Can Currency Crises be Prevented?

Location: London
Author: Shahin Shojai
Date: Thursday, March 4, 2010

In the past few days, both the Euro and Sterling have come under tremendous pressure from the investment community. Both have lost ground on the dollar, a currency that only 5 months ago was deemed unfit for purpose. Back then, in my commentary entitled “Why so much talk about the demise of the dollar when there are much more important issues to worry about?” I suggested that the talk about dollar’s demise was way over exaggerated and that it would be literally impossible to replace it as the currency of choice for pricing most commodities by a basket of currencies, due to the practical issues of conversions, and certainly the Chinese Yuan. I also suggested that if any currency was to replace the dollar it would have been the overpriced Euro, and even that was nothing more than a dream, and that the world had much more important things to worry about than finding a replacement for the dollar.

Well, 5 months have passed and we see that as most people felt even during the booming years of the Euro-zone, it is very hard to manage an economic union with so many self-interests and no political union. The Euro-zone is not even remotely similar to the U.S. I have yet to meet an American that considers him/self a Californian or Texan, more than American. But, just ask how the French feel about their brethren in Belgium or even Spain. This is a union of nations that don’t always like each other, and when given the chance look for ways to take as much money from each other as they can. If you don’t believe me just look at the discussions that took place a couple of years ago on the common agricultural policy, and the French position. So, what took place in Greece is no surprise to anyone. What is of surprise is the reaction of the governments to the attack on the Euro. While, most believe that the Euro is overvalued, they still do not want to allow market forces, irrespective of whether the motivation is greed on the part of hedge funds or simply a need for a correction, to take their course. All are looking for ways to stop hedge funds from shorting Greek government debt and are forcing them to divert their attention onto the Euro, with the hope that with the aid of some kind of legislation they can stop them from pushing the Euro down further.

The truth of the matter is that, as my mentor the late Franco Modigliani used to say, the easiest way to avoid a run on a currency is for there to be perfect collaboration between that currency’s central bank and the central banks of the currencies that are being bought. This is what stopped George Soros from repeating what he did to the Pound to the French Franc. The unwavering willingness of the Bundesbank to accept Francs and hold them in return for Deutschemarks. If you don’t have such an agreement then there is no way of stopping such trends. Now, everyone is feeling that the Euro should fall because of a myriad of reasons that were completely ignored only a few weeks ago. And, it really does not matter if there is any logic to the action. All that matters is that it has now become a trend that few can afford to ignore. The same is true for Sterling. God knows who came up with the notion that there could be a hung parliament in the U.K., it certainly was not the Conservatives or the Labour party. If it was the Liberal democrats, then this is the first time that anyone outside their party has listened to them for the past 100 years. But, the fact is that in financial markets people look for explanations of what happens, which is then used by others to justify why they are following the herd. It is not the reasons that cause the markets to take certain actions, it’s the other way round.

Consequently, now that the world is feeling that the Euro and Sterling should fall, we have an opposite situation to a speculative bubble. Everyone wants in. And unless the Fed agrees to do what Bundesbank did for the Franc for the Euro, it will continue to fall until the markets decide otherwise and then the journalists and economists look for explanations of why it has now reversed. In the meantime, there is a lot of money to be made from selling the Euro and Sterling, irrespective of the threats from the FSA or the European Central Bank and governments. Circuit breakers do not work under any circumstance. They just create pent up energy that moves elsewhere, where it can transact. Given the size of the world’s FX market, and its liquidity, there is very little that such threats can do to stop the Euro and Sterling from falling.

The interesting part of this whole story is that had someone offered the European governments the opportunity to depreciate the Euro by 10% they would have happily said yes. But, now that they know it is the non-Euro-zone hedge funds, based in the U.S. and U.K., which could benefit from this exact similar action they are crying foul. Of course, they are also worried since they cannot control how much the currency could end up depreciating.

I am more than confident that this trend will continue, for the simple fact that the U.K.’s debt situation is much worse than many think, and that the Greek problems are simply the tip of the iceberg and once everyone realizes just how bad the situation is in Spain, Portugal, Italy and Ireland they will want to get out of the Euro as fast as possible.

As for the strengthening dollar, well I am sure that is the last thing that President Obama would have wished for. A strong dollar could slow down some of the recovery that we are witnessing. It would certainly make it harder to export U.S. goods and more attractive to import foreign goods, resulting in a further downward pressure on the U.S. inflation figures at a time they need some inflation, apart from the obvious balance of trade issues that the U.S. has. 2009 was a pretty bad year for many of his domestic agenda, but he was still living through a honeymoon period with Europe. Somehow I suspect that the Greek tragedy might turn it into the kind of honeymoon he was hoping to avoid.

This briefing is provided as general information, and does not constitute definitive advice or recommendations. Any views expressed in the above articles are those of the author concerned and do not necessarily reflect the views of Capco or any other party. Capco has not independently verified any facts relied upon in any of the comments made in any of the articles referred to. Please send any comments or queries to Shahin Shojai (shahin.shojai@capco.com). Shahin Shojai is the Editor of The Capco Institute journal (www.capco.com).

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