Emerging Markets: 30 Years of Crisis. Part 2: The 1990s

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The 1990s

Hyperinflation and Mega-Devaluations of the Early 90s

The first years of the 90s saw several center or right-of-center Social Democratic and Christian Democratic parties take power (Carlos Salinas de Gortari in Mexico, Cesar Gaviria in Colombia, Carlos Andres Perez in Venezuela, Alberto Fujimori in Peru, Sixto Duran-Ballen in Ecuador, Patricio Aylwin in Chile, and Fernando Collor de Mello in Brazil), the exceptions were Argentina, where Carlos Menem was part of the populist Peronist party; and Bolivia, whose president Jaime Paz was part of the Revolutionary Leftist Movement.

Despite this political shift to the right the economic problems dragged on from the 80s were still hurting the economy: empty treasury coffers, hyperinflation, negative trade balances, fiscal deficits and collapsing GDPs, which resulted once again in mega-devaluations seeing Peru devaluate its currency by 1 million, Argentina by a further 10,000 and Brazil by an eye-watering 2.75 million in two different devaluations. Governments started implementing progressive market policies, lowering barriers, floating exchange rates, opening trade; even populist Menem in Argentina introduced several important market reforms in Argentina, including the privatization of most state owned enterprises.  Chile was probably the sole country exempt from the crisis, having sorted their problems in the late 70s and early 80s by privatizing the then recently nationalized enterprises, and most importantly by passing a pensions reform that created a solid internal demand for Chilean investments.  This meant that during regional crises, when the swallow capitals fled, their impact on the Chilean market would be less noticeable.  To a point where it stopped making sense for capitals to flee Chile during crises in say Argentina or Brazil.

Tequila Effect

After the debt restructuring, Mexico experienced a period of sustained expansion – albeit only 3 years.  Having passed the “lost decade”, Mexico got is affairs in order, inflation was in check, exports grew, GDP grew, in 1993 Mexico signed NAFTA with the US and Canada, resulting in increased exports. The peso was controlled allowing for a gradual nominal depreciation which is known as a “crawling peg”.

A crawling peg, also known as “snake in a tube” allows the currency to fluctuate within a tight band.  The central bank intervenes the market at the upper and lower ends of the band to control the exchange rate.  Although the peso was devaluating on a daily basis, it was still artificially high resulting in their current account deficit exploding from US$ 6 billion in ’89, to 15 in ’91, and to over $20 billion in ’93.

An overvalued peso took its toll on exports making them less competitive abroad, by December 1994, the Mexican international monetary reserves had quartered from 25.5 to little over 6 billion dollars.  Mexico’s inflation was higher than the difference between the US inflation adjusted for the exchange rate, and thus by 1995 recently elected president Ernesto Zedillo was forced to widen the exchange rate bands, which resulted in an immediate 15% drop on the peso.  GDP dropped 12%, the IPC stock index dropped 50% in 6 months, while the currency lost 55% of its value in half that time.

Once again a Mexican affair would have a spillover effect…

Tango Effect

From Mexico to Argentina, investors’ fears took over, and money was duly withdrawn causing stock exchanges all over Latin America to drop.  There was a considerable drop in value of the Brady bonds as well.

In Argentina the situation was similar; a convertibility plan had been introduced in 1991.  The goal was to stabilize prices, inflation and exchange rate.  The convertibility plan required the Central Bank to back the entire monetary base with international reserves, and up to 20% could be in dollar denominated government debt marked-to-market.  It was all part of an effort to avoid the plan failing as so many had done in the past.

After the Mexican crisis, GDP in Argentina fell 4.4% while unemployment reached 18.6%.  Interest rates in pesos had their wider gap against dollar deposits reaching a spread of over 16 percentage points in 1995.  There was a flight to quality which meant selling peso denominated assets and buying dollars, preferably away from Argentinean risk altogether.  Within Argentina there were runs on banks.  These massive deposit withdrawals put pressure on the banks, threatening their own existence due to lack of liquidity.  During this period bank deposits dropped approximately 18%, with interest rates peaking at 21%.  The run on the banks exhausted the countries international reserves which were backing the convertibility as well as the confidence in the markets.  Only a rescue package from the IMF helped them maintain the convertibility.

Tiwinza Effect

Ecuador lived a short period of stability between 1992 and 1995 with a pro-market government and strong financial sector; in 1995 however, a series of events took place in what would become known as the “perfect storm crisis”.

