Assessing the impact of political unrest on currency returns: A look at Latin America

The Quarterly Review of Economics and Finance 42 (2002) 143–153

Assessing the impact of political unrest on currency returns: A look at Latin America Frederick D. Crowleya, Anthony L. Loviscekb,* a

Pikes Peak Area Council of Governments and School of Business Administration, University of Colorado, Colorado Springs, Colorado Springs, CO 80906, USA b Department of Finance and Legal Studies, Seton Hall University, South Orange, NJ 07079, USA Received 24 May 2001; received in revised form 1 June 2001; accepted 5 July 2001

Abstract This study assesses the impact of major episodes of political unrest, such as assassinations, bombings, and coup attempts, on the currency returns of Brazil, Chile, Colombia, Mexico, Peru, and Venezuela. Using daily data for the 1990s and standard modeling from the efficient markets literature, we find that instances of political unrest lead to a significant drop in currency returns that lasts for up to twelve weeks. We discuss some implications of these results for investors, researchers, and practitioners. © 2002 Board of Trustees of the University of Illinois. All rights reserved. JEL classification: G140; G150 Keywords: Political unrest; Currency returns; CARS

1. Introduction Major episodes of political unrest, such as assassinations, bombings, coup attempts, uprisings, and revolutions, have long plagued Latin America. Even with its significant progress toward democracy since the mid-1980s, the region still experiences these episodes, and to such a degree that some scholars have begun to question if the progress is sustainable. For example, Hagopian (1998) asserts that democratic accountability is too weak and party systems are too fragile at this time. Roberts and Wibbles (1999) express the same concerns

* Corresponding author. Tel.: ⫹1-973-761-9127; fax: ⫹1-973-761-9217. E-mail address: [email protected] (A.L. Loviscek). 1062-9769/02/$ – see front matter © 2002 Board of Trustees of the University of Illinois. All rights reserved. PII: S 1 0 6 2 - 9 7 6 9 ( 0 1 ) 0 0 1 1 2 - 0

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in their study of the area’s electoral volatility. Schulz (2001) states that Colombia, Peru, and Mexico, to name three, have been experiencing destabilizing political trends, including flawed elections, drug-related violence, and a rise in guerrilla-based activities. Ratliff (1999), in comparing East Asian and Latin American governments, believes that the political prospects for East Asia, even with the Asian financial crisis of the late 1990s, are more promising than those for Latin America. Munck (2000) reports that the consensus among Latin American intellectuals is that the area’s progress remains uncertain, and that confusion and crises are to be expected. Empirical research on emerging economies, including those in Latin America, shows that the implications of political unrest extend beyond political stability. They also appear to affect economic and financial markets. In a comprehensive study, using cross-sectional and time series data on a large sample of emerging economies, Gasiorowski (1999) shows that political variables, including measures of unrest, affect wage growth, fiscal deficits, and ultimately inflation and economic growth. The reverse, however, appears not to be true. In a more specific study, involving an analysis of events that caused a large change in stock market volatility, Aggarwal and Inclan (1999) show that political shocks can exert strong and sustained impacts on emerging stock markets. The impacts, however, do not appear to have contagion effects on other markets. In yet more specific studies, Rivoli and Brewer (1997) find that episodes of armed conflict impair a country’s ability to make timely debt and interest payments, and Melvin and Sultan (1990) report on the effect of South African political unrest on gold futures and spot prices. Concerning Latin America, Kamal (1994) finds that net capital outflows, often referred to as “capital flight,” can be a harbinger for political unrest in the region, and Baily and Chung (1995) uncover evidence for Mexico that political unrest can affect stock returns. Beyond these studies, there does not appear to be much work on the impact of political unrest on emerging markets, and the studies by Kamal and by Baily and Chung seem to be the only ones specific to Latin America. Moreover, there appear to be few, if any, studies on monitoring the impact of major episodes of political unrest on Latin American markets. Issues concerned with assessing the impact of specific events, determining when the markets account for the events, and monitoring how long the impacts last have yet to be fully explored. This is surprising, because political risk, of which political unrest is a major component, is considered to have a major effect on economic and financial decisions (Erb, Harvey, and Viskanta, 1996; Goetzmann and Jorion, 1999). Without an awareness of the depth and duration of the impact of political unrest on markets, our understanding of political risk in particular and total risk in general is incomplete. The aim of this study is to help broaden our understanding of political risk by assessing the impact of political unrest on the currency markets of six Latin American countries: Brazil, Chile, Colombia, Mexico, Peru, and Venezuela. The period of study is the 1990s. Although this period marks a time in which Latin America embraced democratic reforms, significant episodes of political unrest were frequent and often far-reaching, such as coup attempts in Peru and Venezuela, guerrilla warfare in Colombia, and assassinations of major political leaders in Mexico. As additional evidence, Table 1 gives the list of events under study, 36 in all. Helping to motivate the study is the timely reporting by nationally and internationally

