Internal Report Urges Gulf States to Rethink Their Dollar Pegs

It makes perfect sense for high growth countries to de-peg from the US dollar, since the Fed does not have the latitude to raise rates to fight inflation, and a monetary inflation is gripping most of the world, sourced by the US dollar as the world's reserve currency and its negative interest rates.

The US dollar peg could transmit a troublesome easing of monetary policy to those who peg to its currency since the US is in recession, but inflation is more of a problem in the growth countries like the BRIC and the Middle East, and to a lesser extent in Europe.

The postential downside is that this provides an all too convenient for government and economic demagogues to denounce countries that drop the peg as causing the US' problems, shifting blame from themselves and the reckless and irresponsible US banking system, its regulators, the Fed, and the corporations that have sprung up around them.

Gulf states urged to rethink dollar pegs
By James Drummond in Abu Dhabi
Sunday Jul 6 2008 14:45
The Financial Times

Abu Dhabi has reignited speculation that the United Arab Emirates may break its fixed peg to the US dollar. The UAE is one of the world's main holders of dollar-denominated assets.

In a report published at the weekend, the Abu Dhabi department of planning and economy floated the idea of tracking a basket of currencies in advance of formation of a currency union in the six-member Gulf Co-operation Council.

The department is answerable to the emirate of Abu Dhabi and is not a federal policymaking body. However, it reflects official thinking in the most wealthy of the seven statelets that comprise the UAE.

Inflation in the UAE runs at 11 per cent and is higher elsewhere in the Gulf. The dollar peg means Gulf central bankers have to match the interest rate moves of the US Federal Reserve and thus have only limited tools with which to curb inflation.

"Although the UAE has officially made it clear that it would not de-peg its currency from the flagging US dollar, international financial institutions as well as experts and analysts have maintained that the UAE would do well [to float] its currency as a means [of] curbing inflation," the report said.

Qatar and the UAE are usually thought to be the most likely states to quit the dollar peg. Speculation mounted last year that the UAE was about to break with the dollar after ambiguous comments by Sultan Bin Nasser Al Suwaidi, central bank governor, but the authorities acted to deny it.

Of the GCC states, only Kuwait manages a currency basket dominated by the dollar but it can decide its own interest rate policy. Inflation in Kuwait is lower than in the other GCC states.

"GCC states need to peg against a basket of world currencies, taking into account the latest trading patterns, which tend to be bent toward the eurozone and Asia," the Abu Dhabi department said.

"That the Gulf states continued to have fixed-dollar exchange rates, even as the dollar continues to decline, causes greater harm to the Gulf countries," it said.

Analysts did not believe a change in the UAE's currency administration was imminent, although the report clearly reflected a strand of thinking. Simon Williams, economist at HSBC in Dubai, said the report showed a preference for joint action over unilateral action.

"The case for reform of the GCC currency regimes is strong but we don't anticipate change taking place in the near-term. The report may indicate that debate is ongoing but I don't take it as a sign that change is nigh," Mr Williams said.

The UAE yesterday said that it was forgiving up to $7bn (€4.5bn, £3.5bn) in principal and arrears of Iraqi debt to help Baghdad with reconstruction. The announcement coincided with a visit to Abu Dhabi by Nouri al-Maliki, Iraqi prime minister, and with confirmation that the UAE will send an ambassador to Baghdad two years after one of its diplomats was kidnapped there.

Currency Crisis in the Dollar May Be the Next Shock - BMO Nesbitt Burns

The Bottom Line: The Latest View on the Economy
Next Shock: Currency Crisis?
by Sherry Cooper
July 7, 2008
BMO Financial Group

The malaise of the U.S. economy is palpable. Not only have sky-high food and gas prices drained consumer discretionary income, but the weak dollar has dampened travel plans and the stock market declines have exacerbated the wealth destruction coming from the housing collapse. Businesses in many sectors continue to lay off workers as earnings collapse in the auto and airline industries, banks and brokerages, housing-related retail stores or just about anything discretionary.

Consumer finances are in perilous condition, a harbinger for further declines in consumer confidence. With growth running at about a 1% annual rate in the second quarter, most of which is in net exports, the Fed would have trouble doing anything but remaining on the sidelines, despite the mounting inflation pressure.

The ECB hiked rates last week for the first time in just over a year in a pre-emptive strike against inflation. The move had been so well telegraphed that the U.S. dollar actually rallied on the news, especially after Trichet indicated he had no bias on further moves.