First there was an energy crisis.  Lack of rain in the Amazon meant that the main rivers feeding the main electric dam were drying up, which resulted in power outages of up to 16 hours a day in certain parts of the country.  This took a toll on the industry and real economy.  At the same time a financial crisis was brewing, recently liberalized trade allowed people to start importing goods at an all-time high, which accelerated the outflow of dollars from the economy.  People and corporations were also getting into car and house loans that were usually at 3 to 5 and 10 to 15 years terms, while banks kept funding themselves with short term interbank paper.

Finally, a war between Ecuador and Peru over an unsettled dispute in the southern border broke out.  The territory was a small strip of land known as Tiwinza in the southernmost province of Ecuador believed to have sizable gold reserves. This was the straw that broke the camel’s back.

Interest rates shot to an all-time high of 340%, and the economy promptly contracted.  The stock market entered a period of recession from which it hasn’t yet recovered, which saw the collapse of 80% of the country’s brokerage firms. The economy as a whole prodded along, with the Brady bonds from 1994 being honored and no major devaluations took place.  Investors referred to the three crises in Latin America during 1995 as the “3Ts”.

The Asian Crisis

Since 1987 and up to 1997, the Asian Tiger economies had been growing at rates between 5% and 10% per annum.  But once again fixed exchange rates, large current account deficits, and high levels of indebtedness were the protagonists of one of the largest crises to ever engulf the emerging markets, mostly because of the size, the speed and the number of countries affected.

By 1996 the Thai baht was pegged to the US dollar at a rate of 25, the Malaysian ringgit, Philippine peso and Indonesian rupiah all had trading bands.  A period of prosperity for the region comes to a halt when Japan hinted that it would raise interest rates to defend the yen, the market shifted its perception about the Southeast Asian economies.  Hedge funds started selling and short-selling the Thai baht, although the government threw everything but the kitchen sink at it, they were unable to hold the currency and, after spending US$33 billion of their reserves trying to defend their currency, the baht was forced to float.  Bearing in mind that attacks on the currency are not the exclusive domain of the FX markets, but can be also achieved in the equity and debt markets by selling, short-selling, or taking out options, futures, or forwards against any baht denominated asset.

Next the market turned its sights to Philippines, and started attacking the peso by the same means, something similar to the crisis of 2008, where the market speculators started attacking one-by-one the investment banks that they felt were at risk.  As Hedge funds and speculators such as George Soros focused on the Malaysian ringgit and the Indonesian rupiah, all countries involved began seeking help from the IMF and World Bank.

After all currencies were allowed to float freely in the market, and had reached their true value, the stock markets had bottomed out, and rescue packages were on their way, the markets turned their sights to Hong Kong, South Korea.  The HK dollar and the Korean won came under speculative attack, while the Hong Kong government took aggressive measures to defend the currency; the stock market took a plunge.

By then the crisis was no longer limited to the Asian Tiger economies, but it was spreading to larger markets.  Once Hong Kong and South Korea’s stock markets were affected, their listed US ADRs started putting pressure on the US markets leading to a drop of the wider indices.

Later that year the crisis spread to Japan, where the Nikkei took a hit and several financial firms collapsed; then, as the agreements between the different parties and the IMF were struck, the crisis came to an end, and recovery started.

Russia and Brazil

“In 1998 Boris Yeltsin went to bed drunk, and Fernando Cardoso woke up with a hangover”

Once again, in a completely different part of the world artificially high valued currencies in a declining economy led to yet another crisis.  The Russian crisis of 1998 was fueled by increasing yields in government debt (up to 47%), inflation bordering 10% and an increasing feeling among market investors that the government would have a hard time meeting its obligations.

Investors began pulling their funds, selling ruble denominated debt and other assets prompting the sovereign debt to tank in a very short period.  Under pressure the government widened the currency trading bands and the ruble promptly lost 33% of its value.  As the crisis grew the government defaulted on its sovereign debt, and declared a 90 day moratorium on all banking obligations.

“In 1998 Boris Yeltsin went to bed drunk, and Fernando Cardoso woke up with a hangover” – a phrase coined around the time of the Russian crisis, still resounds today as an example of global interdependence between markets.  The contagion effect between Russia and Brazil is not that of Mexico and Latin America, or Asian Tigers and the rest of Asia.  This was a situation where Brazil was relatively healthy, but the crisis in Russia had made investors’ holdings’ value to drop so dramatically that margin calls were the order of the day, and since prices were so depressed in Russia, selling Russian securities – at a loss one might add, wouldn’t be enough to cover the gaps.  Investors then had to make a decision, whether to sell high grade debt, or to get rid of lower grade debt that had outperformed over the preceding period.  Investors opted for the latter and in one swift motion dumped Brazilian investments, resulting in considerable disruptions to the markets.

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