As of this writing, the U.S. dollar (USD) has been in a bit of
a tailspin against all of the major currencies. Much of this is a
result of the unwinding of multiple months of buildup of
risk-aversion trades. More interesting is the fact that against the
major currencies, the USD is now back up to levels seen at the end
of September, just when the full force of the financial meltdown
hit. So, what does this really mean? Is the financial crisis over
or - like the old TV soap opera Dallas, where its finale tried to
convince the audience that effectively the whole series was a dream
- did it never happen? Is the USD back on its pre-June 2008 course
of significant decline? Are +1.60 euro (EUR) and +2.10 British
pound (GBP) back in scope? Have the markets priced in such gains
that they somehow forgot to factor in an evaporation of over $70
trillion in credit fueling such financial asset gains from 2005 to
early 2008? We'll explore some of these questions and provide some
guidance for you to operate in the "New Post Crisis World."
The Return of Volatility
In a nutshell, the crisis has given us a cold reacquaintance with
persistent, elevated volatility as a result of the following macro
trends.
- Safe haven retreat mindset shifts to risk
seeking - Is the safest place to put one's money actively
hedged flows? Until five weeks ago, the safe haven was the USD. The
safety motivation no longer exists and it appears the fearful have
been coming out of their caves since late February 2009. They are
buying Australian dollars (AUD) (+30.4 percent), New Zealand
dollars (NZD) (+33.4 percent), Canadian dollars (CAD) (+20.2
percent), British pounds (GBP) (+20.5 percent) and Norwegian krones
(NOK) (+16.6 percent). Annualize these numbers and you are facing a
daunting 85-percent to 140-percent price change in these
currencies. Sustaining those levels of gains is unlikely, but the
real question is have you factored this volatility into
your FX impact planning and actioned against it through a very
tight hedging program?
- Spend, spend, spend - The U.S. government has
astounded the market with a spending commitment of $12.8 trillion
(80 percent of its GDP) to break the credit freeze and help the
U.S. avoid a full-blown depression. The Eurozone - of which
Germany, France and Spain account for 60 percent of its economy -
spent/pledged 22, 19 and 23 percent of GDP respectively. Japan
committed about 5 percent and England 19 percent. Add China's USD
$500 billion commitment and you have a lot of taxpayer money trying
to solve the problem and not very well, with the exception of
China. The implication for your FX strategy is whether
to protect against price inflation or
deflation.
- Emerging markets, emerging again - This trend
is being bolstered by the BIC, not BRIC! In other words, China,
India and Brazil. China appears done with its worst. Just on
Purchasing Managers Index (PMI) data alone, its production activity
has been above 50 for 4 months and GDP estimates are bottoming out
at 6.5 percent, which in this environment is spectacular. India has
passed its election, which has had the effect of relieving pressure
against the currency which weakened to 52 with a scope now toward a
1- year average of 44.55. Watch for Emerging Markets
(EM) currency appreciation through the next several years
particularly for the Chinese renminbi (CNY), Indian rupee (INR),
Korean won (KRW) and Brazilian real (BRL).
First Region out of the Recession
This is an important question because we may be looking at a new
world economic order where the USD shares its base reserve status.
The caveat is that it will take quite some time. The U.S. still
holds economic hegemony over the world, but ever since the ground
zero of the crisis last July, the United States' status in the G10
faces its first diminishment. It is China that is arising as both
an influencer and capital warehouse. Bottom line, the U.S. will
drive the first real stage of economic recovery, as the world is
still dependent on its consumers. However, Chinese consumer
spending, production, lending and business activity have all shown
buoyancy, whereas U.S. consumers are still reeling from losing
$11.2 trillion in wealth last year and won't be buying much other
than food and gas for awhile. That leaves both countries even more
reliant on exports for growth. A weaker currency would be the
answer for both countries. The USD is experiencing that naturally,
while the People's Bank of China (PBOC) is attempting to balance
its huge USD currency reserves against upward pressure in the CNY.
The possibility of a regional Asian currency is intriguing at best.
It's not practical yet, but a key development would be a type of
economic d�tente with Taiwan, which could firm up China's dominance
in the region.
