We at BNP Paribas have been bearish about the Euro for some time, expecting a drop in value, but the speed with which the currency has fallen has taken the whole financial industry by surprise. Investors had completely underestimated the impact of the crisis that began in the US and has spread to the rest of the globe. One year ago, investors believed that Asia would be protected by its largely unspecialised financial market, high current account surpluses and build up of foreign exchange reserves. But as the cases of Korea and India have signalled, when credit conditions tighten in the Western world, the availability of credit and liquidity that many Asian companies and banks depend on also dries up. Investors failed to realise how such conditions could substantially change the cost of funding for these organisations even though the crisis did not begin in Asia. Furthermore, many Asian investors have been caught off guard by the weakness of local equity markets and their currencies
Market volatility like this has never been seen before
When they think of the financial crisis, many people think of the US and then the UK and Europe. Uncertainty over the economic stability of many Asian countries has had the effect of adding much more volatility to currency and equity markets. This increased volatility has had the effect of pushing the value of the US Dollar upwards as investors look for a safe haven in the midst of the crisis. Nobody active in the market today has experienced such volatility before and hence the devastating effect of high volatility in combination with the brutal de-leveraging which has gone on might still be under estimated.
We expect the Euro to fall to a valuation of US $1.13 at the beginning of 2010. Even this prediction, however, might prove to be far too conservative.
How does volatility affect currency markets?
The impact of volatility on FX markets works via various angles. First, a high degree of asset fluctuation suggests investors will reduce the size of their asset holdings. US investors in non USD denominated markets are driven to make higher returns in riskier markets, trying to boost returns by taking aggressive risk on to their books. As asset prices decline across the globe, particularly in emerging markets, many investors have shelved this strategy and instead 'repatriated' assets back into the US, boosting the value of the US currency.
Despite equity markets reaching attractive valuation levels and therefore becoming more expensive for investors, there are no signs as to what could stop this 'falling knife'.
A further reason is the flawed action undertaken by European policy makers in reaction to the financial crisis. The crisis taking place in these emerging markets was not foreseen by the European Central Bank. The ECB mistakenly raised interest rates in July, thinking that the worst of the global financial crisis was over when in reality it was only just beginning. The effect of the fall in emerging market asset valuations was of significance because much of the crisis affected those countries in the European Union's backyard - the fragile economies of Eastern and Central Europe - many of which have been suffering economic problems as a knock-on of the financial crisis. The interest hikes did not foresee the effect of this downturn on the Union - 23% of the European Monetary Union's exports have been to Emerging Markets (mainly Eastern and Central Europe) in recent years. In raising interest rates, the ECB was too quick to believe the worst of the financial crisis had been contained within the US and Western Europe. It failed to protect itself against the global escalation of the crisis.
The poor policy response to the crisis is another issue which we under-estimated in our predicted valuation of the Euro. The real issue affecting markets is the lack of co-ordination between different countries in dealing with imploding global markets. New 'global' thinking is what is needed - policy makers across the globe have seen that trying to solve the financial crisis by issuing national solutions is not a solution and in some cases national responses were even counter productive. Many governments still seem reluctant to take this approach. French President Nicolas Sarkozy wants to introduce a European wealth fund to nationalise key industries. He mentioned two reasons: First, steering the economy and secondly preventing European companies being 'sold on the cheap' to foreign investors. Protectionism springs to mind. There seems to be little understanding that there is no 'national' capital market and that in this day and age countries and regions are interdependent for business and trading. The solution to the current crisis is only found on an international and not a national level.