By Frances Coppola
In the turbulent 1990s, many such countries did, in fact, experience high exchange rate volatility and sudden stops. Repeated FX crises flowed around the globe, one seemingly leading into another: the “tequila” crisis of 1994-5, the Asian crisis of 1996-7, Russia’s default in 1998 and Brazil’s economic crisis in 1999. The crises continued into the new century, with Argentina’s sovereign default in 2001.
Understanding the causes of the 1990s FX crises helps explain why many countries that aren’t in the safe haven league have now built up large FX reserve buffers. Those buffers bring some risks of their own, but overall this might make them less risky, more attractive destinations for U.S. export trade, after all.
The exchange rate crises of the 1990s began in Mexico. As the decade opened, central banks in safe haven countries were cutting interest rates to stimulate their economies, leading investors to look elsewhere for yield. Mexico attracted investors because it was aligned with the U.S. and had a liberalized economy. To control inflation, Mexico’s government had pegged its peso to the U.S. dollar; to attract investment and spur economic growth, it had deregulated its banks and lifted capital controls. In the absence of exchange rate risk, Mexico’s relatively high interest rates compared to the U.S. attracted large inflows of capital.1
But in 1994, as the U.S. economy strengthened, the Federal Reserve started to raise interest rates. Simultaneously, political disturbances in Mexico damaged investors’ confidence. Capital started to flow out of Mexico, putting downwards pressure on the peso’s exchange rate. The central bank sold down its FX reserves to maintain the dollar peg. In December 1994, the central bank devalued the peso by 15 percent, but this merely intensified capital flight and worsened the central bank’s dollar shortage.2 In December exchange rate volatility leapt when the central bank ran out of dollars and was forced to float the peso. The peso-dollar exchange rate promptly fell from $3.99 per peso to $4.80.3 As Mexico’s crisis deepened, foreign exchange rate volatility spread to other Latin American countries; their currencies also fell, in what became known as the “tequila effect.”4
The peso’s sudden collapse made it impossible for the Mexican government to meet its dollar-denominated debt obligations. In January 1995, the U.S. government, together with the International Monetary Fund (IMF) and the Bank for International Settlements (BIS), organized a sovereign bailout package of $50 billion. Despite the bailout, Mexico experienced a severe recession, with GDP falling by 6.2 percent in 1995, high unemployment and rising poverty. The peso’s exchange rate continued to fall, reaching $7.60 in March 1995.5 The economy did not start to recover until the late 1990s.6
The tequila crisis helped set the scene for the second 1990s exchange rate volatility crisis. As investors pulled their funds from Latin America, some opted to invest in the fast-growing “Asian tiger” economies. At that time, East Asian countries such as Thailand, Malaysia and the Philippines were experiencing economic booms fueled by inflows of foreign capital and helped by a carry trade between their currencies and the yen.
But from mid-1996 onwards, foreign investors became increasingly concerned about rapidly widening current account deficits and soaring external debt in the booming Asian economies, and started to withdraw their funds.7 As the carry trade unwound, capital fled from Thailand, which had benefited the most from the carry trade. This put pressure on the Thai baht, which was pegged to the dollar. In response, Thailand’s central bank raised overnight interest rates to unprecedented levels and imposed capital controls. But it proved impossible to defend the peg. In July 1997 Thailand abruptly floated the baht. Its currency exchange rate promptly dropped by 14-19 percent against all currencies.8
As Thailand ran to the IMF for help shoring up its fragile finances, exchange rate volatility spread across the East Asian region. Central banks raised interest rates to unprecedented highs and burned through FX reserves to defend exchange rate pegs: the Philippines central bank spent $540 million in a single day. But most were eventually forced to allow their currencies to depreciate.9 There were widespread debt defaults across the region, notably in South Korea where the government was forced to bail out eight giant “chaebols” (manufacturing conglomerates). In Indonesia, the economic crisis triggered a political crisis that brought down the government. The IMF eventually bailed out South Korea, Thailand and Indonesia.
