PETALING JAYA: Sri Lanka is at risk of an exchange rate crisis mainly due to its still-weak fiscal finances and a fragile external position.
Sri Lanka charted the highest Damocles score of 175, among 30 emerging market (EM) economies.
The Damocles index by Nomura summarises macroeconomic and financial variables into a single measure to assess an economy’s vulnerability to a currency crisis.
A score above 100 suggests a country is vulnerable to an exchange rate crisis in the next 12 months, while a reading above 150 signals that a crisis could erupt at any time.
Sri Lanka has large refinancing needs, with foreign exchange (forex) reserves of less than five months of import cover and high short-term external debt of US$ 7.5bil.
“Political stability also remains an issue, as recent resignations have weakened the government (its term ends mid-2020) and despite retaining a simple majority, complicates the task of continuing to implement International Monetary Fund (IMF)-induced reforms.
“However, without IMF support, the risk of a currency crisis would be higher,” said Nomura in its global research report.
Meanwhile, South Africa, Argentina, Pakistan, Egypt, Turkey and Ukraine are currently vulnerable to an exchange rate crisis, having Damocles scores of more than 100.
“Based on our definition, Argentina and Turkey are experiencing currency crises, while Argentina, Egypt, Sri Lanka and Ukraine have turned to the IMF for assistance, leaving Pakistan and South Africa as the standouts.
“As investors focus more on risk, it is important not to lump all EMs together as one homogeneous group; Damocles highlights a long list of countries with very low risk of currency crises,” said Nomura.
Eight countries, namely, Brazil, Bulgaria, Indonesia, Kazakhstan, Peru, Philippines, Russia and Thailand, have Damocles scores of zero.
It is notable that China’s Damocles index has maintained since dropping to 36.9 in late 2017 from 62.4 in October 2017.
The index far below the 100 threshold suggests that the risk of an exchange rate crisis in China is limited.
Nomura concurred that China’s balance of payment position remains healthy, given it has the world’s largest foreign exchange reserves at US$3.1 trillion, as of July 2018.
“However, we highlight that its pockets are not as deep as they once were, given that current account deficits at minus 0.4% of gross domestic product (GDP) in the first half of 2018 may occur more frequently, net direct investment inflows may moderate further, and external debt has risen significantly.
“Moreover, we see domestic challenges from weakening aggregate demand and other fundamental problems, and external risks from the escalation in China-US trade tensions and trade protectionism,” said Nomura.
As for India, its Damocles score has fallen to 25 in the third quarter of 2018, from 56 during 2012 to 2013.
India’s most recent currency crisis occurred in 2013 and was due to weak domestic macro fundamentals and worsening external funding conditions. Since then, consumer price index (CPI) inflation has moderated to about 4.5% in 2018 from 9.7% in 2012, as has the current account deficit at an estimated -2.5% of GDP, compared to minus 5% in 2012. Furthermore, India’s central bank has a sufficient forex reserve buffer of 9.3 months of import cover versus 6.4 in 2012.
“However, given India runs a current account deficit, it remains vulnerable to bouts of global risk aversion. Higher oil prices and portfolio outflows are its key external vulnerabilities.
“Aside from these, the key risks stem from the government turning more populist ahead of the 2019 general elections (worsening domestic fundamentals) and a sharper-than-expected domestic growth slowdown (triggering equity outflows),” said Nomura.
The Damocles index comprises eight indicators that are found to be the best predictors of exchange rate crises in the 30-country sample, in which there have been 54 crises since 1996. It includes five single indicators which are import cover, short-term external debt or exports, forex reserves or short-term external debt, broad money or forex reserves and real short-term interest rate.
On the other hand, the three joint indicators are non-foreign direct investment (FDI) gross inflows of one-year and three-year, fiscal and current account, as well as current account and real effective exchange rate deviation. To date, Damocles has correctly signalled 67% of the past 54 crises in Nomura’s sample, including the Asian financial crisis (1997 to 1998), Russian financial crisis (1998) and the 2018 EM currency crises in Argentina and Turkey.
“The advantage of Damocles lies in its objective nature in letting the data speak, not clouded by conventional misperceptions or biases based on past experiences. While the results achieved are encouraging, but given the inherent limitations of any early warning system, it would be foolish to make any exaggerated claims.
“For instance, Brazil’s Damocles score of zero implies very low external vulnerability; yet the Brazilian real (BRL) has depreciated more than 10% in August alone due to an uncertain presidential election outlook,” said Nomura.