Global markets have tumbled again this week, following the downgrading of Italy’s debt rating and a series of negative comments from leaders of the world’s financial institutions.
International Monetary Fund Managing Director Christine Lagarde and World Bank Robert Zoellick chief warned that global growth was set to stall, while US Federal Reserve Chairman Ben Bernanke voiced doubt about the economic recovery in his country.
The local share market posted losses throughout week on the comments, and negative sentiment pushed the Australian dollar to below parity with the US dollar for the first time in months.
Given the impact of the comments from Lagarde, Zoellick and Bernanke, would it better for financial leaders to stay quiet during crises? Melbourne Business School Associate Professor Sam Wylie explains the logic behind the leaders’ brutal honesty, and the potential short-time impact of the market slump for the Australian dollar.
Should Lagarde, Zoellick and Bernanke, keep quiet during crises?
These people are not politicians, so their creditability really matters to them.
Politics is essentially a form of organised lying. Central bankers and heads of global financial institutions, on the other hand, need to be able to speak with authority during times of crisis. If they talk rubbish most of the time, then people won’t listen to them when a crisis hits.
This leaves a tension between them not spooking the markets, while also maintaining their credibility.
Ben Bernanke can’t just go around making happy talk, especially in a real crisis like in the wake of the Lehman Brothers collapse.
When Bernanke said this week that growth was slowing in United States, he wasn’t saying anything people didn’t know already. But it had a significant impact because he was speaking with authority.
What is surprising is that the heads of these institutions are not particularly coordinated in their comments. It’s not surprising that each one of them should say something negative, but it is unhelpful for them to speak all at the same time.
Given that the G20 meeting is coming up, they are probably in frequent contact anyway. So would make sense for them to stagger their comments to reduce the impact on confidence.
How bad was the impact of this week’s comments?
The biggest impact has been on equities markets, and on the Australian dollar, which demonstrates that investors think that global growth is going to slow.
Until recently were looking at 4% global growth over the next few years, which is very healthy and very good for Australia.
For Australia, it doesn’t really matter where the global growth comes from, as long as it is reasonably high. Growth above 3.5% would be sufficient to ensure demand for our resources and keep commodity price high.
But if you look at the share prices of BHP Billiton and Rio Tinto over the past week, you can see that people believe that commodity prices will fall due to slowing global growth.
Does this have the potential to push down the Australian dollar?
If I knew what was going to happen to the dollar then I’d start a hedge fund.
But it is interesting to look at what happened the last time the market was spooked.
The last time the markets got very spooked was in March 2009, six months after the collapse of Lehman Brothers. This was actually the low point of the Australian market during the global financial crisis.
At that time, the Aussie was tracking about 94 US cents, and then it fell to 60 cents.
Nobody knows exactly what happened, because these are over-the-counter transactions and it’s hard to know who was trading.
But what is believed to have happened is that there were very large carry positions, where people – hedge funds in particular – were borrowing in low-interest-rate currencies and then lending into Australia.
They often borrow in Japanese yen and lend in the Aussie dollar and earn the difference in interest rates – that is what’s know as the “carry”.
It is quite a dangerous thing to do, because if the Aussie dollar goes down then the lower exchange rate means that they don’t have enough proceeds to pay off the debt in yen.
If the Aussie dollar does start to go down, they have to close-off their position so they don’t lose too much. They have to put stop-loss orders in place, and they all head to the exit at same time.
This pushes the Aussie down even faster, and appears to be what pushed it off a cliff in March 2009.
I point this out because the Aussie has gone from about $US1.07 at the beginning of the month to as low as 96 US cents overnight. So while it hasn’t fallen off a cliff, it has gone to a point where the people who have carried that money into Australia to capitalise off the interest-rate difference might be looking to exit again.
I don’t know what is going to happen to the Australian dollar in the short term, but the events of May 2009 demonstrate the potential danger of hedge funds trying the cut their losses.
If there are very large carry trade positions in place this time, and the hedge fund are looking to unwind their positions, then there is a danger that the dollar could fall off a cliff.