The Forex Nitty Gritty

Will 1% loans from the European Central Bank to struggling European banks result in stabilization of the European banking system or a Euro carry trade? The European Union has been in a sovereign debt dilemma for a couple of years. The Southern tier of EU nations, plus Ireland, has become the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) group. These nations, most notably Greece, would have been unable to finance their national debts without aid from lenders, the IMF, the European Central Bank and other EU nations in particular. The possibility of a breakup of the European Union or at least the departure of Greece and a couple of other nations loomed over the continent for the last few months. Just recently EU leaders met in Paris and agreed to amend the EU treaty to allow closer financial integration. (Read this as putting a cap on politically motivated pork barrel spending to buy local votes.) In addition EU members gave the European Central Bank greater authority and autonomy in dealing with the overall debt situation as many banks were weak and many considered a run on French banks a distinct possibility as many had invested heavily in bonds from Greece, Italy, and the others. But, just what does this have to do with a Euro carry trade?

The expression, carry trade, is usually associated with the Yen and not the Euro. Japan has had extremely low interest rates for two decades. Investors holding Yen can engage in foreign exchange trading and obtain US dollars or other international currencies in search of better returns on investment. Then the investor buys US Treasuries if he now has dollars or, perhaps, Italian or Greek national debt bonds if he has turned in Yen into Euros. Anyone who bought dollars before the rally last fall and then purchased treasury bills before rates fell did doubly well.

On the other hand many Japanese repatriated offshore assets to pay for the destruction of the worst earthquake and tsunami in their history. This Yen repatriation sent the currency up dangerously fast. The rise in the Yen was only halted by threats of the G7 ministers to intervene in strength. Anyone who held offshore assets in a Yen carry trade did poorly at that point. The point of the Yen carry trade is to have or borrow assets in a nation where interest rates are low, convert to another currency, and invest where interest rates are high. The point is also that a change in currency rates does not erase all profits. This is the connection to a so called Euro carry trade.

A concern of some is that struggling European banks that have received 1% interest loans may be tempted to invest in high risk, potentially high return, debt. Whether this would be European debt or to use foreign currency trading in order to practice a Euro carry trade debt elsewhere in the world the potential for profits could be great, providing that the global economic picture brightens. On the other hand the loans could amount to throwing good money after bad if anyone tries such an aggressive and risky strategy. The good news for those fearful of such a scenario is that overnight deposits at the European Central Bank are at an all-time high. Apparently many of the European banks that needed bailouts have learned their lesson. They are avoiding any semblance of a Euro carry trade and putting their short term money in the most secure location available, even at low overnight interest rates.

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Will an increase in China foreign investment limits lead to a wave of Chinese acquisitions worldwide? If the relevant Chinese authority gives the go ahead individual Chinese investors will be able to purchase and use increased amounts of foreign currencies. Considering the country’s mammoth currency reserves an increase in China foreign investment limits could greatly widen the range of investments available to wealthy Chinese. As Chinese exports decline Forex traders expect less upward pressure on the Yuan. The Euro crisis and the US debt dilemma are far from resolved. Continued slow economic growth in North America and a new recession in Europe are likely to further reduce demand for Chinese exports although trader surpluses are likely to continue into the far distant future. While there threatens to be a run on French banks and a Moody downgrade of European nation debt ratings China may be extending its foreign investments and internationalizing the Yuan.

China has been under increasing pressure to let the Yuan float versus other currencies. The rationale of both European and North America leaders is that if allowed to float to its true value the Yuan will go up significantly in price. The rationale continues that a higher priced Yuan will make Chinese products less competitive and those of the EU, USA, and other nations more competitive. The goal of leaders in the West is to staunch the perpetual red ink in their balances of payments with the Chinese. For the Forex trader deciding how China foreign investment limits fit into the picture may spell the difference between profit and loss. It may be with an eventual increase of the Yuan that China is talking about allowing more of its citizens to convert Yuan to US dollars, Euros, Yen, and other major currencies in order to diversify the wealth of the nation. However, China has done spectacularly well in the last forty years since opening up to the rest of the world and done so under a very strictly controlled regime. It can be argued that they would have done better with less control. However, things as they are, China’s financial leaders may be concerned about too much capital escaping their direct control. Thus any moves to increase China foreign investment limits may be slow. Of course, if recession returns to Euro and North America, Chinese exports will suffer and in the Forex markets one may need to trade a declining Yuan.

In order to make purchases of foreign products, parts, or services, Chinese companies must purchase foreign exchange from the Central Bank and other institutions. A measure of Chinese foreign trade is the net value of foreign exchange sold by banks in a given month. When companies make a profit in a foreign currency that must sold back to the Central Bank or other financial institutions. Most recent available figures show $4.4 Billion US dollar value in sales of Yuan. This is the highest in four years. China has the world’s largest foreign currency reserves valued at over $3 Trillion USD. Because the Central bank recently sold more foreign currency that it has purchased it appears that there has been a net exit of capital from China in the last month or so which has also been seen in a diminished China current account surplus. All of this is pertinent in sorting out the end Forex result of increased China foreign investment limits.

