Australian Dollar and IRP

My students frequently ask me about Interest Rate Parity in what they call “the real world”. They are eager to know if this arbitrage blah blah can help them make money. The Australian dollar is on fire, needless to mention its New Zealand cousin. Take a look at the following chart (from yahoo finance). For the last 3 months the AUD and NZD have risen 6 and 12 percent respectively against the dollar. (Nice return!) During the same time frame an investment in the SP&500 would have lost value (2 percent), while the Euro was barely above 0.

According to fxstreet.com the interest rate in Australia has been 4.75% since November 2010 while the FED has set the rate in the US at 0.25% since December of 2008. Tempting… isn’t it? One should borrow in the USD and deposit (lend) that money in AUD.

So what if a student had borrowed $1,000,000 and used the money to buy AUD back in March 2011?

On March 21^st the student would have borrowed $1,000,000 at 0.25% and bought Aussies at the going exchange rate. According to Oanda, the bid /ask rates were 1.0037/47 AUD to get 1 USD. Therefore USD1,000,000 would have bought AUD1,003,700. The student would have the deposited the money in an Australian Bank earning 4.75%. At the end of the 3 months this is what we have.

a)      Owed to American Bank: USD 1,000,000 x (1+(0.0025/4))=$1,000,625, this needs to be paid on June 21^st .(today)

b)      To be received from Australian Bank: AUD1,003,700 x (1+(0.0475/4))=AUD1,015,618.94, which would have to be exchanged at today’s rate. Again, according to Oanda, the bid /ask rates are 0.9465/67 AUD per 1 USD. Our student would get a total of  resulting in a total of USD1,072,799.13

Our student would now pay the loan to US bank and clear USD72,174 in profit. Not bad... I don't even want to do the numbers for the NZD. Not bad but not riskless either.

Here is when I break the news. Our student spent 3 months with a long open position on the AUD. It could have gone either way. To lock the exit of the position we must have bought a forward contract to purchase the USD back... and that is the end of the profit.

Too small to fail and foreign exchange

 

I grew up listening to the following saying… When the US economy catches a cold, the developing world catches pneumonia. Forget about that. It is the reverse what holds.

Forget about the behemoth corporations so big and influential that their demise could compromise the entire financial system of the planet.

   

How about too small to fail? How is it possible that the world markets are so obsessed with one country; Greece which represents a mere 0.44% of the world’s GDP? Even if we add Portugal and Ireland we only get 1.06% of the world’s GDP…

You may be thinking, well the markets are really worried about Spain, the big daddy of the PIGS… Let’s add it and we reach a still minuscule 3.07% of world’s GDP.

When was the last time that Australia (same size as Spain) threatened to derail world's financial system.

  According to reports, today between 20- 40 thousand protesters took the street s of Athens and clashed against the police. These protesters have immense power over 7 billion fellow human beings.

Think about it. Too small to fail is the new too big to fail.

The only difference… the Euro and its artificial imbalances. Forex market would have corrected this issue long time ago.

The Quimera of Latin American Unity

Quimera is the Spanish word for illusion. For centuries LATAM politicians have promoted unity saying that a continent of brothers with one voice will be a strong force against the evils of a capitalist world that simply wants to strip its natural resources. Dozen of organizations with lofty goals have been created all of them with little practical achievements.

LATAM is now presented with a unique opportunity. It can offer a united front in the race for managing director at the IMF. So far most LATAM countries have jumped onboard. Why does and Argentina, Brazil, and Chile (ABCs) do not offer support for Agustin Carstens’ bid? What are they waiting for? What small political gain or loss is preventing them?

The ABCs decision is ironic (at best) when even Spain has declared support for the Mexican candidate.

What can Greece learn from Chile and Argentina?

A Lesson for Greece from the South

By the south I mean south America.  Northern European countries could use a little economic history from two not so distant currency, debt and financial crises in LATAM. In 1982 Chile abandoned an unsustainable peg of the dollar. The USD went from 39 pesos to 46 over night. Many Chilean firms and Small Enterprises (including my father’s) had borrowed in USD. You can imagine the composite effect. As the country came to a halt and unemployment reached 30%, the debt burden of firms rose sharply simply by currency exchange. The banking system (which was also indebted in USD but receiving pesos from its customers) soon collapsed. Instead of fiddling around with temporary measures, Chilean authorities bought all the bad debt from banks. Chile did not default. Yes, the government assumed the debt of private banks and gave them a clean balance sheet and repayment terms that banks could afford.  A few months into the devaluation, out of 41 banks, 16 were bankrupt, and 6 were intervened.   Private banks now had a debt with the government. Large privatizations followed to pay for this debt. The impact on the economy was very, very strong. In 1981, Chile’s GDP was 32 billion USD, in 1985 a mere 16 USD Billion, it was not until 1990, almost 8 years later that Chile’s GDP returned to the pre-crisis levels. Chile’s GDP in 2000 was USD75 billion and USD170 in 2010. Perhaps the most dramatic illustration is the following chart. Before the Crisis in 1982 the government debt was about 30$ of the total debt, by 1988 it was 70% and by 2010, it was 6.1%.

