Archive for the ‘Currencies’ Category

What will happen if Uncle Sam does not raise the debt ceiling?

Wednesday, July 27th, 2011

Today, the financial markets are abuzz with chatter about the possible default of the US government due to Congress not raising the debt ceiling. A lot of investors are also interested in this topic and hence, this article.

First, what do we think will happen? We do not know what will happen in future. But our bet is that the debt ceiling will eventually be raised. If not by August 2, then it will be soon after. Maybe that will involve Obama invoking the 14th amendment clause in the Constitution to bypass Congress to raise the debt ceiling. Or maybe some other measures that we have not thought off. Or maybe there will be a surprise hugs and kisses in Congress as both Democrats and Republicans agree to raise the ceiling. Maybe… Anyway, this is not the first time this is happening. Every time, the debt ceiling is eventually raised. But because it was always raised eventually, it becomes like a game of crying wolf. So, each time it happens, the brinkmanship has to bring the country nearer to the edge in order to be taken more seriously.

But what if the unthinkable happens? What if the Uncle Sam fails to raise the debt ceiling and defaults on its debt?

US government debt is supposed to be the safest forms of cash in the world. It is supposed to be the debt that can never ever be defaulted. As a result, the yields on long-term US government debt become the benchmark to appraise every other investment, including stocks and bonds. The heart of value investing depends on the sacred safety of US government debt (see our series, Value investing for dummies). Now, there is talk that the US government may default on its debt. The fact that such a talk exists shows that it can happen. It hasn?t happen yet. But you can be sure that if it happens, it will throw chaos into the world of investing because if the world?s safest form of cash becomes unsafe, how do you value all the other investments?

So, what will happen?

Obviously, the US dollar will go down. But go down relative to which currency? Euros? Nay, Europe has its own sovereign debt problems. Yen? Maybe yes, but Japan?s government debt as a percentage of GDP dwarfs even the Greeks. Chinese Yuan? Perhaps, but it is still not a fully convertible currency. Australian dollar? That sounds better, and that can explains why the AUD is surging. Gold and silver? Yes, if the sacred safety of Uncle Sam?s debt is no longer safe, then there?s no recourse but to return to what is historically money for thousands of years.

Next, what will happen to interest rates in the US? Imagine all the US government bond holders heading for the exits together. US government bond prices will tank, which means its yields will surge. That will then lead to surging borrowing rates in the US.

But wait! Will Ben Bernanke sit there and do nothing while interest rates sky-rocket? Of course not! We think the Federal Reserve will step in by conjuring up money from thin air to buy the bonds from the panicking herd in order to support US government bond prices. And Bernanke will surely be praying that this will turn the tide of the massive wave of selling. What if the herd saw Bernanke?s money printing and believes that he is going to unleash a tidal wave of money into economy. That?ll be hyperinflationary! But if Bernanke does not do what it takes to support the US government bond prices, it will be hyperdeflationary as the already weak US economy get crunched by oppressively high interest rates.

Remember two years ago when National Party Barnaby Joyce suggested that Australia must have a contingency plan for an US government debt default. The then Prime Minister Rudd denounced him as an irresponsible loony. Today, that loony looks to be saner than Rudd.

Interesting times lies ahead. Those who had read our book, How to buy and invest in physical gold and silver bullion and had already taken action have much less to fear. And by the way, our book is now also available in iTunes, for those who owns Apple’s iPod Touch, iPhone and iPad.

Is there any benefit for Aussies to invest in gold?

Tuesday, November 16th, 2010

Recently, one of our readers who bought How to buy and invest in physical gold and silver bullion wrote to us,

I live in Perth so am looking to buy bullion from the mint, just down the road, literally, however I?m concerned about how the fluctuating US dollar affects my investment. Surely during hyperinflation of the US dollar gold will obviously go up, but also the Aussie dollar will strengthen significantly at the same time. If the Aussie dollar goes up more than the gold price, I actually loose money in Aussie dollars for which i use to pay my gold (If I use us money trading account…i will loose money when i finally exchange us to aus $$ if the exchange rate is super high)…is this a realistic situation or in a case of hyperinflation, is gold likely to spiral upwards whereas the Aussie dollar marginally increase in relation to the US$…….i.e will the spiralling gold price and hyperinflation in the states cause equivalent hyperinflation worldwide and therefore maintain the “approx” AU/US $$ exchange rate.? I can see gold skyrocketing but if the Aussie dollar also sky rockets also…this is of no benefit is it>>> or is it???

our dollar is very strong at the moment and predicted to get stronger, hence, i will loose money by investing in gold or silver, but i have no trust in the US financial system. Is there a way i can hedge myself against a strengthening Aussie dollar??

