In this second weekly article on the global meltdown, the writer explains the relationships between equities markets and forex, and trade deficit problems.
Magically everything got off to a wobbly levelling off by Tuesday – March 6, 2007 – due to a significant weakening in the yen exchange rate by more than 1% reversing the previous weeks' strengthening of almost 7% against the US dollar. By Wednesday, the global equities markets had recovered to find their own levels.
Yen in reverse
To move the yen into reverse gear by more than 1% in a day is not easily done and bore evidence of a Bank of Japan (BOJ) move, thus calming the jittery “carry-traders” who made imprudent borrowings and investments. The world must thank the BOJ for staving off a prolonged equities meltdown and possibly a global equities disaster – impoverishing millions of investors and reducing confidence in the workings of markets.
US Treasury Secretary
Henry Paulson, the US Treasury Secretary, was just a week before the global market collapse all charged up prior to his departure for China to demand an immediate and significant yuan appreciation to bail out the US trade deficit and ameliorate employment problems at home. That was simplistic economics.
The constant US harping coupled with the rising yen and yuan interest rates coalesced into sudden changed perceptions by “Yen-Yuan Carry Traders” into Chinese equities, which then triggered the Shanghai collapse. That was followed very quickly by yen-US dollar carry trades which were invested in sub-prime mortgage papers. The fact that the “carry traders” had borrowed the yen heavily for the US subprime mortgage market meant that sudden and immediate reversals of forex rates would also harm US citizenry interests. That stopped Paulson in his tracks.
Fortunately for the US, a huge block of Chinese reserves was recycled on a government-to-government basis by buying into US Treasuries. There was less pronounced panic arising from the strengthening yen versus the yuan as it is still pegged to the US dollar.
Paulson in Beijing
When Paulson landed in Beijing on March 8, the tune was different. There was no public stricturing of China's forex policy. Instead he urged the Chinese to develop a more balanced economy and hasten the modernisation of its financial system to bring benefits to its hardworking population. So Paulson was learning fast that the easy way out of meddling with seismic forex changes was enpasse in this era. China had in the past week appealed for non-communist help to narrow its rich-poor gap. So quite obviously, US calls were already noted. How can a communist system adopt capitalist methods so quickly? Guaranteed collapse would be the outcome.
The carry trades
“Carry trades” have developed into a global mechanism for global capital allocation. This means sudden forex changes to correct trade imbalances is now limited in scope and can be contained by central banks. The BOJ had acted responsibly and quickly enough to curb the tide of global financial panic and destruction. The use of political pressure on matters financial is clearly limited.
Trade deficits and world wars
Past world wars were triggered largely by trade imbalances. The evolution of the “gold standard” to correct trade imbalances ended in 1972. The de facto global US dollar reserve currency replacing the gold standard worked with limitations for the past 35 years. The build-up of huge forex reserves by exporting countries has posed new challenges. The world is at an early stage of adopting the US dollar, euro and yen combination as global reserve currencies. New ways must evolve to restore global growth and greater equity markets stability.