Monday, November 28, 2005

The Forex Fumble

Never forget that it is the spirit with which you endow your work that makes it useful or futile. - Adelaide Hasse

Most readers are likely familiar with the notion, the spirit of the law, as opposed to the letter thereof. In the arena of political campaign finance, the spirit of any reform law almost always aims at the same ideal, one man, one vote-pure representative government. The intent is to stop concentrations of wealth from producing concentrations of votes. As a practical matter, this intent manifests in a series of written laws. Those who, for a variety of reasons, some of which include placing personal over systemic gain, disagree with the spirit of the laws then work diligently to get around the letter of the law. This idea of the spirit can apply, as the opening quote suggests, to all human endeavor. People can either go through the motions or do it like they mean it and eventually those observing your actions will know what drives you and act accordingly.

While the recent unsatisfying, to the extent one aim of elections is the easing of popular tensions, elections in Iraq might be a good example of the distinction between a good faith election and a going through the motions election, I'll stick to a collection of elections with which I had some first hand experience, those in Indonesia in 1997-1998.

On May 29, 1997, Golkar, the Party headed by Suharto, Indonesia's de facto dictator for the preceding three decades, increased their majority in Parliamentary elections. The result was never in doubt to those in the US House of Representatives Committee on International Relations, where, on May 7 of 1997, Rep. Berman of California stated, No one doubts that the ruling Golkar Party will once again win on May 29. Next March, I think it is everyone's expectation that President Suharto will win a seventh 5-year term.

By the end of 1997, the Asian Financial Crisis, which lists as its proximate causes, rising current account deficits and a large stock of external debt which made further debt expansion unlikely, once the hot money crowd got cold feet, was being felt in Indonesia. I was living in the region at the time and used to do quite a bit of island hopping, with Bali, just east of Java, the main island of the Indonesian archipelago, one of my favored destinations. As something of a regular I noted the stark change in attitudes around this time. Even the Balinese, noted for their non violent variant of Hinduism, were depressed and conditions in Jakarta, the capital city in Java, not known for their non-violence, were extremely tense.

In March of 1998, Suharto won election as President (surprise!) for the seventh time. As a result, tensions, which had only occasionally manifested in violence previously, boiled over. The student demonstrations became bigger and bigger, and the riots become more and more violent. By the end of May, after trying a few political tricks, like offering to change his cabinet, Suharto finally stepped down. In October of 1999, Abdurrahman Wahid was elected President in what was billed as Indonesia's "first free presidential election." Although tensions still manifest in Indonesia, that they were increasing while the people felt that they had no other option and were decreasing as people saw that they could affect change seems clear. As President Kennedy opined, Those who make peaceful revolution impossible will make violent revolution inevitable.

As an aside, I sometimes wonder if Paul Wolfowitz, now head of the World Bank but before that one of the architects of the Iraq War and notably one of those who pushed the "they will welcome us as liberators" view, based his sense of things on his experience in Indonesia in particular and SE Asia in general. Prior to his incarnation as Bush II's War Chief, Mr. Wolfowitz was Ambassador to Indonesia during the 80s. As one of the advisors to Suharto, Mr. Wolfowitz pushed a banking sector deregulation plan which set the stage for the currency implosion a decade later. Only a few months before Indonesia's financial sector was thrown into turmoil, the effects of which on the poor I saw first hand, Mr. Wolfowitz spoke to the aforenoted Committee on International Relations, clapping himself on the back for his role helping (quoting from his testimony): to not privatize the Indonesian economy, because that was a bad word, but they used the word deregulate. Does anything this guy touches turn out right? Not so far on the public stage, but then again, Ms. Hasse has perhaps suggested to us why that might be.

How sad that in 1997 you can already see the same bait and switch tactics, oh if the people think privatizing is bad, we will call it deregulation. And this was the guy who wanted to promote "democracy" to the world. What kind of democracy is it when the leaders routinely mislead the led?...a corrupt one. To avoid misunderstanding, I'm not arguing that aristocracies are inherently wrong, or democracies inherently right. What seems wrong to me is calling an aristocracy a democracy...but that, I guess, is what happens as cultures become sophisticated. Anyway, by early 1998, as part of the Project for a New American Century, Wolfowtiz and the rest of the gang, perhaps emboldened by the ease with which long standing governments were falling in SE Asia, began to push for War with Iraq. Now, back to our main program.

