Investors Send Stern Message Via Devaluations

Move over, Mexico: The currency devaluation game now is a global affair.

Spain's peseta and Italy's lira both have slid to record lows in recent weeks against the German mark, while Canada's dollar hit a nine-year low against the U.S. dollar this week.

In Asia, meanwhile, the normally stable Hong Kong dollar and Thai baht have slipped against the U.S. dollar in recent days, spurring rumors of official devaluations to come.

The driving force behind this devaluation wave is global investors' painful reassessment of the potential risk--versus the potential reward--of keeping their money in certain markets.

Indeed, currencies are just messengers of bigger problems: Investors are bailing out of stocks and bonds of countries whose economies are borrowing and spending too much, saving too little or importing too much--or some combination thereof.

The market's shocking 40% devaluation of the Mexican peso since mid-December, for example, has thrown a harsh spotlight on that country's huge trade deficit and massive appetite for short-term loans, neither of which was sustainable. By abandoning Mexico's stock and bond markets and clobbering its currency, foreign investors' simple message to the Mexican government is: Get your house in order.

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And because devaluations are so devastating for foreign investors left holding the victim country's securities, no one wants to be blindsided by another Mexico. Thus, some investors have been pulling out of countries whose economic fundamentals are questionable--like Canada, Italy and Thailand--in effect spurring a de facto devaluation of those nations' currencies.

"These things do tend to occur together," says Rudiger Dornbusch, professor of economics at MIT in Cambridge, Mass. "When something like Mexico happens, people ask, 'Where is the next one?' "

Two years ago, that question was directed at the Europeans, as the world witnessed the collapse of the "Exchange Rate Mechanism" that had kept the continent's currencies aligned. Sweden and Britain, among other countries, let their currencies sink, while the German mark rose in value.

Stability of exchange rates is a noble and comforting idea but, as the Europeans found, it isn't practical when individual countries' economic fundamentals diverge hopelessly. Eventually, the stronger economies--those with budget surpluses, trade surpluses and low inflation--will attract more investment and enjoy stronger currencies.

Of course, devaluation isn't the end of the world, and even may be welcomed. The United States has helped engineer the dollar's slide against the Japanese yen since the mid-1980s, which has made U.S. firms' exports vastly more competitive by lowering their prices versus their Japanese rivals'.

The danger in the latest currency disruption is that its effects are being magnified by capitalism's spread worldwide since 1990, which has led to unprecedented border-crossing by investors.

"There has been an explosion of international capital flows," says C. Fred Bergsten, director of the Institute for International Economics in Washington. U.S. investors have played a key role in that explosion, pumping record sums into international stock mutual funds in 1993 and '94.

That army of investors searching worldwide for hefty returns wields a two-edged sword: As the Mexicans quickly found out, many of those dollars will run away when trouble hits, with potentially awful consequences for the abandoned nation's currency and financial markets.

As Bergsten notes, however, the rap on the head imposed by such capital outflows is precisely what many of the victim-countries need, at least theoretically. "Capital flows have replaced the International Monetary Fund as the disciplinary force for the global economy," he says.

A devaluation raises the cost of imports for a country, jacks up interest rates (to lure investors back) and demands that the government take steps to address the budget and/or trade problems that led to the market's devaluation decision in the first place. And by automatically lowering the prices of a country's exports, a devaluation also provides an economic handout of sorts.

But there also is a human cost to devaluation: The poor of a country get poorer as their currency buys less. America is rich enough to cope with a devalued dollar; Mexico's pain is much worse.

Hence, the long-run risk to the global economy from the current wave of currency devaluations--and the abrupt shift in capital flows--is that some politicians will be pressured into closing the doors to freer trade and investment that only recently opened for much of the world. The pending U.S.-led bailout of Mexico is aimed at keeping those doors open as much as it is to assist a southern neighbor in need.

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Devaluation, U.S.-Style

Third World countries aren't alone in suffering currency devaluation. The U.S. dollar, for example, has lost more than half its value against the Japanese yen since the mid-1980s.

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