Perhaps It's Time to Think of a New Currency Regime?

One of the most intriguing aspects of the current crises has been the behavior of the currency markets. One can blame the Fed for keeping interest rates low and encouraging misallocation of resources to US housing. But the way currencies have moved over the last few years, one can argue that currency markets have misallocated resources across nations.

How should a cross-currency rate be determined? In a world where there are no capital flows across borders, it should be based on interest rate and inflation differential between two countries. One can argue it is the rate at which the current account deficit between two countries goes to zero.

Put the capital flows in, and the whole picture changes. As we see now, investors rush in when something is hot. So, when a country is hot, investors will rush in and the currency of that country can appreciate meaningfully above what its "fair-value" is.

This will entice even more investors, which will push the currency even further above its fair-value. A positive feedback loop develops, and a currency bubble takes shape. This is what happened in emerging markets in the last few years.

Like all bubbles, however, it bursts. And then, investors rush out. But when they leave, they cause absolute mayhem and destruction, particularly in smaller countries. A huge negative feedback loop develops - some investors leave pushing the currency down, which causes even more investors to pull out, which suddenly becomes a stampede.

Let's take the case of India. In 2007, as investors suddenly warmed up to the decoupling theory, they rushed into India. Suddenly, the rupee appreciated against the dollar, from Rs 45 to Rs 40, and people started talking of the coming golden days when the rupee would touch Rs 35 and Rs 30. Probably it was this thinking that encouraged some Indian companies to go on expensive overseas acquisition binges (the theory being, take a dollar loan today, and repay it 5 years later when the rupee will have appreciated 20%).

And now suddenly, India finds itself staring into the barrel. The rupee has depreciated suddenly to Rs 50. Overnight, the capital allocation decisions made in 2007 by India Inc. have turned into demons. Suddenly, the currency derivative bets made by importers and exporters have backfired and caused some of them to go bankrupt.

What does the current currency regime expect? That the CFO of a small local company will be smart enough to figure out how currencies are moving and hedge appropriately?

Even the most educated financiers and businessmen are unable to look through the currency movements and are carried away by the momentum. The probability of an emerging market currency bust in a decade is almost 100%, if I were to extrapolate the history of the last 20 years. Is a young person setting up an export unit in India really making the right career choice from a 10 year perspective, considering that the biggest variable that will affect him - the currency - is outside his control.

So what is the solution? I dont know. A fixed exchange regime doesn't work either, as we know from Bretton Woods. Different countries grow at different rates and have differing inflation and interest rates. Over time, the fixed exchange regime becomes inflexible and a black market in currency develops.

One solution could be that countries become part of larger currency blocs like the euro. But this means that countries need to give up their sovereignity, which is something not a lot of countries would like to do. One currency means a broad consensus on fiscal and political philosophy.

If the outcome of this crises is that more countries come together and better global institutions are created, it would all be worthwhile. It could also go the other away - like it did in the 1930s. So lets hope for the best.

Comments

[Gem Hudson:]

What you have sold. The customers have bought into their money worth and you have produced what sells. Earned money is capital money and the money appreciate out from paper money but producing nothing worth their money is not only making none of this work. Print money is nothing but paper money until earned. Dollar appreciation day is in the economics and the dollar devaluation are in the stag inflation receding back further than a recession.

2008 Oct 28 11:05 AM

[Thanks Be T...:]

What's the solution? First you have to identify the problem...

And the problem is fiat paper. Why are FX markets increasingly volatile? Because central banks around the world are increasingly manipulating the supply of money.

Would you hold Zimbabwe dollars to store your wealth? Not when annual inflation is over 9,000% and it costs over Z$100 billion to buy a dozen eggs!

Now how about the Indian rupee? How much currency will India's central bank print tomorrow? What about the U.S. dollar? Do you trust the Fed to control the printing presses? Personally, I have no idea who is running their printing press faster.

