The “Currency twins” rally causing economic turmoil as Japanese equities fall nearly four percent and who exactly voted for the IMF?

After Friday’s rallies in world equity markets yesterday came as something of an about-face. The Dow Jones Industrial Average fell some 140 points to lose nearly all of Friday’s gains. The feeling of well-being engendered by better than expected US growth figures and a relatively optimistic speech by Ben Bernanke does not appear to have lasted for long. I guess as I pointed out yesterday markets started to think of the implications for the future of the US economy in the trend for GDP figures who have gone 5%,3.7% and now 1.6%. Perhaps also they began to wonder about the limit to the powers of the Federal Reserve and the four options outlined by Mr. Bernanke. After all he has deployed the resources of the Federal Reserve to the order of US $1.3 trillion and cut rates to just over zero and yet we still face a situation where the US economy is plainly slowing.

Personally as time passes and more perspective is gained I feel that option 2 as described by Mr. Bernanke actually looks rather unwise to say the least. “Better communication” is likely to be of no use when it is communication about  the Fed. keeping rates lower for longer. After all if markets have not taken that on board with the rush to reduce US government bond yields along the maturity spectrum I do not know what they have been doing recently. The US two-year government bond yield is 0.5% and the five-year is 1.37% so really option two is already in the markets.

US Personal Income and Personal Consumption

These figures give us in one sense a clear signal about the state of the US economy and that is how many people are interested in them this time around! Over the years they have been issued to a fair bit of indifference whereas now they are much more widely debated and analysed, and this is because every little rune and signal from the US economy is being poured over to try to find out where it is going. The actual numbers themselves showed personal income rising by 0.2% which was less than expected and also less than personal consumption which rose by 0.4%. So spending rising at a faster rate than incomes at a time the economy is slowing is not entirely reassuring if you think through the likely implications. The savings rate which has improved since the credit crunch dipped back to 5.9%. So not inspiring figures but not in themselves enough to cause the equity market drop on the scale that occurred, in my view.

The Japanese economic and indeed cultural problem

After the turnaround in US equities one might reasonably have expected falls in Japanese equities too overnight, particularly as I recorded yesterday that the initial response to the so-called policy easing by the Bank of Japan had been for markets to push the Yen higher against both the US dollar and the Euro. However there were in fact quite substantial falls with the Japanese Nikkei 225 index falling some 325 points to 8824 which is 3.55% and the wider Topix index fell by 2.96%. So in spite of a solid fall in the Dow Jones the spread between the two indices widened substantially again to 1185 points which is 13.4% of the value of the Nikkei. This is a large relative underperformance and leaves the Nikkei solidly in bear market territory if you use the definition of a 20% drop being the boundary.

There are two main problems in Japan in terms of official economic policy. The first is that most if not all policy options have been tried. The second is that the Bank of Japan is usually at loggerheads with the government. So political pressure builds up from time to time on the central bank which in my view responds with a policy move which involves as little as it can get away with. This is why I called Monday’s move a so-called policy easing as it is a new variation on a scheme introduced last November which has already been expanded once and has shown no real signs of helping Japan’s economic problems. The government is invariably cautious about using fiscal policy because the size of the national debt in gross terms is over 200% of GDP and looks on its way to 250% by the middle of this decade. Just to add to the caution about fiscal policy the new government of Mr.Kan had set reducing the deficit and the national debt as a main policy goal. Rather unfortunate timing for him as I am sure the contradiction between policy and possible reality has contributed to the leadership challenge he is suffering from.

I wrote last week that I felt it would be better if the Japanese authorities stayed out of any intervention for a while to see if markets settled down. In the end pressure for action led to the move on Monday which so far has made things worse. Against the Euro the exchange rate has moved back towards the recent highs and is now at 106.86 whilst against the US dollar it is at 84.29. At least they did not make the mistake of foreign currency intervention but I guess that needs the caveat of so far. This morning the Ministry of Finance is suggesting that Japan could have an inflation target and that the Bank of Japan could cut rates to zero. I would forgive the Governor of the Bank of Japan if he bashed his head against the wall at this point as his institution has been battling Japan’s deflation and disinflation for years and interest rates are at 0.1% so the gain would be 0.1%. What is needed is new ideas and not headline grabbing.


