The weak shall inherit the earth

New government priorities and an enthusiasm for unconventional monetary policy are changing the way the currency markets work

Oct 6th 2012

OVER most of history, most countries have wanted a strong currency—or at least a stable one. In the days of the gold standard and the Bretton Woods system, governments made great efforts to maintain exchange-rate pegs, even if the interest rates needed to do so prompted economic downturns. Only in exceptional economic circumstances, such as those of the 1930s and the 1970s, were those efforts deemed too painful and the pegs abandoned.

In the wake of the global financial crisis, though, strong and stable are out of fashion. Many countries seem content for their currencies to depreciate. It helps their exporters gain market share and loosens monetary conditions. Rather than taking pleasure from a rise in their currency as a sign of market confidence in their economic policies, countries now react with alarm. A strong currency can not only drive exporters bankrupt—a bourn from which the subsequent lowering of rates can offer no return—it can also, by forcing down import prices, create deflation at home. Falling incomes are bad news in a debt crisis.
Thus when traders piled into the Swiss franc in the early years of the financial crisis, seeing it as a sound alternative to the euro’s travails and America’s money-printing, the Swiss got worried. In the late 1970s a similar episode prompted the Swiss to adopt negative interest rates, charging a fee to those who wanted to open a bank account. This time, the Swiss National Bank has gone even further.

It has pledged to cap the value of the currency at SFr1.20 to the euro by creating new francs as and when necessary. Shackling a currency this way is a different sort of endeavour from supporting one. Propping a currency up requires a central bank to use up finite foreign exchange reserves; keeping one down just requires the willingness to issue more of it.

When one country cuts off the scope for currency appreciation, traders inevitably look for a new target. Thus policies in one country create ripples that in turn affect other countries and their policies.

The Bank of Japan’s latest programme of quantitative easing (QE) has, like most of the unconventional monetary policy being tried around the world, a number of different objectives. But one is to counteract an unwelcome new appetite for the yen among traders responding to policies which have made other currencies less appealing. Other things being equal, the increase in money supply that a bout of quantitative easing brings should make that currency worth less to other people, and thus lower the exchange rate.

Ripple gets a raspberry

Other things, though, are not always or even often equal, as the history of currencies and unconventional monetary policy over the past few years makes clear. In Japan’s case, a drop in the value of the yen in response to the new round of QE would be against the run of play. Japan has conducted QE programmes at various times since 2001 and the yen is much stronger now than when it started.

Nor has QE’s effect on other currencies been what traders might at first have expected. The first American round was in late 2008; at the time the dollar was rising sharply (see chart). The dollar is regarded as the “safe havencurrency; investors flock to it when they are worried about the outlook for the global economy.

Fears were at their greatest in late 2008 and early 2009 after the collapse of Lehman Brothers, an investment bank, in September 2008. The dollar then fell again once the worst of the crisis had passed.

The second round of QE had more straightforward effects. It was launched in November 2010 and the dollar had fallen by the time the programme finished in June 2011. But this fall might have been down to investor confidence that the central bank’s actions would revive the economy and that it was safe to buy riskier assets; over the same period, the Dow Jones Industrial Average rose while Treasury bond prices fell.

After all this, though, the dollar remains higher against both the euro and the pound than it was when Lehman collapsed. This does not mean that the QE was pointless; it achieved the goal of loosening monetary conditions at a time when rate cuts were no longer possible. The fact that it didn’t also lower exchange rates simply shows that no policies act in a vacuum. Any exchange rate is a relative valuation of two currencies. Traders had their doubts about the dollar, but the euro was affected by the fiscal crisis and by doubts over the currency’s very survival.

Meanwhile, Britain had also been pursuing QE and was slipping back into recession. David Bloom, a currency strategist at HSBC, a bank, draws a clear lesson from all this. “The implications of QE on currency are not uniform and are based on market perceptions rather than some mechanistic link.”

In part because of the advent of all this unconventional monetary policy, foreign-exchange markets have been changing the way they think and operate. In economic textbooks currency movements counter the differences in nominal interest rates between countries so that investors get the same returns on similarly safe assets whatever the currency. But experience over the past 30 years has shown that this is not reliably the case. Instead short-term nominal interest-rate differentials have persistently reinforced currency movements; traders would borrow money in a currency with low interest rates, and invest the proceeds in a currency with high rates, earning a spread (the carry) in the process. Between 1979 and 2009 this “carry tradedelivered a positive return in every year bar three.

Now that nominal interest rates in most developed markets are close to zero, there is less scope for the carry trade. Even the Australian dollar, one of the more reliable sources of higher income, is losing its appeal. The Reserve Bank of Australia cut rates to 3.25% on October 2nd, in response to weaker growth, and the Aussie dollar’s strength is now subsiding.

