FX debate - Investing in FX: learning history lessons

CKG, Société Générale Many financial institutions, but not all, have in some ways overstretched themselves in the past. They have either overly relied on shorter-term borrowing which they could not roll; or overly invested in assets whose risk profiles proved far more toxic than they could have ever expected. In hindsight, they were overly leveraged. These excesses are being removed and with dramatic consequences on the capital levels of banks.

We are probably somewhere between halfway and two-thirds through this process. At the end of it, the banking industry will look very different – witness a lifetime of changes already since the demise of Lehman Brothers. The hedge fund industry may have just half the assets under management it did at the peak. It is easy to understand why there is a broad lack of optimism currently.

Our next challenge will be the economy.

DB, HSBC The impact on the real economy only really started in October of this year. Even once deleveraging is over, after the fire you’ve still got to walk into the building and assess the damage. We haven’t come close to looking at the problems for the real economy. It will take years before the process has run its course.

EP, UBS The process we’re witnessing is a deleveraging of the private sector but a leveraging up of the public sector. The number of fiscal stimulus plans announced by governments worldwide and the recent growth in the Federal Reserve’s balance sheet are good examples.

Can central banks fix problems?

PL, Polar Capital Do central banks understand what is going on and are they in control?

DB, HSBC Part of the euphoria associated with the bounce in mid-November was that central banks started to understand the problem. The fear remains that the central banks don’t have the tools to fix this.

PL, Polar Capital Is it that they don’t have the tools or that the tools don’t exist?

DB, HSBC The standard policy tools don’t work any more. You could argue that the transmission mechanism of monetary policy is effectively broken – we are heading into a Japanese-type situation. We are turning to big government and fiscal policy as a possible policy solution.

RO, Oanda There is a big issue with governments increasing leverage. That will haunt us.

PL, Polar Capital Do you think they shouldn’t be doing that?

RO, Oanda For political reasons they have no other choice, but it is wrong.

PL, Polar Capital You think it is economically wrong?

RO, Oanda It is as if Keynes hadn’t written the extra chapter to his book. He didn’t mean that governments should intervene so much that they themselves go bankrupt – and this is what they are heading for.

PL, Polar Capital What is the alternative?

RO, Oanda In private they should be clear that this cannot continue. They have to address the problem at its core. To the outside world they have to appear to protect the status quo. They have to do this on the one hand but at the same time they have to be honest within the closed group and initiate reforms at the core.

PL, Polar Capital What is the core problem that they need to fix?

RO, Oanda We have not invested in solid technology to understand financial markets. If you compare the financial industry with other industries, such as computers, cars, pharmaceuticals, these other industries have huge research and development budgets with ten of thousands of researchers. In economics and finance, this does not exist. No one has done the ground work.

DB, HSBC I take issue with the statement that governments have no option. We are facing the paradox of thrift, which is that as unemployment rates go up, we will save more and consume less – and for every corporate and individual round this table, that may be the correct decision, but collectively it’s the wrong decision. Governments have to break the savings mentality, otherwise we will save more, consumption will go down and unemployment will go up and we will be in a deflationary spiral.

OG, SGAM I would not say that central banks are completely impotent. They can prevent a systemic crisis and long-term deflation as occurred in Japan. What they cannot do is prevent a recession. The lags will be very long, so they can just be there to prevent a long-term depression. The question is whether through fiscal policies governments can add stimulus. There is currently a transfer of risk from the private sector to the government sector. Governments can temporarily play the role of risk absorber as a last resort but because most of them in Europe and in the US are already highly leveraged, they cannot do that over the long term, unless they become a new breed of giant hedge funds.

The key question is whether we will find long-term investors, such as pension funds or insurance companies, able to take the relay of governments over the longer term. It is unlikely that these investors will do that in the near future. Most of them are also subject to pro-cyclical regulatory or accounting rules. So it is difficult to see who could take the risk burden.

The question is whether we will find new investors such as pension funds or insurance companies that can take the relay and it is difficult to imagine that they are ready to do that. They also have constraints and procyclical behaviour, so it is difficult to see who could take the risk burden.