F. D. Crowley, A. L. Loviscek / The Quarterly Review of Economics and Finance 42 (2002) 143–153 145 Table 1 Episodes of Political Unrest: February of 1991–January of 1999 Date

Country

Event

02-Feb-91 27-Jul-91 15-Nov-91 04-Feb-92 23-Feb-92 29-Mar-92 05-Apr-92 26-May-92 02-Jun-92 22-Jul-92 24-Jul-92 11-Jan-93 30-Jan-93 15-Apr-93 24-Oct-93 02-Jan-94 24-Jan-94 23-May-94 12-Jun-94 28-Sep-94 16-Feb-95 13-Mar-95 21-Oct-95 22-Jan-96 30-Jan-96 17-Dec-96 22-Jan-97 12-Mar-97 22-May-97 15-Jun-97 27-01-98 28-Mar-98 04-May-98 16-Nov-98 12-Jan-99 20-Jan-99

Colombia Colombia Peru Venezuela Colombia Chile Peru Chile Mexico Colombia Chile Peru Colombia Colombia Colombia Mexico Colombia Mexico Mexico Mexico Brazil Peru Chile Colombia Venezuela Peru Columbia Venezuela Brazil Colombia Mexico Colombia Colombia Chile Brazil Chile

Bomb kills 22 and injures over 150 War between drug cartels kills 15 Violent uprising leads to over 100 deaths Military coup attempt Simon Bolivar Coordinating Front attacks military convoy Bombings by leftists shakes Santiago Military coup attempt Pinochet and army assert forceful tactics Mexican-U.S. border disputes threaten NAFTA Drug lord, Pablo Escobar, escapes from prison Military in opposition with constitutional reforms Shining Path guerrillas assassinate United Left Party candidate Terrorists bomb Bogata killing 17, 40 injured Huge car bomb, linked to Escobar, kills 15 in Bogota 13 bombs go off in Bogota Political uprising in Chiapas Revolutionary Armed Forces attack rival leftist group Luis Colosio (PRI party candidate) assassinated Zapatista rebels reject peace agreement Ruiz Massieu (PRI party head) assassinated Political turmoil over constitutional reforms Legislative and judicial unrest over actions by President Fujimori Terrorist attacks rock Santiago Evidence that President Samper took drug money for campaign Violent uprising threatens government administration Hostage crisis involving over 600 individuals U.S. relations plunge to new lows over anti-drug enforcement Antigovernment protests lead to violence Scandals and corruption plague President Cardoso Guerrillas score major propaganda coup Assassination in Chaipas leads to breakdown in peace talks Guerrilla offensive leads to violent uprising Massacre kills 22 British detainment of General Pinochet causes tension and unrest Crisis of confidence in President Cardoso More tension and unrest over the detainment of Pinochet

distributed newspapers and newsletters. They routinely report material instances of political unrest, and often include the date and time of the event. The reports make it easy to track the impact of the events. By knowing when they occurred, we can examine how rapidly markets adjusted to them, and assess the depth and duration of their impact. To guide the study, we refer to the literature on efficient markets. Because the media quickly report major episodes of political unrest, we look to the semistrong form of the efficient markets hypothesis. It says that public information cannot be used systematically to earn abnormal returns. In this study, semistrong form efficiency means that Latin American currencies should adjust so rapidly to new information on political unrest that it is not worthwhile to try to profit from it. Testing semistrong market efficiency in response to instances of political unrest is in itself

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noteworthy. This is because tests of this nature are mostly concerned with economic and financial events, such as dividend declarations, stock splits, and merger announcements.1 Little work has been done on the impact of political events, and this is despite the long-recognized importance of incorporating political risk into decision making. The rest of the paper is organized as follows. In the second section we discuss the model, the data, and the estimation of the results. The third section is concerned with the results. The fourth section deals with the implications of the results, and the fifth section contains a summary and conclusion.

