Not Every Currency Collapse Is the Market Telling the Truth

A collapsing currency is often presented as the final and most honest verdict on a country’s economic management.

Governments can manipulate statistics, postpone reforms and disguise fiscal deficits. Politicians can blame foreign investors, speculators or previous administrations. But, according to the orthodox interpretation, the exchange rate eventually reveals the truth.

There is considerable wisdom in this argument.

Currencies tend to weaken when inflation is uncontrolled, fiscal policy is unsustainable, reserves are depleted, productivity stagnates or political institutions lose credibility.

But the argument becomes dangerous when converted into an absolute principle.

Markets are powerful information systems. They are not infallible judges. Exchange rates can also be driven by leverage, global risk aversion, forced selling, thin liquidity, index rebalancing and contagion from events unrelated to the country’s fundamentals.

A new IMF Staff Discussion Note provides a useful framework for distinguishing between these two worlds.

The finding is significant: in emerging and developing economies, a substantial part of currency pressure can arise from financial shocks rather than macroeconomic fundamentals.

In those circumstances, foreign-exchange intervention may be economically defensible.

But it can also become the perfect excuse for governments determined to deny reality.

Fundamentals and financial shocks are not the same

A currency can depreciate because a country imports more than it exports, accumulates excessive debt, runs persistent fiscal deficits or allows inflation to erode purchasing power.

Such a depreciation performs an economic function. It makes imports more expensive, exports more competitive and domestic assets cheaper for foreign investors. Painful as it may be, the adjustment reflects underlying imbalances.