FX debate - Investing in FX: learning history lessons
Deleveraging is the key word of the moment and there is still a long way to go for banks and hedge funds. Beyond that, the impact in the real economy of the banking crisis is only just starting to appear. The tools at governments’ disposal may not be strong enough to handle the challenge. Is a raft of new regulation inevitable?
Euromoney’s panel debates the issues in the first of a two-part debate.
Part 2: Foreign exchange debate: The future’s bright despite the tough fines
Delegate biographies: Learn more about the panelists
• Deleveraging still has a long way to go
• The tools at governments’ disposal may not be effective
• Avoiding Japan’s deflation experience is a big challenge
PL, Polar Capital If you had to use one word to describe what is going on in the global economy it is deleveraging. Where it will end?
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.
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.
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.
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.
CKG, Société Générale I think Olivier’s concerns are clearly expressed by what happened in Iceland. Here’s a country where the liabilities of the banking industry dwarfed the economy. When we look at the market’s pricing of sovereign CDS levels in Europe, there is clearly a bias against the smaller, more highly indebted countries. Clearly, the market is suggesting there is the possibility of more Icelands out there.
CKG, Société Générale You’re right. But let’s play Devil’s advocate for one moment, if you would allow me. I think the market is taking this one step further. While I may not share its conclusion, the argument proffered by some goes something like this. In order to avoid Japan’s "lost decade", western economies will extend debt guarantees for their banks and underwrite further substantial liabilities. If we would go even part of the way Japan did with its debt expansion, we note that Japan’s GDP/debt ratios reached extraordinary levels, possible only because of its extensive savings pool. Applied in Europe, such debt levels could possibly undermine the foundations of the euro itself. It’s not my core view, but it’s out there.
DB, HSBC I take the opposite view. This is exactly the time when there are advantages in being in the euro. Even the UK may start considering it again.
CKG, Société Générale I agree with you David, the euro has been a source of stability, but there is a belief out there that we may be in for a challenge to its status with all that might entail for the usual suspects.
DB, HSBC This is the time during a crisis when you want to be in the big economies because, as you say, the small economies get smashed and the big survive.
CKG, Société Générale We are aligned David, but let me continue with playing Devil’s advocate. The argument goes further to remind us that the euro is based on Economic and Monetary Union, and not on Political Union. If the global economy is due for a protracted recession, then the outlook for those locked into the euro at non-favourable currency levels is potentially challenging. The terms of trade of these countries could get much worse, possibly worse than those seen in 1992 when ERM fragmented. With limited policy options to support their own economies in the euro, ie, limited ability to set their own independent interest rates, or devalue their own currencies, what will the challenged countries do?
DB, HSBC Hungary would have been a beneficiary had it been in the euro. If Italy had been out of the euro it would have been in Hungary’s position. The attraction of being part of the euro is greater than ever.
CKG, Société Générale I think you are right. But I wonder whether the existing euro members are going to be as enthusiastic about future new joiners as they have been, given the budget challenges ahead they all face?
Exchange rate inflexibility
PL, Polar Capital To what extent has exchange rate inflexibility globally, thinking particularly about China, contributed to the situation? Part of the reason leverage has been able to grow to the extent that it has is because central banks have had inflation targets. Inflation has been very low because deflation has been exported by Asia, which has been allowed to keep exchange rates at very competitive levels. Now Asia is seen as part of the solution because of the reserves that they have built up while keeping their exchange rates at competitive levels. Is China the solution or was it the cause?
OG, SGAM Global excess liquidity resulted from market and coordination failures. First, excess saving in areas such as China and the Middle East could not be recycled domestically, because local capital markets were not sufficiently developed. As a result, this excess saving flooded into US markets, and indirectly contributed to the credit bubble. Second, the Fed de facto became the world central bank, due to the increased role of the US dollar as the world anchor currency. However, the failure was that the Fed continued to run monetary policy with targets based only on US domestic inflation. We can understand that because it would have been difficult for Mr Greenspan or Mr Bernanke to say to Congress: "I have to hike interest rates because inflation is too high in China." So we cannot say that the sole culprit is the exchange rate policy of China. It is also a problem of inappropriate monetary policy coordination between the US and the other countries of the de facto dollar zone.
