Towards a new currency crisis in 2018? Similarities and differences with 1997

There is something with the ends of years finishing in -7 and -8 that make them particularly vulnerable to currency and financial crises. 1987 was the year of the Black Monday in the US (Black Tuesday in Australia) when stock markets fell by more than 20% in just one day. In 1997-1998, strong currency devaluations in Thailand and then South East Asia in July triggered a global stock market crash in October that had consequences well into 1998 around the world, culminating with the Russian default and further currency turmoil in Turkey, Brazil and Argentina. In 2007, US financial institutions exposed to subprime loans and credit default swaps unfolded events that led to the worst global financial crisis the world had known since 1929 culminating in September 2008 with the crash of Lehman Brothers and failures of whole countries like Iceland, Greece, Ireland and Spain, with recessions in all OECD countries but two (Australia and Poland).

Yet again, August 2018 started with strong devaluations in Turkey, Argentina and Venezuela ignited by US protectionist measures that could potentially transform into a new global crisis. For the record, it seems all started with a tweet from President Trump on 27 July threatening Turkey of “large sanctions” if they did not release a US pastor that they accused of spying. This sent the Turkish lira into a spiral of heavy devaluation and had contagious effects in other emerging countries at odds with the US. The Turkish lira lost 40% of its value so far this year including 20% in August, the Argentinan peso also 40%, the Venezuelan bolivar 96%, and even the Chinese yuan felt the hit with losses of 9% (the worst since 1994) and the Euro with a drop of 6.5% against the US dollar.

On one hand, lessons have been taken since the last global financial crisis with stronger regulations like the Basel III accord implemented by the BIS, but on the other hand, the world is at the end of a global economic cycle where excesses have built up and new risks, yet ignored or overlooked by current regulations, could materialise in a new global crisis.

Events in 2018 are unfolding just like in 1997

Indeed, the sudden devaluations in Turkey of August 2018 look a lot like the events in South East Asia of July 1997 and could potentially result in a global currency crisis. The same causes could produce the same effects: the end of an economic cycle, the flattening of the yield curve, collapses of emerging markets… However, the world in 2018 is a very different place to what it was back in 1997.

The crisis in 1997 started with strong currency devaluations but was sustained by large-scale rating downgrades of the affected countries by the rating agencies. In 2018, the same phenomenon is under way as S&P downgraded Turkey’s sovereign rating from ‘B+’ to ‘BB-‘ and Moody’s from ‘Ba2’ to ‘Ba3’ further to the devaluation of its currency while Venezuela is in selective default.

Already Spanish and French banks are feeling the hit of the Turkish currency crisis as they are heavily invested in Turkey, and Germany would also be impacted by a Turkish slowdown as it is the second largest foreign investor in Turkey.

So, the domino effect seems to work the same way as it did in 1997. Sharp devaluations of emerging country currencies are followed by sovereign rating downgrades, and then banks of developed countries who invested in these countries are affected and this can potentially lead to a global crisis.

Today’s world economy is more deconcentrated, yet more reclusive

However, the economic world in 2018 is different from what it was in 1997. In 1997, the world economy was still dominated by the US and the EU, who respectively accounted for respectively 27% and 25% of the world GDP, that is more than half between them two. In 2017, the US only accounts for 15.26% and the EU for 16.52% of the world total GDP in purchasing power parity, merely one third of it, while emerging countries like China and India account respectively for 18.23% and 7.45% of the world GDP in PPP (source: IMF). So, the world economy is much more deconcentrated now than it used to be.

However, in 1997, the world was on a path to more free trade with the NAFTA treaty implemented in North America since 1994 and the EU expanding to Central and Nordic (Austria, Finland and Sweden in 1995) and then Eastern European countries (Hungary, Poland, Czech Republic, Slovakia, Baltic countries, Malta and Cyprus in 2004, Romania, Bulgaria in 2007). Now free trade is no longer the flavour of the day especially with Trump’s accession to power, his denunciation of the Trans-Pacific Partnership and even parts of the NAFTA deal and his introduction of heavy tariff on steel and aluminium with his principal trade partners and

This make today’s economic world a more deconcentrated, yet a more reclusive and riskier place.

In the end, the US economy is the most at risk

Thus, the hardest hit country could be in the end the US whose revalued dollar could make it even harder to rebalance its trade deficits and still record high debt-to-GDP ratio (105.4% in 2017). Indeed, the stronger dollar makes it more difficult for the US to export and make imports from China and other Asian countries and European countries alike, as they become cheaper, despite the tariff increases imposed by Trump.

The Dow Jones and NASDAQ indexes are at their highest level ever, at respectively 25,000+ and 7,800+. They have been fuelled by Trump initial measures to lower corporate tax, remove government and environmental regulations and favour the corporate world. However, there is no much room to go much further in this economic cycle as employment is reaching an all-time high (3.9% unemployment rate in July 2018) and markets are going to realise that a stronger US dollar and Trump protectionist measures are not going to help US corporations export and make more profits. Sometime, in September or October 2018, financial markets are going to realise this, fall suddenly and sharply like they always do, and this might trigger another global financial crisis, hopefully not as severe as the previous one thanks to a more deconcentrated world economy and stricter world financial regulations.

#Turkey #Currencycrisis #US #Trump #Devaluations #Trade #Protectionism