Economists say that the worst affected countries had wide current account deficits and high FX debt, often in the private sector. When exchange rates collapsed, these countries became unable to obtain FX needed for debt service and essential imports.10 This caused “debt deflation,” in which people cut spending and defaulted on debts, causing a rapid and damaging economic contraction.11
The Asian crisis sparked capital outflows from other developing countries as investors sought safety in traditional safe havens. In parallel, the price of oil dropped. Russia, a major oil exporter, suffered a significant loss of FX reserves due to deteriorating terms of trade as well as capital outflows. Despite sharply rising interest rates, maintaining the ruble’s dollar exchange rate within its fluctuation band caused a severe shortage of dollars. The central bank was eventually forced to float the ruble. As the ruble’s exchange rate fell, the government became unable to service its dollar-denominated external debt. It halted payments and initiated talks with creditors with a view to restructuring it.12
Russia’s default sent shock waves round the world. Investors fled to traditional safe havens, withdrawing capital from countries far beyond Europe. One of the countries worst affected was Brazil. The Brazilian real’s exchange rate, like the ruble’s, was pegged to the dollar within a fluctuation band. As investors dumped Brazilian assets dollars flowed out of the Brazilian economy, exchange rate volatility hit the real.13
As the real’s exchange rate plummeted and Brazil’s economic recession deepened, Brazil’s neighbor Argentina came under pressure. The depreciation of the real rendered Argentina’s exports less competitive than Brazil’s, causing a sharp fall in exports and a widening current account deficit. Argentina followed Brazil into recession in late 1998. But because Argentina’s peso was pegged to the dollar, the central bank was unable to respond by cutting interest rates or devaluing. As Argentina’s economic outlook worsened, the cost of servicing its high foreign debt rose. By July 2001, it was shut out of international financial markets, and in September 2001 it was forced to borrow from the IMF. But economic instability continued, and by December 26 Argentina defaulted on its foreign-denominated debt.14
The repeated crises of the 1990s show that to prevent exchange rate volatility, countries whose currencies are not safe havens need substantial reserves of safe haven currencies—particularly dollars. Mexico, the “Asian Tiger” economies, Russia, Brazil and Argentina all suffered severe FX crises because they tried to maintain exchange rate stability despite inadequate FX reserves. Today, many developing countries have built up large FX reserves as a buffer against exchange rate volatility. Because of this, exchange rate contagion may now be less likely. Recent exchange rate disturbances in Argentina and Turkey have not caused widespread FX crisis.
However, the need to protect against exchange rate volatility by building up FX reserves can result in persistent trade imbalances. There are three ways of building up FX reserves: borrow them, buy them, or earn them. The first two can lead to high-risk vulnerabilities. So, many countries have opted to earn FX by trading with safe haven countries. Since this involves exporting more than they import, building up FX reserves through earnings may mean running large and persistent trade surpluses.
Economic theory says that when the exchange rate is floating, trade surpluses should be short-lived. Thus, despite the fact that it increases the risk of exchange rate volatility, many countries not in the safe haven club still have some kind of exchange rate peg to help them maintain those trade surpluses.
In the 1990s, repeated exchange rate volatility crises taught developing countries about the importance of having adequate FX reserves. Now, many developing countries have built substantial FX reserves by running large and persistent trade surpluses. The exchange rate stability that large FX reserves tend to impart may make these countries attractive partners for import-export trade. However, some risks still remain for businesses because of trade imbalances and exchange rate pegs.
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “Mexico’s Financial Crisis of 1994-5,” Harvard Business School; https://dash.harvard.edu/bitstream/handle/1/9056792/12-101.pdf?sequence=1
3. “Mexico/U.S. Foreign Exchange Rate,” FRED Economic Data; https://fred.stlouisfed.org/series/DEXMXUS
4. “Mexico’s Financial Crisis of 1994-5,” Harvard Business School; https://dash.harvard.edu/bitstream/handle/1/9056792/12-101.pdf?sequence=1
5. “Mexico/U.S. Foreign Exchange Rate,” FRED Economic Data; https://fred.stlouisfed.org/series/DEXMXUS
6. “Mexico’s Financial Crisis of 1994-5,” Harvard Business School; https://dash.harvard.edu/bitstream/handle/1/9056792/12-101.pdf?sequence=1
7. “Causes and sources of the Asian financial crisis,” UNCTAD; https://unctad.org/en/Docs/ux_hi_akyuz.en.pdf
8. “The East Asian crisis of 1997,” Winton; https://www.winton.com/longer-view/east-asian-crisis-1997
10. “What caused the Asian currency and financial crisis?,” Corsetti, Pesenti & Roubini; https://www.newyorkfed.org/medialibrary/media/research/economists/pesenti/whatjapwor.pdf
11. “The Debt Deflation Theory of Great Depressions,” Irving Fisher; https://phare.univ-paris1.fr/fileadmin/PHARE/Irving_Fisher_1933.pdf
12. “The Russian Default and Contagion to Brazil,” Baig & Goldfajn; http://siteresources.worldbank.org/INTMACRO/Resources/BaigGoldfajn.pdf
14. “The Argentine Crisis 2001/2,” Rabobank; https://economics.rabobank.com/publications/2013/august/the-argentine-crisis-20012002-/