Searching for a haven
Massive increases in government debt have turned the dynamics of the currency market on its head. Central banks have amassed vast holdings of US dollars, a traditional safe haven, but now worry that they will see their value dwindle as the US government pursues its policy of quantitative easing. What happens if central banks try to sell their dollars? And if they did, where would they go? Solomon Teague reports.
Debt has not traditionally been a significant consideration for currency markets. But the unprecedented scale of the debts taken on by governments in response to the credit crisis has changed the rules of the game.
Government indebtedness, especially in the US, is giving investors pause and putting downward pressure on the dollar in particular, said Simon Derrick, chief currency strategist at Bank of New York Mellon. He estimates that since the US government commenced its fiscal response to the crisis, its debt has ballooned from around US$455bn to US$1.7trn. The US budget deficit is on course to reach 13% of GDP this year, up from about 3% in 2008.
The sheer magnitude of this debt has forced investors to consider the implications it might have on the dollar. One obvious question is how the debt can be repaid. There are two options, according to Derrick: printing money or foreign investment. Foreign central banks already hold dollar reserves of around US$7trn – approximately 70% of which is in emerging markets. It is doubtful whether many will want to continue adding to their positions indefinitely – on the contrary, they are likely to be considering how best to unwind the positions they already have.
That leaves printing money, leading to inflationary pressure and ultimately devaluation.
In search of safety
Currency markets have always been driven by risk aversion and the US dollar and Japanese yen have been beneficiaries of the highly risk-averse climate that has prevailed in recent months. Both have been viewed as safe haven currencies.
In the case of the dollar this had less to do with the underlying economic picture in the US than with its reserve currency status and the positive influence of repatriated capital. The dollar’s status as the world’s reserve currency has delayed the sell-off that afflicted sterling and other currencies representing highly indebted economies.
Now US policymakers have a dilemma. There are clear advantages to managing the world’s reserve currency, and these depend on the dollar maintaining its value. But the US current account deficit is increasingly expensive to finance, and a depreciating dollar would reduce the deficit and the cost associated with managing it.
According to Jonas Thulin, head of economic research at Nordea in Stockholm, the euro-dollar exchange rate should be around 1.45 – 1.50, compared to around 1.37 at the time of writing. “I expect it to move in that direction over the coming months,” he said.
Global central banks face an even more difficult conundrum. Everybody knows the dollar has to depreciate, but everyone has a vested interest in maintaining its value – or at least ensuring any declines are orderly – because so much of the world’s wealth is denominated in dollars.
“Money is already flowing out of dollar treasuries and into other markets as investors look to diversify,” said Derrick. “Even things like the Brazilian equity markets are beneficiaries of this.” The dollar’s slide is already under way.
The dynamic is slightly different for other currencies. Repatriated capital has also been a positive influence on the yen. Japanese investors were joined by foreigners as risk aversion led to a massive unwind of carry trade positions, exerting significant upward pressure on the yen.
But unlike the US, Japan has sizeable foreign exchange reserves – the second largest in the world – and a high budget surplus. The underlying fundamentals are therefore favourable for Japan in a climate of risk aversion. When risk appetite returns, the outlook for the yen could be turned on its head yet again.
The UK has amassed debt levels comparable to what is seen in the US as a proportion of GDP. Yet paradoxically the outlook for sterling looks relatively good. This is partly because sterling has already seen massive declines against other currencies, so to some extent the debt is priced in. But sterling is also benefiting from central banks’ need to diversify their holdings, said Derrick. One obvious liquid currency to buy is sterling, providing some upward pressure in defiance of the logic working against the dollar. The protection offered by reserve currency status is under considerable strain.
Reversal of fortune
Many FX analysts believe sterling has been oversold, along with the Australian and New Zealand dollars and the Swedish krona, amid fears about the economies underlying them. The countries are seen as high yielders, each with large capital requirements to finance their external debts, said Mitul Kotecha, FX and IR research analyst at Calyon in Hong Kong.