I realise u don’t have a crystal ball…I’m not holding you to anything i just want your opinion.

As we can all see, currently there?s a correlation between Australian dollars (AUD) and gold price. Hence, from the point of view of Australian investors of gold, a rising gold price (in USD) does not benefit them. We see that correlation working out in 2007 and today. Today, even though gold prices had hit a record high in USD terms, it is still below the record high in AUD terms- gold hit a record high of around AU$1500 in 2009 when the AUD was very ?weak?.

To answer our reader?s question, we have two points to make:

Back to the basics?

First, let?s revisit the basics. As we wrote in How to buy and invest in physical gold and silver bullion, when we invest in gold, we are not so much into ?making? money. We are doing so to hedge and protect our existing wealth. In other words, gold is not so much of an investment. Instead, it is more of an insurance policy. Therefore, we wouldn?t be so concerned if our ?investment? in gold is not turning out well in terms of AUD. However, what we are more concerned is the possibility of an AUD currency crisis. We have written about that in Will there be an AUD currency crisis?. We are not saying it will happen. Instead, we are suggesting that there?s a possibility that it may happen and by ?investing? in gold, we are hedging ourselves against that.

USD the reserve currency

Regarding the mess in the US financial system, it would be quite an entertaining spectacle if the US is just an inconsequential banana republic like Zimbabwe (which incidentally fell into hyperinflation- a object lesson for the US to learn). In that case, the case for ?investing? in gold will be much weaker.

Unfortunately, the US is not an inconsequential banana republic. It is a superpower whose currency is the world reserve currency. As we wrote in How to buy and invest in physical gold and silver bullion,

The United States, with ?helicopter? Ben Bernanke at the helm of the Federal Reserve, is committed to money printing to solve America?s economic woes. To the extent that the US dollar is the world reserve currency, it will affect the rest of the world.

Because it is the world?s reserve currency, China ?saved? most of the fruits of its hard work in the form of that reserve currency (a cool US$2 trillion worth). Same thing for Japan. Ditto for many other countries.

By printing money, the US is devaluing the world?s reserve currency. But the world cannot afford to have its reserve currency devalued towards the value of confetti. As we wrote in Why did the foreigners bail out cash-starved financial institutions?,

China?s trillions of US dollars reserve is a form of savings that will be used to acquire their future needs for resources to power their economy in the long term. Therefore, any threat to the long-term value of their savings will be a long-term threat to their economy.

So, what is the solution to the devaluation of the reserve currency? As we wrote in What if the US fall into hyperinflation?,

Now, in this age of freely fluctuating currencies, the currency?s value is a relative concept. For example, a falling US dollar implies a rising Australian dollar. Therefore, one way to ?maintain? the value of the US dollar relative to the Australian dollar is to devalue the Australian dollar. Perhaps this is the route that central bankers will concertedly take to instil ?confidence? in the US dollar in order to create the illusion that the US dollar is still a reliable store of value? Well, they can try, but growing global inflation and skyrocketing gold price relative to all currencies will be tell-tale signs of such a dirty trick.

That?s why there?s a threat of a currency war between the US and China right now. The US is accusing the Chinese of manipulating their currency while the Chinese are pissed off with the US for exporting their inflation to China. As the US prints and devalue its reserve currency, China will be hard pressed to devalue theirs too (in the form of a currency peg). If China let their yuan soar in value, their exports will collapse, which will severely affect their economy and social stability. Japan is in the same situation too. A strong yen (relative to the USD) is very bad for their economy too. That’s why Japan recently cut their already super-low interest rates and there’s talk of more money printing on the Japanese’s part.

