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3 Financial Disasters That Recently Hurt the Economy [GUIDE]

Posted On June 30, 2017 9:00 am
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A puzzle with the word Brexit spelled across it

In a world dominated by fiat money, confidence in the bills in one’s pocket ultimately stems from one’s confidence in the government. It follows logically that any sudden shocks that weaken the market’s faith in a particular government will also affect that government’s currency. Certainly, this is apparent in countries where the government’s ability to service its debt is fundamentally questioned, like Zimbabwe or Venezuela, to use some extreme examples. But what about more immediate political shocks?

Glancing at three different currencies in the aftermath of major crises, it seems that healthy currencies — can at times — prove quite resilient in the face of short-term political disruption. There’s often a drop in a currency’s value immediately after an event, but the market will regain its confidence shortly afterwards so long as a sense of normalcy returns. If that basic stability is not forthcoming, then the slump will be more prolonged.

To illustrate how this tends to work out in action, here are three examples from recent history in which short-term political shocks affected a currency. In each case, the shock and the economic circumstances of the country in question are going to be different, but there’s still a pattern where without deeper economic stresses, the decline in the currency’s value tends to level off. These examples will be presented in reverse chronological order, starting in 2016 and going back to the late 90’s in the case of East Asia’s financial crisis.

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Brexit: Hard Brexit Exacerbates Fears

The aftermath of Britain’s referendum on continued membership in the European Union was certainly tumultuous. In the two weeks after the vote, the value of the pound dropped about 15 percent. This eventually leveling it out at the lowest rate against the dollar in over 30 years. However, after reaching that nadir in early July of 2016, the pound managed a modest recovery, returning from the $1.27 low, a far cry from its pre-referendum high of $1.50. However, the exchange rate was still reasonably stable for the rest of the summer in 2016.

A Bloomberg Brexit Chart showing the effect it has had on sterling

This began to change at the end of September, as the pound started dropping again. It exceeded the lows it reached in the fortnight after Brexit. These fears stemmed from the crumbling of consumer confidence following official announcements that led many to believe a “hard Brexit” was looming. This was a withdrawal from the EU where — in exchange for not accepting EU regulations on immigrant movement — Britain would withdraw from the EU’s free trade zone altogether. Jane Foley, a financial strategist at Rabobank International in London, stated that, “The market facing that Brexit is about to begin and we could be faced with hard Brexit, just lacing the concerns the market already has about the outlook for growth, investment, and jobs in the UK economy.”

What this suggests is that investor confidence was returning due the consequences of Britain’s eschewing of the EU might not be so severe. However, insecurity returned once Theresa May’s government was forced to lay out a timetable for the withdrawal process. Apart from driving home the reality of what transpired, the developments in Fall 2016 also raised the deeper concerns of a hard Brexit — a more severe break from Europe than many Britons expected. This sudden readjustment of expectations explains the return of the currency woes. So long as the economic landscape perception remains chaotic, consumer confidence will remain slumped. The mid-2017 pound-dollar exchange rate matches the October low.

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2014 Ruble Crisis: More than Just a Supply Shock

In the second half of 2014, the Russian ruble began to decline in value, causing a crisis in consumer confidence in its economy — and ultimately a financial crisis. There are two apparent causes for this panic:

  • The decline of oil prices, which fell from $100 dollars per barrel to $60 from June to December of that year. Given the reliance on oil exports to power the Russian economy, this steep decline in revenue proved painful to the country’s economic growth, as well as to powerful state-owned energy companies like Gazprom and Lukoil.
  • A raft of Western economic sanctions imposed on the country in response to their Ukraine intervention that year. In addition, the sanctions directly impacted the value of the ruble by preventing Russian companies from rolling over debt. To make interest payments, these companies were forced to exchange rubles for other currencies on the open market, which proved more expensive.

Together, these twin blows caused a precipitous drop in the ruble’s value at the end of 2014:

A Bloomberg currency chart showing the highs and lows of the US dollar from May 2016 to December 2016

Where this story differs from the pound’s is that the ruble subsequently recovered much of its value. Part of this was likely due to a rebound in oil prices, which will always have a significant effect on Russia’s outlook assuming their economy is dependent on energy exports. That said, another explanation for the recovery regarded the situation in the Ukraine, where a ceasefire was broached at the very end of 2014. That signal of a potential return to normalcy in the region may have resuscitated consumer confidence in Russia to some degree. Although the conflagration in Ukraine remains ongoing, this still suggests that crises caused by political uncertainty can be mended quickly if a sense of stability returns.

East Asian Crisis of 1997: Overborrowing or Bank Run?

Although the financial crisis of 1997 rocked several countries in Eastern Asia, the panic began in Thailand when the national currency, the Thai bhat, came under a speculative attack. The central bank eventually exhausted its reserves of foreign money required to maintain its peg to the dollar, and decided to float the bhat. The result proved catastrophic, as the that lost half of its value by the end of the year, and the economy entered a deep recession.

There are different explanations for the economic fragility that the East Asian crisis revealed in Thailand and other countries — mostly regarding how inherently weak the region’s economies were on the eve of the panic. One view suggests that politicized lending and pegged that exchange rates concealed significant vulnerabilities underlaying the meteoric economic growth Asian countries enjoyed in the years leading up to 1997. Another narrative argues that a surge of foreign investments into Asian economies made them susceptible to a panic. However, the countries had no fundamental inefficiencies.

Which theory regarding Asian economies is closer to the truth is beyond the scope of this analysis. However, the existence of the second theory suggests that the crisis had less in common with cyclical downturns based on the business cycle, and more resembled a bank run, albeit one exacerbated by genuine weakness in Thai and other banks. A combination of IMF loans and increased interest rates enabled a resumption of growth by 1999.

An interesting addendum to the Thai story is that less than a decade later, another crisis in Thai currency erupted following a coup d’etat in September 2006, and the bhat suffered another severe depreciation. The damage was much more contained this time, in large part because the fundamentals of the economy remained solid and the military promised future elections. This suggests that even a coup seems less threatening as long as the emergency is seen to have a clear expiration date.

Final Thoughts on Smaller Crises

In some cases, such as the Thai coup in 2006, a major political shock only causes a shallow currency depreciation, as markets expect conditions to return to normal in short order. This also describes the outcome of the 2016 Presidential Election in the United States, where consumer confidence and the value of the dollar reached historic heights the following month. The severity of the shock seems secondary to whether it seems like a temporary change of affairs. From an investment standpoint, the rate at which some equilibrium can be reached seems like the primary factor in gauging consumer confidence. 

The advantages of a strong currency are similar to those caused by high interest rates: savings denominated in a stronger dollar or euro are worth more, and imports are relatively cheaper. This is certainly something to keep in mind if the dollar continues to strengthen against the euro. Of course, fluctuations between different currencies are simply a part of the normal business cycle. The sorts of major jolts that would demand a more involved response on the parts of governments or investors are ones driven but by protracted emergencies where there’s no apparent light at the end of the tunnel. Barring those situations, there’s usually cause for hope.

 

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