Damocles: Our early warning indicator of EM exchange rate crises

Two countries – Egypt and Turkey – are currently at risk of a currency crisis with Romania coming close behind, just under the 100 threshold.

  • A Damocles score of more than 100 suggests an economy is vulnerable to an exchange rate crisis within the next 12 months.
  • Only two countries – Egypt and Turkey – are currently at risk of a currency crisis with Romania coming close behind, just under the 100 threshold.
  • The largest declines in scores were seen in Indonesia, Ukraine, Pakistan, Czech Republic, and South Africa. By contrast, scores have increased in Turkey, Colombia, India and Romania.

The Covid-19 outbreak sparked record portfolio capital flight from emerging markets (EM) in March and April 2020. However, this was short-lived, thanks to the unprecedented size of global monetary and fiscal policy stimulus. However, the ‘feast’ of capital inflows can, over time, do more harm than good to EM economies. Too low interest rates or too heavy FX intervention can cause a build-up of excess liquidity and a borrowing binge, fueling asset price bubbles, overheated economies, inflation and billowing current account deficits.

Perhaps it is human nature, but during the good times, it can often be difficult to foresee a crisis, even when possible triggers – such as when the Fed announces its plans to taper quantitative easing – are known in advance. Thus, it is important to be prepared for the worst. This is where Damocles, our early warning model of EM exchange rate crises, can prove to be a useful tool and provide a wake-up call.

Damocles summarizes a lot of disparate information in a simple but rigorous manner to produce a single summary measure, and has the advantage of offering an objective and consistent rules-based approach to assess how vulnerable an economy is to an exchange rate crisis. In this update, we have also included two additional countries (Kenya and Morocco). There are eight key indicators which best predict the 61 different exchange rate crises in our 32-country sample.

Our findings suggest that, whenever the Damocles index exceeds the 100, it should be interpreted as a warning signal that the country is vulnerable to an exchange rate crisis in the next 12 months, particularly if the reading is persistently above 100. Setting a threshold of 100, Damocles correctly signaled 64% of the past 61 crises in our sample. A Damocles reading above 150 is a starker warning that a crisis could erupt at any time. In this update, Egypt and Turkey are currently at risk of a currency crisis with Romania coming close behind, just under the 100 threshold. What is more striking about the latest results, particularly amid a global health crisis, is the large number of countries with low Damocles scores, signaling very low risk of a currency crash. Of the 32 EM countries, 17 have Damocles scores of 19 or below, and nine have scores of 0.

The Damocles scores have decreased in 13 countries, with the largest declines in Indonesia, Ukraine, Pakistan, Czech Republic, and South Africa. The most common reason for a decline in an economy’s Damocles scores is a smaller current account deficit, or a shift to a surplus. Somewhat ironically, the pandemic has caused a collapse in domestic demand and hence imports, which has improved current account positions in many EM countries. By contrast, the Damocles scores have increased since our previous update in April 2020 in only four countries: Turkey, Colombia, India and Romania.

Overall, our latest Damocles results paint a favorable picture of a low risk of exchange rate crises in EM. That said, most countries have racked up large fiscal deficits and, if we assume the vaccinations will be successful in suppressing Covid-19, then in all likelihood many countries will start running larger current account deficits (as imports rebound) and become more indebted to foreigners. We suspect that our next update will show a rise in Damocles scores, but for now, EM exchange rate crisis risk appears low.

For a more in-depth look at our latest Damocles update, read our full report.

Contributor

  • Rob Subbaraman

    Head of Global Macro Research

  • Rebecca Wang

    Macroeconomic Research Analyst, Asia ex-Japan

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