I use the election metaphor to allegorically describe what I sense in the forex markets these days. As elections are the theoretical means by which people are able to affect government polices, the foreign exchange markets are the theoretical means by which investors are able to affect change in economic policies. In both cases, these are the means by which the led can give feedback to the leaders.

Lets go over a bit of history to flesh out this point. The currency crises of the early 70s which led to the breakdown of the Bretton Woods system arose in part because the US was unwilling to abide by the rules of the game, and because others correctly bet that they would be unwilling, as seems to be happening now. Although the spirit of the Bretton Woods accord called for member nations to adjust their policies so as to avoid significant trade imbalances before such actions were necessary, the enforcement mechanism of calling gold to settle external debts was the supposed Sword of Damocles. Nixon's closing of the Gold window in 1971 was, in our election metaphor, like telling voters they could vote for whomever they liked so long as it was Nixon. Hit this link to read the opinion from Japan's Ministry of Finance on the topic (go to bottom of linked page)

One of the reasons behind the financial turbulence in the 70s was the lack of a system in which investors felt comfortable to invest over the long term. This isn't to suggest that financial flows ceased but rather that their character changed from longer term real sector investment to hot money, speculative flows. The foreign exchange market, which prior to the point had been a rather minor banking function, was then chosen as the new means by which external adjustments could be signaled and enforced.

By the late 1980s, when I found employment in the Forex market, it was booming. In part the boom was an effect of the profits made during the first US test of the new external account enforcement mechanism, the Plaza Accord. In the frame of this discussion, the Plaza Accord was like a free election in a time of domestic stress, proof that the players in the system could affect change and that the big guys were willing to take a hit. In terms of daily trading volumes, the Forex market has never looked back, rising from US$206 Bil in March 1986 to US$2,408 Bil in April 2004 (BIS).

In the intervening years since the Plaza Accord, many nations have suffered the ill effects of forex market mediated external account adjustments, from Britain and Italy in the early 1990s to the aforementioned SE Asian nations in the late 90s, to Russia right thereafter. Particularly in the case of the SE Asian nations, initial currency weakness led eventually to contractionary policies; higher interest rates, reduced public sector debt, and a much weaker currency. Admittedly, most of the nations in SE Asia initially tried to hide the problems, a choice which eventually left some of the former leaders in jail. Eventually, however, they all took their medicine. Generally, the forex market was proving to be a means to affect change or as Ms. Hasse might put it, people were acting in the spirit of the articles of agreement of the IMF.

As noted above, the economic prescription which follows from the forex market as signal for external adjustment will often lead to political change. Argentina, Brazil, S. Korea, Indonesia, Thailand and Russia all experienced political change in response to the contractionary economic policies of external account adjustment. As an aside, I don't think there is much a nation can do to avoid the pain of the contraction besides acting sooner, under the view that it is easier to lose 5 pounds on a diet than 50.

Following in the footsteps of the late 90s financial turmoil, attention began to turn to the United States, whose external accounts in terms of both stock (net investment position) and flow (current account) were negative and deteriorating. The collapse of the Nasdaq bubble and the election of George W. Bush, who ran on a platform including a return to responsible government that would abide by the rules, in 2000 hinted that the long awaited adjustment might be upon us. The attacks of 9/11 poured cold water on those harboring that hope. The current account deficit reported by the government was US$389B in 2001. By 2004, that deficit had climbed to banana republic status of more than 5% of GDP at US$668B and continues to increase.

Statistics like these and the historical perils to which they allude in part led investors like Warren Buffett to enter the forex markets assuming that they were the preferred vehicle by which such adjustments were instigated. This is to argue that investors, like Mr. Buffett, acted in good faith by accepting that in the new post Bretton Woods order, other currencies within the forex system would be the anti-national currency, not gold or other valued goods.

