Bad bounce on the yen could end in a crunch
The dollar's collapse has stunned the US and left European policymakers wondering how long the single currency will be safe. Amid all this madness, a repeat of the Depression no longer seems fanciful
By Mark Atkinson
Monday October 12, 1998
Last week's interest rate cut, the first for more than two years, may have grabbed all the headlines on Friday, but the really important news was to be found on the City pages, which reported an outbreak of turmoil on the foreign exchange markets.
In the space of a few hours, while the monetary policy committee was deliberating at its two-day meeting, the dollar plunged against the yen, falling at one point to a low of 122 and sliding 18 per cent in 48 hours. As currency market movements go this was a big one - in fact the greenback's second-largest since 1971, when it left the Bretton Woods system of fixed exchange rates.
By comparison, the pound's exit from the exchange rate mechanism in 1992 was a side show. So what was behind it, and what will its consequences be for the global economy and for Britain?
The dollar's collapse seems to have been caused by financial market activity focused on Japan rather than on real economic developments - in other words, a case of the tail wagging the dog. Two factors seem to have been at work at once.
First, foreign banks have begun demanding higher interest rates to lend to cash-strapped Japanese institutions, believing them to be concealing larger losses than they are prepared to admit to. To get around this, Japanese banks have begun selling American assets and repatriating their money.
Second, highly secretive hedge funds are thought to be selling dollars to buy yen. They have been borrowing heavily in yen to take advantage of low Japanese interest rates and then converting to other, higher-yielding currencies, such as the dollar. The interest rate differential between the currencies has allowed investors to pocket a healthy 5 per cent profit. The drop in the dollar-yen rate, however, has left many of them desperate to unwind those positions.
Both these factors helped send the dollar into a freefall that was only checked by unconfirmed rumours of intervention by the United States Federal Reserve bank.
Underlying these market movements was concern over the US economy, in particular its ballooning trade deficit and its financial system's vulnerability after the collapse of hedge fund Long-Term Capital Management.
In that sense, there may have been an element in the foreign exchange markets responding to real economic factors as well as to financial phenomena. But they were not the central cause of the sudden change in sentiment towards the dollar.
The impact on the real global economy of the fall in the dollar-yen rate will depend on whether it is short or long-term. In an environment of extreme volatility, it would not be surprising to see it reverse - in which case it would not alter the economic outlook much. If it lasts, however, it could be good news.
True, a stronger yen may make life hard for Japanese exports, the only sector enjoying much growth at the moment. But the currency's strength may have an up side for the economy by helping Japan's banks rebuild their battered balance sheets.
If the banking system recovers, it could lay the foundations for a broadly-based and sustained recovery in Japan, the world's number two economy.
A stronger yen should also take some of the pressure off currencies in the ailing South East Asian economies, allowing them to lower their interest rates to spur growth.
It will ease, too, any lingering fears of a competitive devaluation by the Chinese, which would inevitably lead to a damaging break of the link between the Hong Kong and American dollar.
So far, so good - but volatility on the foreign exchange markets may not necessarily have such a benign outcome.
For a start, a weaker dollar will put upward pressure on the euro when it is launched next January. Recent days have already seen the monetary union currency bloc - Britain's biggest trading partner - surging against the dollar. "A period of sustained euro strength would clearly represent more bad news for Europe's industrial sector, which is already being hit by a sizeable slow-down in world trade growth and inventory concerns in some countries," says HSBC in its journal, World Economic Watch.
The obvious response by the authorties would be to cut interest rates to counter the currency-induced slow-down, yet Europe's leading central bankers seem in no mood to countenance such action.
Wim Duisenberg, president of the European Central Bank, and Hans Tietmeyer, president of the Bundesbank, believe that the euro-zone will be relatively shielded from violent currency fluctuations because of its reliance on internal trade.
While interest rates in Spain, Ireland and other, smaller European economies may be reduced to bring them in line with Germany's ahead of the euro's launch, it seems German and French rates - the starting point for that of the euro - are likely to be as low as pan-European rates will for some time.
Situated geographically and economically between the dollar and the euro, the pound could go either way during the coming months.
With interest rates heading downwards, as in the US, the pound ought to fall. That is certainly what exporters want. But perversely it actually rose after last week's base-rate reduction. Where it heads next is anyone's guess.
One thing is for sure, with the dollar and euro's gyrations it will not stay still for long. Exchange rate stability, for so long the goal of economic policymakers, will remain a distant hope.
The other, more sinister worry signalled by last week's violent currency swings is that we are in the midst of a prolonged period of blind panic in the financial markets which could end in a full-blown credit crunch.
Liquidity, the ease with which financial assets can be brought and sold, is already drying up. The spreads on dollar-yen exchange rates, seen as an indication of how liquid a market is, have widened to levels normally expected in developing countries, not in the two largest economies in the world.
In a research note published on Friday, Brian Reading of Lombard Street Research, joked that the US is now the latest, largest developing country to suffer the Asian contagion.
"Perhaps the US should call in the International Monetary Fund to prevent the dollar's freefall," he said.
"Doubtless the IMF could arrange an international bail-out with a large yen loan, so official inflows replaced lost private ones. The loan would be conditional on the US raising interest rates to dampen the excessive demand.
"The American government would also be made to undertake the structural reform of its poorly regulated financial system to eliminate the speculative excesses, the uncontrolled bank-lending to the hedge funds and the excessive leverage."
On Friday there was little sign that the financial markets' storm was abating.
Instead it began to spread to the normally safe haven of government bonds; investors began dumping their long-dated government stock in favour of shorter-dated, more liquid stock.
Sooner or later this sort of financial market turbulence will feed through to real economies everywhere.
At the moment, instead of directing funds into worthwhile investments, investors are intent on putting their money into the most liquid and accessible form possible.
It seems that it will not be long before they start stuffing huge piles of notes under their mattresses.
Amid all this madness, a repeat of the 1930s Depression no longer seems fanciful. It is no wonder, then, that central banks around the world - Germany and France excepted - are rushing to ease credit conditions by lowering interest rates.
Quarter-point cuts by America's Federal Reserve and the Bank of England, however, have not been large enough to reverse negative sentiment on the financial markets. A bigger, bolder response will be required.
reports.guardian.co.uk |
