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Investment of the quarter: Market forces

Could currency volatility be the first symptom of wider stress in financial markets? William Cain reports

Could currency volatility be the first symptom of wider stress in financial markets? William Cainreports 

Currency considerations are never far away from any debate about the economic fortunes of the world’s three largest economies. China’s switch to a freer-floating currency regime in mid-2015 saw the yuan devalue, triggering a bout of market panic in the third quarter of last year.

Japan has the opposite problem, battling against a persistently strong yen, while markets continue to monitor US interest rates for clues on the future direction of the dollar.

And, elsewhere, the United Kingdom’s vote to leave the European Union saw sterling register its biggest one day fall against the dollar since the end of the Gold Standard in 1971. The abandonment of the Swiss franc-euro peg in early 2015 also shook markets.

Foreign exchange volatility, and the fall out for financial markets, has grabbed the headlines but it is a different anomaly which has caught the attention of some of the world’s leading financial thinkers.

Bank of International Settlements economic adviser Hyun Song Shin points out that one of the key laws governing the value of contracts in foreign exchange markets has started to fail, signaling wider pressure in financial markets.

The law, known as Covered Interest Parity (CIP), dictates that foreign exchange contracts for future delivery should be relatively easy to price.

The formula is based on today’s rate of exchange for the two currencies involved, combined with interest rate conditions within both countries, or currency zones, over the course of the contract.

But this relationship has recently broken down for the first time since the financial crisis, according to Song Shin.

“Traditionalists will be surprised – shocked even – to discover that CIP fails,” he said in a June speech at the World Bank conference in Washington DC. “But there it is, in the full glare of daylight. Not only does CIP fail systematically, the observed deviations from CIP have become more pronounced in the last 18 months or so.

“In textbook settings where someone could borrow and lend without limit at prevailing market interest rates, the cross-currency basis could not deviate from zero, at least not by much, and not for too long. “This is because someone could borrow at the cheaper dollar interest rate and lend out at the higher dollar interest rate.”

Song Shin proposes parallels between violations of CIP, a stronger dollar, and recent stresses in financial markets, notably in emerging countries. The dollar’s role as an international currency, coupled with increased levels of dollar-denominated debt in emerging markets are key factors, he argues.

Song Shin stops short of forecasting a fully-fledged emerging markets financial crisis, arguing central banks in these countries now hold higher levels of foreign reserves than in the past. But he adds there is no room for complacency.

“Even a central bank that holds a large stock of foreign exchange reserves may find it difficult to head off a slowing real economy when global financial conditions tighten,” said Song Shin.

“Arguably, such a slowdown is part of what we are seeing right now in emerging market economies.”

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