US Dollar vs Japanese Yen: "chaos" in theory and practice
Last week's plunge was the US dollar's greatest fall in history. It fell 13.8% against the yen and 10% against the NZ dollar. The fall has excited little comment. Are we already inured to the perpetual disorder of 'turbo-capitalism' (ie Edward Luttwak's term for our world of dynamic creativity, rapid innovation, inequality and uncontrolled capital markets)?
The domino effect in currency markets has proceeded from a disturbance in peripheral Thailand to the core US dollar: the world's favoured trading and reserve currency. Something amazing is happening when the yen moves from 147 to the dollar in August to 111 in October. The pathology of a disease of the skin which is now attacking the heart is little understood and therefore extremely dangerous.
The body of the world's financial system seemed robust in 1997. There was a respected Federal Reserve, an all powerful Treasury, a cluster of sophisticated trading banks, an expert IMF and wonderful investment funds led by confident financial wizards. Such a majestic system surely had a strong immune system that could readily overcome threats. But there was no effective response as the "emerging markets" suffered twin assaults upon their currencies and stock markets. Huge amounts of credit were needed. The IMF provided stingy credit with its usual prescriptions of cuts. It also encouraged export-led recovery, and import curtailment: an absurd doctrine in a general crisis, for it depressed commodity prices, and exacerbated balance of payment problems which provoked more devaluation, and a downward trade spiral.
Inexorably, the crisis spread from Asia to Russia, Eastern Europe, Australasia, Canada, Brazil, the oil exporting countries and finally the dominant stock markets. As the crisis widened, it also deepened. Clearly the hedge funds raised the temperature. Long Term Capital Management almost provoked a stroke (NBR Oct. 2 and 9).
The Hedge Funds are central to the yen's rise. Earlier in the year, they had short sold the yen until the US intervened to halt the yen's plunge. The yen's stability seemed doubtful when the LDP lost the July election and a political solution to the Japanese banks insolvency seemed unlikely. Many hedge funds wagered then that the yen would depreciate from around 140 to around 180 to the dollar. A cheaper yen is almost a prerequisite for hedge funds that borrow to add leverage to their deals. Hedge funds borrow huge sums the equivalent of $3 trillion as gambling chips to arbitrage in the interest-rate market or in shorting currency in making raids. Vast sums were deployed against the Hong Kong dollar, the stock market and in interest rates. Japan has the world's lowest interest rates and is therefore the preferred source of funds. It adds icing on the cake when yen loans can be repaid in a depreciating currency.
In the last two weeks, several funds have been obliged to repay their yen loans. The sale of dollars and the purchase of yen has had the usual market effect of raising the yen's value.
But why has the yen appreciated by so much? I surmise that as the yen appreciated, debtors became anxious to repay before their debt became higher. So the yen appreciated faster, provoking a near panic in other debtors, who bought yen at a premium. Many players have made "easy money" in the "carry trade" by borrowing in Japan at 1% and investing in US bonds or treasuries at 5%. These players have to bail out to stop capital losses when the yen appreciates. Last week naturally saw mayhem in the US bond market. The surging momentum was sustained by hedge funds, who had bet on the yen plunging, baling out of their positions. They had sold yen earlier hoping to buy it back cheaper subsequently. To close out their contact, and cut losses, the hedge funds have been extraordinarily active yen buyers.
Many hedge funds will go broke if this dollar plunge continues. Their positions are big, but usually designed to cope with marginal changes in asset prices - fractions of a cent, a few pfennigs, a few points on bond interest rates. A 10% movement in a couple of days might be controlled by some stop-loss orders but it will destroy many positions. So it is no surprise that the biggest fund, Julian Robertson's Tiger Fund is said by Wall Street Journal to be losing two billion dollars a day. As the Fund's capital is $20 billion, this hemorrhage could prove fatal. The Tiger Fund uses leverage sparingly, nevertheless the possibility that its failure could destroy some major banks can not be overlooked. Hedge Funds are now pariahs. Three months ago they were shining examples of capitalism at its best in the New Age of continuous bull markets. Now they are villains, pandering to the whims of the super-rich, who might bring the whole financial system crashing down.
Perhaps the dollar will recover quickly. But its plunge against the yen in part recognises some change in attitudes. Japan is making belated progress on curing its diseased banking system. It has gained in confidence, and is promising $30 billion in credit to its neighbours. The USA has lost confidence. The New Age of ever-rising stocks is widely accepted as chimerical. Wall Street is wobbly. Vast wealth has been lost, while the politicians remain obsessed with sordid sexual politics, the economy is faltering. J. P. Morgan forecast a recession next spring, and Greenspan has evidence of a growing credit crunch hurting business. The chances are that the US dollar will remain weak as Clinton believes it helps exports. Greenspan is likely to cut interest rates to stimulate stocks and the economy. But lower interest rates, a bear market, and a huge current account deficit will make the dollar less attractive to overseas buyers. Capital could fly to higher quality.
The rapidly changing US/Japanese currency conversion rate is a symptom of a massive financial convulsion. Enormous de-leveraging is occurring, liquidity is tightening, and credit is drying up. The hedge funds have amplified movements and have distorted asset values. Financiers are also feeling the pinch as customers opt for safety. Job lay-offs are quickly occurring. Wherever I look I see the classic signs of panic and disorder. Michael Camdessus of the IMF is correct in saying the market has become disorderly and "irrational". Odd, that my lecturers in economic theory, reputedly the world's best, always assumed markets were inherently rational. My lecturers spoke too much about equilibriums. If I were teaching theory today, perhaps I would explore chaos theory where a central tenet is that the flap of a butterfly's wing in Thailand set in train consequences which bring a great storm in New York.
NEVILLE BENNETT
Christchurch, New Zealand
20 October 1998
Neville Bennett teaches "Japan and the World Economy" at the Canterbury Graduate School in New Zealand and writes a business column for the prestigious National Business Review. He is also a regular contributor to Le Metropole, www.lemetropolecafe.com and can be reached in New Zealand at 03-364-2086.
Also by Neville Bennett
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