Investors fled the currencies earlier in the year, with the nadir coming for sterling at around 1.35 to the US dollar on January 23, and for the Aussie a few days later at around 0.62 on February 2. Since then things have showed signs of improving and there is a feeling that risk appetite is coming back, and with it optimism for the outlook for these currencies.
The euro saw weakening in the second half of 2008 but has already started strengthening against the dollar in the first half of 2009. It is set to continue strengthening as the dollar continues to weaken, predicted Kotecha. Its appreciation is unlikely to be as dramatic as the moves in sterling, however, due to ongoing concerns about the European financial system, and the slower response seen in Europe relative to the UK.
Thulin agreed the outlook for sterling looks more favourable than for the euro: the former, underpinned by a service economy, looks well placed for recovery relative to the manufacturing-orientated euro. Euro bears can also point to the state of European banks as a cause for some concern. In the UK, although the picture for a number of its domestic banks looks grim, at least most of the problems are thought to be out in the open and their considerable debts have been factored in. This contributed to the pummelling sterling has already taken. Conversely, a number of European banks, for example Germany’s Landesbanks, have been much more secretive about their balance sheets. Some are braced for nasty surprises from them.
Just as debt has become a greater concern to traders in the currency markets, so political concerns appear to concern them less. North Korea’s nuclear test in May might have been expected to cause considerable volatility in the markets surrounding it, particularly Japan and South Korea. In fact, they barely registered the event. Perhaps investors have become accustomed to global political tensions and no longer give them much thought. Or maybe Asia’s vulnerability has already been priced in, but it is still seen as the place to be. Either way, it points to a change in behaviour from the currency markets.
The overall picture, therefore, is one of reversal. The risk aversion that has driven global currencies is in retreat, transforming the prospects of all currencies: the formerly attractive ones look set to endure a more difficult second half of the year, while those that have been shunned find they have come back into favour. In the case of the dollar, this fall is set to be dramatic. It traded up a long way on risk aversion, and should retreat at least as far as it advanced, said Kotecha. This is good news for the US, which has used most of the fiscal and monetary stimulus available to it, and will make US assets progressively more attractive to foreign investors as the trend plays out.
In the longer term the euro looks set to gain influence as central banks continue to sell dollars and replace them with euros. The currency is maturing, and has attained a level of liquidity that positions it as an important global currency, representing an important economic block.
The dollar’s status as the world’s reserve currency came under renewed pressure earlier this year at around the time of the G20 meetings in London in April. China, whose US$2trn of FX reserves mean that it stands to lose the most from dollar devaluation, called for the IMF’s Special Drawing Rights to be the starting point for any new discussions about a global reserve currency.
The not-so-hidden agenda, say bankers, is that China has its own ambitions to provide a reserve currency in the form of the yuan – although obviously it would first need to become freely convertible.
Kotecha doubts any single currency will replace the dollar as the reserve currency. “The euro is a viable alternative for the reserve currency in the long term as it gains liquidity and gains importance in central bank reserves,” he said. “There is no doubt it is gaining importance. But it wont replace the dollar any time soon. Maybe they will come to share that role – with the yuan also coming in as China opens up its currency. It is a more multi-polar world we live in now and I think that will be reflected in currencies.”
That will take years, even decades, to play out. In the nearer term, currencies are likely to broadly maintain current levels over the summer, said Thulin, as the markets gauge the likely severity of the global recession. Currencies are likely to make more pronounced moves – down for the dollar and yen, up for sterling, krona, Aussie and kiwi, as well as some of the emerging markets currencies that have sold off since the crisis began – in the autumn, he added. It will take this long for the extent of the US current account deficit and the disappointing prospects for global growth to properly sink in.
If he is correct, a profitable strategy will be currency pairs trades, with shorts of the Swiss franc, the yen and the dollar paired with longs in the Turkish lira, the Russian rouble and sterling.