Currency Crashes in Emerging Markets
EM Crisis Investing with a Currency Lens
By: Igor Vasilachi with Martina Roman
Severe currency devaluations are common in emerging markets. We wanted to better understand these crashes: how fast they happen, how this relates to equity returns, and the nature of the recoveries.
We studied the evolution of exchange rates and equity market returns before and after currency crashes since the mid-1990s, when EM equity return series first became widely available. We defined a currency crash as a 20%+ depreciation against the USD over a three-month period. We excluded markets with pegged currencies, such as Saudi Arabia, or common currencies, such as Greece, as their currencies do not reflect their underlying economy. In the remaining pool of countries, we found 16 instances of currency crashes across eight emerging markets. Of these, 12 happened during global crises, and 4 were idiosyncratic events. Below we show the average exchange rate curves before and after currency crashes (T=0).
Figure 1: Average Exchange Rate Curve (T-12M to T+12M)
Source: Refinitiv
The above chart suggests that currency crashes tend to be sudden and are not prefaced by a weakening currency until three months before the crash. To make sure this was not the result of our forced definition (20% depreciation over a three-month period) we also tested depreciations over six months and confirmed that crashes tend to happen suddenly in the last quarter.
In addition, exchange rates tend to stabilize at the new level, with only a 6% strengthening against the USD in the subsequent 12 months. This holds in both global crises and idiosyncratic events.
To better understand the implications of exchange-rate crashes for investors, we looked at equity market performance during depreciation events. Below we show the average equity market return curves before and after currency crashes (T=0) in both USD and local currency denominations.
Figure 2: Average Equity Market Performance Curves (T-12M to T+24M)
Source: Capital IQ, MSCI
If equity markets act as a proxy for a country’s economy, a weakening currency indeed seems to be reflective of a weakening economic environment. In local currency terms, equity markets exhibit significant (~20%) drawdowns during currency crash events. These are then exacerbated in USD terms by the weakening currency. However, the subsequent recovery seems driven by market fundamentals, not FX, making EM recovery trades robust. Equity markets tend to post a significant recovery rally beginning about three months after the currency crash. Of all crash events, only once have the equity markets had negative returns on a 24-month forward basis.
To put this in context, below we break down the equity market returns contribution of the exchange rate versus the underlying market fundamental components in crashes (i.e., trailing three months) and in recoveries (i.e., 12 months forward).
Figure 3: % Contribution to Equity Market Returns in Crashes (T-3M) and Recoveries (T+12M)
Source: Refinitiv, Capital IQ, MSCI
During crashes, exchange rates and weakening equity market fundamentals both tend to contribute to USD-denominated market returns in a near-equal manner. The picture is very different in recoveries, when the effect of exchange rates is minimized, and strong equity market fundamentals drive equity market returns. This holds in both global crises as well as idiosyncratic events.
To conclude, currency crashes can reflect weakening economic conditions in the reference country and tend to coincide with significant equity market drawdowns. Most often, these crashes seem to happen in the context of global crises. These are times when US investors see deteriorating underlying equity markets and weakening currencies working against them. On average, EM equity investors can lose 40% of their position driven by both factors. In such times, investors tend to run away from a perceived EM apocalypse. However, our data suggests that such EM crises see a 90%+ probability of recovery over 24 months, driven almost exclusively by improving fundamentals with stabilized exchange rates. In other words, while the street might still be panicked after a recent crash, contrarian investors in emerging markets can benefit from a robust recovery that does not require currency hedging.
Acknowledgement: This piece was co-authored by Martina Roman, a rising junior at Yale University studying math, philosophy, and art history. Martina is actively seeking an internship in finance or business for next summer. As a native of Ecuador, she is interested in emerging markets, particularly Latin American markets. In the long-term she wants to invest in Latin America and help drive innovation in the region.