CKG, Société Générale But excess liquidity was in part due to the exchange rates.
OG, SGAM Yes, indeed. But we have to keep in mind the structural factors behind under-valued exchange rates. For political stability, China needs to absorb a huge pool of unemployed or underemployed workers.
EP, UBS The extent to which big economic blocs can issue additional debt and act as the leverager of last resort will likely be tested. One likely result will be greater exchange rate volatility. As issuance of government debt increases, buyers will, at some point, require incentives to continue buying. These will take the form of either higher interest rates or a cheaper exchange rate. There is some risk therefore of a round of competitive devaluations which would be very destabilizing from a macroeconomic and perhaps even geopolitical perspective. Our next bear market could be in the very basic notion of fiat currency.
RO, Oanda We will see much higher exchange rate volatility. Recent weeks have not been a brief aberration, but will be the standard.
DB, HSBC Going back to exchange rates, the approach we’ve taken is to try to look at countries’ external accounts – what people have bought through the world. People have bought equities in Europe unhedged, and we also know investors have bought Australia, New Zealand and the UK because of their high interest rate structure. When you have an interest rate unwind, currencies reliant on hot money flows suffer. When you get an equity market move those reliant on equity finance get hit. So some currencies are reliant on equity money and as equities fall, so those currencies go down. The currencies’ reaction function in a deleveraging process is determined by the asset class investors hold in that currency. When we get back to worrying about real economies again we can start understanding how exchange rates work but in the deleveraging process it’s difficult to know because it comes back to how far we are through this. It makes a huge difference to how currencies behave. Knowing the answer to how far we are through the process is the key and no one has the analytical tools to answer this.
The dangers of rigidity
PL, Polar Capital The authorities are very active with monetary policy and fiscal policy and they are meeting to talk about regulation. Who worries that they may decide to impose a Bretton Woods 2 solution to take one kind of volatility out of the system and reimpose a fixed exchange rate regime on the world?
CKG, Société Générale What tools do they have to impose this now?
PL, Polar Capital If the G10 decide that they will have a Bretton Woods 2 and a fixed exchange rate regime, that is what we’ll have.
NS, Deutsche Bank We haven’t seen the protectionist policies including devaluation that brought on the need for Bretton Woods and the establishment of exchange rate control. If governments have learned lessons from history we’re not going to get an environment where everyone depreciates their own currency for economic benefit because of the inflationary repercussions.
CKG, Société Générale I would say that exchange rate regimes are normally used to control inflation. We don’t have that problem now – we have the reverse!
DB, HSBC The problem isn’t currencies. FX markets are a by-product of another problem. People can’t use FX to solve a problem because it is simply a by-product of deleveraging and the movement of assets around the world – the selling of the dollar was during strong global growth and whilst the decoupling theory was running hot. We saw the bull run back into the dollar again as the world switched to low global growth and contagion. The problem is in credit and the debt markets. Movements in FX are a by-product of other problems and the volatility in the FX world is only following equity markets and the problems in the credit markets. To try to solve this through FX would be tackling the wrong problem.
EP, UBS And yet the credit markets are still not functioning properly. Although some private sector imbalances have been reduced, as long as credit markets continue to malfunction we should expect equity and exchange rate volatility to remain high.
PL, Polar Capital Is anyone likely to try to competitively devalue?
MC, Aberdeen AM The G20 illustrated that they don’t want to do that. The meeting was passed off as a non-event, but I think they had the 1930s in the back of their minds; that they would come together and make statements that they had no intention of going down the protectionist route. That can obviously change; if suddenly you go into an 8% of GDP recession/depression, domestic policy constraints can alter.
PL, Polar Capital So if the lessons of the 1930s were: don’t have fixed exchange rates, don’t have a gold standard that forces you to contract your money supply when you have a monetary shock, don’t restrict your fiscal policy and don’t have protectionism, what have we got wrong so far?
CKG, Société Générale Remember, they also imposed regulations on leverage in the 1930s, and it looks as though we will see those again.
RO, Oanda Prior to the crisis we leveraged up so heavily that during the crisis we don’t have the degree of freedom any more.
