Sometimes we find indicators where we least expect them. Who was paying attention to the Thai bhat prior to its collapse in July 1997? Who is paying attention to the currencies of the more successful former Communist states of Eastern Europe today, such as the Czech koruna, the Hungarian forint and the Polish zloty?
The problems in South Asia in 1997 stemmed from rapidly increasing trade deficits and external debt levels denominated in hard currencies such as dollars or yen. The problems emerging in Eastern Europe are not of internal origin, but derive from a combination of such factors as rising interest rates in the U.S. and a weak euro.
Strangely enough, if the problem persists,
and the rest of the
gang may have to go easy on the tightening. Today's announcement notwithstanding, this may give the U.S. equity markets a little more upside momentum.
As these Eastern European countries try to prevent their currencies from becoming overvalued against the euro, those same currencies risk becoming undervalued against the dollar. While most of these countries' bilateral trade in goods and services is within the euro zone, the price of many of their key imports, including that of crude oil, is denominated in dollars. The Eastern European countries are facing a classic squeeze on their trade balances as their dollar-denominated energy imports surge in price, while their exports are becoming increasingly expensive within the euro zone.
There is no known policy mix available to Eastern Europe that is capable of simultaneously weakening the currencies against the euro while strengthening them against the dollar.
Only an actual appreciation of the euro against the dollar would accomplish this, and raising euro-denominated interest rates would be necessary. Any decision is in the hands of the
European Central Bank
and its 11 national constituents. Pity poor Poland: It has been a victim of bad geography over the centuries, and now it hopes that a central bank run by a committee will come to the zloty's rescue.
The countries have adopted different interest-rate strategies in response to these stresses. The Czech Republic has driven the rate down on 90-day Prague interbank offerings (PRIBOR) by nearly 40% since the euro's inception. Hungary, in turn, engaged in a period of gradual interest-rate erosion on 90-day Budapest interbank offerings (BUBOR). Poland, ever marching to the beat of a different drum, raised rates on 90-day interbank offerings (you guessed it, WIBOR) by close to 20% during 1999 before cutting rates at the start of 2000.
Jan. 4, 1999 = 100%. Source: Bloomberg
We've had sufficient experience with politicians and central banks playing currency and interest-rate games with taxpayers' money over the past quarter-century to know this isn't a good idea. It certainly wasn't in the U.S. during the 1980s, and it certainly won't be in Eastern Europe today. Like all rapidly growing economies, Eastern European countries depend on international investment flows for capital and development.
While much of this money flow is in the form of direct investment in plant and equipment, a good deal is in the form of portfolio investment -- the notorious "hot money" of urban legend.
Should this money exit in a hurry, as it did in South Asia in 1997 and Russia in 1998, where will we see it first, in the foreign-exchange market or in their equity markets? We'll submit the latter; the actual exchange rates of the zloty, forint and koruna are too affected by the euro/dollar rate to convey a pure signal.
We can take a look at the relative performances of the Polish
index and the
Czech PX 50
index against the
Morgan Stanley Euro
index since the euro's inception for hints of impending trouble.
One of the most notable features is the long-lived underperformance of the PX 50 despite continuously lower PRIBOR rates; this indicates growth and profitability strains in the Czech Republic. A second notable feature is the relative rebound of the Traded Index since BUBOR rates were cut at the start of the year.
Until Hungarian rates started to fall, the relative overvaluation of the forint to the euro started to squeeze Hungarian profitability. A similar pattern emerged in Poland, although the relative decline of the WIG 20 index in the last two weeks is starting to signal stress from the zloty's fall against the dollar on the back of WIBOR cuts.
Next Stop Equities?
Jan. 4, 1999 = 100%. Source: Bloomberg
As U.S. rates move higher, the dollar's strength against the euro will hurt the smaller economies of Eastern Europe first; they'll be the miners' canaries of the system. The stock indices of Eastern Europe will indicate when the euro has become "too weak."
If Eastern European countries start selling off at a rapid rate relative to senior Western European markets, the Fed will once again have to put domestic tightening on hold for international reasons, just as it did during the Asian and Russian crises.
And, after the initial scare, such actions will once again be quite bullish for the U.S. markets.
Howard L. Simons is a professor of finance at the Illinois Institute of Technology, a trading consultant and the author of The Dynamic Option Selection System (John Wiley & Sons, 1999). Under no circumstances does the information in this column represent a recommendation to buy or sell securities. While Simons cannot provide investment advice or recommendations, he invites your feedback at