While Phase II remains ongoing, the economic patient is still showing no major sign of recovery. Phase III, by contrast, deals with the first inclination of improvement in the vital signs. Put bluntly, the economy hits bottom and a period of stabilisation ensues. Readers should note that the economic stabilisation does not mean the same as recovery, in the same way that the hitting the ground after a fall from some height does not entail recovery (indeed, if the height is sufficient there is unlikely to be any recovery!). Both processes usually entail a prolongation of pain, but at least the pain is not getting worse. Thankfully, economies are not as frail as the human body. They can indeed fall from great heights, smack down hard on the concrete with a sickening thud and yet still recover; the timing of that recovery depending crucially on the extent of the fall.
At the micro-economic level, companies are still continuing the process of rapid de-stocking of their inventories. Individual consumers remain extremely cautious and in the shops and department stores, the rental agencies and the real estate agents, prices are still falling. Yet, by this time, the liquidity-based rally in local currencies which we looked at in Phase II and most importantly the fall in interest rates which that entails provides crucial support for cash-strapped local companies and banks. Sensing this, at the local level companies seek to plan for better times to come by hastily completing their inventory de-stocking process, switching most of that supply to export markets unaffected by the crisis where possible (in Asia, many Asian companies were quick to switch exports destined for fellow Asian countries to the U.S. where domestic demand remained very strong) and starting the process of restocking. At the international level, both in terms of offshore and onshore investors, the reality of the economy hitting bottom, as evidenced by declining contractions economic indicators, leads to the expectation of Phase IV, economic recovery. Phase III is not plain-sailing for local currencies however. As domestic economies stabilise, so do imports. Indeed, year-on-year basing effects accelerate that process. Thus, what we usually see in Phase III is the trade and current account surpluses peaking on a monthly basis. During Phase II and the initial part of Phase III, trade flows are actually more important than capital flows - as most offshore investors have already left by then, taking their capital with them. Reduced trade surpluses thus have a greater effect on market movements than would otherwise be the case, serving to weaken the local currencies - and again, that is exactly what we saw in the first quarter of 1999 in Asia. More specifically, the Thai baht rose to a high of 35.65 against the dollar from its record low of 56.30, only to fall back to around 38. The same thing happened to the Indonesian rupiali, the Philippine peso and the Singapore dollar (note that the Malaysian ringgit was pegged to the dollar on September 1, 1998 at 3.80, hence it did not experience this renewed setback, nor for that matter did it experience the fundamental recovery which most Asian currencies enjoyed in the second quarter and part of the third quarter of 1999.
In the case of Brazil, Phase II and Phase III occurred much more quickly, partly because Brazil, unlike in Asia, was alone in its devaluation and was not affected by region-wide devaluation. In addition, it continued to benefit from strong demand for its exports, both from the rest of Latin America and perhaps even more importantly from the U.S.. Finally, at the corporate level, there was not nearly the same degree of structural dislocation as Brazilian corporates were by then well aware of what had happened to their Thai and Indonesian counterparts and had already begun to hedge external liabilities long before the real’s final devaluation in January
1999.
The case of Russia is special for many reasons, not least because several key elements of the Russian government were not informed of the decision to devalue the rouble and default on the domestic debt market until the actual announcement was made. In addition, the size of the black market economy relative to the real economy and the seemingly persistent state of chaos in the Russian government has somewhat distorted price and economic development as anticipated by the model. Nonetheless, the key aspects of the model - the turnaround in the trade account, the defeat of inflation, the liquidity- based rally (we have not got to Phase IV yet in Russia or anything like
So Phase III sees a decidedly more bumpy ride for emerging market currencies than Phase II, indeed for many this means a reversal of some of the gains made in Phase II. Yet, economic stabilisation, all else being equal, gradually becomes economic recovery - the person eventually picks him/her self off the floor after lying there in pain after the fall.
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