Currency Exchange Rates: Playing Musical Chairs with Fire

Currency exchange rates have been much in the news as President Obama makes his first visit to China. The dollar is sinking, and China has ensured that its yuan falls in tandem with the dollar. Other nations, disadvantaged by the drop in two of the most important currencies in the world, complain vociferously. The U.S. government proclaims a strong dollar policy, and then looks away as the dollar continues to fall. The Chinese government scolds the U.S. government, which lectures back.

The currency markets are different from other markets. They don't just consist of private buyers and sellers. Governments also get involved, and generally do so for political and macro-economic reasons. Since nothing is as unpredictable as politics, currency exchange rates can move in ways that seem seriously out of whack.

To make things worse, currency exchange fluctuations are, at best, a zero-sum game. One currency's gain comes at the expense of other currencies, and resulting trade imbalances have a similar effect on the nations issuing the currencies. Only today, it's worse than that. Two powerful nations--America and China--rely on policies that may produce near term gains for them but potential longer term losses for everyone. The currency markets may now be a negative sum game.

For decades, China has linked the yuan to the dollar. Thirty years ago, the rate was about 8 yuan to the dollar. Today, it's around 6.8 yuan to the dollar. By contrast, the Japanese yen has tripled in value against the dollar during the same time period. The yuan has never been fully convertible into other currencies, as China has sought to prevent the rapid inflows and outflows of foreign capital that have bedeviled the development of other Third World nations. Considering the devastation wreaked in Asia by the 1997-98 financial crisis, one would have to concede that the Chinese have a point. They aren't unvarnished capitalists, and won't allow markets to operate freely simply as a matter of principle. They utilize market forces pragmatically, mixing in government dictat whenever they believe Adam Smith's invisible hand may be a little shaky. By holding the the yuan relatively steady against the dollar, they ensure pricing stability for their exports to dollar bloc nations (i.e., nations that use the dollar or maintain currency stability against the dollar, including the U.S. and, at times, various nations in Latin America). Chinese manufacturers could largely ignore the complexities and costs of currency fluctuations and commit to low, fixed prices to buyers abroad.

China's fixed exchange rate did much to make China a dominant exporter. But it had to take a lot of dollars in exchange--ultimately trillions of dollars. These were mostly invested in U.S. Treasury securities and American mortgage-backed securities (on which the Chinese have already taken nasty losses resulting from the mortgage crisis). Now, as the dollar falls in value, China loses more money on these assets. Hence, China's scoldings to the U.S. government to get its house in order and prop up the greenback.

The U.S. government in turn has countered that China is itself responsible for this dilemma, having created the trade imbalance that resulted in its enormous dollar holdings. The U.S. government would have China restructure its economy to focus on domestic consumption, and reduce exports to take pressure off the dollar.

However, neither government is doing much to change the status quo. China's government has launched a major stimulus program to forestall economic slowdown, with much of its spending directed at building infrastructure. These are wise expenditures for a developing nation, but they do little to promote domestic consumption. The Chinese are among the world's most frugal people, because they have no other choice. China has no Social Security system. Most Chinese have no pensions; the pensions that exist are meager. The health insurance that was part of Communist China's iron rice bowl has disappeared along with sales of Chairman Mao's little red book. The Chinese save because it's the only way they can have health care and a half-way decent retirement. The Chinese government has done nothing to alter this dynamic. Since China needs about 8% economic growth every year simply to keep up with population growth, it has no choice except to keep exporting. And to do that, it has to keep its currency stable against the dollar.

The U.S. government has responded to America's economic crisis primarily by borrowing and printing dollars--shiploads of dollars. Pushed by the forces of a lot of supply and not so much demand, the dollar has not surprisingly fallen in value. Euro bloc nations have grumbled about the rise of the Euro, especially export-dependent Germany. Several smaller Asian exporting nations have recently been buying dollars in order to defend their currencies. Oil exporters, like Russia and the OPEC nations, have complained of losses in their holdings of dollar-denominated assets and hinted at pricing oil in a basket of currencies to free themselves of dollar risk. In short, the U.S. government's primary response to the economic crisis has imposed losses on the rest of the world.

The flood of the cheap money being pumped out by the Fed has fueled the "carry trade," in which speculators borrow dollars at extremely low interest rates, convert them into currencies where interest rates are higher (such as in much of Asia) and invest overseas for those higher returns. This outflow of dollars is stimulating economic activity in other nations, and appears to be creating asset bubbles in Asia. While other nations don't mind a touch of stimulus courtesy of the Fed, many in Asia have vivid and disturbing memories of the Asian financial crisis of 1997-98, when asset bubbles fueled by inflows of foreign capital burst painfully and caused severe recessions.