Chilean Foreign Debt by year, Banco Central de Chile

Argentina in 2001 also had to end a currency board arrangement and impose severe limitations to capital outflows.  The economy had been faltering and debt mounting since 1999, invertors demanded ever greater returns from Argentine bonds to compensate them for their risks. Pressures from the IMF (much like the ones are being made on Portugal and Greece) pointed to austere policies like those applied in Chile. Nestor Kirchner decided he would not submit his countrymen to such a treatment. The barber of Buenos Aires decided to default and repudiate the debt. In 2001 Argentina’s GDP was around USD270 Billion, (almost 4 times that of Chile). By 2002, after the haircut, it had fallen to USD102 Billion. (Yes these figures are correct). In 2007 Argentina had recuperated its pre-crisis GDP.

In the end Chile and Argentina seemed to have solved their problems.

Lessons,

1) No easy way out. There will be a lot of suffering, for a long time, expect 50% - 70% decrease in GDP. Expect very high unemployment and very high poverty levels. Default is no cheaper that the bad tasting medicine.

2) It will pass, so plan for the Greece of 2030.

In the aftermath of earthquakes: The limits to creative destruction

By Andrés Ramírez and Nezih Altay

Though it is difficult to imagine anything positive arising from the devastation and loss of life caused by intense earthquakes in China, Haiti, Chile and now Japan, massive destruction caused by such natural disasters can lead to innovation.

Such a statement may seem counterintuitive in the wake of the human toll these disasters take. But our five-plus years of research on the topic has found support for creative destruction.

In 1942 Joseph Schumpeter argued that “the fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers, goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates.”

Businesses that by all measures appear to have lost everything – buildings, equipment, employees, customers – in fact have gained a unique opportunity to change or improve their assets and technology and adapt in ways that Schumpeter says keeps economic engines in motion.

Take businesses in Chile as an example, where an earthquake of magnitude 8.8 struck on February 2010. Before the quake, some businesses in this developing country employed basic technologies such as basin flood irrigation for farming or land lines for communications. In the aftermath, as they rebuild, Chilean businesses have an incentive to adopt the next level of technology -- perhaps drip irrigation and wifi. Chilean wineries could adopt new technologies – from bottling equipment to inventory software.  Such innovations induce a large jump in productivity. These increases are then reflected in higher stock market valuation.

So what about Japan? In the last months several experts have offered largely contradicting predictions about its future. For a developed country such as Japan, which already uses the latest technology to produce high-value-added products and services, the gains will be marginal. In fact firms Japanese firms are likely to experience a reduction in cash flows. Toyota can rebuild its damaged plants but it is unlikely that productivity will increase dramatically because they already had cutting edge technology before the earthquake. The same can be said about Fujitsu or Sony. For these companies, the costs (even after insurance payments) will greatly exceed the benefits. The only good news for a developed open economy such as Japan’s is that its multinational firms will fare better; they will experience a lower decrease in cash flows compared to domestic firms.

Our research is based on an analysis of 299 earthquakes between 1990 and 2004 and their impact on almost 150,000 companies in 50 countries. Among our findings:

-      A business will experience increases in market capitalizations even three years after an earthquake hits its country. A closer look, however, reveals that this result is valid only for companies in less developed countries, particularly those from non-G8 countries.

-      Regarding operational cash flows, businesses in Latin America and Asia – the two regions most prone to earthquakes – see an increase in cash flows; companies in other regions see a decline.

-      Earthquake damage generates a great deal of uncertainty about the future to which companies respond by increasing their cash holdings, even three years after the event. This cash hoarding can be detrimental to reconstruction efforts.

 Disaster damage is not a straightforward measure, and research on the impact of natural disasters on companies and corporations is in its infancy. We can focus on economic losses, lives lost, people affected. But in terms of creative destruction, what we do know is this: It is limited to the developing economies.

Andrés Ramírez is a professor in the Department of Finance at Bryant University, Smithfield, R.I. Nezih Altay is a professor in the Department of Management at DePaul University, Chicago.