A recession in the U.S. is apparent, but other G7 countries are now more vulnerable than ever to a punishing slowdown as well. After a decade and a half of continuous growth in Canada and Britain, a downturn comes as a painful shock. Ontario’s economic decline portends the spreading pain. Britain appears to be following the U.S. in a downturn in housing and retailing. As in the U.S., the bad news has weakened the prospects for the incumbent political parties.

Though many are calling for the government in both Britain and the U.S. to do something to spur the economy, the rising inflation pressure ties the hands of the central banks. Moreover, the governments cannot afford more crowd-pleasing giveaways, and there is a question just how effective the U.S. tax rebates were in the first place.

In the meantime, for decades, many emerging countries have fixed their currencies against the dollar to protect economies that were small, undiversified and dependent on the United States. But they are now the engines of global growth as the G7 struggles.

The BoE and the Fed have commented that inappropriately low interest rates in countries that peg their currencies to the dollar were helping to fuel commodity price inflation. Many of the countries in the Middle East and Asia are running double-digit or record-high inflation; but central banks cannot raise interest rates in response as long as they choose dollar pegs to keep their currencies undervalued.

The sustainability of the dollar pegs hinges on the U.S. interest rate outlook. If the Fed refrains from raising rates because of economic weakness, despite the rise in inflation, pegs will come under significant further pressure. This is a pressure cooker running over the boiling point.

The Bottom Line: The world may realize that it is no longer reasonable for the dollar to be the anchor currency. If several dollar-pegged currencies were revalued, we could expect to see some panic selling in the U.S. dollar, further destabilizing the global economy.

Dr. Sherry Cooper is the Executive Vice-President, Global Economic Strategist, BMO Financial Group, and Chief Economist, BMO Capital Markets & BMO Nesbitt Burns

Banking Crisis Will Be Much More Severe Than Expected Reaching $1.6 Trillion in Losses

This weekend a story appears in the Swiss Sunday newspaper SonntagsZeitung. It is based on a confidential report from Bridgewater Associates, one of the world's largest hedge funds.

Below is our translation from the German, and the original with a link. We find it amusing that stories of this magnitude from American sources are reaching us via Europe.

Based on these estimates we are about one-fourth of the way through this financial crisis.


SonntagsZeitung
Explosive Study: The banking crisis will be much worse

Westport (USA) - The expected losses from the financial crisis will be 1,600 billions of dollars. ($1.6 trillion). So far financial institutions have only declared 400 billion. This pessimistic forecast comes from a confidential study by Bridgewater Associates, the second largest hedge fund in the world.

"We are facing an avalanche of bad assets," says the study. The biggest losses have been in the U.S. banks. "We have significant doubts that the financial institutions will be able to raise new capital in order to cover the losses," says the report.

Bridgewater Associates enjoys a first-class reputation in financial circles, and several central banks are among its customers. "Bridgewater are on the pessimistic side," says George Magnus, Senior Economic Adviser at UBS in London, "but they have been absolutely right."


Original Story in German


Brisante Studie: Die Bankenkrise wird noch viel schlimmer

Westport (USA) - Die zu erwartenden Verluste aus der Finanzkrise werden sich auf 1600 Milliarden Dollar summieren. Davon haben die Finanzinstitute bisher erst 400 Milliarden bekannt gegeben. Die pessimistische Prognose stammt aus einer vertraulichen Studie von Bridgewater Associates, dem zweitgrössten Hedge- Fund der Welt.

«Wir stehen vor einer Lawine notleidender Vermögenswerte», heisst es in der Studie. Die grössten Verluste stünden den US-Kreditbanken bevor. «Wir haben grosse Zweifel, dass es den Finanzinstituten gelingen wird, genügend neues Eigenkapital aufzunehmen, um die Verluste zu decken», schreiben die Autoren.

Bridgewater Associates geniessen in Finanzkreisen einen erstklassigen Ruf, mehrere Notenbanken zählen zu ihren Kunden. «Bridgewater sind auf der pessimistischen Seite», sagt George Magnus, Senior Economic Adviser der UBS in London, «aber sie haben absolut Recht.»

Lessons from the Panic of 1907

I have just finished reading The Panic of 1907: Lessons Learned from the Market's Perfect Storm, written by Robert Bruner and Sean Carr in 2007. It is extraordinarily well documented step by step study of one of the worst bank panics and stock market crashes in modern times. (The broad stock market declined 37% from peak to trough in less than 15 months.)

Here is an extended quote from the author's closing remarks.

"Why do markets crash and bank panics occur? Any single case study, such as the one we have presented here, is subject to a range of interpretations, and we encourage the reader to draw one's own conclusions from the foregoing narrative.

Yet we think that the story of the panic and crash of 1907 inspires consideration that major financial crises can be the result of a convergence of certain unique forces - the forces of the market's perfect storm - that cause investors and depositors to act with alarm.