Now, look at Australia. Let?s imagine that the AUD reaches US$1.20 and is threatening to march forward to $1.40 and beyond. If the AUD gets too strong, it will hurt the Australian economy. In such a situation, Australia will be hard pressed to devalue its currency too (e.g. by cutting interest rates, direct intervention). Or maybe impose capital controls.

In other words, the world is in a situation where there?s a competitive devaluation of currencies. In the recent G-20 summit, countries are pledging not to engage in that. Well, if you doubt their words, then you will sleep better to have your own reserve currency in the form of gold.

In any case, it?s going to be very rough ride in the forex markets. If you are forex speculator, this is heaven. If not, then it is going to suck.

How ‘speculative’ is the AUD (and other currencies)?

Thursday, November 11th, 2010

Recently, we took a look at this report from the Bank for International Settlements (BIS). The average daily foreign exchange turnover (including derivatives) is around US$3.9 trillion. The Australian dollar is the 5th most traded currency (at 7.6% of volume).

So, roughly AU$300 billion of AUD are turned over daily. Of that, US$249 billion of the trade is in the AUD/USD currency pair alone.

Now, let?s take a look at Australia?s balance of payment data. If you take the last 4 quarters of import and export volume, approximately AU$500 billion worth of goods/services are traded in one year.

Compare the amount of AUD that is traded daily in the foreign exchange market and the value of the import/export in one year. What do you see?

Mind you, we are just taking the AUD as an example. The volume of daily turnover in the foreign exchange (for all currencies) far exceeds the value of import/exports. If you look at the report from BIS, between 2004 and 2007, turnover increased by 73%! No wonder forex trading has now become a cottage industry.

Expectation of US Dollars (USD) printing creates an Australian Dollar (AUD) bubble?

Sunday, October 10th, 2010

Everyone on the streets know that the Australian Dollar (AUD) is rampaging towards parity with the US Dollar (USD). Joining the media circus, some forex pundits are even prophesying that the AUD could reach $1.20 against the USD. The masses in Australia are cheering because it is now cheaper to buy stuffs overseas due to the ?strong? AUD. Politicians (Wayne Swan) are cheering because it is a great excuse to brag about the ?strength? of the Australian economy under the stewardship of their political party. Businesses that has their costs paid directly or indirectly in terms of USD are cheering (e.g. retail import). Businesses that receive their revenue in terms of USD (directly or indirectly) are in pain (e.g. mining, tourism).

We wouldn?t be surprised if the next round of readings for consumer confidence in Australia will show a marked increase. We have no doubt that this in turn will add fuel to more cheering by politicians and the media circus.

But as contrarian investors, you have to understand the context and big picture behind the surging AUD. Do not be like the masses by being caught up with the euphoria. Instead, be prepared and even profit for what is to come.

Firstly, it is not just the AUD that is rising against the USD. The euro, yen, base metals, gold, silver, etc are also rising too. However, the expectation of more interest rate rises by the Reserve Bank of Australia (RBA) is acting like rocket boosters to the already rising AUD (see Return (and potential crash) of the great Aussie carry trade). In other words, it is more of the USD that is deprecating, not the AUD appreciating. As we wrote in What if the US fall into hyperinflation? on April 2008,

Now, in this age of freely fluctuating currencies, the currency?s value is a relative concept. For example, a falling US dollar implies a rising Australian dollar. Therefore, one way to ?maintain? the value of the US dollar relative to the Australian dollar is to devalue the Australian dollar. Perhaps this is the route that central bankers will concertedly take to instil ?confidence? in the US dollar in order to create the illusion that the US dollar is still a reliable store of value? Well, they can try, but growing global inflation and skyrocketing gold price relative to all currencies will be tell-tale signs of such a dirty trick.

Already, the Japanese central bank are cutting interest rates, taking token measures to intervene in the forex market to weaken the yen and even talking about buying government bonds (i.e. ?printing? money). Basically, the Japanese want to devalue the yen. For Australia, we would hazard a guess that one of the major contributing reasons why the RBA did not raise interest rates last week is because of the surging AUD (that was also the suggestion of one of the economists in CommSec).

