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A question of balance

Currency crises in emerging markets are the result of too much foreign capital, not too little. An early warning barometer is a country's "fundamental balance" - current account plus foreign direct investment. But even then, if small economies can't absorb the inflow they should form regional currency blocs. Roll on the Singapore yen, the Polish euro and the Mexican dollar, writes Michael Howell.

Too much money is as bad as too little. Foreign capital inflows can be of poor quality. And emerging financial systems are often unable to absorb the shock of such an influx. They can act as a trampoline, bouncing the cash straight into a domestic spending boom.

One barometer of domestic economic excess - and of the sustainability of growth - is the fundamental balance. Paying attention to this barometer reading could warn when an investment bonanza is heading for trouble.

The fundamental balance is defined as the sum of a country's current account position plus its total net receipts of foreign direct investment (FDI), less any scheduled foreign debt repayments. It represents the long-term demand for a currency.

Because currency values are determined by the interaction of supply and demand, countries that run fundamental surpluses (ie, strong demand) and impose relatively tight monetary policies (ie, limited supply) - such as Japan and Germany in the 1980s - enjoy long-term currency strength. Those that follow the opposite path - such as the UK and the US in the 1970s - suffer currency weakness.

The domestic counterpart of the fundamental balance is the gap between domestic savings and investment by indigenous firms.

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