So instead of looking at short-term interest rates that are almost identical, investors are paying more attention to yield differentials in the bond markets.

David Woo, a currency strategist at Bank of America Merrill Lynch, says that markets are now moving on real (after inflation) interest rate differentials rather than the nominal gaps they used to heed. While real rates in America and Britain are negative, deflation in Japan and Switzerland means their real rates are positive—hence the recurring enthusiasm for their currencies.

The existence of the euro has also made a difference to the way markets operate. Europe was dogged by currency instability from the introduction of floating rates in the early 1970s to the creation of the euro in 1999. Various attempts to fix one European currency against each other, such as the Exchange Rate Mechanism, crumbled in the face of divergent economic performances in the countries concerned.

European leaders thought they had outsmarted the markets by creating the single currency. But the divergent economic performances continued, and were eventually made manifest in the bond markets. At the moment, if you want to predict future movements in the euro/dollar rate, the level of Spanish and Italian bond yields is a pretty good indicator; rising yields tend to lead to a falling euro.

The reverse is also true. Unconventional interventions by the European Central Bank (ECB) over the past few years might have been expected to weaken the currency, because the bank was seen as departing from its customary hardline stance. They haven’t because they have normally occurred when the markets were most worried about a break-up of the currency, and thus when the euro was already at its weakest. The launch of the Securities Market Programme in May 2010 (when the ECB started to buy Spanish and Italian bonds), and Mario Draghi’s pledge to “do whatever it takes”, including unlimited bond purchases, in July 2012 were followed by periods of euro strength because they reduced fears that the currency was about to collapse.

Currency war, what is it good for?


Currency trading is, by its nature, a zero-sum game. For some to fall, others must rise. The various unorthodox policies of developed nations have not caused their currencies to fall relative to one another in the way people might have expected. This could be because all rich-country governments have adopted such policies, at least to some extent. But it would not be surprising if rich-world currencies were to fall against those of developing countries.

In September 2010 Guido Mantega, the Brazilian finance minister, claimed that this was not just happening, but that it was deliberate and unwelcome: a currency war had begun between the North and the South. The implication was that the use of QE was a form of protectionism, aimed at stealing market share from the developing world. The Brazilians followed up his statement with taxes on currency inflows.

But the evidence for Mr Mantega’s case is pretty shaky. The Brazilian real is lower than it was when he made his remarks (see chart). The Chinese yuan has been gaining value against the dollar since 2010 while the Korean won rallied once risk appetites recovered in early 2009. But on a trade-weighted basis (which includes many developing currencies in the calculation), the dollar is almost exactly where it was when Lehman Brothers collapsed.

Many developing countries have export-based economic policies. So that their currencies do not rise too quickly against the dollar, thus pricing their exports out of the market, these countries manage their dollar exchange rates, formally or informally. The result is that loose monetary policy in America ends up being transmitted to the developing world, often in the form of lower interest rates.

By boosting demand, the effect shows up in higher commodity prices. Gold has more than doubled in price since Lehman collapsed and has recently reached a record high against the euro. Some investors fear that QE is part of a general tendency towards the debasement of rich-world currencies that will eventually stoke inflation.

The odd thing, however, is that the old rule that high inflation leads to weak exchange rates is much less reliable than it used to be. It holds true in extreme cases, such as Zimbabwe during its hyperinflationary period. But a general assumption that countries with high inflation need a lower exchange rate to keep their exports competitive is not well supported by the evidence—indeed the reverse appears to be the case. Elsa Lignos of RBC Capital Markets has found that, over the past 20 years, investing in high-inflation currencies and shorting low-inflation currencies has been a consistently profitable strategy.

The main reason seems to be a version of the carry trade. Countries with higher-than-average inflation rates tend to have higher-than-average nominal interest rates. Another factor is that trade imbalances do not seem to be the influence that once they were. America’s persistent deficit does not seem to have had much of an impact on exchange rates in recent years: nor does Japan’s steadily shrinking surplus, or the euro zone’s generally positive aggregate trade position.

In short, foreign-exchange markets no longer punish things that used to be regarded as bad economic behaviour, like high inflation and poor trade performance. That may help explain why governments are now focusing on other priorities than pleasing the currency markets, such as stabilising their financial sectors and reducing unemployment. Currencies only matter if they get in the way of those goals.

October 4, 2012 6:31 pm

Energy: Corridor of power
Fears are rising that Iran’s cornered leadership could block the world’s most critical oil choke point
Iranian military personnel participate in the Velayat-90 war game in unknown location near the Strait of Hormuz©Reuters

The chart showed deep water beneath the keel as the M Star supertanker steered a smooth course out of the Gulf. But minutes after midnight, at 26°27’ North, 56°14’ East, in Omani waters, the ship suddenly lurched.