To put it simply, the depreciating USD is creating a bubble-like conditions for the currencies of foreign countries. That is problematic, not the least because it is making their exports uncompetitive (just ask any Australian mining company). What is the solution for these countries? Devalue their currencies too (if it can be done without the masses being aware, all the better).

The next question is: why is the USD depreciating?

The reason is simply because of the expectation that the Federal Reserve is going to embark on a second round of massive money printing (see Bernanke warming up the printing press). What is the background behind the Federal Reserve?s money printing idea? To answer this question, we would refer to the late Professor Murray Rothbard?s book, Mystery of Banking:

In Phase I of inflation, the government pumps a great deal of new money into the system, so that M increases sharply to M?. Ordinarily, prices would have risen greatly (or PPM fallen
sharply) from 0A to 0C. But deflationary expectations by the public have intervened and have increased the demand for money from D to D?, so that prices will rise and PPM falls much less substantially, from 0A to 0B.

Unfortunately, the relatively small price rise often acts as heady wine to government. Suddenly, the government officials see a new Santa Claus, a cornucopia, a magic elixir. They can increase the money supply to a fare-thee-well, finance their deficits and subsidize favored political groups with cheap credit, and prices will rise only by a little bit!

It is human nature that when you see something work well, you do more of it. If, in its ceaseless quest for revenue, government sees a seemingly harmless method of raising funds without causing much inflation, it will grab on to it. It will continue to pump new money into the system, and, given a high or increasing demand for money, prices, at first, might rise by only a little.

Murray Rothbard wrote this book more than 25 years ago. Yet, it is pertinently relevant for today?s context. The US government?s budget is in great deficit. It will get worse as they have to spend even more money to prop up and stimulate the economy. The current environment of deflationary expectations is providing an excellent cover for Bernanke to print money (see Bernankeism and hyper-inflation).

But as Murray Rothbard continued,

But let the process continue for a length of time, and the public?s response will gradually, but inevitably, change. In Germany, after the war was over, prices still kept rising; and then the postwar years went by, and inflation continued in force. Slowly, but surely, the public began to realize: ?We have been waiting for a return to the good old days and a fall of prices back to 1914. But prices have been steadily increasing. So it looks as if there will be no return to the good old days. Prices will not fall; in fact, they will probably keep going up.? As this psychology takes hold, the public?s thinking in Phase I changes into that of Phase II: ?Prices will keep going up, instead of going down. Therefore, I know in my heart that prices will be higher next year.? The public?s deflationary expectations have been superseded by inflationary ones. Rather than hold on to its money to wait for price declines, the public will spend its money faster, will draw down cash balances to make purchases ahead of price increases. In Phase II of inflation, instead of a rising demand for money moderating price increases, a falling demand for money will intensify the inflation.

Given the large and exponentially growing debt of the US government, monetary inflation is the only path they can take as far as the eye can see.

There is a lot more in Professor Murray Rothbard?s Mystery of Banking if you want to learn how money and credit are related to each other through the banking system work. You can read a sample of this book here (at the right of that page, click on the ?Read First Chapter Free? button).

What can you do to protect yourself from increasing currency volatility?

Sunday, September 19th, 2010

Six months ago, we wrote about America’s consideration to label China as a “currency manipulator” in Watch April 15 2010: simmering tensions between US and China. Just before the deadline, China appeared to make a little concession about their RMB, thus avoiding the “currency manipulation” label.

Today, currency tension between the US and China is rising again. The little concession that the Chinese government made was simply not enough. American lawmakers are getting impatient and are itching to enact laws to slap China with trade sanctions. Should that happen, it will be the beginning of a damaging trade war between the world’s largest economies. Their charge is that China’s artificially low currency is responsible for (or at least contributed to) America’s economic woes. But as we wrote in Watch April 15 2010: simmering tensions between US and China,

But the mob wants to find a scapegoat to blame for their woes. It so happens that the most convenient scapegoat is China (specifically, China?s policy of artificially holding its currency down) because at this point of the cycle, China is looking very good. It is perceived that this policy worsen America?s unemployment rate. By implication, it is perceived that with China?s official unemployment rate much lower, China is ?prospering? at America?s expense.