EP, UBS That’s the contrast with Japan, which entered the 1990s with significant savings. Many western economies are not in that position now.
A gloomy outlook?
PL, Polar Capital Is the outlook for the global economy worse than the outlook for Japan was in 1990?
RO, Oanda Definitely, because everything is coming together.
CKG, Société Générale My personal concerns are for a worse outlook. Japan’s debt dynamics were different. It had a tremendous savings pool built during its years of excess, so it could expand debt. Unfortunately, the Chinese have the US’s savings pool, so where does that leave them? And Europe is not far better. Japan was isolated to some extent – this is now global.
EP, UBS And aging populations will place additional strains on major western economies in the coming years.
PL, Polar Capital Is there anything to be optimistic about?
DB, HSBC It’s unlikely that any of the governments are going to be able to stop the recession, but they will limit the depth of it and also limit the duration. I don’t believe we’re going to have a long and substantive downturn, as Japan did. Most people think it will be over in three years. That is the median expectation. I’m certainly not expecting a Japan. Nor, however, are we expecting a quick and fast bounceback.
MC, Aberdeen AM Some things will change for ever. The price of risk has, I believe, irrevocably changed.
DB, HSBC This was said after the Nasdaq bubble.
CKG, Société Générale As Mark Twain said: history may not repeat itself, but it sure does rhyme!
CKG, Société Générale Remember that UK domestic banking was bailed out by the UK government in the early 1970s, and 35 years later we are witnessing a similar event. It is in the nature of human forces that we will speculate – and the cycle will repeat itself again.
MC, Aberdeen AM Yes, but there has been a super-cycle of risk getting cheaper. You clearly had sub-cycles around the super-cycle and the 2000 Nasdaq bubble was one of those. By late 2007, we had got to the point of pricing risk so cheaply it was crazy. In the same way we’ve had a broadly disinflationary economic super-trend coinciding with the risk pricing. I think that process will end as a result of this downtrend.
CKG, Société Générale This is probably right. When the governments make injections of capital into banks and then ask that the banks now support the real economy, the amount of autonomy that banks have may have changed.
PL, Polar Capital Have we reached the bottom for the banks?
EP, UBS As was mentioned earlier we’re working through both a financial crisis and a crisis in the real global economy. Banks continue to work through the first and are coming to grips with the second. With investors and consumers now taking stock of their previous mistakes, such as overinvestment in consumer non-durables, it’s fair to expect overall banking activity to decline – both in retail and investment banking. The challenge in 2009 will be to successfully match demand for and supply of banking services.
OG, SGAM As long as the US dollar is firm, the G7 or G20 will not talk about exchange rates because against the current deflationary environment everybody is pleased to have a weak currency against the US dollar. And a firm dollar can also help the US Treasury to finance its huge and rising deficit. However, if there were a sudden and sharp fall in the US dollar against all the other currencies, we would again see governments talking about currencies and possibly intervening in FX markets. Exchange rate issues could thus come back on the global policy agenda.
The quantitative easing quandary
PL, Polar Capital The San Francisco Fed released a paper about non-standard monetary policy easing in the US. Is it consistent to be the global reserve currency and engage in quantitative easing?
DB, HSBC The question is whether you do it on your own. If you do, you have a problem. The US would find some willing partners and then it becomes a question about the repricing of the developed world against the emerging world. The US will not go down that route alone. It will find willing partners, probably in the UK and Antipodean countries. The saving nations will be less willing to go down the route of monetization, those countries with high savings running current account surpluses. Perhaps there will be a repricing of the emerging world against the developed world. That is when you get the big currency tectonic plates moving. The future doesn’t herald looking at the euro against the dollar or sterling against the kiwi. It looks at repricing the G10 against the emerging world.
PL, Polar Capital Does the emerging world then get subdivided into the savers and non-savers in the emerging world?
DB, HSBC You might get the savers, the young populations, the dynamic economies, the ones running at reasonable positive growth. That is where the future will lie. When we have the appetite for risk again and markets have levelled out, we will revisit these countries. The developed world will come out of this damaged and the emerging world will eventually come out of it better. You have no option at the moment but to go with the deleveraging – that means a strong dollar, lower equities and bonds continue to rally, but at some point that will end. When it does the EM world will be the future.