So what is the solution? A gold standard. Not a pseudo gold standard ala Bretton Woods - but a system whereby _all_ currencies around the world are freely convertible into gold (or silver or whatever real good the free market wants to hold).

Hope this helps.

2008 Oct 28 01:12 PM

[jmkeynes:]

Here's something from Soros that appears in the FT.

America must lead a rescue of emerging economies

George Soros

Published: October 28 2008 22:05 | Last updated: October 28 2008 22:05

The global financial system as it is currently constituted is characterised by a pernicious asymmetry. The financial authorities of the developed countries are in charge and they will do whatever it takes to prevent the system from collapsing. They are, however, less concerned with the fate of countries at the periphery. As a result, the system provides less stability and protection for those countries than for the countries at the centre. This asymmetry – which is enshrined in the veto rights the US enjoys in the International Monetary Fund, explains why the US has been able to run up an ever-increasing current account deficit over the past quarter of a century. The so-called Washington consensus imposed strict market discipline on other countries but the US was exempt from it.

The emerging market crisis of 1997 devastated the periphery such as Indonesia, Brazil, Korea and Russia but left America unscathed. Subsequently, many peripheral countries followed sound macroeconomic policies, once again attracting large capital inflows, and in recent years have enjoyed fast economic growth. Then came the financial crisis, which originated in the US. Until recently peripheral countries such as Brazil remained largely unaffected; indeed, they benefited from the commodity boom. But after the bankruptcy of Lehman Brothers, the financial system suffered a temporary cardiac arrest and the authorities in the US and Europe resorted to desperate measures to resuscitate it. In effect, they resolved that no other big financial institution would be allowed to default and also they guaranteed depositors against losses. This had unintended adverse consequences for the peripheral countries and the authorities have been caught unawares. In recent days there has been a general flight for safety from the periphery back to the centre. Currencies have dropped against the dollar and the yen, some precipitously. Interest rates and credit default premiums have soared and stock markets crashed. Margin calls have proliferated and spread to stock markets in the US and Europe, raising the spectre of renewed panic.

The IMF is discussing a new credit facility for countries at the periphery, in contrast to the conditional credit lines that were never used because the conditions attached to them were too onerous. The new facility would carry no conditions and no stigma for countries following sound macroeconomic policies. In addition, the IMF stands ready to extend conditional credit to countries that are less well qualified. Iceland and Ukraine have already signed and Hungary is next.

The approach is right but it will be too little, too late. The maximum that could be drawn under this facility would be five times a country’s quota. In the case of Brazil, for example, this would amount to $15bn, a pittance when compared with Brazil’s own foreign currency reserves of more than $200bn. A much larger and more flexible package is needed to reassure markets. The central banks at the centre should open large swap lines with the central banks of qualifying countries at the periphery and countries with large foreign currency reserves, notably China, Japan, Abu Dhabi and Saudi Arabia, ought to put up a supplemental fund that could be dispersed more flexibly. There is also an urgent need for short-term and longer-term credit to enable countries with sound fiscal positions to engage in Keynesian counter-cyclical policies. Only by stimulating domestic demand can the spectre of a world-wide depression be removed.

Unfortunately the authorities are always lagging behind events; that is why the financial crisis is spinning out of control. Already it has enveloped the Gulf countries, and Saudi Arabia and Abu Dhabi may be too concerned with their own region to contribute to a global fund. It is time to start thinking about creating special drawing rights or some other form of international reserves on a large scale, but that is subject to American veto.

President George W. Bush has convened a G20 summit for November 15 but there is not much point in holding such a meeting unless the US is serious about supporting a global rescue effort. The US must show the way in protecting the peripheral countries against a storm that has originated in the US, if it does not want to forfeit its claim to the leadership position. Even if Mr Bush does not share this point of view, it is to be hoped the next president will – but by then the damage will be much greater.

The writer is chairman of Soros Fund Management and author of The New Paradigm for Financial Markets

2008 Oct 28 07:08 PM