Currency tensions between China and the US are nothing new. As we wrote in that article, it’s been around for the past 3 to 4 years. Many times, the rhetoric about America labelling China a “currency manipulator” came and went away without eventuating into reality. However, that does not mean that it will never happen. As America’s economic woes worsen, the pressure to find a scapegoat will increase. As a result, the probability of a trade war will increase.

The Chinese, on the other hand, are not standing idle, waiting for a trade war to happen. For starters, they are establishing trade and investment links with Asia, Middle-East and Africa. Secondly, it is no secret that they have been diversifying their colossal hoard of reserves away from the US dollar. Given the well-known intention of the Federal Reserve to print more money, diversification has become increasingly urgent. But that in itself is not easy because given the colossal size of the money involved, any whispers and hints about any particular Chinese diversification strategy will move the markets quickly in a big way. For example, the recent rumours that China was buying up Japanese government bonds probably helped to contribute to the surging yen. As a result, the Japanese government became very unhappy because a very strong yen will negatively impact on their export-oriented economy. In response, the Japanese government may take concrete actions (beyond just talking about it and taking token measures) to weaken the yen, in which the end result is more Japanese purchase of US government debt.

In such an environment of competitive currency devaluation and price volatility, what should investors and savers do?

To us, it is clear that having all your savings and investments confined to a single country or currency is an increasingly risky proposition. Currency exchange rates will become more volatile, with implications on asset values, price inflation and economic growth (see Real economy suffers while financial markets stuff around with prices). For example, in Japan, real businesses are suffering as a result of the rising yen. The Germans, on the other hand, are secretly gloating whenever the euro weakens. In Australia, should the banking system fall into a crisis as a result of the bursting of the property bubble, the consequence of a resulting collapsing Australian dollar will be price inflation (see Can price inflation occur in the midst of debt deflation?).

If currency volatility goes to the extreme, investors will even have to question the idea of national currency as a store of value. So, what can investors and savers practically do to mitigate against this?

Quite some time ago, we talked to the guys at and learnt of how a lot of their clients (presumably the “rich”) use them. In case you do not know, (a regulated company operating in the financial services industry) enables

… you to hold gold, silver & platinum that is fully insured and stored securely in specialised bullion vaults in London, Zurich and Hong Kong. All metal is owned directly by you with no counterparty risk.

You can “easily buy gold, silver & platinum and take delivery of physical bars of gold.”

What their clients did was to use their account as a conduit to link their bank accounts all over the world. This strategy makes sense as it gives investors and savers the flexibility to shift their savings all over the world, using gold, silver and platinum as an anchor for the store of value. In an environment of currency volatility, this flexibility is a valuable aid in helping to protect your hard-earned savings from hare-brained government interventions.

However, for those who are ultra-pessimistic and distrust any assets that have any hints of paper, the only way to go is to take possession of physical gold and silver (see How to buy and invest in physical gold and silver bullion).

Marc Faber: Short the AUD

Wednesday, June 16th, 2010

In case you’ve missed it, this is what Marc Faber said in a recent interview:

And as a special tip, I think I would short the Australian dollar, because talking about a housing bubble, Australia has 10 times a bigger bubble than China. In Australia you have what you said we don?t really have in China, namely the low leverage that we have in China, we have the opposite in Australia, very high household leverage. ? So I think a big downfall is about to happen.

The worst case scenario would be a falling AUD in the context of a currency crisis. Our favourite hedge against this will be in gold (see our book, How to buy and invest in physical gold and silver bullion).

Is the Chinese export surge really good news?

Monday, June 14th, 2010

Last week, the mainstream financial news media was cheering on the news that China’s exports surged on a year-on-year basis. This led to the belief that China’s economic recovery is on track, which implies that the recovery in commodity demand will be sustained, which will then flow on to the Australian economy. As a result, according to media narrative, the stock market rose on that ‘good’ news.

But before we get carried away with this bout of optimism, let us put on our thinking caps and consider the bigger picture. Firstly, is the surge in Chinese exports and imports really a good news for Australian mining companies? To answer this question, consider this news article,

But rising textiles and electronics exports will do little to offset the slump in Chinese demand for Australian commodities that will come with an expected construction slowdown.