The captain and some of his crew of 30 Indians and Filipinos reported a flash, quickly followed by what sounded and felt like an explosion.
The double hull, holding about 2m barrels of crude oil, withstood the explosion but damage was visible inside. The captain ordered an immediate change of course to the nearest port of Fujairah, in the United Arab Emirates. When the tanker dropped anchor, the crew found an 11-metre wide, one-metre deep dent in the starboard hull just above the waterlinescarred by the marks of a blast.

Mystery still surrounds the incident. According to Mitsui OSK Lines, owners of the vessel, there seemed to have been “an attack from external sources”. But whatever happened that night in July 2010, the explosion that hit the 330-metre tanker serves as a reminder of the risks of the Strait of Hormuz, the world’s most critical energy nexus. Some 35 per cent of all crude oil carried by ship passes through the 21 nautical mile wide choke point between Iran and Oman.

In the M Star case, Tehran quickly distanced itself from the blast, saying it must have been accidental. Yet two years later, worries about Iran have only intensified.

Sanctions imposed over Iran’s nuclear programme have grown tighter, and the effects are being felt across the country. Fears are rising that Iran’s leadership, facing increasing domestic unrest over spiralling inflation, has less and less to lose through brinkmanship in the channel now that its own oil income is being squeezed to a trickle. For years, oil traders were inured to rhetoric from Iran that it stood poised to shock world energy markets by blocking the seaway in retaliation for sanctions or an Israeli attack. They were sceptical it would engineer a crisis in a region so critical to its own economic survival. But Iran’s plummeting oil exports mean that a cornered Tehran could see a confrontation in the strait as less an act of self-immolation and more a calculated gamble.

Given Iran’s vertiginous economic decline, governments are paying more heed to what Tehran’s threats mean to their crude supplies. Only last month, western nations conducted their biggest minesweeping drill in the Gulf, stressing the critical importance of safeguarding Hormuz.

Governments, including Saudi Arabia, have also spent billions on pipelines to bypass the strait, accelerating work over the past 18 months. In addition, they are building oil storage facilities near key markets in an effort to guarantee the supply of oil even in the event of a military clash.

Earlier this year, Riyadh and Abu Dhabi opened new pipelines that will increase the ability of countries to bypass the strait. Fully operational, 6.5m barrels per day, or about 40 per cent of total flows, will now be able to take alternative routes. “The Middle East is much better prepared now than a year ago to cushion the impact of a disruption in the Strait of Hormuz,” says Edward Morse, head of commodities research at Citigroup and former US deputy assistant secretary of state for international energy policy.

However, in spite of these new projects, the vast majority of oil trade will remain seaborne and at the mercy of the Strait of Hormuz. Kuwait, Qatar, Bahrain and Iran itself have no alternative routes through which to ship their oil.

It is hard to overstate the waterway’s role in energy markets. Cyrus Vance, former US secretary of state, once called it “the jugular vein” of the global economy.

Strangling that jugular would push oil and natural gas prices to levels that would endanger economic growth worldwide. David Goldwyn, a Washington-based consultant and, until recently, the US state department’s top diplomat for oil affairs, says the strait is at “the top of the risk list” for energy and military planners. “It is one of the single, largest vulnerabilities that we have in terms of oil supply.”

Last year, roughly 17m b/d of oil produced in the UAE, Qatar, Bahrain, Saudi Arabia, Kuwait, Iraq and Iran passed through the channel. Moreover, about 2tn cubic feet per year of liquefied natural gas – or supercooled gas turned into a liquid so it can be shipped sailed through the strait, equal to almost 20 per cent of global LNG trade.

Trade on such a scale hands preponderant leverage to the Iranian military. Only last month, General Mohammad Ali Jafari, head of the Revolutionary Guards, said: “If war occurs in the region and [Iran] is involved, it is natural that the Strait of Hormuz, as well as the energy [market], will face difficulties.” Last year, one admiral quipped Iran could close the straitmore easily than drinking a glass of water”.

Energy traders had long been confident that Iran’s threats were bluster, intended to discourage Israel and the US from air strikes against its atomic facilities. The strait is, after all, the gateway not only for all of Iran’s own oil exports but also for much of its food imports. There seemed little danger Iran was ready to risk conflict. But the country’s financial decline has started to worry policy makers.

Its moribund crude oil industry is a particular worry. Sanctions mean that production is declining fast, recently hitting a 22-year low. Its exports had fallen from 2.4m b/d in early 2011 to just 0.8m b/d in August. If exports were to drop much further, the incentives on Iran to shut down the strait would grow as it would not need to worry so much about its oil flow.

