In its latest quarterly review, published this morning, the Bank for International Settlements (the organization that comes up with international bank capital adequacy rules) presents results of research into currency collapses that is of particular importance to stock market investors.
the bottom line
The research studies a large number (79) of past currency collapses, mostly in developing countries. There’s a complicated definition of what constitutes a collapse, but it’s basically meant a drop of 22% or more in the value of a country’s currency in a short period of time.
Collapses are associated with a permanent loss in real GDP of 6%–not a good thing. –also something you’d expect to see.
What’s interesting about the study, though, is that it finds the output loss begins three years before the currency drop. Therefore, although the currency decline is correlated with the output loss, the currency movement doesn’t cause it.
In fact, quite the opposite. The currency collapse appears to mark the beginning of a period of accelerating economic growth that would likely not have occurred in the absence of the currency decline. The better economic performance continues for several years, and ends up offsetting about two-thirds of the economic loss.
In other words, the currency decline, although frightening, is the first sign of economic healing, not the harbinger of further economic doom. (Note, again, there’s no claim to have established causation. The only assertion is that the better economic performance comes after the currency debacle.)
think: the euro
The fall in the euro vs. the US dollar has been 21%+ over the past half year or so. For my money, this counts as a currency collapse.
We know in theory that currency decline has three effects:
–it acts like a drop in interest rates as a stimulus to economic growth,
–it redistributes economic energy toward exporters and import-competing industries. It channels growth away from importers and foreign manufacturers. And,
–it increases the value to locals of foreign hard-currency assets.
Said a different way, a stock market investor should look for companies that have hard-currency revenues and weak-currency costs.
My experience with European stocks has been that recognition of the new currency facts of life lag the actual currency movements by a couple of months.
What does the BIS study add to these theoretical musings? The fact that in 79 past instances, this is the way things have turned out.