Chapter 9. Foreign Exchange
“Today has been an extremely difficult and turbulent day.”
British Chancellor Norman Lamont, Wednesday, September 16, 1992
Foreign exchange is supposed to be a series of zero-sum games that creates no value. But a series of currency coups in the 1990s prompted investors to treat it as its own asset class. Stock and bond investors played the currency markets and exchange rates started to synchronize with stock markets.
As the City of London started trading on Wednesday, September 16, 1992, it was hit by dramatic news. The Bank of England, not then independent of the government, had raised its base rate by 2 percentage points, from 10 percent to 12 percent. It set in motion a day that proved beyond doubt that markets, not governments, set exchange rates—and convinced many mainstream investors to start playing in the foreign exchange market, a decision that led markets to move ever more in alignment.
Most British homeowners had variable-rate mortgages, and the country was in the grips of a real estate slump. The Bank’s move meant that monthly mortgage payments would instantly go up by 20 percent. It also implied that the government was deadly serious about defending the value of the pound sterling, which for two years had been part of the exchange rate mechanism of the European Monetary System, an agreement to keep Europe’s main currencies trading within a broad band of each other. A drastic interest rate rise was a way to maintain the pound’s value.
The pound continued to fall.
At 2:00 p.m., the few City financiers who had found the time to go to lunch got back to their offices to find that the Bank was raising rates again, this time by 3 percentage points, to 15 percent. By extension, the government was so determined to defend the pound that it was ready to raise homeowners’ borrowing costs by 50 percent in one day. Nobody believed it. The pound kept falling, even as the Treasury bought pounds with its currency reserves in an attempt to bolster it.
That night, Norman Lamont, the chancellor, announced he was “suspending” sterling’s membership of the exchange rate mechanism. It never rejoined. The pound dropped about 10 percent against the dollar within hours and the next day, he cut British interest rates to nine percent.
The incident went down in British political history as “Black Wednesday,” and sentenced the ruling Conservative party to more than a decade in opposition. Global investors were more intrigued to find out exactly how it had happened. Later that month, The Times of London talked to George Soros, a big international investor. He admitted that his funds had made a $950 million profit from the fall of the pound and as much again from other currency bets during the chaos surrounding the exchange rate mechanism.1
Having studied the economic situation, he believed that the British could not keep the pound within the necessary band against the Deutsche Mark. The UK economy was in recession and he did not see the German government helping out by lowering interest rates. He also decided that any move to bet against the pound must be done with overwhelming force, so that his move could become a self-fulfilling prophecy.
Soros told The Times he had bet $10 billion, after negotiating lines of credit with dozens of banks in advance. He took the Bank’s rise to 12 percent as the signal that sterling was about to crack, so he borrowed the maximum that he could in pounds, and used it all to buy Deutsche Marks. This forced the pound down. Once sterling had dropped by 10 percent, Soros converted his Marks back into pounds, and made a 10 percent profit.
These details made him sound to British ears like a villain in a James Bond film. To investors, however, they showed that there were opportunities in foreign exchange (known as “forex”). Maybe forex might even be an asset class in its own right.
There are strong arguments against this. Unlike stocks or bonds, forex cannot grow over time. Every forex trade has a winner and an equal and opposite loser. If you sell dollars for euros and the euro gains, then you win; and whoever bought your dollars loses exactly as much as you won. To this extent, every trade is a “zero-sum game,” in which the sum of the winnings and losses of the various traders is always zero. The total worth of shares can rise from year to year, if companies trade profitably. The sum value generated in the forex market each year should be zero. While Bretton Woods was in force, and rates were pegged to gold, the opportunities were in any case very limited.
But reality is more complex. Forex is the biggest and most liquid market that exists. Every day, some $3.2 trillion moves between currencies. Many of these bets are not placed by investors. Instead they are placed by tourists, or importers or exporters who receive payments in a foreign currency. These people are generally dealing out of necessity, and they are not trying to predict trends in the forex market. Thus, forex is a series of zero-sum games, in which many of the competitors are not trying to win, or are forced to play at a time when they are likely to lose. Thus forex begins to look like an interesting investment opportunity.
In the 1990s, it also had the advantage that it was not correlated with stocks, so it offered the opportunity to diversify risk. And the fallout from the end of the Bretton Woods system had created other opportunities. The Chicago Mercantile Exchange started trading foreign exchange futures contracts in 1972. These allowed companies to fix an exchange rate for transactions in the future, and thus helped them hedge their risks—but they also made it easier for a speculator to make a straightforward bet on future moves in exchange rates.
