Monday, September 27, 2010

Currency meltdown

David Uren has a useful piece this morning suggesting the bull market in gold is presaging a global currency crisis.
If money is a store of value, printing more of it represents a devaluation. These concerns were further fanned last week by the central banks of England and Japan. Minutes of the Bank of England's interest rate setting committee also discussed the need for further quantitative stimulus amid concerns that the recovery may falter. The committee was divided, but the idea is again on the table.

And in Japan, acting on the instructions of the Ministry of Finance, the central bank intervened in the currency market to stem the yen's rise in value, spending the equivalent of $US20 billion ($20.8bn) in a day buying US dollars. The intervention, which pushed the value of the US dollar up from 83 to 85 yen, is funded by the central bank by simply printing more yen.

The increasing intensity of competitive devaluation is a serious issue and Uren is right to highlight it (he doesn't mention that Brazil and Peru also joined the ranks of central banks buying dollars last week). However, when he turns to analysis, Uren loses his focus:
RBS foreign exchange analyst Greg Gibbs, who says the odds are building of a meltdown in major currencies, argues that the ECB will come under increasing pressure to restart its the quantitative easing as its economies suffer from their rising exchange rates.

But what exactly is this looming "meltdown"? Competitive devaluation by the major powers doesn't look likely to trigger any imminent "meltdown" so much as a melt-up in gold.

Devaluation, nonetheless, can signal two other possible crises in the future. First, it is a sign that countries are looking to push a shortfall in demand onto their neighbors. If everyone is doing it at once, and therefore be definition failing, the next steps on the road are toward more obvious and destructive policies that seek the same goal: protectionism.

Second, we must remember that the global economy is a series of concentric circles. The inner and smallest circle is normal commerce and trade. The next circle out is the regular channels of savings and lending, currency exchange and transactions that finance the inner circle. Well foreshadowed fiscal and monetary manipulations of the second circle are normal business, even if more exaggerated now.

The third circle, and by far the largest, is the esoteric and etherial universe of derivatives that help manage and bet upon movements in the second circle. It is here that we will find any trigger for a "currency meltdown".

Like LTCM in 1998, we need to be cautious of an outsized bet, using an exotic instrument and vast leverage, that goes bad because of an unexpected and dramatic move in the underlying currency. The only candidates this blogger can see for this right now is in Europe. If one of the PIGS makes an unexpected move to dump the Euro and return to a dramatically devalued native currency. Such a move could catch a large currency player with his pants down and set off a chain of losses that are impossible to track, thus unhinging confidence and setting off a run on associated currency products. It is Europe that we need to watch.

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