Analysis Brief

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Currency Conundrums

Author: Lee Hudson Teslik
October 29, 2008


The 2008 financial crisis has prompted many analysts to speculate about the decline of major developed economies like the United States and Japan as hubs for global capital. Currency flows, however, tell a different story. As markets worldwide stumbled, foreign governments have poured money into dollar- and yen-denominated holdings, sharply reversing a trend that saw steep declines in both currencies over the past few years. In late October, the dollar jumped to a two-year high against the euro (FT); it has also risen sharply against the British pound, the Swiss franc, the Canadian and Australian dollars, and several other major currencies. The Japanese yen has risen even more sharply--even against the dollar--prompting G7 officials to indicate they may move to intervene (WSJ) in currency markets to dampen the yen's volatility. It may be comforting for some analysts to see renewed confidence in formerly maligned currencies, but the trend also poses major economic concerns.

The yen's rise is the most imminent threat. The run-up could undermine exports and growth of one of the world's largest economies, but the more immediate concern for the finance sector stems from bets many investors had made through an obscure practice called the "carry trade." Investors would take out loans in low-interest rate currencies (like the yen), exchange the money to higher-interest-rate currencies (like the dollar or euro), and reloan it out. In so doing, they stood to make more interest on the second loan than they paid on the first one--free money, so long as interest rates and currency valuations remained steady. The past year has seen these rates change rapidly, however, as the U.S. Federal Reserve and European Central Bank have been forced to cut their benchmark interest rates to boost their struggling economies. Carry traders, including some large financial institutions, now find themselves "in front of a steamroller," the Financial Times says in an editorial. The New York Times cites an analyst who estimates over $425 billion of global funds could be tied up in the international carry trade, and the FT says a collapse could further slam the Japanese economy and perhaps even bring back dreaded deflation.

Officials from leading economies have urged action. Europe and the United States could try to push down the value of the yen by making a coordinated move to sell it; Tokyo could do the same, or it could try to dampen the currency's rise by cutting interest rates. In a recent interview with Bloomberg, French Finance Minister Christine Lagarde kicked responsibility to the Bank of Japan: "We wished to support this possible intervention of Japanese authorities, knowing this would be about a purely Japanese intervention," she said. Yet Japan's benchmark interest rate is already at levels (0.5 percent) much lower than U.S. or EU rates, and the Japanese stock market has crashed in recent weeks faster than its developed-world counterparts. Nor has the Bank of Japan shown much appetite for intervening in currency markets by buying or selling yen.

Meanwhile, the dollar continues its sharp rise against all major currencies other than the yen, posing other problems for financial stability--for one thing, rapid currency fluctuations can make it difficult to price exports and imports (NYT). Simon Johnson, a former IMF chief economist, expresses surprise (FT) that the G7 focused only on the yen at its October 27 meetings. As investors have fled from emerging markets and commodities, they have increasingly poured money into U.S.-dollar denominated holdings as a safe haven. One analyst, Al Breach, describes this flight of capital in a recent podcast focusing on distressed Russian markets. In another podcast, CFR's Brad Setser notes the strong recent correlation between oil prices and the dollar, implying that the collapse of crude might also have something to do with the dollar's spike. The rising dollar means U.S. exports are less attractive to foreign consumers, further crippling U.S. firms (Reuters) at a time when many are facing severe problems.

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