Damocles: Our Early Warning Indicator of EM Exchange Rate Crises
Our early warning model of EM exchange rate crises shows Turkey, Czech Republic, Sri Lanka and Romania are at risk
- A Damocles score of more than 100 suggests an economy is vulnerable to an exchange rate crisis in the next 12 months.
- Four countries – Turkey, Czech Republic, Sri Lanka and Romania – are currently at risk of a currency crisis with Damocles scores above 100.
- Since our 2022 updates, five out of eight countries that had Damocles scores above 100 have had exchange rate crises.
In a year when investors have been piling into the EM carry trade – an investment strategy of borrowing money from low-interest currencies to invest in higher-yielding emerging markets – it is prudent to ask if investors are being adequately compensated for the perceived risk premium.
The triple shock of the pandemic, the conflict in Europe and high inflation has widened the disparity of economic fundamentals in emerging markets, according to a Nomura assessment. Though some countries have sustained healthy fundamentals, others have seen a marked deterioration in fiscal finances, along with widening current account deficits, inadequate foreign exchange reserve cover and deeply negative inflation-adjusted interest rates.
Damocles, our early warning model of EM exchange rate crises, can be a useful tool to warn of possible risks. Whenever the Damocles index exceeds 100 for any country, it is a warning that it is vulnerable to an exchange rate crisis in the next 12 months. The model correctly signaled 64% of the past 61 crises in our initial sample of 32 emerging market economies from 1996 to 2021. Since our 2022 updates, five out of eight countries that had Damocles scores above 100 have already had exchange rate crises.
In this update, Turkey, Czech Republic, Sri Lanka and Romania are currently at risk, all with scores over 100. Chile, Hungary and Brazil have scores nearing that threshold. Though Turkey and Sri Lanka have recently experienced exchange rate crises, Damocles indicates that they are not yet out of the woods.
The sum of the Damocles scores for the current sample of 31 EM countries has decreased to 1,799 from 2,190 in our previous update in November 2022. This score is still high by historical standards. It warns of the latent vulnerabilities in EM that have built up amid the pandemic, the Russia-Ukraine conflict, the global inflation surge and the subsequent aggressive global rate hiking cycle and a strong US dollar.
An important lesson from the large number of past crises is that risk premia do not follow a monotonic process, increasing steadily as risk increases; rather, investors’ perceptions of risk seem to develop in a binary on or off fashion. In other words, the re-pricing of EM risk premia can be sudden and self-fulfilling, which is why early warning models such as Damocles can be useful.
For an in-depth look at our latest Damocles update, read the full report here.
Contributor
Rob Subbaraman
Head of Global Macro Research
Si Ying Toh
Economist, Asia ex-Japan
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