With emerging-market turmoil sending the occasional shiver up investors’ spines as summer drew to a close, analysts at Nomura revived a tool they say has an admirable record of predicting past currency crises.
The subtly named “Damocles” index uses eight indicators — import cover, short-term external debt/exports ratio, FX reserves/short-term external debt, broad money/FX reserves, real short-term interest rate, non-foreign-direct-investment gross inflows (1-year and 3-year), fiscal and current account, and current account and real effective exchange rate deviation.
The analysts use the criteria to produce a score, with a reading above 100 taken as a warning signal of a potential exchange-rate crisis (see chart below).
Anyone who’s been paying attention probably won’t be shocked by the results, particularly with Argentina’s peso already down more than 50% versus the dollar in the year to date, making headlines last week over the past two weeks as its currency plunged USDARS, +0.7036% to an all-time low versus the greenback. That forced the Argentine government and the International Monetary Fund to scramble to reassure investors, while the country’s central bank hiked its interest rate from 45% to 60%.
Read: Here’s why emerging-markets turmoil will continue to keep traders on their toes
Turkey has also attracted plenty of attention amid chronic weakness for the lira, which is down 41% year to date, USDTRY, +1.0005% amid economic worries, a diplomatic row with the Washington over Ankara’s detention of U.S. pastor Andrew Brunson, and President Recep Tayyip Erdogan’s hostility toward the country’s central bank. South Africa, meanwhile, unexpectedly fell into recession in the second quarter.
Among other countries on the list, the Sri Lankan rupee USDLKR, +0.22% carried the highest Damocles score. It’s down 5.5% versus the U.S. dollar so far in 2018. Among the others on the list, the South African rand USDZAR, -0.1910% is down 18.8% year to date, the Egyptian pound USDEGP, -0.3242% is down 0.4%, the Pakistani rupee USDPKR, +0.05% is off 10.3% and the Ukranian hryvnia USDUAH, +0.0000% is down 0.5%.
On the equity front, the iShares MSCI Emerging Markets ETF is down 4.5% in September, contributing to its 12.5% year-to-date decline. The S&P 500 SPX, +0.28% is up 7.6% so far this year.
Nomura’s index is named after a Roman parable in which a courtier named Damocles agrees to swap places with a king. In the midst of enjoying a sumptuous meal, he notices that a sword has been suspended above his head, hanging only by a horsehair. The danger renders him unable to enjoy the feast.
The Nomura analysts said the index correctly signaled 67% of past crises in its sample, including the 1997-98 Asian financial crisis, the 1998 Russian financial crisis and the current woes in Argentina and Turkey. They also note that eight countries, including Brazil, which has been buffeted by political uncertainty of its own, carry scores of zero.
At the same time, they caution that it would be “foolish” to make exaggerated claims about the index’s predictive power. Used in a broader assessment of the global, economic, political and institutional landscape, it can help better assess risks, they said, adding that they plan to update the scores each quarter.
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