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.