Can You Predict Forex Crisis?

The type of exchange rate system is vital for normal market trading conditions, but it is particularly important for abnormal periods of market stress that may lead eventually to a “currency crisis”. Let’s consider the occurrence of currency crises and whether or not they can be forecasted.

In the wake of the emerging market crises in Mexico (1994–1995), Asia (1997–1998), Russia (1998), Brazil (1999) and Turkey (2001), considerable effort has been made by the academic and financial communities to create models that might be able to forecast such crises in the future.

As with long-term estimate models meant for discovery of a currency’s “equilibrium” level, most of these are based on highly difficult mathematical formulas and make certain key expectations about human behavior and psychology.

Equally, like the equilibrium models, the outcomes of these have been mixed at best to date. No-one has as yet come up with the conclusive model capable of consistently forecasting currency crises ahead of time. The best that has been achieved is some degree of success, albeit claimed after the fact.

Most of the existing models focus largely on the rationality of human behavior. In a financial context, this implies rational investors investing where the best returns are to be found. If those returns diminish or if better returns are available elsewhere, it is assumed that they will leave.

Such a rationally-dominated view does not allow for herd behavior, that buying may continue long past the point at which yield returns have diminished significantly. There is an emotional hang-up, both within economic theory and within the official community, which labels buyers as investors and sellers as speculators.

Yet, buyers can also be speculating. Indeed, some of the best examples of speculative excess gone mad have come from buying rather than selling, notably the internet bubble.

Markets are ruled by such fundamental sentiments as greed and fear, and it is safe to say that in 1999–2000 greed was running rampant.

Easy money was to be had—as it always is during such periods of market hysteria. The financial bubble got bigger and bigger and then burst spectacularly in mid-2000.

We are still feeling the after-effects of the bursting of the economic bubble, that tidal wave of increasingly unprofitable investment.