In a nutshell
There is substantial research evidence to show that foreign debt and exchange rate crises are strongly linked in emerging economies.
When foreign debt becomes unsustainable, then reforming fiscal and exchange rate policies is essential to avoid fiscal, monetary and exchange rate crises.
Morocco and Tunisia have sustainable fiscal and exchange rate policies; Egypt and Turkey have unsustainable external debt but sustainable exchange rate policies; and Jordan has unsustainable external debt and exchange rate policies.
The conduct of exchange rate and fiscal policies in the emerging Middle East and North Africa (MENA) economies of Egypt, Jordan, Morocco, Tunisia and Turkey has recently become critical in determining those countries’ future economic and fiscal stance. This is due to a combination of the accumulation of a sizeable level of external debt since the early 1990s, the pursuit of a fixed exchange rate regime and the recent debt and financial crises (see Neaime, 2012, 2016, 2015a, 2015b; and Mora et al, 2013).
It is well known that some MENA countries have been running permanent current account deficits for the past decade, resulting in an external debt that was close to 100% of GDP by the end of 2017 (see Neaime 2000; and Mansoorian and Neaime 2003). With the accumulation of a sizeable foreign debt, the pursuit of a fixed exchange rate regime became essential in order to keep the costs of debt servicing under control.
Subsequently, monetary policy became subordinated to preserving the exchange rate peg, and central banks lost a tool that constituted an effective mechanism to neutralise monetary and macroeconomic imbalances, as well as external shocks.
Policy-makers and academics have devoted considerable efforts to examining the sustainability of external debt, as well as the links between external debt and exchange rate regimes, particularly in MENA countries that are exposed to various external shocks.
These efforts have primarily been devoted to establishing the links, if any, between external debt and exchange rates, and exploring whether they are sustainable. When foreign debt becomes unsustainable, then reforming fiscal and exchange rate policies is essential to avoid fiscal, monetary and exchange rate crises.
There is substantial research evidence to show that foreign debt and exchange rate crises are strongly linked in emerging economies (see Neaime, 2008, 2010; Neaime and Gaysset, 2017, 2018; Neaime et al, 2018; and Guyot et al, 2014).
Reinhart (2002), for example, finds that 84% of all default episodes in her 59-country sample over the period 1970-99 were followed within 24 months by currency crises. In her developing country subgroup, 66% of all currency crises were followed within 24 months by debt defaults.
What remains to be understood is why the links between the two phenomena should be so strong empirically. In addition, we need to understand why in some cases the two types of crisis tend to occur together while in others they do not.
Our research identifies the underlying macroeconomic characteristics that help to explain the links between these phenomena in the context of the MENA region (see Michelis and Neaime, 2004). After identifying the sources of fiscal and monetary imbalances, we propose a set of adjustment measures for implementation in future economic policy formulation in order to avert future exchange rate and external debt crises.
Our empirical results point to sustainable fiscal and exchange rate policies in Morocco and Tunisia; unsustainable external debt but sustainable exchange rate policies in Egypt and Turkey; and unsustainable external debt and exchange rate policies in Jordan.
Jordan is still following an exchange rate regime fixed to the US dollar. Given the accumulation of a sizeable external debt, any currency devaluation would mean that Jordan’s external debt servicing would increase significantly, triggering perhaps a currency and debt crisis, and obliging the monetary authority to float the currency.
Before introducing some flexibility into the exchange rate, Jordan would need to introduce proper fiscal adjustment measures and debt management policies to reduce the level of external debt. Unless they are introduced in timely and effective manner, Jordan will experience further pressure on interest rates and subsequently on foreign reserves.
Recurrent current account deficits and a fixed exchange rate system imply that Jordan will have to generate foreign currency from sources other than exports: first, to cover a huge and widening gap between exports and imports; second, to service a fast growing external debt; and third, to maintain its exchange rate peg to the US dollar.
If hard currency is not generated, then the by-product would be the continuous accumulation of a sizeable and unsustainable external debt, and a significant depreciation of the currency. In all cases, if Jordan still opts for maintaining exchange rate arrangements fixed to the US dollar, it will have to implement crisis prevention measures – by exercising fiscal discipline; by managing its debts and foreign reserves properly; and by avoiding future real exchange rate appreciations.