IG, Credit Suisse And what of the bullish notion of China surviving the impact of the western countries. Isn’t the China story the globalization story? Aren’t they linked?
DB, HSBC They are, but they can sustain economic downturns with fiscal policy as a major help. They have highly educated people, a very disciplined workforce and they are able to sustain problems like this and come back from it. They have for thousands of years and I can’t see why they won’t do it again.
IG, Credit Suisse It’s problematic that China will consistently run growth rates at 6% above the developed countries when their export markets stop buying. There are some important links there that will persist and there will be a hit on those economies.
RO, Oanda There is a reason to be optimistic, if we carefully analyse what has gone wrong and suggest new solutions, not old ideas repackaged.
PL, Polar Capital Can micro-management solve this macro problem?
RO, Oanda Very much so; for instance, micro problems bring your computer down. This attitude has been lacking in financial markets. We should be far more rigorous in looking at all the details because this will determine whether financial markets derail or not. For instance, in the case of asset-backed securities there are Excel spreadsheets that list what properties are included in the security. This technical set-up is not appropriate for a complex financial product, where the owners of the properties included may go bankrupt, sell the property, etc. and the investor needs transparency.
PL, Polar Capital If we think that asset-backed securities were a bad idea, that doesn’t make the problem go away.
RO, Oanda That is an excellent idea but it is executed in the wrong way. Let us turn to history – property was initially not a financial asset, it was an employment contract that became a financial asset and we created notaries to make sure that property transfers were efficient. We need the same thing for our securities. We have to transfer securities in a digitalized format so that the buyer knows what is inside and can have computer models to assess them. He can’t do that with an Excel spreadsheet. We have to think about the underlying mechanics.
MC, Aberdeen AM You may have better information deliverance, but you will never deliver a system that creates perfect foresight.
RO, Oanda It would be great to have perfect foresight, but this is not realistic. If we can build early warning systems for tsunamis; we should definitely do the same for the global economy. No one has aggregated the data or has weather maps to show what is going on.
IG, Credit Suisse A lot of people did call the increase in the cost of risk. Many people running trading books were aware that risk was running too cheaply a long time before it got repriced. Inertia prevented institutions from repricing that risk: they wanted to give customers the kind of prices that they had historically enjoyed. It wasn’t that no one was aware of a change in conditions; many of those running a forwards book or trading less liquid currencies could see that the rational risk price was different before it actually moved.
EP, UBS The current crisis highlights the risk inherent in our industry’s use of VAR as a risk measure. Depending on how it is used it can underestimate the risk of "tail" events and even encourage pro-cyclical behaviour – condoning or encouraging increased risk in low-volatility environments. The problem, as we’ve seen recently, is that periods of extreme volatility are often preceded by periods of apparent calm.
IG, Credit Suisse The technical measures and the trader intuition were there; it was just institutional reluctance to do the repricing that this implied.
PL, Polar Capital Competition sometimes stops you doing what you feel you should.
CKG, Société Générale Some parts of the regulatory framework could have been much improved. In the US, we are aware of the extensive mortgage fraud that occurred, both in terms of the statements of earnings, and in the valuation of properties themselves. Then there was the work of the ratings agencies on asset-backed securities, especially sub-prime. And some of the most robust institutions themselves can have questions raised about them. Should the Fed have included the underlying price of homes in its measures of inflation, instead of rental equivalence, which understated inflation? But this is not a new question. And who was measuring the leverage of the banks? As a share of GDP, the profits of banks were at levels never seen before. So there was clear evidence of excess and failure everywhere. But nothing was actually done.
IG, Credit Suisse What has often been described as being a regulatory crisis was not that at all, but a supervisory crisis. There was no shortage of regulatory levers but, as you say, some of the systematic issues around what was going on in the credit markets and issues of leverage were not addressed.
DB, HSBC It will take us a long time to get back into other products. We have to get back to basics, understand what we are doing and build up again.
PL, Polar Capital We will see further rounds of capital injections into banks and increased government control of banks.
