Gambling On The Dollar

Sharp movements in exchange rates often reflect sophisticated speculation. Is there much we can do about it?

While the near parity of the Australian and New Zealand dollars got a lot of breathless attention recently,  there was little analysis of why it was happening. Explaining the exchange rate depends upon the time horizon. In the long run, exchange rates reflect relative prices between economies; in the medium run the price effects are influenced by their investment-saving balances; in the short run there are cyclical effects influenced by interest rates and capital movements. All these are important in the exchange rate between the Australian and New Zealand dollars, with the additional complication that other countries’ economies and exchange rates are impacting as well,  while the dynamics – the transitions through time – can be horrendously complicated.

As likely as not, when there are sharp movements in the very short term, there is financial speculation. So, probably, the recent movements are result of betting on the New Zealand dollar rising to parity or higher. Speculators who bought a $NZ100 at $A98 and sold it at $A102 would make a tidy return over a short period. Except they were betting millions of dollars not a hundred.

Who was betting? We cannot be sure but practically banks, importers and exporters do not usually go in for these short-term squeeze plays. Typically those betting involve managed investment funds – often called ‘hedge funds’ – with billions of dollars of financial resources pursuing high-risk high-return investments. For our purposes we do not need to go into the intricacies of how they operate; relevant, though, is that they are generally based offshore and not in Australasia.

And yes, the funds are gambling. There use to be much mention in the financial media of how they contributed to the management of risk, but that theme has been, unsurprisingly, silent since the Global Financial Crisis of 2008 where it became apparent the funds were contributing to the financial instability instead. Moreover a lot of the gambling in 2008 proved to be with other people’s money. Some people, not those making the financial decisions, lost a lot and states found themselves reluctantly bailing out failed financial firms at the taxpayers’ cost. Not to have done so would have collapsed the whole payments system with substantial collateral damage to production, employment and consumption.

If it is gambling, then it is a zero sum game (or slightly negative since resources are required to play; foreign exchange dealers take their clip from each transaction). If some hedge funds are winners then there must be others who are losers. Presumably some hedge funds screw up on occasions, but for the industry to stay ahead it needs suckers from outside. Australians who had to buy New Zealand dollars (say for travel) probably don’t pay the industry’s coffee expenses. There may be some small investors who speculate and lose their shirts. Some businesses (and banks) may have the misfortune to need to roll-over the foreign exchange at the wrong moment (and sometimes a junior staffer of the firm loses their head – remember Nick Leeson of Barings?). Very rarely today, central banks intervene – taking them to the cleaners is one of the joys of the hedge fund industry.

But does not a rise in the New Zealand dollar show how healthy the economy is? Not if it is the result of a speculative attack against the Australian one. It is a bit like a bookie scam in which the odds in favour of a crippled horse improve.

Events are not helped by naive journalists asking those in the finance industry with fancy titles what is happening. What we hear and read must surely be clips from longer interviews. It almost invariably ends with a prediction which proves to be wrong. Journalists really should ask their ‘experts’ whether they, or their firm, are getting involved in the speculation. The honest answer is ‘of course not; I’m here to give my business some free publicity’. (If they say ‘yes’ get your funds out of the business, pronto.)

Should we do anything about these sorts of goings on? A high value of the New Zealand dollar damages our export firms and the jobs in them. So ‘yes’, we should do something (but it is complicated because there are numerous exchange rates). But that is a longer horizon issue – which belongs to another column – it’s not about dealing with speculative attacks.

The options to deal with the attacks are limited. Most central banks are small compared with hedge funds. (Our Reserve Bank has lots of New Zealand dollars, but its foreign exchange holding are small and they are what matter.) Obviously the more informed people who are involved in foreign exchange markets the better. Journalists for a start.

There are attempts to regulate hedge funds but that is proving difficult. There is not much New Zealand can do, other than support the bigger regulators. It is noticeable that the industry has not been that profitable since the Global Financial Crisis; some funds have closed down. While we may be broker as a result of the GFC, we are probably wiser. (Don’t worry, the wisdom will wear off as those in today’s short pants join the dealing rooms so the global gambling will return.)

I support the adoption of a Financial Transactions Tax, but New Zealand should impose one only if some bigger players do. Going it alone would be like our Reserve Bank taking on the world’s hedge funds. However, while an FTT would reduce the level of speculative financial activity it would probably do little to deal with currency attacks. They happen offshore even if they use New Zealand dollars. Our crippled horse gallops on.