November 4, 2008 | Stuart Loh
STANFORD, CALIFORNIA – As an international student, I keep a close eye on exchange rates. The majority of my savings and investments are denominated in Australian dollars, but the majority of my expenses flow out in U.S. dollars. Therefore, fluctuations in the AUD/USD rate affect my purchasing habits. And the fluctuations that have happened over the last three months have been nothing short of breathtaking. Breathtakingly bad.
Over the last several months, the AUD/USD rate has plummeted from a high of about 0.98 to a low of 0.55. This means the cost of the car I had been planning to buy here has risen almost 75% in AUD terms. In fact, amid the fallout of the credit crisis, with plunging worldwide equity markets, illiquid credit markets, and slowing economic growth, the USD has surged against all other currencies except the Japanese yen. Australia’s has gone in the opposite direction.
Against the yen, it’s even worse. The AUD/JPY briefly touched an all-time low a week or two ago.
Why has the AUD collapsed? Why has this been the case if the U.S. has been the source of trouble? Why has this been the case if the U.S. economy looks shakier than Australia’s? After all, Australia should be cushioned by its ties with Asia, which appears to be holding up better then Europe. And China is Australia’s largest trading partner, not the U.S.
One simple reason that’s been suggested for the USD’s rise is that since it was the first economy to run into trouble, it should be the first economy to recover. Maybe. But this reason is too simple to stand on its own.
Let’s look at the Aussie first. The AUD has fallen against most other currencies, not just the USD and the yen. Several factors share responsibility for this.
The first reason is the departure of the “carry trade” phenomenon. A carry trade is where you borrow the currency of one country whose interest rates are low, and invest those borrowed funds by buying the currency of another country whose interest rates are relatively higher.
In the years leading up to the credit crisis, Japan and the U.S. have had low interest rates. Japan saw its interest rates being held at zero percent for a period, and of course low U.S. interest rates are part of the reason we’re in this mess in the first place (borrowing money was cheap, so people borrowed a lot — too much, in fact — and spent it on buying houses, but couldn’t pay it back). By comparison, Australian interest rates have been consistently over 5% during the same period. This interest rate differential made the AUD/JPY and AUD/USD currency pairs ideal for the carry trade. (There are lesser developed countries with higher interest rates, but their currencies tend to be less stable, less liquid, and more prone to government intervention and country risk. By contrast, the AUD is one of the most traded currencies in the world.) So, for example, it costs you nothing to borrow in yen, and when you convert it to AUD, you’re making over 5% interest.
Of course, if you’re a Japanese carry trader, when the time comes to convert your money back to yen, you’d better hope the AUD has fallen in value against the yen in the meantime. While you can spend a whole year waiting for that “free” 5% interest, if the AUD/JPY rate falls by 5%, those interest gains are wiped out.
But what happened was that the carry trade was attractive and had been for some time. Times were good. Australian inflation was beginning to creep up, and since the usual response to that is for the central bank to raise interest rates, expectations were that interest rate differentials would further widen. More people piled into the trade, and the large quantities of AUD purchases pushed it up even higher. The carry traders were doubly benefiting from interest rates and an appreciating AUD.
That all ended with the onset of the credit crunch.
Everything arguably started to unravel when securitized asset write-downs started being made. Because of this, Bear Stearns’ ludicrously named High-Grade Structured Credit Strategies Enhanced Leverage Fund took massive losses before finally folding. This fund, and many others, were “highly leveraged.” That is to say, lured by low interest rates, they borrowed a lot of money. A lot. They had more debt than assets. Multiples more.
When asset prices fell away, investors were repeatedly margin called and forced to scramble around for extra cash to meet their debt obligations. This debt was denominated in currencies such as USD and yen (which were cheap to borrow, remember?). To meet debt payment obligations, people started liquidating assets. Anything they could find. But very few people were interested in buying. The sustained, distressed selling pushed down asset prices further, and the cycle continued. Some of these assets of course were AUD.