Construction starts for government infrastructure projects have slowed sharply and private sector transactions have been bludgeoned by government measures.

Private sector measures show real estate transactions fell by as much as 70 per cent from April to May in Beijing, Shanghai and Shenzhen, where policy restrictions have been most severe.

To put it simply, China’s demand for Australian commodities post-GFC is mainly influenced by China’s construction ‘boom’ in 2009. It is open knowledge that there’s overcapacity in China’s steel and cement industries. As we wrote in Marc Faber: Beware of investing in Australia (as it follows the Chinese business cycle),

It had been reported that China?s excess capacity for steel and cement production is around the current capacity of United States, Japan and India combined.

A rise in Chinese exports will not be likely to offset the slump in construction.

Next, when you look at the big picture in mind, an export surge is the last thing the world needs. In the this post-GFC world, where growth is anaemic and unemployment is stubbornly high, countries are covertly engaging in competitive currency devaluation in order to prop up their exports in order to prop their economies. The Americans wants to re-balance their? economy with more exports, which implies other countries have to import more from America. Yet, on the other side of the Atlantic ocean, as Niall Ferguson said in this recent interview, the Germans are shedding crocodile tears over the falling Euro because that would boost their exports, which in turn is good boost for their economy. As Marc Faber said in this interview, a falling Euro (i.e. rising US dollar) will give the Americans the excuse to print money to give their economy another adrenaline boost.

Unfortunately, growth-via-exports is a zero-sum game because a for every export, there is an import on the counter-party. If every country wants to increase their exports to boost economic growth, who’s the one doing the importing? Thus, China’s export surge is one step in the wrong direction. The world needs a rebalancing of exports and imports, not more of the same unsustainable imbalance.

Already, the Americans are murmuring about this ‘good’ news. As? China export surge stirs U.S. anger reported,

A surge in Chinese exports and rising anger in the US Congress will put renewed pressure on China to allow its currency to rise against the US dollar.Chinese trade figures showed exports leaping by 48.5 per cent in May over the year before, way ahead of analysts’ forecasts. Data released in the US showed America’s trade deficit widening slightly in April, with some economists arguing that the improvement in net trade and its contribution to US growth appeared to have stalled.

The data gave more ammunition to China’s critics in the US Congress, who have said they will proceed with legislation to restrict Chinese imports to correct the perceived misalignment of the country’s currency. The US Treasury has been pursuing quiet diplomacy with Beijing to allow the renminbi to rise, but lawmakers said they were losing patience.

In the bigger picture, rising trade tensions between the US and China is moving them towards trade war. This can hardly be good news.

How will the market perform from now on?

Thursday, May 27th, 2010

This is what Marc Faber thinks:

Note the last part of the interview- currencies are on the race to the bottom.

How to buy and invest in physical gold and silver bullion

Why central banks are forced to raise interest rates in a currency crisis?

Tuesday, May 25th, 2010

We will continue from the currency crisis theme today. As we mentioned in our previous article, the threat of a currency crisis in Australia is not something we will dismiss out of hand. We rather be prepared for one and for nothing to happen than be unprepared and be caught with our pants down.

Now, what can the government do if currency speculators launch an assault on the AUD?

For one, the Reserve Bank of Australia (RBA) can use its foreign currency reserves to buy up its domestic currency in order to ?support? the AUD. This strategy works until the reserves are used up. Australia, being a chronically current account deficit country, does not rank well in terms of quantity of reserves for an advanced country. As you can see from this list, Australia has less than US$40 billion of reserves. Even tiny Singapore has 5 times as much as Australia.

But what if the speculators? assault prove to be too strong for the RBA to intervene? In that case, it would be forced to raise interest rates. As we quoted the Bank for International Settlements (BIS)?s 79th Annual Report in Bank for International Settlements (BIS) warning on stimulus spendings,

External constraints could also bind for some countries. Particularly in smaller and more open economies [e.g. Australia], pressure on the currency could force central banks to follow a tighter policy than would be warranted by domestic economic conditions.