As I think on it now,
keeping the economic players of the world on sides, so to write, within the paradigm they created and managed was a stunning achievement by the financial industry. In accordance with that paradigm, the US$ lost value in a fairly ordered way. By late in 2004, the speculative world was heavily short leveraged US$, perhaps with visions of those Plaza Accord profits in their heads and the financial press was abuzz with demise of the US$ stories. The writing, as they say in Daniel, was on the wall. Then, the fumble, as I see it, although in terms of history, the instant replay judges have obviously yet to rule.

In early 2005, as the USDX (an index value of the US$ vs a basket of different currencies) flirted with multi decade lows while speculators of a contrarian nature were shouting "oversold" and old timers responded with graphs of the US$'s post Plaza Accord descent, a curious thing happened, at least with respect to the forex market as adjustment mechanism paradigm. The US$ failed to break to new lows. Perhaps it was just recalcitrance on the part of the US, intransigence by the Chinese, the inherent flaw in the system which is that you really can't force the guy in charge, he must submit voluntartily, or more likely some combination of those and other factors, including the sense behind this bon mot via Stephen Roach, We all know these imbalances you speak of are unsustainable -- we just can’t afford to focus on the endgame. There's a slice of wisdom for ya, being unable to afford to focus on the end game, which is admitted to be inevitable. Reality, in my view, bites hard for people who live within that paradigm.

By the middle of this year, the US$ had recovered nearly 10% from its nadir. Just recently, I see that the fumble was picked up by the other team, so to write. While a few countries like Argentina, who had earlier thumbed its nose at the IMF, had been buying gold as reserves it was only recently that Russia's Central Bank, which used to speak of, and in fact, implemented the policy of decreasing the percentage of US$ in its reserves by buying Euros, announced they would be doubling the percentage of current reserves they denominate in Gold. I also see that Warren Buffett has begun exiting his US$ shorts, and taking a bit of a loss in the process. This is where I see the true faux pas. Buffett, as far as I know, was not a leveraged speculator but a true asset hedger. His US$ sales were attempts to shield his clients from the inevitable effects of overdue government policy. He, and others who acted within the paradigm put forward by the financial world acted in good faith and got smoked.

One cost of this process is that the commodity inflation that would have been visited on the US has been shared with the rest of the world. That is, the US$ didn't rise over the past 12 months, all the other currencies just lost more ground versus goods and services. This is a sign to me that this resolution is not to be forestalled much longer. Another, and I think more costly error for those hoping to keep the investing world within the current financial paradigm, is the loss of faith, the experience of a rigged election, if you will. If the forex markets are not going to be the vehicle through which external account adjustments are mediated, and given that the effects of the adjustment, by virtue of the US$'s position as reserve currency, will extend far beyond US shores, the political will to take that route seems small, then investors will look for alternatives. That is, if being short US$ in the forex markets is no longer a hedge against a depreciating US$, then
Gold, which has been the anti-national currency of choice for millennia, seems the next obvious choice.

Given the decoupling of Gold to the US$ in 2005, perhaps other investors are of like mind. Speculators in 2004 had made great money buying Gold when the Euro rose and vice versa. This year, however, Gold is breaking out in all currencies, while the US$ gains within the forex system. The game laid out in the IMF's articles of agreement seems to be at a crucial point. The desire to divest from the US$ seems strong but like Hotel California, it seems like you can check out any time you like, but you can never leave. Either the US$ begins to decline within the forex exchange system, with US-Asia rates bearing much of the change thus validating the post Bretton Woods paradigm, or this new game of token currencies will end. The good faith, engendered by the decision in 1985 to abide by the spirit of the agreement, will ebb.

In a sense it is kind of ironic, the problem, as I see things, with the old systems of bi-mettalism, gold standard, or gold exchange standard, to name a few, weren't with the systems themselves but rather in finding the will to go along with the rules, to act in accord with the spirit of the agreement, whatever it was. You can build the most high tech scale we want, write the most complex law, and devise the most intricate computer monitoring system, but it won't do any good unless you are willing to change your behavior.