Egypt moved to a flexible exchange rate regime in 2001, and that has been perceived as an important step in the right direction. The exchange rate float has helped to ease pressure on interest rates and to reduce the servicing of a huge accumulated external debt.
The move to flexible exchange rates and the 2001-03 devaluation of the currency have also helped to stimulate exports and to reduce pressure on the current account deficit and, as a consequence, on foreign reserves. This means that despite the unsustainability of Egypt’s external debt, the potentially negative implications for the sustainability of exchange rate policies are insignificant.
After the currency and debt crisis of 2001, Turkey has recently experienced renewed pressures on its currency. Despite the move to a flexible exchange rate, there are now renewed pressures on interest rates and inflation, and subsequently on foreign reserves and the larger accumulated foreign public debt.
The recent devaluation of the currency by about 300% has not helped to stimulate exports, and it is contributing negatively to the servicing of a huge accumulated external debt. This means that the unsustainability of Turkey’s external debt is having a detrimental impact on the sustainability of its exchange rate policies.
Morocco and Tunisia
Morocco and Tunisia’s exchange rate policies appear to be in line with their fiscal policies. Both countries have been able to manage their rising external debt effectively, while maintaining a flexible exchange rate regime. This has helped to ease pressures on interest rates and foreign reserves. The monetary and fiscal policy mix appears to be benefiting Morocco and Tunisia’s economies, rendering both sets of policies sustainable.
Guyot, Alexis, Thomas Lagoarde-Segot and Simon Neaime (2014) ‘Foreign Shocks and International Cost of Equity Destabilization: Evidence from the MENA region’, Emerging Markets Review 18: 101-22.
Mansoorian, Arman, and Simon Neaime (2003) ‘Durable Goods, Habits, Time Preference, and Exchange Rates’, North American Journal of Economics and Finance 14(1): 115-30.
Michelis, Leo, and Simon Neaime (2004) ‘Income Convergence in the Asia-Pacific Region’, Journal of Economic Integration 19(3): 470-98.
Mora, Nada, Simon Neaime and Sebouh Aintablian (2013) ‘Foreign Currency Borrowing by Small Firms in Emerging Markets: When Domestic Banks Intermediate Dollars’, Journal of Banking and Finance 37(3): 1093-1107.
Neaime, Simon (2000) The Macroeconomics of Exchange Rate Policies, Tariff Protection and the Current Account: A Dynamic Framework, AFP Press.
Neaime, Simon (2008) ‘Twin Deficits in Lebanon: A Time Series Analysis’, Lecture and Working Paper Series No. 2, Institute of Financial Economics, American University of Beirut.
Neaime, Simon (2010) ‘Sustainability of MENA Public Debt and the Macroeconomic Implications of the US Financial Crisis’, Middle East Development Journal 2: 177-201.
Neaime, Simon (2012) ‘The Global Financial Crisis, Financial Linkages and Correlations in Returns and Volatilities in Emerging MENA Stock Markets’, Emerging Markets Review 13(2): 268-82.
Neaime, Simon (2015a) ‘Sustainability of Budget Deficits and Public Debts in Selected European Union Countries’, Journal of Economic Asymmetries 12: 1-21.
Neaime, Simon (2015b) ‘Twin Deficits and the Sustainability of Public Debt and Exchange Rate Policies in Lebanon’, Research in International Business and Finance 33: 127-43.
Neaime, Simon (2016) ‘Financial Crises and Contagion Vulnerability of MENA Stock Markets’, Emerging Markets Review 27: 14-35.
Neaime, Simon, and Isabelle Gaysset (2017) ‘Sustainability of Macroeconomic Policies in Selected MENA Countries: Post Financial and Debt Crises’, Research in International Business and Finance 40: 129-40.
Neaime Simon, and Isabelle Gaysset (2018) ‘Financial Inclusion and Stability in MENA: Evidence from Poverty and Inequality’, Finance Research Letters 24: 230-37.
Neaime, Simon, Isabelle Gaysset and Nasser Badra (2018) ‘The Eurozone Debt Crisis: A Structural VAR Approach’, Research in International Business and Finance 43: 22-33.
Reinhart, Carmen (2002) ‘Default, Currency Crises, and Sovereign Credit Ratings’, World Bank Economic Review 16(2): 151-70.