Commercial debt suddenly became expensive and, despite the best efforts of governments to lower interest rates, people started “deleveraging”—getting rid of debt. As the AUD became increasingly sold by people rushing to convert their money back to USD and yen, the AUD fell, wiping out carry traders’ interest rate gains. Speculators, such as Mrs Watanabe, the apocryphal Japanese housewife who represents Japanese housewife carry traders, were badly burnt, especially as many of them were leveraging their carry trades.
Similarly, hedge funds, caught up in the turmoil, were drawn into forced selling of their assets.
So, asset prices fell, forcing carry traders and hedge funds to liquidate their AUD holdings. The AUD fell, forcing further sales. Sentiment turned against the AUD and despite the relatively high interest rates, no one wanted to buy AUD. Illiquidity bred volatility and uncertainty, which in turn further killed the attractiveness of the carry trade. It didn’t take long for carnage to unfurl, and several years of trading gains were given up in the space of several brief sessions of frenzied selling.
A second reason revolves around Australia’s monetary policy — what it is doing with its interest rates. When times were good, Australia’s inflation rates were beginning to nudge out of the 2-3% comfort zone targeted by the Reserve Bank of Australia. The natural response to this is to raise interest rates to stem demand so this tended to widen interest rate differentials and, at least in the short-term, made the AUD more attractive for the carry trade. However, once growth became an issue because of the global economic slowdown, this cycle of raising interest rates reversed.
With Australia’s rates peaking at 7%, Australia had a lot more room to move than the U.S. and Japan (whose rates at the same time were 2% and 0.5% respectively) when it came to lowering interest rates to stimulate its economy. As of this week, U.S. interest rates are 100 basis points lower at 1.0%, Japanese interest rates are 20 basis points lower at 0.3% and Australia’s is 175 basis points lower at 5.25%.
The interest rate differential eroded, which further encouraged carry trades to be unwound.
The third reason revolves around the AUD’s status as a “commodity currency” (along with the New Zealand dollar and Canadian dollar). Commodity sales make up more than half of Australia’s exports, so global commodity prices directly affect the profitability of Australia’s significant mining and agricultural sectors. Consequently, there is a strong correlation between commodity indices and the Australian dollar. After spiking earlier this year in what some would say was a commodity price bubble created by a rush of speculation, commodities across the board have taken a spectacular dive (see diagram).
Rogers International Commodities Index from January 2007 to October 2008
This dive has come due to an expected slowdown in global economic growth, compounded by people deleveraging by divesting their commodity investments. As the problems of Wall Street move to Main Street, developed economies around the world have become vulnerable to lapsing into recessions (if not already). Even the mighty China will slow and it has revised its GDP forecasts downwards. The result is that the demand for commodities is expected to fall away, and falling prices for oil, gas, metals and minerals reflect that expectation.
The fourth reason, which also explains why the USD and yen are doing well, is “risk aversion.” People panic. Panic breeds more panic. Money starts being lost, and when people start to get fed up enough with their losses, their appetite for risk vanishes. They just want to retreat to somewhere safe, lick their wounds, and wait until the chaos blows over.
While currency is traditionally seen as a barometer of a country’s economic health (normally when a country runs into problems, their currency falters as well), this explains why, somewhat perversely, the USD is doing so well despite the ill-health of the U.S. economy. To be more precise, it’s not that it’s doing “well,” it’s just doing better relative to other currencies.
When enough people panic, dramatic things happen, such as major Wall Street banks running into solvency issues. With banks everywhere cavorting with insolvency, no one is sure which bank will have solvency issues next, or prevent depositors from withdrawing, or investors from redeeming, their funds. Witness the diplomatic spat which occurred when a troubled Icelandic bank refused to let British depositors withdraw their money. Credit risk becomes a huge concern.
When enough people panic, the contagion of panic spreads around the world and all investments start to look dodgy. People start to really think about where they put their money because they might not get it back. So, what do people do when they aren’t sure where to turn to?