2. Model, data, and estimation Guided by the literature on semistrong form efficiency and event studies (e.g., Brown and Warner, 1985; Mikkelson and Partch, 1988; Barber and Loeffler, 1993; Mathur and Waheed, 1995; Liang 1999), we assess the impact of major episodes of political unrest on Latin American currency returns. In general, this literature examines whether investors can earn abnormal rates of return, or returns above what investors would expect to earn for a given amount of risk, by following public announcements (e.g., press releases, newscasts, etc.), or events, that might materially affect an asset’s returns. In the context of the present study, we examine if investors can earn abnormal currency returns by following public announcements of political unrest. Following the literature, for each major episode of unrest in a given country, we begin the examination by estimating the relationship between the returns on the home currency and the returns on the market. The test is based on the following two-variable equation, or market model, as follows: R i,t ⫽ ␣ i ⫹ ␤ iR m,t ⫹ ␧ i,t,

(1)

where Ri,t is the home currency’s rate of return at time t (where t is a given day); Rm,t is the market rate of return at day t; ␧i,t is the error term at day t; and ␣i and ␤i are the coefficients to be estimated by ordinary least squares. Abnormal returns are computed as follows: Aˆ Rˆ i,t ⫽ R i,t ⫺ ␣ˆ i ⫺ ␤ iRˆ m,t,

(2)

where Aˆ Rˆ i,t is the abnormal return on currency i for day t. By summing the average abnormal rates of return for all events at time t and accumulating them over the testing period, we obtain cumulative average abnormal rates of return, or CARS. Values of CARS that are statistically insignificant from 0 would be evidence of semistrong form efficiency. This is the null hypothesis under investigation, and it means that abnormal returns are not systematically possible. To test the significance of the CARS, we compute the variance of these returns and obtain standard Z values by following Mikkelson and Partch (1988) and Salinger (1992). Table 1 shows the major instances of political unrest across the six countries. The period covers February of 1991 through January of 1999. The episodes are varied. They include

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coup attempts (e.g., Venezuela, February 4, 1992), assassinations (e.g., Mexico, March 23, 1994), bombings (e.g., Colombia, January 30, 1993), and a hostage crisis (e.g., Peru, December 17, 1996). We obtain the reports and the dates of the events from three nationally distributed newspapers, The Wall Street Journal, The New York Times, and The Washington Post, and from one newsletter, The Latin American Weekly. Table 1 does not include elections. This is because political unrest, as used in this study, connotes a negative event. The news surrounding elections, however, may be either positive or negative. As a result, including elections may confound the analysis. To compute the CARS and assess their significance, we focus on the spot market and use daily closing prices of each country’s currency, relative to the U.S. dollar, to calculate Ri,t and daily closing values on special drawing rights to calculate Rm,t.2 We obtain the data from Bloomberg’s financial data base, The Wall Street Journal, and The Financial Times. The occurrence of political unrest at any time and on any day, the use of daily data, and the fact that currencies serve as the securities of interest lead to three possible concerns. The first two are concerned with the matching of the timing of the event with the measurement date. For example, if an outbreak of unrest occurs on either Saturday or Sunday, the earliest that the unrest could affect currency returns is the following Monday. Given that 11 of the 36 episodes occurred on a weekend, there is the possibility that markets will appear to have reacted somewhat more slowly than was actually the case. In another instance, if the event occurred after 3:00 p.m., Eastern Standard Time, the posting time for currency values in the Wall Street Journal, it is more accurate to measure the currency returns beginning with the following day. For example, the assassination of Mexico’s Luis Donaldo Colosio occurred at about 8:00 p.m., Eastern Standard Time, on March 23, 1994. As a result, the impact of this event needs to be assessed beginning on March 24. The third concern deals with fixed exchange rates. On seven occasions, three countries, Chile, Colombia, and Mexico, fixed their respective currencies against the U.S. dollar immediately following an occurrence of political unrest. They imposed the fixed rates for periods ranging from two to seventeen trading days. These moves could conceivably give the appearance that the markets reacted slowly to the events. They also might blunt the full impact of an event. These moves are noteworthy for yet another reason. They also suggest that the governments of these countries perceive that political unrest can have a significant impact on financial markets.3 To prevent an episode of political unrest from contaminating the estimates of ␣i and ␤i, we estimate Eq. (1) from 151 trading days (i.e., days in which the currency trades on the open markets) prior to the actual occurrence of the episode to 20 trading days before it, or (⫺151, ⫺20). The length of the estimation period follows the work of Salinger (1992). He shows that, for accuracy in a study of this kind, long estimation periods are preferred to short ones. We then use the results from the estimation period to generate the abnormal returns and the CARS from 19 trading days prior to the occurrence of the event to 65 trading days after it, or (⫺19, ⫹65). In other words, we perform a series of ex ante tests.

