Strong currency will cause new problems

Just when investors must have begun to feel that some stability was about to return to stock markets, currency markets suddenly experienced major turbulence. In particular the US dollar/yen exchange rate, the world's most important cross exchange rate along with the US dollar/DM cross, suffered from some violent fluctuations. In the space of a short few days the $/yen exchange rate fell from over 130 yen to the dollar to as low as 110 yen at one stage.

The root cause for this sudden change in fortune for the dollar seems to lie once again in the activities of hedge funds. Because Japanese interest rates have been at rock bottom levels, hedge funds, and indeed banks and some industrial companies, had borrowed enormous amounts of yen which they converted into dollars which they then used to purchase bonds and equities.

Over the past few years this was a strategy which was profitable on all fronts. The yen was depreciating against the dollar reducing the loan value while at the same time dollar assets were in a major bull market. It was an enormously profitable strategy generating large and regular profits. As long as the yen remained weak the strategy looked like it could withstand the contagion spreading throughout the capital markets. The fundamentals of the Japanese economy continue to look awful so that ongoing yen weakness seemed to be the order of the day.

However, the near collapse of one of the largest US hedge funds, Long Term Capital Management (LTCM), seems to have created a chain reaction whereby hedge funds have had to start paying back their very substantial loans. The only way to do this was to sell dollar assets using the proceeds to buy yen thereby creating huge demand for yen.

From an Irish perspective these wild gyrations in the $/yen cross exchange rate do not have any major direct implications. However, it is very significant if it signals an environment whereby the dollar weakens against all currencies. As the table shows the dollar has weakened considerably over the past six months. The Irish pound has appreciated by close to 10 per cent against the dollar over this period.

Of course the key exchange rate from the Irish perspective is the DM/$ exchange rate and the sterling/DM exchange rate. With the birth of the euro now imminent the Irish pound has been closely tracking the deutschmark. A sustained appreciation of the currency eventually leads to a loss of competitiveness for the economy.

For Ireland, dollar weakness takes on an added significance because sterling often moves in tandem with the US dollar. In recent months, this has been borne out with the pound now trading at just under 90p against sterling. Market expectations now take the view that the euro will be a strong currency and therefore it is quite likely that the pound will go to the euro-equivalent of parity against sterling over the next year or so.

While a stronger currency will have benefits in terms of limiting the rise in inflation it will make the Irish economy less competitive. Given that the economy needs to slow down from its current breakneck speed this may be no harm. However, if the new euro proves to be very strong, particularly against sterling, the economy could well slow down very significantly.

It is just such fears that may well be behind the very poor performance of the Irish equity market since the July peak. In particular overseas investors may well view strength in the currency as a sign of much slower profits growth in the future. After all, it was currency depreciations in the European peripheral economies (including Ireland) which kickstarted the bull markets in many of these economies.

There is little that Irish policymakers can now do to ward off these dangers except to continue to reduce the State's debt. Ironically, for Irish investors, entry into EMU looks like it is simply going to replace one set of currency issues with another.