banking. From 2009 to 2012, she was the chief strategist and economist at Bank of America Merrill Lynch Canada. Prior to that, Sheryl was the assistant chief economist at Merrill Lynch in New York, from 2004 to 2009. More


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