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Fig. 1. Cumulative average residuals testing period t⫺19 to t⫹65.

3. Results Fig. 1 and Table 2 present the CARS for the testing period under investigation. Fig. 1 shows the results for the 19 trading days before a significant outbreak of political unrest and those for the 65 trading days after it. The vertical line indicates Day 0, the day in which an instance of political unrest occurred. The drop in the CARS over the 65 days following an episode of political unrest is revealing. It strongly suggests that major occurrences of political unrest had a significant and predictable impact on the currency returns of the six countries. Note that the drop in the CARS appears to occur almost immediately after the occurrence of an event. The CARS, however, show no pattern in the 19 trading days prior to it. This suggests that, unlike with many financial events, the currency markets do not “price” major episodes of political unrest until after they occur. Given the unique nature of these events, this is not surprising. If information about a planned event, such as a revolution, were to leak, there would undoubtedly be countermoves to prevent it from happening. Fig. 1 shows that the CARS trail off almost continuously for about 32 trading days after an event, reaching a low of about ⫺4.5%. After that, there is some recovery. The CARS rise to about ⫺1.7% before falling again to around ⫺3%. As a perspective, the 65 trading days over which the drop occurs amount to about three calendar months. Overall, the evidence indicates that major episodes of political unrest can have a significant and sustained impact on currency returns. The numbers in Table 2 confirm the observations of Fig. 1.4 Table 2 provides the actual values of the CARS and a Z statistic that indicates the significance of the CARS. Prior to day t⫹0, there is no evidence of a significant pattern emerging from the CARS. Right up to the day of an event they are almost 0, which is consistent with the notion of semistrong form efficiency. The low Z values confirm this observation; none is statistically significant at the 5% level. By day t⫹3, or three days after the event, however, a negative pattern has begun

F. D. Crowley, A. L. Loviscek / The Quarterly Review of Economics and Finance 42 (2002) 143–153 149 Table 2 Average cumulative abnormal returns: (t⫺19 to t⫹65) Event Day

CARS

Z value

⫺19 ⫺15 ⫺10 ⫺3 ⫺2 ⫺1 0 ⫹1 ⫹2 ⫹3 ⫹10 ⫹11 ⫹12 ⫹13 ⫹20 ⫹25 ⫹29 ⫹30 ⫹31 ⫹32 ⫹33 ⫹40 ⫹45 ⫹50 ⫹54 ⫹55 ⫹56 ⫹64 ⫹65

0.00013 0.00058 0.00427 0.00141 0.00037 0.00027 0.00052 ⫺0.00427 ⫺0.00527 ⫺0.01049 ⫺0.02270 ⫺0.02354 ⫺0.02623 ⫺0.03256 ⫺0.02855 ⫺0.03552 ⫺0.03571 ⫺0.04488 ⫺0.04386 ⫺0.04474 ⫺0.04436 ⫺0.02837 ⫺0.02754 ⫺0.02276 ⫺0.01738 ⫺0.01725 ⫺0.01649 ⫺0.02864 ⫺0.02512

