John Taylor says three decades of currency trading taught him that a financial turmoil prompts large banks to favour local lending, and that’s why he’s buying US dollars for the biggest foreign-exchange hedge fund.
“Whenever a banking system realises it’s in big trouble, it says, ‘I have to take care of my next door neighbors and the businesses down the block,” said Taylor, who manages $11.4 billion as the chairman of New York-based FX Concepts. “Then the currency of that country, if its banks are big in international lending like in the US, will strengthen.”
Evidence of so-called financial protectionism surfaced last week. Stephen Hester, CEO of Royal Bank of Scotland Group, said on February 26 that the largest government-controlled bank of UK will cut back or withdraw from 36 of 54 countries where it operates to focus on its “heartland.”
The pound and franc will also benefit from such moves, while currencies of New Zealand and other nations dependent on international banking will suffer, said Hans-Guenter Redeker, BNP Paribas’ chief currency strategist in London. He predicts the dollar will strengthen 4.4 per cent to 1.20 a euro by June 30.
Concern about home-lending favoritism follows pledges of more than $10 trillion by governments around the world to prop up banking systems. More than $1.1 trillion of writedowns and losses created the worst financial crisis since the 1930s and triggered a global recession.
Protectionist measures
US President Barack Obama’s $787-billion stimulus plan, enacted last month, includes “Buy American” provisions. French President Nicolas Sarkozy created a fund in November to protect “strategic” companies from “foreign predators.” Russia increased duties on automobile imports in December, while India limited steel imports and imposed tariffs on soybean oil.
Historians blame a trade war during the Great Depression, starting with US passing the Smoot-Hawley Tariff Act in 1930, for deepening the worldwide economic slump. History also shows that exchange rates are vulnerable to protectionist threats, said Derek Halpenny, the London-based European head of global currency research at the Bank of Tokyo-Mitsubishi UFJ. The dollar slid to a record low of 79.75 yen in April 1995 after the US threatened to impose tariffs on Japan.
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Redeker said financial protectionism adds a layer of danger to the foreign exchange markets, where trading increased to $3.2 trillion a day as international banks expanded. Loans to overseas borrowers, along with other foreign claims, totaled $31 trillion in mid-2007, up from $11 trillion at the end of 2000, the Bank for International Settlements said in a report today.
Royal Bank of Scotland
“The problem is that many banks that operate internationally have received government funds,” Redeker said.
Those banks will be pressured into “prioritising local markets and withdrawing from abroad at an increasingly rapid rate. This will prove to be quite a negative move for those countries that don’t have a strong enough banking system of their own and have in the past, relied on banking from abroad.”
After posting the biggest loss in UK history, Edinburgh-based Royal Bank of Scotland plans to boost lending to UK homeowners and businesses by £50 billion ($71.1 billion) as part of an agreement with the government to shift £325 billion of investments into a state insurance programme.
Decline in the shares of financial companies helped push the Standard & Poor’s 500 Index to a 12-year low last week, on concern that the deepening recession will force banks to seek more government aid.
The premium banks charge each other for short-term loans. A barometer of willingness to lend known as the Libor-OIS spread, was 1.02 percentage points on February 27, about 10 times the average for the decade before August 2007.
Dollar Index
The dollar rose to the highest in almost three years against the currencies of six major US trading partners on February 27 as investors sought refuge in the world’s preferred reserve currency. The Dollar Index, which the ICE exchange uses to track the US currency versus the euro, yen, pound, Swiss franc, Canadian dollar and Swedish kroner, reached 88.490, the highest level since April 2006. It’s up 8.2 per cent this year.
Last month was the worst for yen against the dollar since 1995, as Japan’s currency weakened 7.85 per cent. The euro depreciated versus the dollar too, losing 1.2 per cent last week and New Zealand dollar declined 2.1 per cent against its US counterpart.
‘Road to disaster’
For Taylor of FX Concepts, who worked at Citibank until 1979, today’s markets are reminiscent of the late 1970s and early 1980s.
Oil prices more than doubled and the Federal Reserve lifted its target rate for overnight loans to 20 per cent by March 1980 from 10 per cent at the beginning of 1979, leading the US into a recession that lasted from January to July 1980. The Dollar Index surged 22 per cent between the end of 1979 and the close of 1981.