Tuesday, October 28, 2008

Time to think of a new currency regime

One of the most intriguing aspects of the current crises has been the behavior of the currency markets. One can blame the Fed for keeping interest rates low and encouraging misallocation of resources to US housing. But the way currencies have moved over the last few years, one can argue that currency markets have misallocated resources across nations.

How should a cross-currency rate be determined? In a world where there are no capital flows across borders, it should be based on interest rate and inflation differential between two countries. One can argue it is the rate at which the current account deficit between two countries goes to zero.

Put the capital flows in, and the whole picture changes. As we see now, investors rush in when something is hot. So, when a country is hot, investors will rush in and the currency of that country can appreciate meaningfully above what its "fair-value" is. This will entice even more investors, which will push the currency even more above its fair-value. A positive feedback loop develops, and a currency bubble takes shape. This is what happened in emerging markets in the last few years.

Like all bubble, however, it bursts. And then, investors rush out. But when they leave, they cause absolute mayhem and destruction, particularly in smaller countries. A huge negative feedback loop develops - some investors leave pushing the currency down, which causes even more investors to pull out, which suddenly becomes a stampede.

Lets take the case of India. In 2007, as investors suddenly warmed up to the decoupling theory, they rushed into India. Suddenly Rupee appreciated from Rs 45 to Rs 40, and people started talking of the coming golden days when Rupee will touch Rs 35 and Rs 30. Probably it was this thinking that encouraged some Indian companies to go on expensive overseas acquisition binge (take dollar loan today, and repay it 5 years later when Rupee would have appreciated 20%).

And now suddenly, India finds itself staring into the barrel. Rupee has depreciated suddenly to Rs 50. Overnight, the capital allocation decisions made in 2007 by India Inc turn into demons. Suddenly, the currency derivative bets made by importers and exporters have backfired and caused some of them to go bankrupt.

What does the current currency regime expect? That the CFO of a small local company will be smart enough to figure out how currencies are moving and hedge appropriately? Even the most educated financiers and businessmen are unable to look through the currency movements and are carried away by the momentum. The probability of a emerging market currency bust in a decade is almost 100%, if I were to extrapolate the history of last 20 years. Is a young person setting up an export unit in India really making the right career choice from a 10 year perspective, considering that the biggest variable that will affect him - the currency - is outside his control.

So what is the solution? I dont know. A fixed exchange regime doesn't work either, as we know from Bretton Woods. Different countries grow at different rates and have differing inflation and interest rates. Over time, the fixed exchange regime becomes inflexible and a black market in currency develops.

One solution could be that countries become part of larger currency blocs. Like the Euro. But this means that countries need to give up their sovereignity, which is something not a lot of countries would like to do. One currency means a broad consensus on fiscal and political philosophy.

If the outcome of this crises is that more countries come together and better global institutions are created, it would all be worthwhile. It could also go the other away - like it did in the 1930s. So lets hope for the best.

1 comment:


The gold standard kept governments from printing unlimited amounts of money.