The Emerging-Market Currency Rout
With the currencies of Malaysia, Indonesia, Turkey, Brazil, Colombia, and Chile hitting record lows last week, currency traders around the world are asking how much lower emerging-market currencies can go. The answer is: Quite a lot.
SANTIAGO – With the currencies of Malaysia, Indonesia, South Africa, Turkey, Brazil, Colombia, Chile, and Mexico hitting record lows recently, currency traders around the world are asking: How much further can emerging-market currencies weaken?
The standard approach to answering this question takes a relatively normal base year and measures how much a country’s currency has depreciated since then. That number is then adjusted for the inflation differential between the country and its trading partners. If the resulting real exchange rate is not too far from that of the base year, the market is said to be in equilibrium, and little or no further depreciation should be expected.
Now consider an alternative method. Take the same country’s current-account deficit and ask how large a real depreciation is needed (making some assumptions about trade elasticities along the way) to close that external gap. If the recent real depreciation achieves that threshold, no further change in the exchange rate should be expected.