They tend to take back their money out of wherever they have it invested, bring it back home, and stick it under their mattresses. Except that you can’t really stick a billion dollars in cash under a mattress (apart from reasons of physical space, it won’t earn any interest). So people put it into the next best thing: government bonds of the world’s largest economy.
They will do this even though bonds will still lose them money — if bond interest rates are lower than the inflation rates, the real value of their money gets slowly eaten away.
They will do this because government debt, and especially U.S. government debt, is classically seen as “risk free,” at least in relation to credit risk. It is risk free because, in theory, governments can always just print more money to pay their debt (although that has major problems of its own, and not all countries can simply print money — most notably those in the European Union). Of course, governments can default (Russia did in the 1990s), but the U.S. is, like its investment banks and insurance companies, currently universally regarded as “too big to fail.”
The USD is unique in that it’s the world’s “reserve currency.” Countries around the world keep their foreign exchange reserves in USD. Not sure of where else to turn to, people will just bring their money home by converting it to USD so they can stick it into bonds and also service the debt they have owing which also is denominated in USD. Being a reserve currency means that central banks from around the world can support the value of the USD as well.
Although the yen is not the reserve currency, its financial sector, though weakening, is regarded as relatively stable. (Its banks more so than the U.S.’s.) The USD and yen are essentially seen as safe harbor currencies which capital flees to in uncertain times.
* * *
That is the story at the moment. But faith in the USD will only sustain so long as people have faith in the country. If that faith goes, people will sell American debt and sell the American dollar. Central banks, such as the trillions of USD wielded by the Bank of Japan and the People’s Bank of China, hold massive amounts of such debt. China’s central bank has over a trillion in U.S. government bonds. (Of course, China has an interest in ensuring that the USD does not fall too much against the Yuan since that would make China’s exports to the U.S. more expensive and thus less internationally competitive. It would also devalue their remaining holdings of USD.)
What, in the long-term, could cause this to happen? Well, the same factors that were causing the USD to steadily decline before the credit blow-up.
The U.S. has a massive foreign debt. It’s somewhere in the vicinity of $14 trillion. Being a voracious consumer, it imports more than it exports, resulting in a sizeable current account deficit. Government debt is over $10 trillion. Budget deficits caused by increased government spending by the Bush administration have been exacerbated by the Iraq War, the demands of the Federal Reserve, the $700 million bailout package. This looks like it will continue with the raft of stimulus spending that surely will come with the next administration, although one would hope the magnitude of the deficit will be significantly curtailed over time. This is clearly not an easy exercise.
Where is the U.S. going to get this money it doesn’t have? Well, it does the same thing that Joe Sixpack does when he’s short of cash: borrow it. It also has an option of doing something Joe Sixpack can’t do, which is to print money. But printing money in emergencies is generally undesirable because it creates money out of thin air, without any tangible wealth to back it up. When that happens, the value of all money falls — otherwise reflected in price hikes in goods and services. Inflation. (This is why it cost several trillion Zimbabwean dollars to buy a hamburger in Harare before their government lopped ten zeroes off the currency.)
If you had business dealings with someone who had huge debts which continued to grow, not because it was investing that money wisely, but because it spending it, wouldn’t you eventually get nervous? And of course, nervousness is what begins to eat away at your faith in the ability of that person to pay you back. At the very least, you’d start to diversify your business dealings.
The concept, applied to a country, is not so different. When demand for American debt falters, so too will its currency.
As the world emerges from this crisis, it is likely that the focus will resume on the fundamentals. Once stability returns and the volatility eases, people will once again come out of their shells and begin looking for riskier investments in search of more yield. The gains in the USD will be temporary unless the economy of the U.S. starts being managed in a different way.
Unfortunately for me, this is not going to help me to buy a car for a reasonable price anytime soon.
Stuart is based in Stanford, California.
Article posted
on Tuesday, November 4, 2008 at 2:30 pm in Business & Finance
