The great currency crisis – and what to do about it
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Associate Editor
David Stevenson Oct 31, 2008
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"A couple of years ago – or before banks started going bust – economists sometimes liked to talk about a phenomenon they christened 'The Great Moderation'," says Gillian Tett in the FT, "the idea that the 21st-century financial system had become so stable and sophisticated that dramatic swings in activity had seemingly disappeared." Volatility was supposed to be history. They were wrong.
Not only are stockmarkets oscillating wildly, but in what could be called "the Great Panic", says Tett, "the gyrations of the yen, euro, sterling and dollar have also been wild, pushing levels of currency volatility to heights barely seen in decades". In the past two weeks, almost all of the world's currencies have fallen sharply against the dollar and the yen in a frenzy of selling as the 'carry trade' unwinds (see below). High interest rates are no longer seen as a sign of strength, but of weakness, a prop to shore up a crumbling exchange rate and diving economy. Now a whole string of currency crises is stacking up, threatening to drag even our own pound sterling down into the mire.
So what does a fully fledged currency crisis look like? The biggest casualty so far is Iceland, which effectively turned itself into "the world's first sovereign hedge fund", says Damian Reece in The Daily Telegraph, as its banks embarked on an orgy of overseas borrowing. By the time this reached more than six times the country's GDP of $14bn and the assets supporting much of the debt – like British high-street store chains – were plunging in value, the currency markets started smelling a rat.
The krona has collapsed 50% against the US dollar in the last two months, year-on-year inflation has soared to 16%, and the country's big three banks have been nationalised. Earlier this month, the central bank tried to peg the krona to the euro only to abandon the measure a day later, citing "insufficient support". So the government had to ask the IMF for a $2bn loan and is still approaching the Russians, or other Nordic countries, or whoever will listen, for more.
When the first news of the external loans broke, Iceland tried lowering its interest rates, with a 3.5% rate cut on 15 October, and has been setting the exchange rate using daily auctions to local market makers. But pressure on the krona has continued, and now it's all change again. This week Iceland's central bank hiked its benchmark interest rate from 12% to 18%. There could be more such moves on the way if the country's financial authorities want to get the currency traded internationally again.
Where does all this leave your Icelander in the street? None too happy. Inflation looks set to soar in coming months, says Lars Christiansen at Danske Bank, while the economy will shrink by as much as 10% next year, says the IMF, and unemployment rise. But then if a country has to ask the IMF for help, the medicine it'll be prescribed is bound to taste unpleasant. Its citizens' living standards will be among the biggest casualties.
Even so, the queue for IMF cash is getting longer by the day. The same fate that befell Iceland now faces Ukraine and Hungary. Within the last two months, the Ukrainian hryvnia has tumbled some 40% against the US dollar as currency traders have pulled the plug. Annual inflation is running at 25% and the current-account deficit may widen to $15bn this year. The country faces "economic meltdown" as prices for its main exports, including steel, fall and a weakening currency makes imports more costly, says Bloomberg. Ukraine "will set up a fund to buy stakes in banks", says central bank official Serhiy Kruhlik, "and will pass legislation forcing lenders to halt dividend payments to retain capital". Earlier this month the central bank took control of Prominvestbank, the country's sixth-biggest bank, after a run by depositors. In short, it's not a pretty sight.
And nor is Hungary. The country has been heavily reliant on foreign capital inflows to finance its debt and deficits. But the forint has plunged over a third against the US dollar within the last two months. And now the IMF, EU and World Bank have had to stump up more than $25bn to "stave off growing fears that Hungary could be the next Iceland", says Adam LeBor in The Times, "with potentially catastrophic consequences across the region if an EU member state's economy was allowed to collapse". Unfortunately, the price of IMF aid will cause much more pain for locals. The rescue is expected to be conditional on slashed government spending, including cuts in public sector wages and pensions. So who's next?
"The list of nations to be saved by the fund, or at least helped out of their little local difficulties, is set to grow still longer," says Sean O'Grady in The Independent, listing many more candidates. Serbia was in trouble already, and is hardly likely to be better off now. Pakistan has just days to sort out an IMF package, according to Germany's foreign minister, while Belarus has asked for help. Further, "Brazil, Argentina and other Latin American growth stories, Estonia, Latvia, Lithuania, Turkey, Bulgaria and Romania – whose debt rating has been cut to junk status – have all come under unprecedented pressure", says O'Grady.