0.08908 ⫺0.03331 0.07061 ⫺0.24402 ⫺0.22424 ⫺0.23329 ⫺0.27013 ⫺2.10951 ⫺2.11300 ⫺2.17227 ⫺2.31449 ⫺2.31497 ⫺2.32790 ⫺2.36868 ⫺2.33568 ⫺2.34319 ⫺2.35472 ⫺2.38742 ⫺2.37594 ⫺2.38428 ⫺2.39000 ⫺2.33218 ⫺2.32136 ⫺2.29731 ⫺2.26590 ⫺2.26907 ⫺2.26621 ⫺2.30130 ⫺2.29270

Note: All Z values ⬍⫺1.96: significant at the 5% level.

to emerge. By that time, the CARS fall to ⫺1.049%, and continue falling to day t⫹13, where they reach a low of ⫺3.256%. Buttressing this observation is the fact that each of the corresponding Z values is statistically significant at the 5% level. In other words, if a currency trader quickly reacted to an episode of political unrest, the trader could have earned more than 3% in 13 days, a very high abnormal return. From day t⫹13 to day t⫹29, the CARS remain stationary. From this point, they drop further, reaching a low of ⫺4.474% by day t⫹32. This implies that the full negative impact of political unrest is felt within about six calendar weeks. The recovery from the low is pronounced up to day t⫹40, and by day t⫹56 the CARS reach ⫺1.649%. Between these two days, however, the pace of recovery is slower. Once again, the significant Z values confirm these patterns. 4. Implications of the Results The results have a number of implications. First, consistent with the literature on the importance of incorporating political risk into financial decision making, major outbreaks of

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political unrest appear to have a substantial impact on currency returns. These results support those found in previous research on the impact of political risk on emerging markets. Second, as a guide for researchers and practitioners, they suggest that the depth and duration of the impact of political unrest on currency returns are too significant to overlook. They also imply that, in some cases, models of risk that ignore political variables may be misspecified, and that political risk variables that do not properly reflect political unrest in emerging markets may not be reliable. Third, the results serve as a guide to currency traders and international investors, whether the latter seek the potential of higher returns from emerging markets or the benefits of international diversification. In the case of Latin America, both groups need to know that it may take more than three months for a currency to recover from an episode of political unrest alone. Especially for currency traders and investors with short-term investment horizons, this is valuable information. It could conceivably aid them in the development of investment strategies. The information also suggests that the residents of a politically fragile country may want to diversify away from the risk that accompanies political unrest by investing extensively in world markets. Fourth, the results have implications for the flows of financial capital. Montiel and Reinhart (1999) observe that Latin America during the 1990s, unlike emerging Asian markets, attracted much more short-term capital, or “hot money,” than foreign direct investment, the preferred flow. It is conceivable that instances of political unrest in Latin America moved investors to substitute hot money for long-term investments. If true, then Latin America has had to face an additional problem, because, as Kamal (1994) shows, hot money can be sensitive to political unrest. Thus, an outbreak of unrest tends to trigger large capital outflows. The result is a plunge in the value of the affected currency. Lustig (1995) also makes this point. She notes that it has not been uncommon for Latin America to experience large sell-offs in financial assets, such as stocks and bonds, whenever the region faces a political or economic crisis. Fifth, the results have implications for the semistrong form of the efficient markets hypothesis, the one that guides this study. The evidence appears to run counter to it. It suggests that currency traders in particular may have had the opportunity to earn abnormal returns by monitoring major episodes of political unrest.5 This finding, however, may not be as unusual as it may seem. Levich and Thomas (1993) also find evidence of market inefficiency in their study of the currency returns on the Canadian dollar, Swiss franc, German mark, British pound, and Japanese yen. Before concluding that Latin American currency markets are inefficient with respect to episodes of political unrest, two alternative explanations deserve mention. In one case, we can extend the work of Lewis (1988) on the “peso problem” to political events. In this setting, investors are aware that a major outbreak of political unrest could occur. Given the noisy nature of political unrest, the variety of ways that it manifests itself, and the varied government responses to it, the time needed for the markets to absorb the impact of the event may be long. Yet this need not necessarily mean, especially given the uncertainty surrounding the event, that the currency markets are inefficient. The other explanation is the “uncertain information hypothesis,” as explored by Brown, Harlow, and Tinic (1988). The hypothesis states that a dramatic event, such as a major

