Tension over exchange rates

Amid heightened fears over eurozone sovereign debt risks and increasing concerns about the health of the United States and eurozone economies, worried investors have flocked to the safety of haven currencies, especially the Swiss franc, and gold.

While investors and speculators have since moved aggressively to buy gold, the switch from being large sellers to buying by a number of emerging nation's central banks (Mexico, Russia, South Korea and Thailand) has helped propel the price of gold more than 25% higher this year, hitting a record US$1,920 a troy ounce earlier this month. At a time of high uncertainty in the face of the International Monetary Fund's (IMF) latest gloomy forecast on global growth, few central banks relish the prospect of a flood of international cash pushing their currencies higher.

Massive over-valuation of their currencies poses an acute threat to their economic well-being, and carries the risk of deflation.

The Swiss franc

Switzerland's national currency, the CHF, should be used to speculative attacks by now. So much so in the 1970s, the Swiss National Bank (SNB) was forced to impose negative interest rates on foreign investors (who have to pay banks to accept their CHF deposits).

And, it has been true in recent years, with the CHF rising by 43% against the euro since the start of 2010 until mid-August this year. There does not seem to be an alternative to the CHF as a safe haven at the moment.

With what's going on in the United States, eurozone and Japan, investors have lost faith in the world's two other haven currencies: US dollar (USD) and the yen.

This reflects the Federal Reserves' ultra-loose policy stance and the political fiscal impasse in the United States which have scared away investments from the dollar. The prospect that Tokyo might once again intervene to limit the yen's strength has deterred speculators from betting on further gains from it. To be fair, the CHF has also benefitted from recent signs that the Swiss economy, thanks in large part to its close ties to a resurgent Germany, is thriving.

But enough is enough. SNB made a surprising announcement on Sept 6 that it would buy foreign currencies in “unlimited quantities” to combat a huge over-valuation of the CHF, and keep the franc-euro exchange rate above 1.20 with the “utmost determination.”

On Aug 9, the CHF reached a new record, touching near parity against the euro from 1.25 at the start of the year, while the USD sank to almost CHF 0.70 (from 0.93). The impact so far has been positive: the euro rose 8% on that day and the 1.20 franc level had since stabilised. It was a gamble.

Of course, SNB had intervened before in 2009 and 2010, but in a limited way at a time when the euro was far stronger. But this time, with the nation's economy buckling under the currency's massive over-valuation, the risks of doing nothing were far greater. In July last year, following a chequered history of frustrated attempts, SNB vowed it would not intervene again. By then, the central bank was already awash with foreign currency reserves. Worse, the CHF value of these reserves plunged as the currency strengthened. In 2010, SNB recorded a loss of CHF20 billion, and a further CHF10 billion in 1H'11. As a result, SNB came under severe political pressure for not paying the expected dividend. But exporters also demanded further intervention to stop the continuing appreciation.

This time, SNB is up against a stubborn euro-debt crisis which just won't go away. True, recent efforts have been credible. Indeed, the 1.20 francs looks defensible, even though the CHF remains over-valued. Fair value appears to be closer to 1.30-1.40. But inflation is low; still, the risk of asset-price bubbles remains. What's worrisome is SNB acted alone. For the European Central Bank (ECB), the danger lies in SNB's eventual purchases of higher quality German and French eurozone government bonds with the intervention receipts, countering the ECB's own intervention in the bond market to help weaker members of Europe's monetary union, including Italy and Spain.

This causes the spread between the yields of these bonds to widen, and pile on further pressure on peripheral economies. Furthermore, unlimited Swiss buying of euro would push up its value, adding to deflationary pressures in the region.

The devil's trade-off

As I see it, the Swiss really has no other options. SNB has been attempting to drive down the CHF by intervening in the money markets but with little lasting effect. “The current massive over-valuation of the CHF poses an acute threat to the Swiss economy,” where exports accounted for 35% of its gross domestic product. The new policy would help exports and help job security. As of now, there is no support from Europe to drive the euro higher.

SNB is caught in the “devil's trade-off,” having to choose risking its balance sheet rather than risk “mounting unemployment, deflation and economic damage.” The move is bound to cause distortions and tension over exchange rates globally.

New haven: the Nokkie'

SNB's new policy stance has sent ripples through currency markets. In Europe, it drove the Norwegian krone (Nokkie) to an eight-year high against the euro as investors sought out alternative safe havens. Since money funds must have a minimum exposure in Europe and, with most European currencies discredited and quality bonds yielding next to nothing, the Nokkie became a principal beneficiary. It offers 3% return for three-month money-market holdings.

Elsewhere, the Swedish krona also gained ground, rising to its strongest level against the euro since June after its central bank left its key interest rates unchanged, while signalling that the rate will only creep up. What's worrisome is that if there is continuing upward pressure on the Nokkie or the krona, their central banks would act, if needed with taxes and exchange controls. With interest rates at or near zero and fiscal policy exhausted or ruled out politically in the most advanced nations, currencies remain one of the only policy tools left.