When a currency is rapidly depreciates, it is a tempting target for hedge fund to short it. This can be done by borrowing large amount of money in that currency and selling it. In the absence of capital controls, the central bank, in its attempt to defend its currency, will have to raise interest rates to make shorting as expensive as possible.

How does this work out in reality? For that, we managed to find this old 1997 article from the South China Morning Post.

Why hedge funds cheer as Asian rates explode

If central bank wins, funds make money in lending market and if it buckles they make hay in currency market, says Larry Wee

If there were any doubts that hedge funds had a big part in East Asia?s currency chaos, the word in the market is that at least one major fund was behind the carnage in Hong Kong last Thursday when the key Hang Seng Index plummeted 10.4 per cent.

The story goes that one fund professional?George Soros?s name is inevitably mentioned?had let it be known that he was heavily short on HK$. The reaction of the Hong Kong Monetary Authority (HKMA) was predictable: determined to defend Hong Kong?s peg to the US$, it forced interest rates sky-high.

What the HKMA did not realize, however, is that this hedge fund had borrowed massive amounts of Hong Kong dollars in the money market. On top of this, it also shorted the Hong Kong stock market in a big way. So when overnight interest rates skyrocketed to 250 per cent, and stocks collapsed, the fund was overjoyed.

The cruel irony is that, when HKMA governor Joseph Yam spoke with bravado last week that he would charge HK$ short-sellers punitive rates, the funds that had already loaded up with HK$ laughed all the way to the bank.

This story explains just how the multibillion dollar hedge funds?the vast pools of money managed by the likes of Mr. Soros?have operated to get the best returns. Their blitzkrieg starts behind the scenes, in the money market where funds are borrowed and lent.

The strategy is simple: Well before they mount an assault on a currency, the hedge funds borrow huge amounts of the very currency they want to bring down. Often they borrow as much as ten times the amount they intend to sell. When they start selling the currency, they know for sure that interest rates will spike up as a result?often from below 10 per cent to well past 100 per cent. Lending at, say, 150 per cent when you borrowed at 7-8 per cent is a nice business; it yields huge profits when you?re lending in the billions.

Often these funds?apart from Mr. Soros Quantum Fun, other big ones include the Tiger and Omega funds?corner all available liquidity in the money market, so they become the only major lenders of the currency they have attacked.

The art in this strategy is this: Even if the central bank succeeds in defending its currency and inflicts forex losses on speculators, the hedge funds would have made many times more in the lending market. What if the central bank buckles and allows the currency to fall? Then the funds hit a double jackpot, and wins in the currency market too.

When the baht was attacked this way in June-end?again said to be led by Mr. Soros?the major funds walked away with profits of up to US$1 billion (S$1.58 billion) each, sources say. Not bad for a couple of months? work. Four months later, it?s the turn of the Hong Kong dollar. The question on many people?s minds is whether the peg to the US dollar will be broken. But whether or not it does, the hedge funds have already made a pile by now.

Sources say the big funds entered the money market a month ago to borrow Hong Kong dollars at around 7 per cent; they are now on-lending those dollars at sky-high rates. Last Thursday, when the speculative attack was at fiercest, overnight HK dollars cost as much as 250 per cent to borrow. The benchmark three-month HK interbank offered rate (Hibor) was fixed at 17.3 per cent, while six-month HK dollars funds cost 33 per cent. So the hedge funds will surely wind up this Christmas with record profits for the year. But they leave in their wake Asian economies with mountains of bad debt, crippled stock markets and surging inflation.

When interest rates explode with the force witnessed in Asian markets, the first to plunge are the stock markets. The next to come under pressure are the real estate markets. And if interest rates stay high, the whole economy slows down as companies hold back expansion plans and individuals cut back on spending. Inflation inevitably rises and we get what economists call ?stagflation??a sticky combination of economic stagnation and inflation.

What comes next?as Malaysian Premier Mahathir Mohamad warned over the weekend?is the threat of recession, where economic activities not just slow down but actually shrink. There is a good reason why economies are invariably left wrecked: the hedge funds target economies with serious and often hidden structural imbalances. Their currencies are usually most vulnerable to a sell-off and will topple with a hard shove.