Whilst all this is going on Japan’s population is ageing and her national debt is rising so these two trends are pointing towards insolvency. Now this is a slow-moving influence but in a country where the lost decade has now extended into two lost decades a lot of ground has already been lost. I was reading a report recently which pointed out that even in the relatively good years in this period Japan’s fiscal position has declined. Her government bond market has yields which are domestically driven due to Japan’s high savings rate and are as low as they are partly because Japan’s disinflation means that real yields exceed nominal ones for the domestic buyer. But even so an interest rate of 1.7% on a thirty-year government bond is completely mispriced in my view if you look at a thirty-year timescale and likely economic events for Japan. It is by no means inconceivable that she could be forced into some sort of default over this period if current rends persist and remember many of these pre-date the credit crunch. It is tempting to add the level of disinflation to the nominal yield to raise the real yield but I doubt even Japan can keep that up for thirty years without some sort of economic collapse. In some ways Japan resembles a dam which is starting to creak under pressure. From the other side of the dam there is no problem until it goes but then you get flooded and probably drowned whereas a second before you were dry. Yet to an engineer there would have been signs and signals.

The Swiss Franc and Hungary’s problems

Looking at the strength of the Japanese Yen has made me think of her twin the Swiss Franc. She too is surging as a currency and all of the problems for Switzerland and her central bank are back again to say nothing of the economic woe this rise will cause in Eastern Europe and particularly Hungary as they borrowed in Swiss Francs on a large-scale. Today the Swiss Franc has rallied to 1.292 versus the Euro a new high for a currency which was steady at just over 1.5 a year ago.

The implications of this are bad enough for Switzerland who finds herself saddled with an uncompetitive exchange rate. They are even worse for the Swiss National Bank which has spent much of this year intervening to try to stop this rise. Before this recent further rally the SNB was estimated to be sitting on losses of 7.5 billion Euros because of this failed intervention and these are mounting as I type.

Hungary and Eastern Europe

Many countries in Eastern Europe borrowed in Swiss Francs and I wrote about the problems caused by this on the 10th June and the 19th July . They did so because the interest rate cost was lower in many cases much lower, but the risk is that the currency you borrowed then rises. To look at the numbers and concentrating on Hungary where this was and is a big factor some 1.7 million mortgages were taken out in Swiss Francs and the total sum borrowed is estimated at around half of her GDP. At the opening of this year the exchange rate between the Hungarian Forint and the Swiss Franc was 182 and right now it is 222 for an increase of 22% in eight months. Imagine that being applied to your mortgage debt and I hope everyone gets the idea of the economic drag this situation is likely to cause if it persists.

So bad for Eastern Europe’s economies and also bad for the banks in the euro zone which loaned the money. Shareholders in the banks who loaned this money may well be getting nervous and as ever we come back to the state of Europe’s banks. Officially according to the stress tests they are fine, unofficially problems continue.

The International Monetary Fund

The IMF has announced a “Crisis Prevention Toolkit”. Of course the title suggests something which might more usefully have been applied some four or five years ago rather than now! In a nutshell it has extended its Flexible Credit Line and created a new Precautionary Credit Line for those who do not qualify for the FCL.This leads me to a reply I made to a question about the Triffin Dilemma yesterday. The work of Mr.Triffin led to the existence of Special Drawing Rights and laid the bedrock for an expansion in the role of the IMF.

The second is that his work led to the construction of Special Drawing Rights at the IMF, it is not clear to me that they have turned out to be an improvement as they are in effect a creation of fiat money but by who? Put this another way do we have the right number of SDRs?

If we put aside for a moment the question of whether the world economy has ever been in equilibrium and remain with the IMF.It’s role is expanding and yet whose voters elected it? Personally I would question its authority as it is too easy for usually weak politicians to encourage or allow it to create yet more fiat money. I think Quis custodiet ipsos custodes  is relevant here.


7 thoughts on “The “Currency twins” rally causing economic turmoil as Japanese equities fall nearly four percent and who exactly voted for the IMF?

  1. Thank you again for your commentary both yesterday and today. On Charles Bean it is useful to compare his analysis of asset bubbles, credit crunches,central bank benign neglect of them and the threats they pose to financial stability in his speeches of 2003/04 to that contained in his Jackson Hole paper this August. You would hope to see more humility and less academic machismo!

    On central banks, they face a huge wall of household,corporate, sovereign and financial deleveraging. You’ve mentioned their relative weakness in the foreign exchange markets. An analogy can be made to their relative weakness in the face of this western democratic pay-down, for which they feel partly responsible.Dress it up as many ways as you like but monetising and inflating the debt could summarise the tactic. The Bank for International Settlements are raising a red flag on the temptations to policy-makers.

