Hi Claude: Thanks for the input on forward sales................
Thursday, November 6, 1997 9:55 p.m. EST
Why good currencies go bad
The recent worldwide market woes were sparked by the
collapse of currencies halfway around the globe. In a
special two-part series, Money Daily's Michael Brush
examines this phenomenon and its impact on American
investors. Part one details some of the factors that
can cause currencies to crumble. Part two, scheduled
for release on Friday night, examines which currencies
might crumble next.
By Michael Brush
For historians, 1997 will go down as the year that
currencies crumbled. Beginning in early July, currency
devaluations cut a swathe through Southeast Asia,
eventually roiling companies and stock markets all
around the world. Now the currency weakness threatens
to spread to Latin America and other regions.
What happened? That is, why do currencies fall apart
-- and, understanding that, is it possible to predict
which currencies will be next to crumble?
To answer those questions, it's necessary to go back
to Econ 101 and cover some fundamentals. For starters,
currencies almost never change value dramatically
overnight unless they have been "fixed" or "pegged" to
some other currency theretofore. If they had not been
fixed, they would have made minor day-by-day
adjustments, instead of crashing and losing their
value all at once.
Typically governments -- like Hong Kong's -- that
choose to link their currencies do so because they
believe it will help stimulate international trade by
bringing stability to currency exchange rates.
Generally, the currency is linked to the U.S. dollar
or to a basket of currencies heavily weighted with
U.S. dollars. Pegging to the U.S. dollar is intended
to bolster the confidence of foreign investors that
the local economy will be run in a stable manner.
Here is where things start to go wrong. By fixing its
currency to the dollar, a country implies that it
intends to have more or less the same monetary policy
and inflation rate as those of the U.S. However, this
is not always easy to achieve. Economies, not to
mention the political and spending needs of
governments, vary from country to country. So
differences in inflation, and trade and capital flows
are inevitable,
causing economic pressures to build up on a pegged
exchange rate.
Here are the main kinds of pressures that get fixed
currencies into trouble:
* Inflation imbalances If a country has more
inflation than the U.S., say because it borrows and
spends more, then as time goes by its currency should
be worth less. Each year, consumers can buy fewer
goods with that currency relative to the U.S. dollar,
and yet they can still buy the same number of U.S.
dollars because of the pegged exchange rate. Something
has to give.
Robert Brusca, an economist with Nikko Securities,
estimates that Pacific rim countries were running
annual inflation levels two or three percentage points
above that in the U.S. for about eight years. In other
words, their currencies became 25% less valuable in
that time, even though their official value remained
fixed to the dollar. That kind of situation can't last
forever.
* Big current account deficits. A country's "current
account" is the difference between exports and
imports. And a large current account deficit means a
country is buying lots more than it is selling. This
puts downward pressure on the value of a nation's
currency, because -- thanks to all that spending --
more of its money flows overseas than is needed by
foreigners to buy that country's exported goods. In
general, current account deficits start to be
dangerous once they exceed 5% of gross domestic
product. True, a nation can safely absorb a big
deficit if there are large flows of foreign investment
into the country through its "capital account." That
has been the case for many Southeast Asian nations in
recent years, thanks to investors' willingness to pour
money into the Asian tiger economies. Whether it will
still be the case going forward is another story.
Meanwhile, the export growth of many Southeast Asian
nations has slowed -- in part because China has come
on the scene as a major competitor. That has made
current account deficits worse in many countries in
the region, says Brian Gendreau, a market analyst and
economist with Smith Barney. Conversely, currencies
and stock markets have suffered the least in countries
like Singapore and Taiwan, where current account
positions are the strongest.
* Weak foreign currency reserves. When excess
inflation or a current account deficit puts pressure
on a currency, governments often use foreign reserves
to buy back their own currency in the open market,
taking some of the pressure off. They reason that they
can defend the currency against short-term weakness or
a temporary attack by currency speculators. For
example, economists that reckon Brazil spent $7
billion last week to defend its currency, the real.
Once reserves are low, however, the defense is gone,
and doubts about the currency can push it over the
edge.
* Capital flight. Often governments will raise
interest rates to protect their currencies. This makes
domestic investments more attractive, drawing in
foreign currency. It also tends to slow domestic
growth. That reduces the demand for foreign goods, and
thus can help nudge a current account deficit back
into line.
But the strategy can also backfire. Foreign investors
who put money in the country by buying shares ( as
opposed to building a plant they can't easily get out
of ) will often flee once interest rates start going
up. Reason: higher interest rates threaten to devalue
the shares they own by reducing corporate earnings.
And if higher rates threaten to put domestic banks in
jeopardy -- because companies find it more difficult
to pay back debts in a slowing economy -- then foreign
capital gets even more itchy to leave. Banking crises,
after all, compound domestic economic problems.
These kinds of worries about banks in many Southeast
Asian countries contributed to the flight of capital
away from those countries. And that explains why a
currency crisis spills over into the stock market. If
governments raise interest rates to protect the
currency, then investors will shift money out of
stocks.
Tomorrow: which currency will crumble next?
Another doldrums day in the markets |