The recounting of the events of 1907 suggests that the storm gathers as follows.

It begins with a highly complex financial system, whose very complexity makes it difficult for anyone to know what might be going wrong; by definition, the multiple parts of the financial system are linked, which means that trouble in one institution, city, or region can travel easily and quickly to others.

Buoyant growth in the economy makes the financials system more fragile, in part due to the demand for capital and in part due to the tendency of some institutions to take on more risk than is prudent.

Leaders in government and the financials sector implement policies that advertently or inadvertently increase the exposure to risk of crisis.

An economic shock hits the financials system. The mood of the market swings from optimism to pessimism, create a self-reinforcing downward spiral. Collective action by leaders can arrest the spiral, though the speed and effectiveness which they act ultimately determines the length and severity of the crisis."

My own reaction is similar, except for some different emphasis and a slightly different slant, based on extensive readings about other panics and crashes, including a first hand look at the tech bubble collapse of 2001.

First, almost all panics and crashes are preceded by sustained periods of artificial growth, not based on improvements in productivity, but by a false expansion in the money system, aided and abetted by speculators and financiers. Although they do not act in overt cooperation, yet there is an unmistakable collusion of purpose. It suggests that the impulse to benefit in this way is present in a portion of the people at all times, as there are impulses to do many other things for personal benefit without regard to the public good. But at certain times the prohibitions which normally hold this behaviour in check are weakened, sometimes through active interventions against regulation, at other times from a decline in moral conscience.

Seocnd, almost all panics and crashes involves relatively small groups of people who seem to be at the heart of the matter, and are closely interlinked into small cartels of corrupted self-dealing involving the accumulation of enormous personal fortunes. One is struck by the interconnectedness of the primary players in the Panic of 1907 in each others companies, banks, investments, and boards of directors.

In this instance there did not seem to be any significant corruption of the government, which was actually in a progressive mood under Theodore Roosevelt, although he was by now a lame duck. Rather, the central government at this time was weak, and regulation was largely in the hands of the business principals, of which no greater example than J. Pierpont Morgan. They will act to protect their own interests when threatened, but their benevolent reputations are greatly exaggerated.

Lastly, there is always the overextension of credit and excessive leverage. Always. This is how the Ponzi scheme grows, for that is in every case what precedes and precipitates the growth of a crisis and panic - the unreasonable overvaluation and expansion of assets concentrations provoked again by a relatively small number of men, interlinked loosely through business associations.

As in the case of 1907 and its aftermath, a few visible persons are offered up for punishment and destruction, but the largest and most substantial of the predators remain unscathed, often being lionized as saviours who attempted the rescue of the nation from a few bad apples and the public from its own folly.

Although the authors make a great deal of the need to take swift and decisive action to stem the crisis, they miss the point that the place to stop this is before the leverage and excess build to the point where almost anything will set the overextended system into crisis and panic. Even if decisive action is taken, it is the greater public that is invariably harmed by the cure, with a few becoming even more enriched, although the harm be less than if nothing had been done at all. By the time the crisis is underway, you will be making deals of convenience, and at terms with the devil.

It should be stressed that there is no evidence in the correspondence of any of the principals that they desired to cause this Panic of 1907 for their own benefit. And there does not have to be.

If a general atmosphere of looting is fostered by the provocations of a few like-minded individuals, their subsequent actions need no coordination, other than the insufficient response of society to stop them before they gain sufficient momentum from their desires. It is the apathy and weakness of the many that provides the stimulus and the encouragement for their plans.

The authors do recount the subsequent meeting of many of the principals at Jekyll Island in 1910, to craft a reform of the banking system to be known as The Federal Reserve System. Again, I do not see anything in the system itself that is improper or malignant; it is only in it ability to increase and amplify leverage that makes it a powerful tool in like-minded individuals to seek to defraud the many of their life savings through unscrupulous abuse of anything and everything that comes under their power and control.

If you wish to take the measure of a society, look to how its weakest members are protected from its strongest, and its predators skulking at the fringes.

More concisely, you will receive the results that you incent, the behaviours that you cultivate, the society that you promote, if only by doing nothing and allowing small groups of like-minded individuals to set your greater agenda. We have seen this repeatedly in companies both large and small, in entire industries, and we think in the national economy.

If you wish a hell on earth, do nothing for the benefit of others, for the greater good, or to inhibit those who act solely out of greed, fear, and hate. Soon enough you will have a society that is intensely self-interested, self-concerned, superficial, destructive and self-consuming.

A free and just society is not a prize to be won or a gift that can be bestowed; it is a recurring commitment, and an enduring obligation.