    Finally, I’ve read of large increases in Chinese purchases of Japanese and Korean Treasuries and a reduction of their dollar holdings of US debt ( not necessarily linked). Perhaps some power is slipping away from central banks towards surplus countries who can exercise more subtle influences on foreign exchange and bond markets? I see dangers ahead.

    • I am afraid that Charles Bean’s speech at Jackson Hole was disppointing in that he copied pretty much the arrogance and lack of humility of Kate Barker’s valedictory speech. Nelson put his blind eye to the telescope to achieve a victory I am afraid the MPC are doing it to avoid having to properly address what certainly was not a victory.

  2. Perhaps one lesson of the Japanese experience is that credit excesses may reduce the power of central banks to engineer a bit more or a bit less inflation and confront them with a stark choice between deflation and hyper-inflation (after all, I guess no-one doubts that the Bank of Japan could create inflation by, say, creating a new bank account for every citizen and putting the equivalent of 100,000 Pounds in it).

  3. From today’s post and previous posts, I sense you are deeply uneasy about the role and accountability of the IMF. I agree with your point that only an elected, accountable sovereign government has the right to issue a currency. However, if you believe that the Triffin dilemma is a real issue, then how else can it be solved other than by a supranational reserve currency? (presuming a gold standard is not desirable!) In many ways though, any supranational reserve currency like the SDR would face the same issues as the Eurozone, would it not? i.e. it would be a monetary union but not a fiscal union. Without some sort of redistributive mechanism, surpluses and deficits would be run up just the same. In my opinion this all comes back to the desirability of completely unregulated capital flows and trade for trade’s sake. We have globalized trade and finance without effective globalized government, and this inevitably creates imbalances and perverse incentives. The US played the role of world government for most of the 20th century, but there are signs that this will not last. Perhaps the EU can show us the way if it succeeds with its ‘cart before the horse’ experiment of monetary union, and the same sort of trick could be pulled off with an SDR reserve currency – I wouldn’t put money on it though 😉

    • Hi Graeme
      You are right that I am troubled by the current role and authority of the IMF. Its current incarnation as a type of “International Rescue” makes me think that whilst some IMF may be good more is not necessarily better and in fact is dangerous. The expansion plans of the spring of 2009 have given politicians more money to play with without the need to trouble their electors. For example nobody really believes it is in Greece to help with a balance of payments problem do they?

      The more I think of SDRs the less I like them. However after being asked the question about the Triffin Dilemma I have mostly been thinking of the nature of equilibrium as his worries were essentially that we might fall out of it. This poses the immediate question of whether the world was in one then or has ever been in one. It also poses the question of whether an equilibrium is always a good idea. Also would we know it if we were in it? Probably not. There have been quite a few economic theories looking for equilibrium values that have failed, I wonder if the concept itself is flawed. In a world where many financial markets are driven by computer algorithms for better or worse we are in an unstable environment right now with no immediate end in sight.

      As to effective globalized government I am afraid that I see few signs of effective government right now let alone a global version of it.

  4. Hi Shaun,

    I am really amazed about the amount of CHF mortgages in Hungary. 1,7 million in a country of 10 million? So 1 in approximately every 2 families has such a mortgage to pay for?

    Looks like for the years to come the HUF-CHF exchange rate is a bomb which can explode the whole economy anytime.

    Is there any way out?

    • Hi Angelo
      The numbers are somewhat disturbing to say the least and begs the question of what Hungary’s regulators were doing over that period. Taking a mortgage in a currency that is different to the one you earn your money is a high risk game. They have gained on interest payments but in real life we know these have a way of being spent and now capital losses are rising.
      Looking at Hungary these lower rates of interest probably boosted the economy as consumption is likely to have been higher and it is likely to have supported house prices too. What can they do? The government could return to the table with the IMF which may help a little but they are also subject to worldwide events a bit like a cork on a sea. As to what else they could actively do it is hard to see as the Swiss Franc is attracting foreign investment and the price of the mortgages always involved being dependent on overseas events. It is not a lot of help to say that they should hope that this phase passes and the Swissy falls from grace…

      Rather ironically Switzerland is trapped by this too as their exchange rate becomes ever more uncompetitive and will over time affect her trading industries. In a way they are more hard done by because the only thing the Swiss did in this operation was be Swiss.

      For now the only real way out would be for Hungary’s courts to find a way of ruling part or all of the loans illegal..

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