“The global crisis is caused by pathologies inherent in the global financial system itself. »- George Soros.
George Soros became a distinguished personality in the investment world after he “blow up the Bank of England”. In 1992, he made a contrarian bet against one of the world’s biggest central banks by shorting $10 billion worth of pounds. The “Black Wednesday” that made Soros a billion pounds took place on September 16, 1992, when the British government was embarrassed and was “constrained “ withdraw the pound sterling from the European Exchange Rate Mechanism (ERM). While Mr Soros and other short sellers made a bounty, British taxpayers lost £3.3billion. As the saying goes, one person’s gain is another person’s loss.
Reminiscent of Black Wednesday, the 1997 Asian financial crisis led to a currency crisis in Southeast Asia. The contagion, which started in Thailand, quickly spread to other parts of Asia, and the currency crisis soon led to a sharp decline in stock markets. However, jittery markets were soothed by the IMF and World Bank, which bailed out vulnerable Southeast Asian economies and averted a full-blown global crisis.
Let’s take a deep dive to understand the next “Asian Currency Crisis”!
The end of the Gold Standard in 1971 and the subsequent signing of the Plaza Accord in 1985 made the USD the hegemony of the currency markets. With the demise of the Gold Standard, central banks gained colossal power to print as much money as they wanted regardless of the “reserves” that backed it, as was the case with the Gold Standard.
As the power of the United States expanded globally, the greenback became the preferred choice of central bankers around the world to park their export earnings and their “foreign exchange reserves”. The USD’s “reserve currency” status has led the world’s central banks to park 59% of their global reserves in the form of cash or US Treasury bonds.
The influence of the USD king is such that several countries have adopted the USD as their official currency. In addition, nearly 14 countries have also “ankle” their currencies to the USD. But wait! What does a peg actually mean?
A currency peg refers to an agreement in which the government of a country sets a specific fixed exchange rate for its currency with a foreign currency. The peg curbs currency volatility and promotes stability. However, to maintain the peg, the central bank must hold a sufficient and substantial amount of foreign exchange reserves to be used in times of crisis..
However, pegging the currency can also lead to some problems:
- If a currency is pegged too low against USD (consider INR and USD, INR pegged 100 to USD), then Indians would have to pay too much for imported goods like energy , which would harm citizens’ consumption.
- If a currency is pegged too high against USD (consider INR and USD, INR pegged 10 to USD), then imports would become too cheap, and Indians would go into a spending spree that would cause imports to skyrocket. The ramifications of soaring imports would be an astronomical current account deficit which, in turn, lead to the depreciation of the national currency. But wait, we’re tied. So to stop the depreciation the central bank would have to use the reserves and one day the peg will collapse as the reserves run out!
East Asian countries: Thailand, South Korea, Malaysia, Indonesia, Philippines and Singapore were known as “Asian Tigers” in the 1990s. These economies experienced rapid economic growth in the years leading up to the 1997 financial crisis. outstanding the growth was the result of the following:
ASEAN countries had a large current account deficit (imports >> exports) and therefore needed a surplus financial account to balance the DAC. The surplus financial account had to be either via foreign investment or external borrowing. Unfortunately, the Asian Tigers blundered and took advantage of the cheap dollars/hot money readily available in the financial system by borrowing heavily. Ideally, they should have taken steps to increase their exports and attract long-term foreign capital.
External debt-to-GDP ratios rose from 100% to 167% in ASEAN’s four largest economies between 1993 and 1996 and reached over 180% during the crisis.
Until there was ample liquidity globally, foreign exchange markets operated smoothly in Southeast Asia. The currencies of the Asian Tigers even appreciated against the dollar. However, the problems started to get worse when there was a takeover of the “hot money » due to rising interest rates in the US (as investors wanted to move their money to the USD king). And there was chaos in the currencies of the Asian Tigers:
It all started in Thailand. When there was a huge outflow of capital from the Thai economy, the Thai central bank used all its firepower to keep the Thai Bhat pegged. However, all foreign exchange reserves were depleted and the peg broke, causing the Thai Baht to depreciate sharply against the USD. Likewise, the South Korean won and the currencies of other Southeast Asian countries fell.
The currency depreciation was a double whammy for the Asian Tigers.
- The cost of interest on foreign borrowings for the sovereign and private companies rose sharply → national companies and the government had to earn more in local currency to service their foreign debts!
- The cost of imports has increased dramatically → higher inflation!
The consequences of the financial crisis have been disastrous, especially for the economies of South Korea, Thailand and Indonesia. The IMF stepped in to rescue troubled countries and launched its largest-ever $40 billion program to stabilize the currencies of the “Asian Tigers”. As a result, there were social and political upheavals; however, the IMF’s timely intervention halted the contagion, and the rest of the world was spared a global crisis.
In one of my widely read newsletters, The Contrarian Central Bank, I explained that Japan is caught in a death trap and has only two choices: either tighten: sacrifice its bond markets and destroy its economy , or not to tighten: sacrifice its currency and destroy its economy.
We all know the BoJ is determined to defend its 0.25% JGB “peg” at all costs. However, lately, traders around the world, like George Soros in 1992, have started betting heavily against the Bank of Japan (BoJ). These traders believe that the BOJ will eventually change its stance on yields and therefore short Japanese government bonds (JGBs). This resulted in ten-year swap rates hitting 0.5%, well above the BoJ’s 0.25% peg.
Nonetheless, I think the BoJ has plenty of room to expand its balance sheet further, as it only holds 45% of the total outstanding sovereign debt. Thus, he would continue to buy the JGBs and defend the peg. However, in the process, the BoJ would continue to sacrifice the yen, which is hovering around a fresh 24-year low at 134-135. So how do you get into an “Asian” monetary crisis?
In the 1990s, the Chinese resorted to the devaluation of the CNY (Chinese yuan) to increase their manufacturing exports to the world. In doing so, they gained global export market share at the expense of the Japanese. However, the recent sharp depreciation of the Japanese yen has raised alarm bells in Beijing. The Chinese fear that the depreciation of the yen offers a unfair competitive advantage to the Japanese and harm their exports. Thus, there is a good chance that to support their exports again and give new impetus to their “weak” economy, the Chinese will again devalue their currency.
If the Chinese decided to devalue the CNY, we would see a currency crisis erupt in Asia. The other countries willto be forced” to devalue their currencies to safeguard their exports, which would lead to:
(imports ==> more expensive ==> higher CAD ==> “A vicious circle”)
We have already seen that Pakistan and Sri Lanka appealed to the IMF for bailouts, and their currencies lost ground against the US dollar. Other Asian countries with low foreign exchange reserves would experience similar suffering; unfortunately, there is no way out!
We live in a highly uncertain world. Western central banks have resorted to unprecedented monetary tightening (with the exception of course of the “helpless” ECB and BoJ). The ramifications of central bank actions cannot be ignored; Not only have we witnessed the worst bond rout on record, but we are also witnessing record moves in currency markets around the world.
If the necessary measures are not taken in time to support the world’s sensitive economies, we could witness a global financial crisis of epic proportions.
Want to know what happened when the Fed last raised rates 75 basis points in 1994?
The IMF had to bail out Mexico!