One day in 1997 I received a most unwelcome letter from my bank.
The interest rate on my mortgage, which varied with South Africa’s version of the Federal discount rate, had increased from below 8% to 24%. Since I had bought my house only two years before, interest still made up a large chunk of my monthly payment. The price of gas and other imports also rose massively.
Suddenly, my monthly budget was in complete chaos, as funds allocated to life’s necessities were now required by the bank and my gas tank. What was the reason for this sudden reach into my pocket? I hadn’t defaulted. The fundamentals of the local mortgage market were unchanged. In fact, there were no immediate reasons — those connected to my personal environment — at all.
Instead, the cause lay in a country 6,300 miles to the east … the financial markets of Thailand. That’s why yesterday’s stock market decline reminded me what it’s like to be on the developing-market end of such an event…
Instant on Paper, Not So Much in Real Life…
Sometimes, life is a waiting game. Now, with global stock markets in turmoil, is one of those times.
Economics is deceptively simple. Supply and demand set prices. Production gravitates toward the lowest-cost environment, where wages rise and profits fall to match those elsewhere. If nobody touches anything, everything balances out and everybody prospers. Models can be made to “prove” this instantly.
Of course, the “do not touch” rule in economics is observed about as faithfully as it is when my wife bakes a batch of fresh cookies and leaves them to cool in reach of my daughter and her friends.
Anybody who can fiddle stock markets — from food trucks calling the health inspector on rivals to big corporations buying monopoly-causing rules from politicians — does everything they can to rig the system in their favor. As a result, the prices we actually see in real-world stock markets often have only a vague relation to what they might be if nobody cheated.
Nowhere is this truer than in currency markets. National currencies are creations of government, and governments just love to fiddle with stock markets. In fact, government meddling in the relative prices of currencies is what caused my mortgage payment nearly to quadruple overnight.
Hands in the Cookie Jar
Back in 1997, the Thai government had been keeping the baht on a fixed rate against the dollar for some time. By artificially depressing its price in dollars, the Thai government was able to encourage a massive export boom in electronic components — 9% annual growth from 1985 to 1996 — which pleased its friends in industry very much.
Eventually, however, global currency traders realized that the baht was vulnerable, suspecting the Thai authorities lacked the foreign currency reserves to maintain the peg. They engaged in arbitrage designed to exhaust the government’s dollar reserves, and in July 1997, the government gave up. The baht instantly lost half of its value, the Thai economy contracted massively, and the local stock market lost 75% of its value.
The result was what some economists have called a “bank run” on developing market currencies, starting in East Asia but spreading rapidly. Everybody assumed that (a) other countries were manipulating their own currencies like Thailand and (b) all of these countries were about to crash. Traders therefore pulled their money out of these economies, causing them and their currencies to crash whether they were in danger or not. It was a self-fulfilling prophecy.
Back in South Africa, the Reserve Bank was determined to buck the trend. By massively increasing domestic interest rates, they attracted short-term “hot money” seeking to profit from the rate differential between the rand and the dollar. It worked … the South African rand quickly regained its value and the currency vultures turned their attention elsewhere.
Cold Comfort, But Comfort Nonetheless
By mid-1998 economic conditions in my part of the world had returned to normal. The interest rate on my mortgage went back to single digits, and the resolve shown by the South African Reserve Bank led to a steady inflow of capital over the next decade, attracted in part by capital investment strategies designed to avoid vulnerability to currency crises in the future. Some folks made a lot of money on those.
That’s why I take the following lessons from the current turmoil in global stock markets:
- It will pass, and prices of everything will eventually return to their long-term trend — stocks, bonds, currencies, commodities and so on.
- In most places, the crisis will be over more quickly than people expect, since in most places there is nothing fundamentally wrong with the economy.
- Those who had preemptively invested in a diversified manner — especially in alternatives such as gold and other physical stores of value — will survive and prosper.
- In many places, the crisis will create opportunities, as governments and corporations learn their lessons and take steps to adapt to the threat of a Chinese slowdown, a hamstrung Fed and so on.
I survived a financial crisis once. I know we will all survive this one … perhaps, even profit.
Offshore and Asset Protection Editor