And before they launch their currency attack, they short-sell the stock market too, knowing that other, less agile, market players will have to sell stocks to get their hands on local funds. This stock sell-off frightens genuine foreign investors into selling out too; when foreigners sell off, preferably in a frenzy, they have to convert their foreign currency for repatriation?which only starts another round of selling on the besieged currency.

That?s how it all snowballs. That?s how currencies collapse. And that?s how hedge funds like Mr. Soro?s Quantum make megabucks.

One thing to note: hedge funds don?t wake up one day and decide to attack currencies out of the blue. They prepare beforehand.

How to buy and invest in physical gold and silver bullion

Serious vulnerability in the Australian banking system

Sunday, May 23rd, 2010

Last week, we witnessed one of the most rapid falls on the Australian dollar (AUD). In a matter of a couple of weeks, the AUD fell around $0.10 relative to the US dollar (to a low of above US$0.80).

There were many reasons offered for this rapid depreciation- one of them blames the Rudd government?s resource super-profit tax (see Why Rudd?s mining super-profit tax will encourage more commodity speculation). In reality, there?s probably no specific reasons why AUD fell so quickly for this specific instance. As we wrote in our report, How To Foolproof Yourself Against Salesmen & Media Bias, the desire to pin-point a specific reason is part of the human trait of falling for the narrative fallacy. The simplest explanation laid the blame on ?hedge funds? and ?speculators.?

In any case, in the minds of most lay-people, the AUD is seen as a barometer for the health of the Australian economy. If the AUD goes into a free-fall, many people will see it as a sign that the Australian economy is in trouble. Conversely, if the AUD appreciates strongly, it is seen as a sign of a ?strong? economy. In reality, the foundations for the strength/weakness of the economy has been set long before the currency appreciate/depreciate. Nowadays, with the rise of lightening-speed money, the currency exchange rate is more as a result of capital inflows/outflows from money shuffling and less as a result of the fundamentals of the economy.

For Australia, we are getting more and more nervous about a currency crisis someday (see Will there be an AUD currency crisis?). Jimmy Rogers concurs with our worry. As he said in a recent interview,

If the Australian economy keeps taking on debt, the next time there’s a bear market, the Australian dollar will collapse. And he sees a bleak future for any currency backed by massive debts. Top of his list of bad currencies is the once mighty greenback.


The only disappointment I’ve had is that your politicians are as bad as the ones in America. If the Australian government keeps running up such gigantic debts, the lucky country is going to run out of luck.

However, he reiterates his belief Australia will not be prepared for the next economic shock and for a commodities bear market if it keeps taking on debt.

One thing you have to note is that Jimmy Rogers is probably not talking about Australia?s government debt. Relative to basket case countries like US, UK, Japan and the PIIGS in Europe, Australia?s government debt is tiny. The problem for Australia is its private debt, which is reflected in the foreign debt. As long as foreigners wants to invest in Australia, it will be fine. But the moment foreigners change their mind, Australia will be in trouble (a crashing AUD will be one of the symptoms).

We believe Australia has a serious structural problem that can easily turn this lucky country into an unlucky country very quickly. Recently, we saw this presentation (that explains the problem) making its round around web sites:

How to Profit From the Coming Aussie Property Crash (and Banking Crisis)

Please note that we:

  1. Are not making any investment advice based on this presentation.
  2. Are not making any predictions based on this presentation (see Failure to understand Black Swan leads to fallacious thinking to understand what we mean).

There?s one point made in this presentation that we have not covered in this blog- there are AU$13 TRILLION worth of off-balance sheet liabilities in Australia?s banking system (you can see the figure yourself from the link to RBA?s web site). Inquiring minds should be asking questions about what these liabilities are all about. Does the Australian regulators and central bank (and perhaps the banks themselves) fully understand what sort of hidden risks the Australian economy is subjected to from these ?off-balance sheet? liabilities?

For us, the basic point to take away from this presentation is that:

  1. There is a serious vulnerability in Australia?s banking system.
  2. This vulnerability is simply too colossal to be bailed out by the Australian government (hence the threat to the AUD).

We are not trying to scare anyone here. But these are the sorts of questions investors have to ask.