We discussed the future of Turkish Lira in a previous article, but this is far from an isolated case of a currency in crisis – Argentina peso, Indonesian rupiah, South African rand, Chilean peso, Iranian rial, Russian ruble, and even Chinese yuan have all been falling, albeit some more dramatically than others.
Here, we analyze how reserve-ratios and debt levels in relation to GDP can provide some insight into the risks associated with a particular currency.
A fundamental threat running through global financial markets is the ballooning of US dollar denominated debt worldwide – increasing from $600 billion to over $2 trillion in 2000, and reaching $12 trillion in 2018. Generally this trend is seen as the fundamental problem at the root of all pending crises: bubbles are bursting all around the world due to countries’ inability to meet debt obligations, and more importantly the inability to defend currencies when they come under pressure.
Bank of International Settlements (BIS) has 11 countries on a watch-list – five high-risk, Turkey, Chile, Argentina, Mexico, and Indonesia, and six moderate-risk, South Africa, Brazil, Russia, Malaysia, South Korea, and India. China and Saudi Arabia are listed as examples of no-risk countries. These high and moderate-risk countries have to be taken seriously as together they account for more than 60% of the total USD denominated debt worldwide.
There are two key factors to consider when analyzing a country’s currency: firstly, the USD debt level and the size of reserves that could cover that debt in the long run (as well as the liquidity of those reserves to fend off any runs on a currency in the short term); and secondly, the debt-to-GDP ratios of a country as a whole.
In the case of the Turkish lira, foreign reserves can cover little more than half of Turkey’s USD-denominated debt (according to the Bank of International Settlements 54%); Chile and Argentina are even more exposed, with reserves at 37% and 48% of USD debt respectively; Mexico and Indonesia are only slightly better-off at 66% and 72% respectively. Needless to say, the ability of these 5 countries to cover their total external debt is even more limited (15-25%).
The moderate-risk countries have enough reserves to cover their USD debt – South Africa 133%, Brazil 202%, Russia 242%, Malaysia 255%, South Korea 336%, and India 390% – but fall short of covering their total external debt.
Compare these figures with those from China, a country identified as no-risk and one that holds reserves that are six-times its USD debt and double its total external debt, or with the oil-rich Saudi Arabia, with reserve ratios standing at 4.5 times its USD debt and 2.7 times its total external debt.
Debt-to-GDP ratios (both USD and total external), is also a critical measure of a country’s indebtedness. Among the 5 highest-risk countries, Mexico can cover two-thirds its USD debt from reserves – seemingly better-off than Chile, Argentina and Turkey – however, Mexico is even more exposed than what this may suggest. Its external debt (39% of GDP) is not as high as Chile at 66%, Turkey at 55% or Argentina at 40%, but at 60% of its total external debt, its USD denominated debt is 25% of GDP, behind Chili at 36% but higher than Turkey at 24%, Argentina at 20%, and Indonesia at 15%. Moreover, the size of its USD debt is second highest behind China’s, bearing in mind that China’s USD debt is a mere 4% of GDP.
This is the type of analysis required when trying to identify high-risk situations (opportunities depending on your perspective) but often, further consideration is required: Indonesia, for example, has an external debt-load in relation to GDP of only 35%, lowest among the 5 high-risk countries, and less than half of that is USD denominated (16% of GDP), and its reserves are large enough to cover 72% of its USD debt (highest ratio among the 5); however, since its reserves are still rather limited, Indonesia is still highly exposed, and its currency decline (more than 10% this year) is an indication of this vulnerability.
Compared to the high-risk countries, the six considered moderate-risk all have relatively low levels of USD denominated debt (South Africa, Russia and Malaysia at 11-13% of GDP, South Korea and Brazil at 8-9%, and India as low as 4%) and they have enough reserves to cover their USD denominated debt (India with a margin of 4:1, South Korea 3.4:1, Russia and Malaysia around 2.5:1, Brazil 2:1, and South Africa at 1.3:1).
Their total external debt exposure, however, is much higher in relation to GDP; in fact, Malaysia’s at 68% of GDP is higher than any of the high-risk countries, while South Africa at 52% is only below Chili and Turkey. The remaining 4, Russia at 33% of GDP, Brazil at 32% and South Korea at 28% are only slightly below Mexico and Indonesia, while India at 20% is lower. South Korea and Russia have enough reserves to cover most of their external debts, and India is not much farther behind them. Brazil and Malaysia can cover about half their total external debt, while South Africa is below 30%, closer to the high-risk group.
Reserve-ratios provide some guidance in assessing overall risk levels but do not provide enough information to gauge the state of a particular currency to buy or sell at any particular moment, at least not in any informed way. As we examined in more detail in the case of Turkey, the currency crisis the country faces is the outcome of deeper financial and economic forces at work; moreover, its socio-political instability is playing a huge role in driving the value of its currency through capital flows (limiting inbound investment while boosting outbound flight).
Currency-crises are typically expressions of wider financial or economic difficulties facing the countries involved. Their ability to pull out of crises depends on their capacity to stabilize their economies and restore healthy growth, and in this regard socio-political conditions play as much role as the economic fundamentals. To pass judgment on the future of any currency, be it in high or moderate risk countries, we must understand the broader context through further analysis on a country by country basis.