The global economy has over the past two years has had to navigate a number of risks associated with the bursting of the housing bubble. Unprecedented governmental and regulatory action has averted what seemed a certain financial meltdown in the not too distant past (15 September 2009, to be precise). While those risks have been barely surmounted a new albeit more ominous risk seems to be emerging in the global economy. This risk, if it is confirmed, is that of the US Dollar becoming the new preferred currency for carry trades.
However, it is prudent to note that this is not yet confirmed simply because it is so difficult to confirm its existence till it is in an advanced stage. What has however, given credence to these reported views is that it is increasingly clear that a structural shift may be taking place in the world with greater cynicism setting in about the fiscal health of the US economy and by corollary its currency, the US Dollar. We believe that this event (US Dollar becoming the preferred currency for carry trades) would unleash volatility on an unprecedented scale that would be detrimental to the health of the world economy considering the fact the US Dollar is the de facto Reserve Currency of the world.
The negative sentiment of the US Dollar can be gauged by the recent reported statement of David Bloom, the Chief of Currency, HSBC. He thinks that the USD seems a lot like the Sterling after the First World War and more like the currencies of the emerging markets. He further adds that the risk-reward for emerging market currencies has changed, not because their economies have had an increase in their standards but because of the decline of the western currencies and their economies.
What is carry trade and should we be so worried about what it could do to the world economy? The Short answer to the second part of the question is: Yes. Currency carry trade is essentially a trading strategy used by currency speculators to increase their returns. Utilising this trading strategy, investors borrow in a currency in countries that have low interest rates, sell that currency and use the funds to purchase higher yielding assets (or currencies) that provide either higher interest rates or simply higher returns. To illustrate this with an example, speculators would borrow money in the USA, since it has interest rates that are nearly zero. Sell the US dollars and use the proceeds to purchase other currencies, debt instruments, commodities, equities or any other assets. The premise of the strategy is that the returns from the assets thus purchased will exceed the interest rate paid and also any possible currency fluctuations. This seems to be amazingly simple and seems filled with obvious sound business logic.
The consequences of this are more complex than the seemingly simple trade. Traders will not risk borrowing in a currency in large amounts unless they are confident that the interest rates are low, and that would mean that they expect the interest rates to be low because an economy is mired in difficulties of a magnitude and complexity that the central bank will not be able to raise rates in the medium term. In the past, we had speculators borrowing in Yen once there was sufficient clarity that the Japanese economy would be mired in a deflationary spiral. They Yen became the preferred currency for carry trade for nearly 3 years: 2004-07. In the present instance, it is widely rumoured that the speculators are selling US Dollars and buying the Australian and Canadian Dollar. It is likely that a proportion of this money is also flowing into commodities and other Asian asset classes.
Now if the US Dollar is becoming the vehicle for carry trade, it would probably mean that the speculators do not expect the US Federal Reserve to interest rates till at least the end of 2010. The Fed Futures indicate near zero probability of a interest rate hike till at least March 2010. If the Fed is unlikely to raise rates before the end of 2010 (as per the calculation of the speculators) then it is highly likely that we will not even a semblance of a meaningful recovery till 2011.
If the underlying economy is weak then is likely that the US dollar is likely to remain weak, at least till then. Unfortunately, for the global economy world trade is mostly denominated in US Dollars since it is the World’s reserve currency. That would mean that the next few years (at least as long as the US Dollar weakens) would be followed by a rise in prices of nearly all dollar denominated assets, especially commodities. There will invariably be two sides to this coin. The falling dollar may be good for the USA where its exports become cheaper but it will be a disaster for most of the other economies, especially those in Asia which survive on exports. The list of countries that will be adversely affected is headed by China, little wonder that the Chinese are showing great keenness in entering into Yuan denominated currency swaps and Yuan denominated trade with different countries of the world.
If this process (of a dollar decline) is a long-drawn out process then over the long-term we may actually see a number of Trans-national corporations that invested in various emerging markets to exploit the low wages, may actually migrate back to the USA.
A more immediate problem will be that the export oriented sectors will be decimated in most of the countries. Large amounts of short-selling of the world’s reserve would lead to an exponential increase in the volatility of the currencies world wide. A larger than expected fluctuation of the dollar will lead to either a sharp rise or fall in the asset markets that would have attracted inflows due to their fortitude of being on the other side of the correlation or pairing matrix. Unlike the equity markets, the impact of currency volatility would be detrimental to the economy as a whole. Except the speculators (who are on the right side of the trade) very few would actually benefit. This would be because a large number of industries (and other users) tend to buy their requirements over a period of time. Very few of them actually have the resources plan and hedge their use, especially of commodities and currencies.
Extreme volatility (which will be an invariable bye-product of the carry trade speculation) mean businesses and consumers will not be able to gain any clarity on the nature of the cost of either their business (at best) or losses due to the price fluctuations of commodities, assets as well nearly all other goods and services. Unlike financial speculators, businesses will not be able to raise their prices (or reduce their prices) at the drop of a hat. Any government intervention in the currency markets tends to increase rather than decrease this volatility. A rise or decline in currency could lead to a cascading effect on not only the speculators but also those who borrow in foreign currency, importers as well exporters. This becomes all the more important as the last decade has seen integration of the financial markets and increased flow of capital to different geographies. Extreme volatility will not only increase the cost of capital, not many would want to take a long-term perspective until they gain greater clarity. Therefore, if this situation continues for longer than say 6-8 months, an already speculative financial system will resemble a casino where three months is the new long-term horizon. Commodity speculation, as well as speculative trading in other assets would be one of the major beneficiaries. Various social scientists over the years have clearly pointed out that when capital cannot be profitably invested in a business, it would find its way into speculation. History attests this wisdom. This may already be happening. The increased monetary stimulus instead of finding its way into the real economy may actually find its way into the speculative circulation space.
On a day to day basis, we could be headed for an era of asset inflation (or even bubbles), high prices, low growth and high unemployment. All the right ingredients for a period of possible stagflation, if not anything else.
What can governments do?
• Unfortunately for the governments there could be very few options. Either they could ban carry trade (an impossible task given the complexity of the financial markets);
• They could simply relax all the rules so that industries, business or consumers need not disclose their losses. This could include accounting changes that would enable a longer period to carry on their losses.
• Increase interest rates. This would be difficult as the economies would continue to remain weak and there would be tepid growth (if at all there is growth). Raising interest rates would be counter-productive.
• The best solution may just be to make speculation expensive. There could be a global tax on speculative transactions, which would be vigorously opposed by the financial industry. This opposition is bound to have a sympathetic audience among the US policy makers for the simple reason that the inter-linkages between industry and policy makers are far more complex in USA than in other parts of the world. But that is likely to be the only deterrent for speculators. It would be better if the policy makers this time err on the side of caution and the impose a tax that is on the higher side.
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