The Asian story is still about China, which is coming back at a
strong pace. First quarter 2009 monthly average lending has been
about USD $220 billion, although April and May levels eased down to
USD $87 billion, acceding to the notion that lending has gotten out
of hand. Regardless, this has had the effect of 1) keeping the GDP
above 6 percent, and 2) low unemployment (China does not release
those figures, but estimates for the cities are about 6-7 percent.)
The Taiwan dollar (TWD) is feeling the enormously beneficial
effects of mainland China thawing relations by opening up daily
flights between the two countries and unprecedented trade missions.
All of this is being manifest in huge gains in major Asian equity
exchanges with about 12-15 percent gains on the Sensex, Shanghai
Composite, Hang Seng.
It appears that Europe will be the last region to emerge, but will
serve as an important intermediary or quasi-broker between the U.S.
and China with regard to next generation economic dominance.
Traditionally economic recovery in Europe is led by exports, with
high value goods in Germany particularly leading the way. The
problem is that Euro region exports to the U.S. are down 4 percent
in 2008 and down 25 percent in the months of January and February
this year. Some key European fund managers for long-term fixed
income assets have hedged for a EUR decline later this year to
1.25. It is worth noting that a Goldman Sachs study shows that
every 6 percent appreciation of EUR vs. major economies equates to
a 1 percent interest rate increase. EUR has gained 7.7 percent
since October 2008. This puts the European Central Bank (ECB) in a
very awkward spot about any further easing. As for the UK, there
aren't many signs of a recovery yet. We've seen over a 20 percent
rise in the GBP since its lows in late February as a result of the
market concluding the pound being extremely oversold.
An Alternative Currency to USD?
While there has been some interesting lip service to this notion
from Russia and China, the simple answer is no. First of all, in
terms of liquidity and market share, the USD has no close equal. At
the end of 2008, the USD accounted for 64 percent of all central
bank reserves, up from 62.85 in June 2008. This ratio has not
changed very much in the past five years. Second, no other currency
has the depth of liquidity, stability, consistency of economic,
taxation, fiscal and monetary policy nor trade-weighted equilibrium
as the USD. By definition, this immediately eliminates the Russian
ruble (RUB) as even a remote possibility despite President
Medvedev's recent postulations about a regionally-based currency.
The RMB would be disqualified on obvious grounds based on its
status as a controlled currency, and even more so on its lack of
liquidity, but we would not discount that currency's prominence in
the future. That leaves the EUR in a position in which each
country's (i.e. Ireland, Spain and Greece) fiscal disparities and
resulting distortions make it almost impossible for the ECB, let
alone each country, to manage fiscal policy the way the U.S. does
without potential threats of social unrest. So, for the next couple
of decades, the USD is the reserve currency with the CNY in
waiting.
Are you Prepared?
There are several key questions that you should answer as you
prepare your foreign exchange strategy.
- If you have an FX policy, have you updated to factor in
increased volatility management and implications?
- Are your credit lines in place for increased and/or decreased
exposure?
- Are you inherently long, short or flat of the currencies?
- Have you factored in the weighted average volatility of your
currency per your period flows?
- Are your earnings and dividends protected either through
natural corporate cash flow or hedges?
- Are your existing estimated cash flows over-hedged, meaning
does your cash forecast match your hedging dates? If not, you have
open contract FX settlement risk.
- Is the latest weakness in the USD an opportunity to sell some
of your currency exposures? Conversely, you should consider
including a protection strategy that takes into account a sell-off
of the "hot currencies" of late, like AUD, NZD, and CAD?
- Have you modeled in potential tax levies against foreign
subsidiary repatriations that the Obama administration is
seeking?
- Are you being forced or considering pricing in local currency
and thus preparing your FX exposures?
- Are you bidding for projects globally and considering the use
of currency options to help protect the bid and award?
- Given the recent uptick in U.S. interest rates and potentially
lower rates from the ECB this month, are you considering the use of
foreign currency loans to improve your net cost of working
capital?
The Silicon Valley Bank Foreign Exchange Team is pleased to help
you with any of these questions as you develop an FX strategy to
prepare for this "new post crisis world" and any other FX needs you
might have.