There is little sign that the U.S. government intends to pull its stimulus back. The Fed has made clear its intention to maintain zero interest rates as far into the future as one can foresee. The carry trade will expand and perhaps even explode--in a time of slow economic recovery, it's one of the very few ways to make fast money. China will complain and lecture, but won't change the exchange rate of the yuan by much, because it needs continued access to American markets. Other exporting nations will grumble and defend their currencies with little likelihood of long term success. Oil exporters and other holders of dollars (including China and Japan) will take more losses on their dollar reserves, as there is no other currency or asset into which they can easily transfer their wealth.

American and Chinese expediency have created dangerous dynamics in the world economy. America can win only if other nations continue to fund its gigantic deficits and tolerate its uncontrolled printing of dollars by taking losses as the dollar falls. China can win only if it continues to export to America and hope that other nations will help it fund America's deficits while they become more vulnerable to Chinese exports themselves. The rest of the world is scrambling to figure out how to limit its losses and avoid being blown up by carry trade asset bubbles. Everyone, one way or another, is trying to shift their economic problems to other nations, a process that won't have a happy ending. This is starting to look like a game of musical chairs where the limited number of chairs is diminishing and all could end up net losers. If, somehow, the people running these nations would stop playing a children's game.

Stock Market Volatility and How It Bailed Out the Fed (This Time)

Anyone with even a passing interest in the stock markets has noticed the surge in volatility in recent months. The Dow Jones Industrial Average seems clinically manic-depressive, flying in the stratosphere one day and bungee jumping with a frayed rope the next day. Daily movements of 200 or even 300 points have become commonplace. Antacid manufacturers and therapists are celebrating.

Where does the volatility come from? There's no way of knowing all of the reasons. As discussed in an earlier blog, there are unknown factors that probably will never be known. http://blogger.uncleleosden.com/2007/07/why-stock-market-bounces-around.html. But not everything is unknown. Here are a few thoughts to chew on.

1. The Managed Money Problem. The greatest threat to professional money managers is the index fund. Most money managers can't beat the S&P 500, and many don't even do as well. If a money manager can't beat the S&P 500, why would his or her clients not simply move their money to an index fund? Many index funds have low fees and expenses, and are relatively tax efficient. Money managers feel the pressure to step away from traditional stock picking and try out other strategies in order to get even a tiny increment ahead of the overall market. For example, one can trade futures contracts for the S&P 500. This is a game for bigtime money managers and institutional investors. Individual investors should not try this at home. If a money manager senses that the stock market is likely to fall, he could sell S&P 500 futures contracts in an effort to hedge his stock holdings, or simply to bet on the price drop. Alternatively, he could buy S&P 500 put options, which would hedge his losses if the S&P 500 drops.

If the market begins to sink after the money manager has sold S&P 500 futures contracts or bought S&P 500 put options, the counterparty to that transaction will begin to sell the S&P 500 stocks to hedge its exposure (or do some sort of derivatives trade with another counterparty, who will start to sell stock). Either way, sell pressure is added to the market at a time when it is teetering. Financial history buffs will recall that portfolio insurance had a similar effect in the 1987 market crash.

2. Yen carry trade. Interest rates in Japan have been extremely low ever since the Tokyo stock markets rose in the 1980's and then crashed in 1989. The Nikkei 225 fell from an all-time high around 38,900 to the 7,000 to 8,000 level and has risen to around 17,000 today. The Japanese stock market bubble was accompanied by a real estate bubble so extreme that the Japanese imperial palace was said to be worth more than the entire value of all the real estate in America. Some Japanese home buyers took out 100-year mortgages (that's some inheritance for your kids). Needless to say, the Japanese real estate bubble also popped. Between the stock market crash and the real estate bubble popping, Japan's banks were saddled with such enormous loan losses that they very possibly were insolvent. In order to bail out the banks, the Japanese central bank lowered interest rates to virtually zero (which meant the banks could take deposits and otherwise borrow money for almost no cost). These rates have been kept more or less around zero until recently.

The extraordinarily low interest rates in Japan gave rise to a trading strategy called the "yen carry trade." You borrowed yen at the very low rates available in Japan, converted it into dollars, and invested in the U.S. Because U.S. interest rates and other returns were quite a bit higher than your borrowing costs, you made some easy money fairly quickly. There's nothing like easy money. Many Japanese have been using this strategy. So have many other investors, from places like the U.S., U.K., Australia and New Zealand. Anyone who can borrow yen--and in today's globalized financial system, that means almost anyone who can borrow--can do the yen carry trade.