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Will an upcoming review result in a Moody downgrade of European national debt ratings? If Moody downgrades the debt rating of every nation in Europe will it make a difference? Remember that Moody, Fitch, and Standard and Poors were roundly criticized for not picking up on the sorry state of bank finances running up to the 2008 market crash. The fact that the US and other nations had to ante up trillions of dollars in stimulus payments and money to keep credit flowing has been often blamed on Moody and the others. Now, as the European debt dilemma drags on Moody’s Investors Service has announced that it will review the debt rating of every nation in the European Union. This has to do with the need for bailout money to avoid debt defaults by Greece and the other nations in the so called PIIGS group. If everyone depletes their national treasury in order to bail out the southern tier nations of the EU, and Ireland, will someone else be next in line for bailout or debt default? An up and down stock market and the threat of a run on French banks has kept investors as well as currency traders concerned. The Euro has taken its hits due to possibility of a partial EU breakup. Will a Moody downgrade of European national debt ratings be the next step and, if so, what will be the difference.

In a perfect world of debt rating Moody’s and other merely restate the obvious. If a company or government has poor cash flow and little cash it may not be able to pay its debts. It may, in fact, see its debt rating reduced from AAA to junk. If investors are paying attention they will not need the review of a debt rating agency to tell them the obvious. The recent European debt summit resulted in an agreement by 17 nations to revise the EU treaty giving more power to the European Central Bank. The prospect of more fiscal discipline by EU members has many feeling good about an eventual resolution to the debt dilemma. In the short term there are still problems despite the promise implicit in the new treaty agreement and Fitch Ratings remarked to the effect that the summit did not really fix anything in the short term, a restatement of the obvious. Beside efforts by the EU at large, each nation of the European Union will need to tighten its belt as seen in the new French austerity plan, whether there is a Moody downgrade of European national debt ratings or not.

The proof is in the pudding, they say. The efforts of European nations to exert more control over local finances fix the Greek debt crisis and avoid other calamities, can be successful with sufficient attention to detail. But, once the EU is out of the global spotlight, will efforts to clean up the EU fiscal mess proceed or be swept under the rug? Assigning a number to the likelihood that a company or a nation will not follow through and pay its bills is the business of Moody and others. Although the EU has increased the power of the Central Bank to deal with this crisis there are those who believe that giving more power to the bankers is an effort to let the politicians off the hook. In the case of EU politicians it is the old Walt Kelly saying that “We have met the enemy and he is us.” It will take a lot of insight and honesty for all relevant politicians throughout Europe to forego buying votes with programs when that has been the way to do business since they sent Napoleon to Elba, the second time. Maybe a Moody downgrade of European national debt ratings is the best choice, to keep the politicians honest, another oxymoron.

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Could there be a run on French banks if credit agencies downgrade their debt ratings? A bank run is when many customers of a bank simultaneously wish to withdraw funds. They do this, commonly, because they believe that the bank might go into bankruptcy and that they, the customer, will lose money. If a sufficiently large number of customers decide to withdraw their money for fear of the bank becoming insolvent it can become a self-fulfilling prophecy. A possible run on French banks is of concern because the large deposits that many nations, including Germany and the US have in these banks. It was the run on many US banks in the early 1930’s that helps create the Great Depression. The prospect of a Greek debt default is especially worrisome for French banks as they hold substantial amounts of Greek debt. As with other bank runs it is the prospect of losing money that drives depositors to withdraw funds.

There are a number of ways that banks attempt to prevent a run. An old and often successful procedure is to close the bank temporarily. Such a “bank holiday” stems the flow of capital out of the bank while other measures are instituted to protect the bank. Deposit insurance helps protect depositors but the amounts of deposit insurance are useful for individuals and not for nations. The interconnectedness of banks and other financial institutions is such that damage from a run on French banks and subsequent collapse could spread to North America and Asia. It is a measure of how seriously investors take this situation that when news of a possible resolution to the European debt dilemma emerged this last week socks soared in the US and worldwide. Varying foreign currency rates have been a hallmark of this situation.

Nations throughout the world have been trying to get a hand on the degree to which their banks are exposed to this situation. The US Federal Reserve announced that it is analyzing the books of the six largest US financial institutions for European, especially French, debt. It is pertinent that Bank of America, Citigroup, Goldman Sachs, Morgan Stanley, JPMorgan Chase, and Wells Fargo have deposits equal to two thirds of the US GDP which comes to a little under $10 Trillion USD. The concern of the Fed is the currency swaps in which these folks have engaged. In a currency swap two parties exchange currencies or interest payments on currencies on a fixed future date. These are Forex transactions. Speculators use these in search of profits. Central banks may use these to keep currencies stable. The concern of the Fed is that US banks may have excessive exposure to the Euro and the risk of a Euro collapse if the European debt dilemma becomes unsolvable. This combination of Forex and sovereign debt has plagued the markets for over a year and may, indeed, produce a run on French banks. As credit agencies such as Moody’s appraise the situation Forex traders are wary of movement of the Euro and the US Federal Reserve is pumping dollars into Europe in order to forestall a global financial disaster.

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