Amid the tide of speculation on Monday about the impact of the US $700bn-plus bail-out plan on just-about-everything is some heated debate about the impact it will have on the dollar and forex markets in general. Some analysts say that the massive US expenditure on this so-called TARP (the Troubled Assets Relief Program) and other costly US rescue measures (Fannie, Freddie, AIG etc. etc.) – at a cost approaching $1,00bn -will derail the dollar’s recent rally.
As Bloomberg noted on Monday, while the rescue may restore investor confidence to battered financial markets, “traders will again focus on the twin budget and current-account deficits and negative real US interest rates”.
It quotes John Taylor, chairman of International Foreign Exchange Concepts, the world’s biggest currency hedge-fund firm with about $15bn under management warning: “As we get to the other side of this, the dollar will get crushed.”
But other analysts say that while the dollar may suffer short-term, the US government’s planned rescue will strengthen the currency before long and ultimately will return forex markets to the trend of the past months. Adam Boyton, currency strategist at Deutsche Bank, told Bloomberg the plan will be “ultimately good for the dollar” and while reducing both risk and volatility, will get “the focus back on macroeconomic fundamentals, which suggest weakness throughout the rest of the globe next year, with returning strength in the US”.
On the other hand, as Maurice Pomery, head of FX research at IDEAglobal, told the FT, the danger is that the bail-out vehicle would probably have to sit on the US balance sheet – which would be “very bad news in the longer run” as it may at some point constitute a downgrade of US debt and the ensuing dump of US assets could spark a huge run on the dollar. “This is some way off and there is a lot of noise to get through but the US Treasury is playing with fire,” he warned.
Just like Japan back in the bad old days, the US at this point has little choice.
When Japan developed a similar idea in early 2002, the yen-dollar exchange rate strengthened. But, notes Richard Jerram, Macquarie Bank’s chief economist in Japan, in a Monday note, there are some important differences:
On the assumption that the US financial system needs more capital than the private sector is prepared to supply, some form of public fund injection is necessary. This can come through two routes. The most equitable route is raising as much capital (probably in the form of preferred shares) as necessary once reasonable provision is made for impairments to banks’ balance sheets. This might be unacceptable to a Republican administration.
An alternative is to sell the impaired assets to the government at an inflated price, which can have a similar effect on the capital position of financial institutions. This is less transparent, but has the implication that investors are being subsidised by taxpayers, which could be unacceptable to a Democrat-dominated Congress. Simply selling assets to the government at fair market prices does not resolve the problem of undercapitalisation of the financial system, but it would permit an assessment of the scale of the problem and brings liquidity to the market.
There is an associated problem of bailing out banks by over-paying for their assets, which is that other interest groups can also demand aid. Car makers? Home owners? This risks increasing costs and economic distortions.
In Japan in 2002-03, developing a vehicle for a debt workout of distressed firms – called the IRCJ – was an element in the late stages of the Japanese financial system trauma, notes Jerram. However, it was relatively small scale (“capacity of about 2 per cent of GDP”), and accompanied by the banks raising new capital as well as a cyclical recovery that improved systemic stability. The exchange rate moved from Y122 to the dollar at end-September 2002 to Y107 by end-December 2003, by which time the Bank of Japan was intervening heavily to limit the degree of appreciation. Bond yields rose just 18bp over the same period.
A major difference between the two countries is that in 2003 Japan was running a current account surplus of 3 per cent of GDP, while the US is facing a deficit of close to 5 per cent. Another difference is that Japan was already enjoying a cyclical upswing that was generating foreign interest in domestic assets.
Despite concerns that a $700bn fund to purchase assets from banks will crash the value of dollar, there are two points to bear in mind.
First, it is not very much money – 5 per cent of GDP – and this is gross cost, not net. Second, it is cheaper than procrastination. Japan’s inaction and resultant poor growth and asset deflation took net public debt from 13 per cent of GDP in 1991 to 85 per cent by 2005. Raising confidence that the high costs of forbearance can be avoided should increase the attraction of the dollar.