October, 2008

In a bold but perhaps necessary move, the Central Bank of Brazil recently announced an injection of $50 Billion into forex markets intended to stem the 30% fall in the value of the Brazilian Real that has taken place so far this year. Unfortunately for Brazil, the forces tugging on emerging market currencies far exceed the potential counter-efforts that such a country is capable of waging. Call it a lack of confidence, or a sudden aversion to risk. Either way, investors are fleeing regions that only months ago, they were still flocking to in droves. High interest rates, strong economic fundamentals, even capital injections and liquidity initiatives are no match for the financial tsunami.

The Australian Dollar has lost nearly 1/3 of its value (relative to the USD) over the last few months, as the credit crisis continues to drive investors away from areas perceived as risky. In other words, the best (and perhaps the only reasonable) explanation for its fall has very little to do with Australian economic fundamentals. Then again, the rise in the currency that took place over the last decade was also rooted in technical and financial trends, although rising commodity prices were also a factor. The Australian Dollar (as well as the New Zealand Kiwi) was one of the prime beneficiaries of carry-trades, due to unusually "generous" interest rate levels.

While the Dollar rally may ultimately prove beneficial to US consumers (due to cheaper imports), it is certainly not helping US-based multinational corporations. Companies that earn a significant portion of their revenue abroad would normally be considered stable investments during times of economic uncertainty, since their exposure to individual economies is minimal. In the context of the current crisis, however, such companies have struggled; since they must report earnings in terms of USD, a strong Dollar is equivalent to lower earnings on foreign sales. Some companies have turned to hedging their exposure, while others have opted to either ride out the fluctuations and/or hope that they cancel each other out, banking on the notion that forex is ultimately a zero-sum game.

The G7 Industrialized Nations met today in Tokyo to discuss the credit crisis, with a focus on its impact on forex markets. The Japanese Yen, specifically, has exploded in recent weeks, as nervous investors have fled emerging markets and other risky sectors, and have unwound carry trades (funded with Yen) in the process. Evidently, this is wrecking havoc on the Japanese economy, which has a notoriously frail domestic sector and is heavily reliant on exports to drive growth. The Central Bank of Japan has recently threatened intervention, and now that the G7 is presumably on board, it may do just that. The New York Times reports:

One can usually assume that any talk of the carry trade is in reference to the Japanese Yen. In this case, however, it is the Dollar that is being driven by a shift away from the popular strategy of borrowing in one currency and investing the proceeds in assets dominated in another. In explaining the recent Dollar rally, analysts have tended to focus on the pall of risk aversion that has descended upon global capital markets, coupled with the spread of the credit crisis from the US to the rest of the world. While these are certainly contributing factors, perhaps they should also look at the repatriation of Dollars that were initially sent abroad over the last decade in search of loftier returns.

Emerging Market currencies are becoming the latest victims of financial derivatives, proving Warren Buffet's claim that such contracts represent "financial weapons of mass destruction." Apparently, companies throughout the developing world (although predominantly in Latin America) had used derivatives to bet on the strength of their home currencies, relative to the US Dollar. Given their record appreciation over the preceding few years, such bets probably appeared risk-less. As investors have fled emerging markets en masse, however, such currencies have tumbled. This has forced companies that had bet against the Dollar to rapidly unwind their derivative positions, which only caused their currencies to decline further.

Last week, China revealed that in the most recent quarter, its economy grew at the slowest pace in nearly five years. It also revealed that its foreign exchange reserves crossed $1.9 Trillion, due to a record monthly trade surplus. How can this seeming contradiction in economic peformance be reconciled?

The word "confidence" has become ubiquitous when talking about the credit crisis. Policymakers talk casually about the lack of confidence and offer solutions for its restoration. But wasn't it a surplus of confidence that was responsible for the credit crisis?

Policymakers are once again uttering the dreaded D-word. Not "depression," but rather "deflation." Food and energy prices have retreated from record highs, and the economic downturn is threatening to crimp demand further. In addition, the deleveraging brought about by the credit crisis has sent asset prices (real estate, stocks) tumbling, and it's not clear when they will stabilize. Economists are also forecasting that a tightening labor market and decreasing demand could force workers to accept pay cuts in return for job security. In short, a sustained period of deflation, such as that which plagued Japan in the 1990's, is becoming a very real possibility.

The credit crisis has not been kind to emerging market currencies. Virtually all of them have declined by double digits (in percentage terms) against the USD. Such currencies may receive a boost from the International Monetary Fund, which recently announced plans to make more cash available, especially on a short-term basis. Previously, many analysts and policymakers had written off the IMF as irrelevant, since private sources of capital had gradually become available to countries that previously depended on the IMF for funding. However, as investors flee emerging markets en masse, such countries once again find themselves in dire straits.