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Rocky Market Horror Show

Author: Sebastian Mallaby, Paul A. Volcker Senior Fellow for International Economics
October 26, 2008
Washington Post

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Like the plot of some blockbuster horror movie, the financial crisis shifts from scene to scene with terrifying speed. It opened with a real estate crunch, which hit homeowners and mortgage lenders but left much of the economy unscathed. It continued to a broader banking crunch, in which car loans, business loans and all manner of lending unconnected to real estate suddenly became impossible to obtain. Now, simultaneously, come three new phases of the turmoil in split-screen Technicolor. The non-financial, or "real," economy is collapsing. Once-solid emerging markets are imploding. And trading strategies predicated on the robustness of those emerging markets are being dumped hastily, driving brutal volatility in markets around the world.

Let's start with the (limited) good news. The real estate monsters have lost some of their ferocity, at least for the moment. On Friday, the National Association of Realtors reported that the number of homes sold was up 5.5 percent from August to September. This is the first time in three years that this measure has been positive. Although home prices are still falling, the fact that buyers are plunking down money suggests some light at the end of this particular tunnel.

And government efforts to alleviate the banking crunch appear to be working. Three weeks ago, the payments system in the rich economies was broken. Banks refused to lend to each other even for very short periods; everyone was hoarding cash. By strengthening banks with injections of taxpayers' money and by promising taxpayer guarantees to people who lent money to the banking system, the authorities in the United States and Europe have restored confidence. Despite extraordinary turbulence in the equity and currency markets last week, banks continued lending to each other at interest rates slightly below the panic point.

But there is a lot more bad news than good news. It begins with a recession, both in the United States and abroad. The Fed recently announced that U.S. industrial production in the third quarter was down 6 percent from the same period in 2007; this was the steepest decline since 1991. On Friday, Britain reported its worst gross domestic product figure since 1990-output in the third quarter fell 0.5 percent from the second quarter. Germany recently cut its 2009 growth forecast from 1.2 percent to 0.2 percent. These recession signals explain part of the rout in the rich world's stock markets. In the past three days of trading, the S&P 500-stock index has lost 8 percent. The Japanese and European stock indexes are down 18 percent and 10 percent, respectively.

Next you have the extraordinary meltdown in emerging markets. A month ago, observers were describing the International Monetary Fund as irrelevant. Today it is negotiating bailouts for a dozen countries. In the second quarter, Brazil was growing at an annual rate of 6.1 percent, South Korea at 4.8 percent and Russia at 7.8 percent. Now, all are battling financial crises. Not long ago, the Russians and Koreans were shunting billions of dollars of spare capital into sovereign wealth funds, to be used to buy up Western companies. Today, it's not clear they have enough capital to fix their own financial sectors.

The collapse in the emerging markets has punished a whole variety of behaviors known as the "carry trade." In the years before the crisis, interest rates in the United States and Japan were low. You could borrow in one of those currencies and lend in Australian dollars or Russian rubles. So long as the currency you owed didn't rise against the currency you lent in, you could pocket the difference in the interest rate, often five percentage points or so.

Everybody was in on this. Hedge funds borrowed vast amounts of yen and lent it out in high-interest-rate currencies or used it to buy stocks in emerging markets, U.S. mortgage securities or whatever else paid a good yield. Japanese housewives did the same thing, buying foreign stocks and bonds with money borrowed from high street brokers. Russian banks borrowed cheaply from Westerners in dollars and lent expensively in rubles. In a European variation on the carry trade, Eastern European home buyers arranged mortgages denominated in Swiss francs or euros.

Now all of these currency bets are exploding. The currencies that used to be cheap to borrow are soaring in value, and the ones that reaped rewards for owners are plummeting. In the past month, the Japanese yen has jumped 34 percent against the Australian dollar and 18 percent against the ruble. A lot of speculators in a lot of places are getting pummeled. The more they rush to get out of their positions, the more they reinforce the currency moves that cripple anybody who's still trapped in the carry trade. And the more havoc all of this wreaks in emerging economies.

How this plays out is anybody's guess. The same bug-eyed panic that was evident among bankers last month has seized traders of emerging-market currencies. The really scary thing is that the crisis has migrated into parts of the financial system that are tough to rescue. When push came to shove, the Federal Reserve, the Treasury and their European counterparts could stand behind the banking system. But now we are talking about hedge funds, which lie beyond the traditional reach of regulators, and emerging markets, some of whose governments lack the cash to stage bailouts. Unlike your standard horror movie, there's no telling when this one will end.

This article appears in full on CFR.org by permission of its original publisher. It was originally available here.

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