The problem is, as soon as worries arise about a currency, the fear feeds on itself. Western investors get worried that some or all of these emerging nations will suddenly impose capital controls, locking them out and leaving their investments worthless, so they rush for the exit. But by pulling their money out, they make this more likely to happen. Now the big risk is that the currency crash will result in emerging market nations actually defaulting on their debts. "This is beginning to look like the Asian crises all over again," says former IMF economist Desmond Lachman. In the East Asian turmoil of 1997, South Korea, Thailand, Taiwan, Indonesia and other "Asian Tigers" found themselves in similar holes. Then the IMF's 'structural adjustment programmes' – the prescribed medicine for curing the sick – actually made matters worse by stipulating higher loan rates to help restore confidence in sliding currencies. The plan failed to prevent exchange-rate collapses. In 1997 South Korea's won lost 47% against the dollar, the Thai baht plunged 45%, and Indonesia's rupiah slid 56%. By December that year, South Korea had been forced to hike its benchmark interest rate to 30%. The bankers' mix of massive devaluation, government spending cutbacks and tight monetary policy created unemployment, bankruptcies and political instability.
Ironically, longer-term, this IMF economic expansion model, based on trade surpluses not foreign borrowings, helped prompt the explosion we're witnessing today. East Asian surpluses, particularly in China, helped to power up the Anglo-Saxon borrowing binge on cheap goods and lower interest rates. So investors piled into higher-risk assets in their search for bigger returns. Thus it's very possible that the IMF's medicine will put more pressure on the likes of Ukraine and Iceland than they can handle. And don't think it's just small economies at risk. Prior to Iceland in 2008, Britain was the last Western nation to hold out the begging bowl to the IMF, in 1976. Don't imagine it couldn't happen again. Gordon Brown is keen on spending our way out of recession with money we haven't got. He's invoking the spirit of John Maynard Keynes – the instigator of the idea that governments can even out the economic cycle by borrowing more when the private sector is splashing out less. But it's not that simple – not by a long chalk.
The Keynesian concept is questionable in any case, not least because governments have a poor track record on using money well. More to the point, Keynes suggested using taxpayers' cash that had been squirrelled away in the good times. But right now, there isn't anything spare. The UK economy is in big trouble, despite the £37bn the Treasury plans to pump into the banks to get them lending again. "The Bank of England's latest Financial Stability Report supports our view that the Government's recapitalisation of the banking system is unlikely to head off a sharp slowdown in bank lending growth and a deep economic recession," says Vicki Redwood of Capital Economics. And the state coffers are worse than empty. "Tax revenues are set to slump dramatically because of the effect of the credit crunch," says Hugo Duncan in the Evening Standard, whose analysis last week showed that a recession until 2010 would dig a £125bn 'black hole' in tax-receipt calculations. In other words, the Treasury might have to borrow £275bn over three years – the equivalent of £11,000 for every British household. And that doesn't include the cost of any "public expenditure brought forward", as Mr Brown puts it. So if he really plans to load up Britain with even bigger debts than we have already, the money will have to come from lenders abroad.
For international investors, the risk of holding sterling will rise, a fact that hasn't been lost on the forex markets. At the end of last week, the pound fell by the most against the dollar in 37 years, worse even than 1992's "Black Wednesday" when sterling was drummed out of the European Exchange Rate Mechanism. If the pound weakens further – and with interest-rate cuts and a worsening recession ahead, there's no reason to believe it won't – then Brown's borrowing will cost a lot more, while we in Britain will be far worse off. Nick Parsons of National Australia Bank told The Times this week that he expects the pound to fall as far as $1.40 by early next year, by no means the gloomiest forecast.