At a time of high uncertainty, investors are looking for havens. Apart from gold and some real assets, few countries would welcome fresh inflows which can stir to over-value currencies. Like it or not, speculative capital will still find China and Indonesia particularly attractive.

Yen resists the pressure

SNB's placement of a “cap” to weaken the CHF has encouraged risk-adverse investors who sought comfort in the franc to turn to the yen instead. So far, the yen has stayed below its record high reached in mid-August. But it remains well above the exporters' comfort level.

Indeed, the Bank of Japan (BoJ) has signalled its readiness to ease policy to help as global growth falters. But so far, the authorities are happy just monitoring and indications are they will resist pressure to be as bold as the Swiss, for three main reasons: (i) unlike to CHF, the yen is not deemed to be particularly strong at this time it's roughly in line with its 30-year average; (ii) unlike SNB, Japan is expected to respect the G-7's commitment to market determined exchange rates; and (iii) Japan's economy is five times the size of Switzerland and the yen trading volume makes defending a pre-set rate in the global markets well-nigh impractical.

Still, they have done so on three occasions over the past 12 months: a record 4.51 trillion yen sell-off on Aug 9 (surpassing the previous daily record of 2.13 trillion yen from Sept 2010).

The operation briefly pushed the USD to 80.25 yen (from 77.1 yen) but the effects quickly waned and the dollar fell back to a record low of 75.9 yen on Aug 19. But, I gather the Finance Ministry needs to meet three conditions for intervention: (a) the yen/USD rate has to be volatile; (b) a simultaneous easing by BoJ; and (c) intervention restricted to one day only.

Given these constraints, it is no wonder MOF has failed to arrest the yen's underlying trend. In the end, I think the Japanese has learnt to live with it unlike the Swiss who has the motivation and means to resist a strong currency.

Reprieve for the yuan

I sense one of the first casualties of the failing global economic expansion is renewed pressure to further appreciate the yuan. For China, August was a good month to adjust strong exports, high inflation and intense international pressure. As a result, the yuan appreciated against the USD by more than 11%, up from an average of about 5% in the first seven months of the year. However, the surge had begun to fade in the first half of September.

But with the United States and eurozone economic outlook teetering in gloom, China's latest manufacturing performance had also weakened, reflecting falling overseas demand.

This makes imposing additional currency pressure on exporters a no-go. Meanwhile, inflation has stabilised. Crude oil and imported food prices have declined, reducing inflationary pressure and the incentive to further appreciate the yuan. Looks like September provided a period of some relief. But, make no mistake, the pressure is still there. The fading global recovery may have papered over the cracks. Pressure won't grind to a halt.

Central banks instinctively try to ward-off massive capital flows appreciating their currencies. There are similarities between what's happening today, highlighted by the recent defensive move by SNB, and the tension over exchange rates at last year-end. It's an exercise in pushing the problem next door.

This can be viewed as a consequence of recent Japanese action (Tokyo's repeated intervention to sell yen). It threatens to start a chain of responses where every central bank tries to weaken its currency in the face of poor global economic prospects and growing uncertainty. So far, the tension has not risen to anything like last year's level. But with rising political pressure provoking resistance to currency appreciation, the potential for a fresh outbreak remains real. The Brazilian Finance Minister just repeated his warning last year that continuing loose US monetary policies could stoke a currency war.

Growing stress

With the euro under growing stress from sovereign debt problems, the market's focus is turning back to Japan (prompting a new plan to deal with a strong yen), to non-eurozone nations (Norway, Denmark, Sweden and possibly the United Kingdom) and on to Asia (already the ringgit, rupiah, baht and won are coming under pressure on concerns over uncertainty and capital flight). Similarly, Brazil's recent actions to limit currency appreciation highlights the dilemma faced by fast growing economies (Turkey, Chile and Russia) since allowing currency appreciation limits domestic overheating but also undermines competitiveness.

This low level currency war between emerging and advanced economies had further unsettled financial markets.

Given the weak economic outlook, most governments would prefer to see their currencies weaken to help exports. The risk, as in the 1930s, is not just “beggar-thy-neighbour” devaluations but resort to a wide range of trade barriers as well. Globally co-ordinated policies under G-20 are preferred. But that's easier said than done.

So, it is timely for the IMF's September “World Economic Outlook” to warn of “severe repercussions” to the global economy as the United States and eurozone could face recession and a “lost decade” of growth (a replay of Japan in the 90s) unless nations revamped economic policies. For the United States, this means less reliance on debt and putting its fiscal house in order.

For the eurozone, firm resolution of the debt crisis, including strengthening its banking system. For China, increased reliance on domestic demand. And, for Brazil, cooling an over-heating economy. This weekend, the G-20 is expected to take-up global efforts to rebalance the world overwhelmed by heightened risks to growth and the deepening debt crisis. Focus is expected on the role of exchange rates in rebalancing growth, piling more pressure on China's yuan.

Frankly, IMF meetings and G-20 gatherings don't have a track record of getting things done. I don't expect anything different this time. The outlook just doesn't look good.