March 26, 1995

Article at Sunday Age

BUSINESS | Money’s making the world go round

Global financial markets, unleashed by deregulation, have grown to have unparalleled power over economies even to the point of determining interest rates. But the herd instincts of the markets are driven by perception rather than reality, and governments today have little choice but to toe the line of the new king makers.

By Wilson da Silva

PRESIDENT Bill Clinton could be forgiven for feeling frustrated.

After dipping into the US Federal Reserve’s war chest to rescue Mexico from a financial meltdown, ungrateful currency markets not only dismissed his hairy-chested gesture; they went on to punish the US dollar. 

The waves of selling that have followed recently have been so ferocious, and so immune to the aggressive buying campaigns of the central banks (which have sought to prop the dollar up), that it has done what was once thought inconceivable: it has called into question the US dollar’s once unchallenged role as the de facto reserve currency of the world.

The power of global financial markets most visibly the currency markets but also operating in swaps, futures, forwards and options is restricting the ability of governments to control their own economies. With the currency markets alone now trading close to $1400 billion a day, no government can match the power of the markets, economists say. Even the last defence of national governments, interest rates, are being held hostage to the markets.

“They are now determining the value of exchange rates, they determine the levels of interest rates, despite what national governments want them to be,” said Professor Johannes Juettner of Sydney’s Macquarie University who is also an adviser to Germany’s central bank, the Bundesbank.

“They have now assumed the power, more or less, of setting interest rates, what was once assumed to be the prerogative of central banks.

It’s really frightening; no one was prepared for this very fast change.”

Mr Juettner, along with many economists, considers this beneficial since it imposes discipline on national governments. But it is when perception does not meet the reality that economies can be unnecessarily damaged. This has sobering implications for Australia.

Take the case of the flight of capital from the US currency into the German mark and the Japanese yen. On the basis of equilibrium values and purchasing power parity, and on a trade-weighted analysis, economists say the mark is overvalued by 15 to 20 per cent. In the case of the yen, it is overvalued by some 40 per cent against the US dollar alone. This is despite the fact that the Japanese economy is in the doldrums, and the German economy is a hardly a paragon of growth, with GDP growth static at 2.8 per cent.

In the meantime, the Australian economy, which has been growing strongly at 4.3 per cent and performing moderately well overall, has seen its currency sink, to stand some 20 per cent undervalued on the same measures.

In the case of the US dollar, the chief trigger appears to have been the Mexico bailout. Other factors have been in play: American authorities have not lifted interest rates earlier this year as expected by the markets, and January’s Kobe earthquake in Japan did not have the dire economic implications that were forecast, allowing the yen to appreciate.

But the growing pessimism about the US economy, along with the failure of the US Congress to pass a budget-balancing amendment to the constitution, along with the Mexico bailout, appears to have convinced markets that there is no prospect for a correction of what they see as the country’s structural ills: huge budget deficits and a ballooning balance of payments deficit.

These have turned the US into the world’s largest debtor nation, in many ways hostage to the global financial markets. This does not, however, appear to have seeped in with US leaders.

“There is still a starry-eyed ‘we are the leader of the world’ approach,” said Mr Neville Norman, economics professor at the University of Melbourne. “It is true that the US’s fiscal management has been woeful. But that does not mean it can’t afford to do the things it’s done in Mexico. I don’t think it’s ‘can’t afford’ in the financial sense, I think it’s ‘can’t afford’ in the psychological sense. Perceptions are always important, but they are never more important than in currency markets.”

The twin deficits of the US, although problematic, are not large in percentage terms. The US annual trade deficit is estimated at $US154 billion in 1994, and the budget deficit stands at $US202 billion, a shortfall that is forecast by the OECD to double by 2004 if it is not tackled. But the budget deficit in 1994 only represented 3 per cent of GDP, and the balance of payments deficit some 2.3 per cent. Australia, by comparison, had an estimated budget deficit of 3.2 per cent of GDP and balance of payments deficit that represents 4 per cent of GDP, OECD figures show. However, it is structural problems like these that send institutional investors scampering at the first whiff of trouble.

Hence the Mexico bailout and frustration with the failure of the budget-balancing legislation in the US created an expectation in the market that the mark and the yen would rise. Institutional investors proceeded to increase their mark and yen holdings in anticipation, bidding up the price and making it all a self-fulfilling prophecy.

“That is what we will see more and more of,” said Mr Juettner.

“Interest rates will be determined by these powerful institutions that very often act like a pack of wolves. They have a herd instinct and they are sometimes, under stress, not very rational. I’m absolutely convinced that in the long run, the mark will be devalued, because the German economy is not as productive as the recent revaluations of the currency would suggest. Both the mark and the yen are hideously over-valued.”

Such pronouncements have little effect in the perception-driven, short attention span of the foreign exchange dealing room. Asked if the estimates that the Australian dollar was undervalued by as much as 20 per cent were accurate, trader Mr Dale Felton of HSBC Markets in Sydney told ‘The Sunday Age’: “That may be the case, but my focus is on the short-term. It’s basically not my job to decide where it should be, just where it’s going to be in the next 10 minutes.”

In the past few years, when currencies have plummetted, central banks have spent between $US5 billion and $US10 billion at a time defending them. This was once effective, and markets trembled at rumors of central bank intervention. But these days foreign exchange markets collectively have more cash than the central banks, who, spending less than 3 per cent of a day’s turnover, can only keep the other 97 per cent of the trade temporarily at bay. Markets soon return the focus to what they see as the fundamentals.

These days, the US dollar retreats and rebounds sporadically. But what is interesting about the recent episodes is that the shockwaves haven’t stopped there. The strengthening mark put pressure on the Spanish peseta and the Portuguese escudo, which were forced earlier this month to devalue their currencies in the face of a torrent of selling.

European finance ministers meeting this week were aghast at another currency crisis so soon after the near-collapse of the European Exchange Rate Mechanism in 1992, and called for the International Monetary Fund and the Group of Seven industrial economies to solve the currency instability.

So where does this leave national governments? Has the power to manage economies passed irretrievably from governments to the markets?

Some economists favor a return to the gold standard that operated between 1945 and 1971, when the value of currencies was backed by gold reserves. But US bullion dealers have estimated that for current national gold reserves to properly undepin currencies, the price of gold would have to rise from just under $US400 an ounce to around $US40,000 an ounce.

Clearly, the horse has well and truly bolted.