Amid the carnage, what are the safest currencys at the moment? The choices are fast being whittled down. Weak commodity prices are hurting the Australian dollar. The euro is under pressure as the eurozone enters its own recession, and fears grow over the region's close ties with those Eastern European emerging markets. So it's back to the old favourites: the Japanese yen, the Swiss Franc and the US dollar – the so-called 'low yielders'. That may sound perverse. But remember that currencies are really barometers of national wealth and stability. These are the currencies that aren't having to pay out high rates of interest to attract buyers. In Japan's case, its trade surplus (despite the yen's strength, which makes Japanese goods more expensive to overseas buyers) and huge domestic savings create confidence. The US dollar is still the world's reserve currency – the "go to" safe haven for investors when, like now, markets get the jitters.
The end of the yen carry trade
The collapse in the pound is something we've warned of several times before, most recently in our 11 July cover story. But what's behind the latest slump? Simple. One of the financial world's biggest free lunches for the best part of a decade – the Japanese yen carry trade – is ending. The yen has shot up 40% against sterling and the euro since July, and recently hit a 13-year high against the US dollar.
Carry trading is simple, but risky. You take a long position by buying a high yield (high interest rate) currency – the Australian and New Zealand dollar have been popular – funded by a short position (a loan) taken out in a much lower-yielding currency, such as the Japanese yen. You collect the interest on the high-yielding currencies and pay some of it as interest on loans in low-yielding currencies, pocketing the difference. It's easy money, as long as short-term interest rates don't change and neither currency moves much while your trade is still open.
The yen was the main carry currency because for years the Bank of Japan has maintained interest rates at close to zero to ward off deflation – a constant threat to Japan's economy, which has been largely stagnant for almost two decades. Housing booms and strong growth in the likes of Britain, the EU, Australia and New Zealand meant interest rates were kept much higher to contain inflation – for example, the official rate for the New Zealand dollar hovered around 7.5% until last week. The trade worked like a dream – until its key assumptions fell apart.
First off, currency volatility, as captured by the DailyFX Volatility Index (similar in principle to the CBOE's Vix "fear gauge" for equity markets), has been surging. "Safe haven" currencies, such as the US dollar and the yen, have rocketed as panic sweeps the globe and investors bet that their money is safest parked in currencies backed by the world's first and second-largest economies. But rapid yen appreciation is terrible for carry traders because it quickly pushes up the size of yen loans measured in their own currency. Say you borrow 15,000 yen when the exchange rate is £1:150 yen and the yen then appreciates to £1:120 yen, you now need to find £1,250 (15,000/120) to repay the loan.
That's not the only problem. The other side of carry trades has collapsed too. Worried about faltering growth, many central banks are cutting interest rates in once high-yielding economies. Rates were cut by 1% in New Zealand this week and further cuts are expected soon from the ECB and Bank of England. This sets up a double whammy for carry traders – the interest being earned on invested capital falls, as does the value of the capital itself when translated into another currency. The result? A stampede to grab yen (to pay back yen loans) and dump other currencies.
So who is being caught in the rush? The Japanese for starters. A strong yen hurts exports to other countries just as recession-hit overseas buyers stop spending. Ironically an economy that managed to avoid most of the excesses of the credit boom may suffer as it pops. Sharing the pain will be the many hedge funds who have failed to get out of carry trades quickly enough – and for those who have delayed there's little respite in sight, says Lee Hardman, a currency strategist at Bank of Tokyo-Mitsubishi. He reckons "these moves are due to extreme risk aversion and have further legs".
Then there are the countries facing plummeting currencies – the Australian dollar suffered its largest one-day fall in 32 years last Friday, while the Turkish Lira, South African rand and New Zealand dollar also dived. Meanwhile, as Worldfirst.com notes, the flight to safety also hit emerging markets hard – the MSCI emerging markets equity index fell 15% last week while debt spreads hit a six-year high. Sure, a falling currency can help local exporters but against that is the risk that external investors pull out huge sums of capital before the value of their local investments falls any further. If that happens on a big enough scale you get an Icelandic-style currency crisis (see above).
So does anyone benefit? Well, foreign investors who own yen assets will have seen their value rise. For example, even though the Nikkei 225 is down by around 46% in absolute terms this year, in sterling terms the fall is closer to 26%, better than the FTSE 100. And if you don't own any yen assets, it might be the time to do so – amid all this uncertainty, the one thing that's very clear to Tuhru Sasaki, chief exchange strategist for JP Morgan Chase, is that "we are seeing the end of the yen carry trade".
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