President Mahmoud Ahmadi-Nejad also faces increasingly volatile domestic politics with conservative politicians and businessmen intensifying a power struggle before elections next year. This week, merchants came out on strike over the plunging value of the rial.

Fearing Mr Ahmadi-Nejad could seek a diversion through international sabre-rattling, policy makers say that Iran could easily find ways to disrupt world energy supplies without a direct attack. Some argue it could board every supertanker transiting its territorial waters under other pretexts, such as inspecting for weapons smuggling. Others fear it could even use proxies to fight its war, with terrorist organisations carrying out attacks. Those actions would both slow oil flows and push up prices.

Tehran would win a double victory: continuing its own remaining oil sales while benefiting from higher prices. Amrita Sen, senior oil analyst at London-based Energy Aspects, says that domestic pressure and economic collapse could force Tehran back to the negotiating table over its nuclear programme. “But, on the other hand, it also makes more likely a provocative action by Ahmadi-Nejad.”

Seeking to counter Iran’s influence, many nations are building up their military presence in the Gulf. September’s drills involved dozens of warships from, among others, the US, the UK, Japan, France, New Zealand, the Netherlands, Italy, Australia and Canada. Lieutenant Greg Raelson, a spokesman for the US fifth fleet, which often keeps one of its aircraft carriers in the Gulf, stressed the Strait of Hormuz was critical to “fuel economies around the globe”.

It is almost impossible to calculate the cost of policing the Gulf but Sherife AbdelMessih, chief executive of Future Energy Corporation, provides a back-of-the-envelope approximation: that the US spends roughly $90bn on its Bahrain-based fifth fleet or about $15 per barrel that crosses Hormuz.

While Washington and its Nato allies provide the bulk of the naval presence in the strait, there are growing calls for Asian countries to play a greater role as they are increasingly dependent on Hormuz. Last year, only 16 per cent of the oil that the US bought crossed the strait, down from 24.5 per cent in 1990. In the meantime, the dependence of India and China on the strait has risen steadily, last year hitting 63 and 42 per cent of their total oil imports, respectively. Among developed countries, Japan is the most exposed, as a hefty 82 per cent of its imports pass through Hormuz.

. . .

Beyond improving military readiness, one of the other responses to fears over Hormuz can be seen on the desert scrub beneath the mountains on the outskirts of Fujairah.

Eight white tanks stand on a bustling construction site, each of them measuring 110 metres in diameter, or about the length of a professional football pitch. Together they can hold 8m barrels of crude, enough to supply a medium-sized European country such as Belgium for two weeks. These enormous new vessels sit at the end of a 370km pipeline linking the oilfields near Abu Dhabi with the port of Fujairah in the Indian Ocean. The $3.5bn pipeline has a capacity of 1.5m b/d, or about 55 per cent of the country’s exports.

Such attempts to find ways of bypassing the strait are far from rare. Saudi Arabia has converted a pipeline used, until now, to transport natural gas so that it can carry crude oil. The 1,200km pipeline, which could transport up to 2m b/d – or 25 per cent of the country’s oil exportsruns from the oilfields of the Eastern Province, on the Gulf coast, to a terminal near Yanbu on the Red Sea. The 48in-wide pipeline was initially built in the early 1980s during the Iran-Iraq war, when both sides attacked oil tankers in the Gulf, to transport crude as part of the so-called East West Petroline. The line was later switched to carry natural gas but Riyadh has now quietly upgraded it for crude.

Industry executives say Saudi Aramco fast-tracked the project, with little concern about cost.
Running parallel to that route to the Red Sea, Saudi Arabia also has the biggest alternative link: a 56in-wide pipeline, built three decades ago as part of the Petroline system, which can carry 3m b/d of oil.

Iraq has a 970km-long pipeline linking its northern oilfields to the Turkish port of Ceyhan in the Mediterranean. The twin pipeline has a nominal capacity of 1.6m b/d, but lack of maintenance and attacks have reduced its capacity to 400,000 b/d.

In addition, several other pipelines cross the region, but some are damaged or nearly destroyed. Iraq, for example, has a 300,000 b/d pipeline linking its northern oilfields with the Syrian port of Banias in the Mediterranean. Now half a century old, it is out of operation after being hit by US bombs in 2003.

Finally, Saudi Arabia has a 60-year-old line, known as the Trans-Arabian Pipeline, or Tapline, linking its main oilfields with the Mediterranean port of Sidon in Lebanon, running through Jordan and Syria. However, the 1,200km pipeline has been out of action for decades, and is even presumed destroyed.

Even if all of these pipelines were to work at full capacity and interconnect perfectly, the core security problem would not change significantly. Ships such as the M Star will still have to file through the narrow Strait of Hormuz. On average, 13 supertankers cross it every day. Every one is a potential target.

Copyright The Financial Times Limited 2012.