Dollar Falls Some More

Improved investor sentiment about the world economy seems to be leading to the dollar falling in value.

You can see here that the initial rally happened after Bear Stearns collapsed, and that it accelerated after Lehman's collapse, really after the TARP legislation was first rejected by Congress.

If the world economic crisis is receding then the value of the dollar as a safe haven is less important, and long-term fundamental factors begin to drive investor behavior.

Grading on a Curve

I noted before that this is an amazing crisis. While we may have caused it, the rest of the world feels it much more. Floyd Norris notes, that if we have to grade on a curve, the US probably gets an A for its economic performance in the last year. For example,

In the fourth quarter of last year, the American economy shrank at a 3.8 percent annual rate, the worst such performance in a quarter-century. They are envious in Japan, where this week the comparable figure came in at negative 12.7 percent — three times as bad.

Industrial production in the United States is falling at the fastest rate in three decades. But the 10 percent year-over-year plunge reported this week for January looks good in comparison to the declines in countries like Germany, off almost 13 percent in its most recently reported month, and South Korea, down about 21 percent.

Another way to look at it is to ask what would be the current value of $100 invested in the stock market on Dec 31, 2007 in various countries? Again, we do pretty well. While it would only be worth $53 today, consider that:

Among major markets, only Japan, at $59, has done better. In Britain, France, Spain and Germany, the figure would be around $45. In Italy, it would be $37. About a quarter of the money would still be there in countries like Ireland, Greece and Poland.

Remember the BRIC countries, where growth possibilities seemed limitless not long ago? The stars there are Brazil and China, where about $46 or $47 remains. In India, the figure is $35, and in Russia it is $23. At least they have all done a lot better than Iceland, where you would have just $3 left of your hypothetical $100.

In international finance we often talk of sudden stops. When capital inflows cease because of some shock to confidence (or in this case an increase in risk aversion in the financial capital) then it is like hitting a lamppost in your speeding car. Seems like this unfortunate metaphor is really hitting in many places now. I suppose that makes us the elderly driver driving so slowly that we induced other drivers to make the risky pass.

Eastern Europe in Trouble

The crisis is clearly hitting Eastern Europe hard. See here and here. Countries that had been growing fast, based on cheap foreign borrowing, are now hurting as the capital flow is reversing. Moreover, these countries must now repay their debts denominated in currencies that have appreciated relative to those in Eastern Europe. Fragile banking systems are also threatened.

This is the background to the call yesterday:

European leaders called for doubling the International Monetary Fund's war chest to $500 billion for bailing out financially stricken nations, amid new signs that Europe's former Communist east is sliding into a full-blown crisis.

This is all in the wake of already approved programs for Hungary, Ukraine, Iceland, Belarus, and Latvia worth more than $39 billion, and a request from Serbia will be considered soon.

Crisis Deepens

Two signs that the crisis is deepening worldwide. From Russia we see that industrial production fell in January at an annual rate of 16%. Russia is of course suffering from the collapse of the world economy, oil prices declining, and the outflow of capital from its thin financial system. Moreover, since its prosperity had bubble-like features, it is not surprising that its collapse looks so severe.

Meanwhile, Japan's GDP fell by 12.7% in the last quarter, the worst fall since the first oil shock in 1974. See the pictures here. Japan is suffering from the collapse in demand for its exports, and the unwinding of the carry trade which had kept its currency undervalued. Edward Hugh argues that the aging of Japan's population makes them especially vulnerable to declines in export demand since consumption growth is restrained.

And I was already depressed by the "Buy America" features of the stimulus bill. We live in an interdependent world, and such policies are only going to make things worse.

Crisis Goes Global

The financial crisis has gone global (see also here). Emerging markets were hit especially hard, the Morgan Stanley Emerging Market Index fell 11 percent, its larges daily fall since 1987. Russia and Brazil experienced large losses in their stock markets, where trading was suspended. This reflects the global demand for safety. Consequently, funds are leaving emerging markets for safe havens. You can see this by looking at what has happened to the dollar price of the euro. The financial crisis has ironically caused a large appreciation in the dollar.


This is perhaps even more apparent when one looks at an emerging economy currency, such as Brazil.



Notice that this dollar rally reflects a flight to safety. It is not a long-term rise in confidence in the US economy. Indeed, one must suspect that in the longer term the dollar must depreciate to offset the current account deficit, and as a reaction to the increase in liquidity injected into the economy.

Given how thin some emerging markets are, especially Russia, the flight to safety causes very large shocks to domestic stock markets. I will return to the Russian case in a later post because this raises the question of what the shock signals about Russia versus the world economy right now.