Asia Forms Forex Pool

After nearly six months of currency depreciation, the nations of Asia have finally been spurred to action. Japan, China, and South Korea have joined together with the 10 ASEAN economies to form a $120 Billion pool of foreign exchange reserves, which contributors can tap into to protect their currencies. The goal is to prevent capital flight and currency weakness from engendering the same kind of financial crisis that only 10 years ago ravaged Asia. Fortunately, this time around, the 13 countries possess a combined $3.6 Trillion in reserves, which can be deployed in forex and securities markets in order to restore investor confidence. Ironically, the bulk of these reserves belong to China and Japan (who are also funding a large portion of the forex pool), both of whose currencies remain strong in spite of the crisis. Bloomberg News reports:
The fund is aimed at ensuring central banks have enough to shield their currencies from speculative attacks such as those that depleted the reserves of Indonesia, Thailand and South Korea during the 1997-1998 financial crisis.

Investors Return to Emerging Markets

In the last few weeks, investors have waded cautiously back into emerging markets. Spurred in part by the Obama economic stimulus plan and pending US investment in Citigroup, investors have evidently been persuaded to take on more risk. The Japanese Yen, accordingly, has already begun to beat a retreat from the highs it reached earlier this year. If this trend continues, the US Dollar could become the next “victim.” On the other side of the equation are currencies such as the South African Rand, which have benefited from a renewed interest in yield, as well as increased monetary stability driven by lower inflation. Ultimately, this movement of capital can just as easily reverse itself, which it no doubt will at the next economic hiccup. Bloomberg News reports:
“There is a little more risk appetite,” said..an analyst. “The rand is being driven by offshore sentiment.”

Eastern Europe Plagued by Currency Instability

The credit crisis continues to exact a devastating toll on the economies of Eastern Europe, and capital flight has caused the region’s currencies to plummet precipitously. This has prompted internal debate in countries such as Poland, Czech Republic, and Latvia - to name a few- as to whether the effects of the crisis would have been so blunt had they adopted the Euro. While certainly Euro membership would have spared them from currency instability, it would not have necessarily facilitated financial and economic stability, as Italy, Spain, and Greece have learned the hard way. Regardless of whether Eastern European countries are politically willing to commit to the Euro (itself doubtful), this debate is largely moot, since the credit crisis has all but eliminated their ability to meet the preconditions of membership in the short run. The New York Times reports:
The Baltic states would like to join as quickly as possible, but their economies are contracting so much that it would be impossible to meet the criteria, which, among other things, stipulates that budget deficits should be below 3 percent of gross domestic product

Yuan Revaluation is in China’s Interest

While China remains committed, in rhetoric at least, to a flexible Chinese Yuan that rises and falls in accordance with market forces, its actions suggest otherwise. Beginning in the second half of 2008, China stopped allowing the Yuan to appreciate, for fear that a more expensive currency would exacerbate the domestic effects of the credit crisis by making exports less competitive. What China fails to realize however, is that a more valuable Yuan is not only conducive to global economic stability, but also to its own economic well-being. In fact, the artificially cheap Yuan may have actually worsened the economic downturn in China, because de-incentivized the creation of a domestic economic base. Now that overseas demand has dried up, it is left feeling the consequences of this neglect. The San Francisco Chronicle reports:
With China far too dependent on export-driven growth, it is now extremely vulnerable to the current steep decline in global export demand. Unless that structural imbalance is fixed, China’s long-term growth prospects are as bleak as those of the United States.

Japanese Yen Braces for Intervention

After months of speculation, it appears that forex markets have finally concluded that the Central Bank of Japan is now prepared to bring down the Yen. On the one hand, the Finance Minister of Japan very publicly denied that the overvalued Yen and the consequent need for forex intervention was discussed during either his personal conversation with US Treasury Secretary Geithner or at the most recent G7 conference. At the same time, he pledged the willingness of Japan to fight “excessive swings” in forex and capital markets. Meanwhile, the expensive Japanese Yen has already trickled down to the economy, driving a 12.7% decline in GDP (in annualized terms) for the most recent quarter. The Yen, accordingly, has begun its retreat, already erasing nearly 10% of the gains it racked up against the Dollar over the last year. Reuters reports:
Japan, like the United States, is in recession and can ill afford a rising currency, which puts an extra choke-hold on exporters that are cutting jobs and shuttering factories in the face of a global slump in demand.

ECB Hints at Rate Cut

At its next meeting, to be held in March, the European Central Bank is all but certain to bow to pressure and cut its benchmark interest rate to a record low. This should not come as a surprise, for the ECB’s February decision to hold rates constant was met with a large outcry, in both public and private circles. Soon-to-be-released inflation data is expected to confirm that prices are rising at a slower pace, perhaps even below the ECB’s 2% benchmark. Members of the Bank are also paying attention to the Euro, the continued weakness of which is ironically a product of the ECB’s comparatively tight monetary policy, as investors guard themselves against the risk of deflation. The Guardian reports:
As the economy falters, speculation is also increasing that the ECB may expand its monetary toolbox, possibly through asset purchases, to boost growth while keeping rates relatively high compared to other central banks.

The reversal of Interest Rate Parity

Convention forex wisdom, as well as the "immutable" laws of economics, have long held that higher interest rates correspond with currency appreciation. This has been especially true in recent years, as risk-hungry investors used low-yielding currencies to fund carry trades, the proceeds of which were invested in higher-yielding alternatives. In the context of the credit crisis, however, this logic has been turned on its head, as the countries with the lowest interest rates have seen their currencies outperform. Emerging market economies that have turned bearish on inflation have likewise been rewarded with strong currencies, despite a potential imbalance in the risk/reward profile. This phenomenon suggests that investors are primarily concerned with deflation, and are parking their money in the countries they believe can best preserve their capital, even if the real rate of return is negative. One analyst argues this could spur further interest in gold, reports SeekingAlpha:
If it [the Euro] also joins the zero interest band-wagon then one may wonder what’s left for the currency markets to play with? Is this is a precursor to a crisis brewing here? Does gold get a further leg up – it’s a zero yield currency anyway!