When the U.S. government refused to bail out Lehman Brothers and no buyer could be found for the tottering investment bank, traders and investors around the world realized something terrifying: their profits—worse yet, their capital—were at risk, and the Fed’s lack of action proved no one was going to save them.
Results Round One
The result was panic. Faced with massive losses, these international investors yanked their funds from commodities, stocks and other investment vehicles in emerging markets around the globe and bought bonds offered by developed nations. Any investment seen as riskier than a 90-day T-bill was spurned in what has come to be called “the flight to quality.”
The result of that result was the unwinding of carry trades. In that scheme, traders take out loans in nations with low interest rates (such as Switzerland at 2.0%, the U.S. at 1.0% or Japan at 0.3%) and invest the funds in nations with high ones (such as New Zealand at 6.5%, South Africa at 15.5% or Iceland at 18%), thus earning the “spread” between those rates. But currency fluctuations, caused by shifting interest rates or decreasing economic potential in the investment nation, put both profits and capital at risk, and during the flight to quality traders dumped these investments and repaid their loans. In the process, the South Korean stock market collapsed 40%, Ukraine’s 60%, Iceland’s 90% (see chart of the Icelandic index above, October 17). The Russian market ceased trading for two days, hoping for stability to emerge; it didn’t happen.
The next result was the appreciation of the U.S. dollar against every currency in the world with the lone exception of the Japanese yen. Since mid-August, when the unwinding of carry trades began in earnest, JPY has appreciated almost 18% against USD as these international traders “sell” the dollar and “buy” the yen to repay their Japanese loans. The yen rose so high that the affordability of, and therefore the profit from Japan’s exports, slumped, with Toyota’s profits shrinking 69% in the most recent quarter and Sony’s by 72%.
Results Round Two?
And that’s the good news.
With the worst of the flight to quality complete, most major currencies appear to be stabilizing against USD, albeit at lower than anticipated levels. The Euro, which was worth an historic high of $1.60 as late as July 14, lost $0.37 in value by October 28, or 23%. The U.K. pound, which was as high as $2.11 a year ago, currently trades at $1.56, down 26%. These currencies are also shifting in value against each other. The exchange ratio between the Euro and the Swiss franc, another traditional safe-haven currency in times of financial stress, has fallen 12.6% since July 31.
In terms of international finance, these are huge moves, particularly for emerging economies. With the rise of globalization, loans of all varieties—corporate, individual, inter-governmental—are now made across national boundaries and across currencies. As currencies shift into new relative value ranges, the payment terms of these loans shift to follow, meaning that Swiss loans to Euro-funded nations are now 12.6% more expensive than they were three months earlier.
Current estimates place 90% of all Hungarian mortgages written since 2006 in Swiss francs. With the Hungarian forint down 17%, these mortgages are ballooning in cost just as their adjustable-rate counterparts did in the U.S. when the Fed raised the prime interest rate. The financial world already knows the rest of that story. Rather than waiting for the rush of defaults and foreclosures both corporate and domestic, the International Monetary Fund, European Central Bank and World Bank loaned Hungary 20 billion Euros (US$25.5 billion) on October 29. Loans to Ukraine, Pakistan, Iceland and other nations are following quickly.
But similar circumstances in Romania, Bulgaria, Serbia, Lithuania, Latvia, Croatia, Poland, Slovakia, Belarus and the Czech Republic mean the second round of the financial crisis may be happening across the Atlantic. Even worse, the story is repeated in parts of Asia and in Central and South America. All told, a total of US$4.7 trillion in loans cross these international borders, and Western European banks hold three-quarters of those notes, an amount that dwarfs U.S. banks’ exposure in the first round of that crisis. In Austria alone, bank exposure to these notes is 85% of national gross domestic product and in Switzerland it’s 50%.
Steve Forbes may believe the worst is over. Europe doesn’t necessarily agree.
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