IG, Credit Suisse There is an issue with valuation. When we learn about valuation, what do we do? We look at the price of basic securities for which the value is not disputed. Then we look at all the other traded assets and ask how they relate to the basic securities? We all believed in that process for a long time; now we don’t. Now there is a lot of liquidity in the most basic assets – for example, there is a lot of inter-bank dealing in the G10 currencies in the middle of the European day and if you look at interest rates there is now liquidity in the short end: but we’ve lost belief in how that relates to other less basic things that we might want to trade. At the extreme it’s the longer-dated and more exotic products. We need to get comfortable again with what these other assets are worth because the linkage usually provided by the valuation process is not trusted now.
CKG, Société Générale We are always in an environment of valuation, but it’s the context in which you evaluate things. Five hundred years ago it was OK to burn people at the stake. Now you’d get sent to prison for it. It is the context in which you are valuing. It’s not the valuation issue, it is a belief or confidence issue. If you believe that what you are valuing now is right and other people will value it in the same way, you will get some confidence, and at the moment confidence has been stripped out.
IG, Credit Suisse A lot of liquidity has been injected at the short end and there is plenty of liquidity in, say, the euro/dollar at 2pm – but that liquidity isn’t transmitted into the other things that people usually trade. The liquidity is sclerotic and that is an issue.
DB, HSBC Equities are trading well and in reasonable size and it is still a functioning market, but the credit market isn’t. There is an idea that equities are at a massive premium to credit. This could just be a liquidity premium in equities rather than the pricing in of default risk in the credit markets.
CKG, Société Générale You have to separate vanilla credit from complex. You are talking about complex credit.
DB, HSBC Absolutely, but we have to go back to basics.
PL, Polar Capital Isn’t it difficult to discover the true valuation of anything at the moment?
IG, Credit Suisse But there was confidence about that not long ago. Banks were selling products with embedded correlations and volatilities and were tight in their pricing because we all thought we knew how those relationships worked.
CKG, Société Générale We’ve gone full circle and we’re back to deleveraging.
PL, Polar Capital We’ve found out very quickly that the dataset we based that view on was too short. We are now in a situation where we can’t value anything because we don’t know what our distributions look like, and if that’s the case you have to go back to basics. I agree you go back to the core, but even if you do, you are likely to see a great deal of volatility.
DB, HSBC The worry is that we will not be able to, as markets are not behaving normally.
NS, Deutsche Bank If we are no longer confident in our settlement system in foreign exchange, it stops trading. It is based on confidence in FX spot; it’s not just about valuation, it’s also about clearing. If we’re not confident about clearing, we will have to come up with an alternative solution.
RO, Oanda We should find out what the key issues are and then create the momentum to get that sorted out. We can contribute to that and hopefully we will then get out of the crisis faster.
MC, Aberdeen AM But it will be dealt with in a more fundamental way. This is a sub-cycle that we will continue to go through, but the reason that the super-cycle ends here is because of government ownership. The government will apply control on the banking system that we have never witnessed before and that is why we won’t continue in this super-cycle of ever cheapening risk.
PL, Polar Capital We have witnessed it before, in the 1970s, so will banking go back to the 1970s? Is it banks being told that they have to lend to strategic industries?
CKG, Société Générale The answer, in some form, is almost certainly yes. Gordon Brown in the UK and president Nicolas Sarkozy in France have made it clear now that banks are in partnership with the governments. That’s made even easier when, in some cases, the governments own the banks! There maybe further pressures to comply with governments’ wishes via legislation. The landscape has definitely changed.
Let’s remind ourselves how we got here in the first place – through excess leverage, that’s where we started our discussion. And that leverage issue is still with the banks. Despite the best efforts of central banks to assist banks funding these assets, there are few buyers. And so, on one hand, banks will have their balance sheets tied up with legacy securities and loans, and, on the other, the government may ask them to support the real economy with further lending.
What’s left? A delicate balancing act of how to use the remaining resources most effectively. And this is where FX looks most interesting as the balance sheet consumption and return on equity profiles of FX are very positive indeed.Coupled with the fact that the world’s top-five banks in FX now include some of those with the most challenging capital issues, there can be a change in the outlook for the profiles of the world’s big FX players.
For balance sheet reasons, FX is an attractive business and the door is now open for the tier 2 banks to make themselves relevant again. It’s going to be an interesting time.
To be continued in the February issue