The catch--remember, in all investment schemes, there's a catch--is that currency exchange rates fluctuate. If the dollar drops in value against the yen, the dollar denominated investment gains you get will be reduced by your losses in the dollar. In the last year or so, the dollar has been dropping against the yen. While the drop has been fairly gradual, it's been enough to make yen carry traders nervous.

Then, the stock market fell, sometimes abruptly, in the last two and a half weeks. That's been enough to make a lot of yen carry traders throw in the towel. They've ditched their U.S. investments, and reconverted their money into yen.

3. Hedge Funds. You knew hedge funds would be mentioned sooner or later, and here they are. Hedge funds that invested in subprime and other mortgages (another thing you knew would come up) have been receiving many withdrawal requests from nervous investors who believe too much of what they read in the newspapers. In the case of one Bear Stearns sponsored hedge fund, the fund simply ceased honoring withdrawal requests. But many other hedge funds have been trying to accommodate these nervous Nellies who have a complex about retiring with only Social Security.

The hedge funds have a minor problem, though. There aren't many people paying cash for CDOs these days. Some CDOs, when put up for auction, apparently aren't getting any bids at all. You can't honor a withdrawal request with zero. So, hedge funds have been liquidating other investments, like other debt securities. The private equity debt and junk bond markets have been particularly hard hit by these liquidations, and spreads between these securities and Treasuries have widened sharply. It's also likely that some of the selling in the stock markets has also been hedge funds raising cash to meet withdrawal requests, or just hoping to avoid losses.

4. Short Sellers. Short sellers are viewed by many as a scourge. They are disliked for profiting from misfortune and scorned for scavenging. However, they may assist the pricing function of the market, pushing the price toward its true equilibrium.

Some short sellers have no doubt been shorting the market (through derivatives that allow them to trade the equivalent of the S&P 500 or other broad market indexes). This probably has added to the downward pressure on the market. However, the shorts can also fuel some of the upward pops in the market. When the market begins to rise, the shorts start to take losses on their positions. As their losses increase, the counterparties with whom they traded (in order to assume their short positions) will often ask for cash collateral. If the shorts don't or can't provide cash collateral, or simply want to cut their losses, they'll buy stock to cover their shorts. This "short covering" is fast and intense, and may account for the laughing gas quality of some of the recent upswings in the market.

5. Derivatives Market? The increasingly tattered state of the derivatives market may account for some of the increased market volatility. There's no way to know for sure, since the derivatives market is unregulated and seriously opaque. But many players that might write derivatives contracts to protect holders of stocks from downswings could be inclined to demure these days. They may have taken losses in the subprime and corporate debt markets, and be unable to take on additional equity risk. They may simply be skittish, not knowing how bad things are, and prefer a quiet game of croquet.

Derivatives are said to moderate volatility by shifting risk to parties willing to take it. There's some truth to that. The problem is one of success--they proved so good at risk shifting that more players began investing in risky contracts, with expectation that they'd shift the risk to someone else. That was a clever strategy until it created such a large amount of risk that the mortgage market belly flopped. We discussed these unintended consequences in http://blogger.uncleleosden.com/2007/07/how-cdo-market-increased-subprime.html.

If some of the participants in the derivatives market have stopped playing in that particular sandbox, others seeking to hedge their stockholdings may be unable to lay off their downside equity risk. In that case, they'd have to take old fashioned action to protect themselves--like sell. As the derivatives market pulls back, it won't damp volatility as much.

There may be many other causes of market volatility, although these are probably enough for anyone who owns stock. The past few years have been unusually calm ones for the markets. But an unduly large amount of risk may have been heedlessly created because of the Panglossian perception fostered by that calm. The concern now is that this change in financial climate may have created the conditions for larger and more frequent hurricanes. Let's hope the levees hold.

A Fed Bailout: in the vein of cat-saves-people-from-fire stories, we noted in the preceding blog (http://blogger.uncleleosden.com/2007/08/uncle-alans-legacy-at-federal-reserve.html) that the stock market was hoping the Fed would give the market a little boost at its meeting today. In anticipation of some dispensation, the Dow rose 287 points on Monday (8/6/07), the day before the meeting. With a handicap like that, it was easy for the Fed not to indulge the market, hold interest rates steady and maintain that its primary concern is controlling inflation. The Fed gave the market a bit of a doggy treat by noting the problems in the credit and real estate markets, and the stock market's volatility. But it gave no real indication that an interest rate cut would be forthcoming at any predictable time in the foreseeable future. The Dow closed up 35, apparently satisfied with the crunchy chicken and beef flavor of its treat.

Animal News: you can't take hardly any liquids on board a plane, but if it's a monkey . . .
www.wtop.com/?nid=456&sid=1212487.