A peg in a poke

by The Economist

Currency markets have suddenly become a lot more volatile

THE year is only a few weeks old but already there has been turmoil in the foreign-exchange markets. On January 28th Singapore eased monetary policy, allowing its currency to fall to its lowest level against the dollar since 2010. The Swiss have abandoned their policy of capping the franc against the euro and the European Central Bank (ECB) has unveiled a big programme of quantitative easing (QE), sending the euro to an 11-year low against the dollar (see chart). Meanwhile, a rate cut from the Bank of Canada has pushed the loonie down to around 80 American cents, from 94 cents a year ago.

The main reason for this sudden surge of volatility seems to be a divergence in monetary policy: no longer are central banks moving in the same direction. “There are two huge forces at work,” says David Bloom, a currency strategist at HSBC. “The ECB and Bank of Japan are printing money and devaluing their currencies while the US economy is growing strongly. Anyone who stands in the middle risks getting crushed.”

The Swiss were caught in the middle. Their cap involved creating Swiss francs and using them to buy euro-denominated assets, but they clearly balked at maintaining this policy in the face of QE in the euro area. A much stronger franc, however, will add to the deflationary pressures in the domestic economy.

Falling commodity prices mean this is a potential problem for much of the rich world. A stronger currency can be the difference between low inflation and outright deflation. But currencies are a zero-sum game: if the euro and yen weaken, something must gain. So foreign-exchange markets become a little like a game of pass-the-parcel, in which countries try to offload the threat of deflation somewhere else.

Meanwhile, emerging-market currencies, which took a bit of a battering in 2014, have been recovering. The Brazilian real, the Indian rupee and the Turkish lira have all risen by more than 10% against the euro since mid-December. Simon Derrick, a currency strategist at BNY Mellon, a fund-management group, says there are signs of a “carry trade” at work, with traders borrowing money cheaply in euros and investing in higher-yielding currencies in the developing world.

Volatility is a bit like a bouncy castle: sit down on one side and it will pop up somewhere else. Central banks have intervened heavily in the bond markets, bringing yields down to historic lows. Equity markets have also been boosted by the conviction that central banks will remain supportive. And corporate bond markets have been pretty steady; low government-bond yields have caused income-seeking investors to buy corporate debt and defaults have been very low.

So it is unsurprising that volatility is appearing in other markets—most dramatically in oil and now in currencies as well. However, sudden currency moves can be devastating for companies and individuals who have borrowed abroad. Many east Europeans took out mortgages in Swiss francs to take advantage of lower interest rates and are nursing big losses after the franc’s sudden rise.

Mismatching assets and liabilities by borrowing in a foreign currency is rarely a good idea. Of course, many of those home-owners will have been tempted to take out a Swiss-franc mortgage because of the franc’s peg to the euro. Therein lies the problem with currency pegs. They may eliminate volatility in the short term, but at the cost of a very big currency move if the peg gives way. The problem was faced on an even bigger scale by Thailand in the 1990s with its dollar peg, and by Argentina, which abandoned a currency board in 2002; that shift necessitated the forcible conversion of dollar deposits into pesos, the so-called corralito.

Pegs require a lot of discipline. If monetary policy in the target country changes, the pegging country has to follow suit, regardless of the consequences. Other economic priorities have to be subordinated to the currency target. The strain often proves too much, as it did when Britain left the European exchange-rate mechanism in September 1992.

A single currency is an extreme version of a peg. And Greece’s new government is chafing at the constraints imposed by being part of the euro zone. (Some of those constraints may be unnecessarily onerous but that is another matter.) Greek bank shares have been tanking on fears of capital flight. If the strains prove too much, the result may involve leaving the euro and capital controls—a Greek corralito. That would only reinforce 2015’s growing reputation for currency spasms.

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