And so funds and big investment institutions started to devote money exclusively to playing foreign exchange. The intervention of governments added to the possibilities, after Soros established that artificially set exchange rates simply could not last if investors decided against them. Currencies would have to float truly freely and create ever more interesting opportunities for foreign exchange speculation in the process.
In 1994, another pegged exchange rate came under pressure and buckled. This time it was a familiar victim: Mexico. The cause was the same ruthless dynamic that had played out in the LDCs crisis and again in Japan. Money had poured in to Mexico during the emerging markets boom. Its banks, freshly privatized once more, were indulging in an ill-advised lending binge. Then Alan Greenspan, who took over from Paul Volcker at the Federal Reserve in 1987, decided to rein in markets, which had been rallying since 1990. He raised rates, forcing serious losses on bond investors.
This hurt Mexico because higher rates pushed the dollar upward. After suffering the Zapatista Rebellion and the murder of a presidential candidate early in the year, Mexico was losing credibility and spending its foreign reserves swiftly as it tried to keep the peso within self-imposed limits. In December, a new government came to power under President Ernesto Zedillo. It had not had the chance to build up credibility on world markets and decided to widen the peg at which the peso traded against the dollar.
But when the new finance minister, Jaime Serra Puche, announced on December 20 that the peso would now be allowed to depreciate by 15 percent, it caused turmoil. He had to let the peso float freely two days later, and it soon dropped by more than 50 percent. The luckless Serra Puche resigned less than a month into his tenure.
The peso itself had only been slightly overvalued ahead of the move. But what looked like a speculative assault proved to have been an almost accidental attack. Earlier in 1994, the Mexican government started issuing bonds to foreigners that were payable in pesos but indexed to the dollar, known astesobonos. If the peso weakened, the amount payable to the foreign banks who had bought the tesobonos would increase to stay constant in dollar terms. It thus reassured them about the risk of devaluation—but carried the risk that Mexico might have to find more pesos.
However, unknown to regulators, virtually all $16 billion in tesobonos that were issued were then swapped back to Mexican banks, who instead guaranteed to pay the U.S. banks much the same interest rate that they would receive from a dollar account. If Mexico had avoided a currency crisis, the banks would have done well, because the tesobonos had a high interest rate. But once the peso started to fall, they owed more to the U.S. banks, who started to demand their money. To provide it to them, the Mexican banks had to sell pesos and buy dollars, pushing the peso down further.2
A devaluation that looked as though it would cause a problem for banks in New York instead caused a cataclysm for banks in Mexico City. By the time the crisis was over, more than half of all Mexican bank assets had been wiped out, more than 90 percent of the Mexican banking system was in foreign hands, and a cascading “Tequila Crisis” tipped over into crises throughout Latin America.
The incident showed how interconnected markets had become. Raising rates in the United States had big effects elsewhere, while modern international financial flows made it hard to tell exactly where those effects would be felt. It also intensified the rush by institutions to invest in foreign exchange. The Tequila Crisis was an ugly moment for world markets, but anyone who had bet on a fall in the peso, alongside their investment in stocks and bonds, would have felt much more comfortable.
Investing in forex as an asset class peaked in the years leading up to the crisis of 2007. According to the BIS, total forex daily turnover in 2007 averaged $3.2 trillion—quadruple its level in 1992 when Soros made his attack on the pound.3 Of this, 40 percent came from non-bank financial groups—largely investment funds treating forex as an investment. A decade earlier, such trade had only accounted for 20 percent of forex volumes. Therefore, trading in forex had become vastly greater, and most of the increase came from new investors treating forex as its own asset class.
This was a powerful synchronizing force for markets. A fund manager who liked the prospects for economic growth in Brazil, for example, would buy both the Brazilian currency (the real), and Brazilian stocks. Both actions pushed up the real and encouraged more investors to get involved. This made much of the world doubly vulnerable to swings in sentiment by international investors—but luckily for them, investors in the United States were consistently, or even irrationally, exuberant.
In Summary
• Foreign exchange is now a game for markets, subject to the same herding tendency that marks the stock market.
• Because many traders in the market do not aim to make profits, forex investment may be a profitable investment strategy—but in practice it merely amplifies flows of funds driven by equities and commodities.
• Most investors should not touch forex as an investment in its own right, at least while it stays correlated to equities.