Firstly let me wish all my readers a very Merry Christmas and may I suggest you enjoy it and get some rest and relaxation in as I am expecting plenty of action in 2011! I will not wish you a Happy New Year yet as I will do at least one update in the holiday period although unless something extraordinary happens I will not update every day. Although my plans involve following events in Melbourne I will keep a watchful eye particularly on Japan who has in the past developed the habit of making moves when the gaijin are on holiday. I often enjoy the start of the Boxing Day test whoever is playing but this year has added incentive.
Exchange-Rates and the Carry Trade
One of the factors that has led to the distress of recent years has been the carry trade. For those that are unfamiliar with it let me give an example of how it works. If you do it the interest-rate in your own currency will be higher than the interest-rate of the currency you intend to borrow. For example the countries whose currency was most borrowed for this purpose Japan and switzerland had low interest-rates in the middle of the last decade whereas many parts of Eastern Europe had high single figure interest-rates. Accordingly each year there is an interest-rate or carry profit and in some cases this was fairly substantial.
T o put this into numbers you could borrow in Swiss Francs at just over 2% for ten years at the beginning of 2005. In comparison the Hungarian official short-term interest-rate was 9.5% and she had various ten-year government bond auctions mostly yielding over 7%. So the attraction is obvious for all the players in this. The margins are so wide that the banks arranging the transaction can pocket quite substantial fees and yet still offer what on the face of them are attractive products. For the borrower the attractions of lower monthly payments and is some cases substantially lower are plain.
1. There was an insidious danger in all this which was not thought through except perhaps sadly by the unscrupulous. This carry trade became very popular in Eastern Europe and in fact became such a feature that it began to become so large that it affected the Swiss Franc exchange rate. This then fell due to the weight of money and it began to appear that not only were there interest-rate profits available but capital gains. I think we can imagine without too much effort the unscrupulous advising individuals and companies that both types of profit were available.
The obvious problem is that as even more were attracted to the scheme the problem of an exit strategy got worse. How could this ever be reversed without having the effect of raising the value of the Swiss Franc ? The answer is that it could not and in fact has been taking place recently when the Swiss Franc has been strong due to its safe haven status and a period where gold has done well. The error was the size of the trade which was much too large for the size of the Swiss Franc exchange rate market.
2. I am sure that some were encouraged to borrow more as monthly repayments under such a scheme would be much lower than before. If you think of a mortgage affordability calculation under the new lower interest-rates the possible implications become plain. I guess by now you will not be surprised there was something of a house price boom in Hungary.
3. There are considerable implications for the countries whose exchange-rate has been borrowed and the smaller the economy the more likely it is that it will be swamped. I have concentrated on Switzerland here but different flows of money also swamped Japan and the Yen which is a much bigger economy. They find that their currency is artificially depreciated at one phase of the arrangement and later artificially appreciated at the final stages.
Where we stand now
In 2010 both the Swiss National Bank and the Bank of Japan have tried to fight such tendencies and so far they have failed. Actually my opinion is that they never stood a chance. I expressed my views on currency intervention back in late August and am intrigued to notice that Union Bank of Switzerland now agree with me,perhaps they still follow ex-employees!
Added to this is a theory that I have developed which goes as follows, talk of official exchange rate intervention seems to encourage markets to take the proposed intervention on and I think that we saw some of this yesterday. Sometimes they get bored easily and move onto other matters.
So there are real dangers to my mind in foreign currency intervention and it usually does not work. You might not get that impression from the media who like such news stories but it is true. Politicians like to be seen to do something and so the Bank of Japan may come under increasing pressure but it should hold fire in my view.Markets may concentrate on something else in the short-term which would help and if this is a long-term move then there is little it can do anyway. Accumulating more unrealised losses improves nothing. Sometimes you have to accept the limits of what can be achieved.
In practice the Bank of Japan tried various measures to restrain the Yen and certainly directly intervened once when the exchange-rate was at 83 versus the US dollar and maybe once or twice more. With the exchange rate at 82.89 as I type this is hardly a success but of course we never know how event would have unfolded otherwise.
The Swiss National Bank intervened much harder in 2010 and has lost heavily. At the end of the first half of 2010 it had lost some 14.3 billion Swiss Francs and at an exchange rate of 1.26 as I type the situation is worse now. It looks as though she may have tried again yesterday but why she thinks it will succeed now I do not know. Either way trapped between a possible exchange-rate inspired deflation and exchange-rate losses I would imagine it will not be a very happy Christmas at the SNB. If she keeps this up she may well become another central bank whose financial position becomes questioned.
A worrying thought
One of the reasons I wanted to discuss this issue today is that it is topical and relevant as the Swiss Franc has been strong this week and the economic problems surrounding Hungary have led to her being downgraded by Fitch to BBB-. But there are two points of further news. Earlier in the week I saw that one of the ratings agencies had reaffirmed Austria’s AAA credit rating.Yes the same Austria whose banks were so heavily involved in the carry trade. Secondly I notice that some analysts are saying that there are attractive opportunities in a carry trade against the Euro!
Put another way these two points illustrate how little actual reform we have had since the credit crunch as in the words of David Byrne of Talking Heads it appears that it is indeed (the) ” Same as it ever was”.