Why No Currency Crisis

The historic financial crisis has taken a toll on every country, every market, and every investor. The innocent have been punished alongside the guilty. There is no play book for policy makers to consult for anything outside the bare essentials. Provide ample liquidity. Use both monetary and fiscal policy levers. Prevent a total collapse of the financial system at all cost. As Federal Reserve Chairman Bernanke put it, just like there is no atheist in a fox hole, there are no ideologues in a crisis. Policy makers have to innovate. And innovate they have. We have all observed the innovations have increased the state’s realm of activities. Yet one key part of the capital markets that the state has by and large has refrained from entering directly is the foreign exchange market. It begs the question: why, so far at least, has there not really a currency crisis?

Humongous Moves

No mistake about it. There have been significant moves in the foreign exchange market. Even though the dollar had already bottomed against three-quarters of the G7 currencies by the middle of July when the euro peaked, we will use that as our starting point. The crisis took on a new dimension as the US Treasury and Federal Reserve circled the wagons around Fannie Mae and Freddie Mac. Oil prices also peaked then.

In the past four months, the euro has lost a fifth of its value against the dollar. Sterling has lost a quarter its value. The Australian dollar, where the Reserve Bank has intervened, has lost a third. Even the Norwegians have seen their krone lose 30%.

These are large moves in a short period of time. In the UK’s case for example, the magnitude of sterling’s decline is roughly on par with what it lost around time it was summarily jettisoned out of the ERM in 1992. But there is no crisis, even if some of the tabloids call it that.

In contrast, the Japanese yen has gained almost 10% against the dollar. This is not significant on a bilateral basis, but consider that is has appreciated dramatically against nearly the rest of the world’s currencies that have depreciated and markedly against the dollar. This is a significant shock to the Japanese economy, which has suffered two consecutive quarters of outright contraction as we now know it.

Japanese policy makers have grown increasingly concerned, beseeching their G7 friends for aid. The G7 were not prepared for coordinated intervention in the foreign exchange market. However they sympathized sufficiently with Japan’s straits, issuing an unusual (because it was not associated with any planned meeting) statement in late October, specifically expressing concern about the volatility of the yen, and its ”possible adverse implications for economic and financial stability.”

The large price swings suggest high volatility. The euro crashed and implied volatility rose. The yen appreciated and volatility increased. Here our metric is three-month implied volatility, a standard measure. To appreciate what has happened consider that around 9/11 events the euro and yen volatility spiked to 14% or so. In the current financial crisis volatility peaked, at least so far, at the end of last month with the euro just below 25% and the yen near 30% the Friday before the G7 statement. Since then, volatilities have eased, though they remain quite elevated, being near 20%.

But No Crisis

The main reason there has not been a crisis is precisely because the currencies were allowed to move as much as they have. The countries that tried to resist, like Iceland and Denmark, have had situations resembling a crisis. Russia, which pegs its currency to a euro/dollar basket, has lost 16% of its value, while the central bank has lost about 20% of its reserves largely in defense of its band.

The sterling decline has been as breath-taking as it was 16 years ago. However it is not a crisis, quite the opposite. The fact that sterling could fall and yet HMT was not obligated to defend some financial Maginot line may be beneficial in a number of respects.

First, given that money markets and bank lending is dysfunctional; the depreciation of sterling can still be a transmission mechanism for monetary policy. Second, the decline in sterling may help mitigate some of the deflationary forces that are headed for the country. Thirdly, many economists see the decline in sterling as wholly desirable given the chronic trade deficit.

Sterling’s weakness does not reflect a sudden loss of confidence in British leadership anymore than the dollar’s strength since the summer reflects a sharp increase in confidence in US leadership or Japanese leadership for that matter. If anything public support for UK Prime Minister Brown has gone up in recent weeks.

Nor does sterling’s weakness reflect concern about the UK’s debt, which undoubtedly will expand sharply. After all Japan has a gross debt of more than twice the UK’s and the US debt is set to increase much more dramatically.

The Danes may take away from this crisis a newfound willingness to consider monetary union. Ironically this crisis may strengthen the resolve of the euro-skeptics and maybe even win some converts in the UK. One important lesson from the crisis is that countries should either let their currencies float or adopt another currency which will float against every one else not in that union.

Under a different regime, it is entirely reasonable to believe that there might have been a currency crisis in Europe. The worst regimes are compromise formations, such as pegs, ranges, or bands. These all require defenses (forget the bazooka in one’s pocket ploy, been there, done that and got a t-shirt) and the sacrifice of other policy objectives. Intervention that is meant to smooth out a currency’s movement may be consistent with that of floating currencies.

Currency Adjustment Mostly Beneficial

From another angle, perhaps the reason there has not been a major currency crisis yet is because what is happening in foreign exchange is a resolution of the larger financial crisis. At the heart of the financial crises lies leverage; the bizarro doppelgänger resulting from the miracle of compounding. Said leveraging was financed primarily with dollars, yen and to a lesser degree Swiss francs, and Hong Kong dollars.

Dollar and yen were borrowed and earned, converted and then lent far and wide. As a result there is a substantial short dollar and yen position that needs to be covered. The dollar and yen’s strength are a reflection of a deadly serious global margin call. This is what their rising price is trying to allocate. Contrary to the argument of the perma-dollar bears, that sees a large surfeit of dollars in the world; what is being experienced now is a great dollar shortage. This is also a factor behind the higher dollar interest rates offshore. Short-term momentum traders have jumped aboard anticipating and amplifying the carnage.

Part of the leveraging is a currency mismatch. The current de-leveraging appears to be one of the most powerful forces that have propelled the dollar and yen higher. Just as the leveraging process helped drive the major foreign currencies except the yen to unprecedented high levels relative to robust measures of PPP (IMF/OECD), the de-leveraging process is pushing the currencies, including the yen, back toward PPP. The sharp drop in sterling has pushed it back below its PPP measure, which is not surprising. PPP, as we know, does not represent support or resistance.

Defining the sharp currency moves as a crisis is dangerous. It requires a policy response. There would be grave and potentially disastrous consequences if the policy makers were to interfere in the foreign exchange market, which is essentially reflecting real supply and demand generating by the de-leveraging process. It is working as it should and there has not been a crisis because officials have largely been smarter enough to leave well enough alone.