28 October 2008

How to Control a Currency Panic

Nice Piece ~ This is what must happen ~

October 28, 2008


The financial crisis has ratcheted up a dangerous notch. The currency markets have gone topsy-turvy. The authorities now have to make some pretty big and delicate moves — something like performing microsurgery in a plane in turbulent skies.

The yen has risen by 40 percent against the euro since August, with most of that occurring in October.

This month, the Australian dollar has also fallen by 25 percent and the pound by 16 percent against the American dollar. Swings of this scale are alarming when they happen in the stock market . But they are petrifying in currency markets, because they make it virtually impossible to price exports or imports.

What's going on?

Mainly, the pace of financial de-leveraging is accelerating. In particular, so-called currency carry trades — borrowing cheaply where interest rates are low, for example in Japan, and lending the funds where rates are high, such as in Australia or the euro zone — are ending abruptly.

The unwinding of these trades has jerked currencies around enough to provoke more margin calls on traders, amplifying the pressures on them to sell. Then there is fear: Investors are selling currencies of countries that import foreign capital, precipitating currency crises in eastern Europe and Korea that further hurt their economies.

This combination of de-leveraging and fear has also pushed stock markets into something like a free fall. Japan's Nikkei index is at its lowest since 1982, the MSCI index of non-Japanese Asian stocks is down 33 percent in October and Western stock markets continue the downward spiral initiated by the credit crisis.

While corporate credit, currencies and stocks are in trouble, government bonds are still strong. That's a relief, since the markets are turning to the world's governments to do something to stabilize lending between banks and corporations and, now, international cash flows.

To stop the currency panic, the world's governments should work together to set and then defend target exchange rates. That will probably require countries with big reserves of foreign currency, like China or Japan, to deploy some of the cash for the greater global good, and overspending countries like the United States and Britain to accept devaluations and lower standards of living.

It won't be easy, but the alternative — a breakdown in the global trade system — would be far worse.

Cut the Carry Trade

The expansion of the crisis from credit to foreign exchange has made even clearer the dangers of some types of speculation. In particular, the currency carry trade has been shown up as most unhealthy.

The practice of borrowing in currencies made cheap by low interest rates, like the yen, and investing in high-yield currencies like emerging markets works wonderfully so long as times are good. Speculators don't just benefit from this difference in interest rates, they can also enjoy a capital gain as the assets they jump into rise in value.

But when the market turns and the herd stampedes for the exit, capital gains turn into losses. That's what is happening now. The sharp rise in the yen and, to a lesser extent the dollar, is forcing speculators to repay their hard-currency loans before the currency mismatch sinks them, with the effect of whipsawing emerging market economies. .

For speculators, this painful lesson is ultimately salutary. Once burned to a crisp, many times shy. But the collateral damage is more distressing.

The banks that lent to the carry traders suffer. Investors like pension funds and insurers who hold the assets now being dumped by carry traders find the value of these assets are falling dangerously close to their liabilities. Exporters who sell goods in rising currencies — most obviously Japanese companies — face a huge squeeze on profits.

The currency rebalance should lead to an economic catharsis. The rise in the yen could help rebalance world trade, although the rise in the dollar works in the opposite direction. Certainly, countries like Britain, with its yawning current account deficit, could benefit from a cheaper pound.

That said, this is hardly the moment for the global financial system to face more big losses, more runs on financial assets and, in response, more government capital injections for banks and perhaps insurers.

However this crisis pans out, one thing should be clear: Huge currency speculation of the kind that made the currency carry trade a cornerstone of global finance in recent years is highly destabilizing. When this crisis is over, the authorities should aim to reduce it.

For more independent financial commentary and analysis, visit www.breakingviews.com.

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