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outbreak of political unrest, can systematically increase both the risk and expected return of the affected securities. If investors have absolute decreasing risk aversion, prices will react more strongly to bad news than good. This reaction is perfectly consistent with market efficiency. Although the results suggest that abnormal profits may be possible, it remains to be seen if the pattern persists beyond the period under study. Whether or not it does, the degree to which it occurs if it does, and which explanations hold are topics for future research. If the pattern persists and abnormal profits are possible, then currency traders only need access to up-to-date media news. This is in contrast to research on, for example, stock recommendations, which suggests that investors need to anticipate the announcements weeks in advance (Chandy, Peavy, and Reichenstein, 1993; Mathur and Waheed, 1995). Noteworthy, too, is the possible opportunity to create an inside trading position. Given the nature of the study, any investor or organization might be able to earn abnormal profits by first shorting the home currency and then causing a major episode of political unrest. According to the findings in this study, the result could be the realization of significant profits. Besides the degree of change in the market value of the currency, the only constraint on profits would be the ability of monetary authorities to fix the exchange rate before the unrest has had its full impact and until it has been absorbed. 5. Summary and Conclusions This study assesses the impact of major episodes of political unrest, such as assassinations, bombings, and coup attempts, on the currency returns of six Latin American countries: Brazil, Chile, Colombia, Mexico, Peru, and Venezuela. By reference to the event studies literature and the semistrong form of the efficient markets hypothesis, we examine 36 instances of such unrest between February of 1991 and January of 1999. Throughout the study, we use daily data. The results suggest that significant instances of political unrest, immediately following their occurrence, systematically affect currency returns for up to three calendar months. The results have a number of important implications. First, they buttress previous research that indicates the significance of political risk to financial decision making. Second, they indicate that the depth and duration of the impact of political unrest on currency returns are significant. Third, they imply that major outbreaks of political unrest have made Latin America especially vulnerable to large outflows of short-term capital, or hot money, which appear to have affected the region during the 1990s. This information may prove valuable to researchers, practitioners, currency traders, and investors. Fourth, they point to a possibility that Latin American currency markets were semistrong form inefficient in their reaction to major episodes of political unrest during the 1990s. Notes 1. Unlike categorical business events (e.g., a strike, resignation of a CEO, etc.), political unrest is a “degree” event and, therefore, subject to some interpretation. However,

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2.

3.

4.

5.

there is no doubting the categorical nature of, for example, the assassination of a President or a coup. These are the kind of events that we concentrate on in this study. While it is possible for returns to be simultaneously positive for all stocks, the same cannot necessarily be said for all currencies. However, this is not a problem in this study. The examination is concerned only with the returns on six currencies, each of which is measured against the U.S. dollar. Fixed exchange rates precluded the examination of political unrest in Argentina. This is because the Argentine government, unlike that of any of the other countries, fixed its currency against the dollar during the entire period under study. Without any variation in the currency, there was no way, using CARS or any other quantitative measure, to assess the degree to which episodes of political unrest affected currency returns. We obtained remarkably similar results with variations of the data, and by using different estimation periods and test statistics. Thus, we have a strong reason to believe that the results are robust. Allowing for one-way brokerage fees as high as 0.5% would still leave significant returns. It should be pointed out, as well, that the trading costs for market makers, such as large banks, would be lower.

Acknowledgments The authors are grateful to two anonymous referees, the editor, Richard Arnould, Lisa Harms, (late) Jack Jordan, Ike Mathur, Gail Morrison, Angel Obregon, Jackie So, participants at the 1997 North American Economics and Finance Association Meeting, and participants at the 1998 Midwest Finance Association Meeting for assistance and suggestions on earlier stages of this effort.

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