Past Crises triggered by Direct Attacks

To a certain extent, financial crises occurred in the past were triggered by direct speculative attacks. International speculators, led by hedge funds especially gigantic macro funds, often malignantly attacked against currency, bond and stock markets of other jurisdictions, so as to benefit from extreme market volatilities and disruptions. Crises of this type have successively taken place since 1990s, e.g. the 1992 ERM Crisis, the 1994 Bond Market Collapse, the 1997 Asian Financial Turmoil and the related 1998 HKD Crisis, as well as the LTCM Crisis in the same year. The role of international speculators was particularly crucial in the ERM Crisis and Asian Financial Turmoil.

The ERM Crisis is the first well known financial market turmoil directly triggered by speculators. In early 1992, as European countries gradually "converged" from ERM to EMU, problems arose. International competitiveness shrank in some ERM countries such as the U.K. and Italy, casting doubts on the viability of "convergence play". Besides, failure to contain budget deficits in some member countries and the mismatch of economic cycles added to the difficulties of common monetary and fiscal policies. The veto against the Maastricht Treaty in Denmark and the ambiguity of France towards the Treaty further posed questions on the commitment to EMU. As the market doubted about the prospects of EMU, confidence in the ERM began to shift, aggravating the exchange rate risks among member countries.

Well aware of the situation, hedge funds sold short the European currencies and caused "herding effect" in the market. With only assets of about USD10 billion, hedge funds managed to dominate the market through leveraging. Mutual funds, retirement funds, insurance companies as well as other institutional investors followed in attacking the ERM. This eventually led to the ERM Crisis in 1992.

The ERM Crisis is the first large scale international speculative attack in the foreign exchange market and has brought about massive losses to member countries. Sweden, after banking system losing Swedish Krona 60 billion, withdrew from the ERM. This was later followed by the U.K. and Italy, after also suffering from serious depletion of reserves, while Spain, Portugal and Ireland had to implement capital controls for a period of time to stabilise their currencies.

An even larger scale and prolonged market crisis "designed" and led by international speculators - the Asian Financial Turmoil, took place in 1997-98. The Thai baht was the first target of the speculators in July, followed by the Philippine Peso in August, the Malaysian Ringgit and the Indonesian Rupiah in October. The Korean Won, Singaporean Dollar and New Taiwan Dollar were no exceptions. Forces were later shifted to the Hong Kong dollar, with speculative attacks spread across the FX, stock and futures markets.

The Asian Financial Turmoil was a "multi-market" crisis. It first appeared as a currency crisis excluding only the HKD and RMB, involving nearly all Southeast Asian currencies. But it was also a stock market crisis, as stocks fell amid elevated interest rates to counter the FX speculations. Declines in stock markets far exceeded the 1987 Global Stock Crisis. Besides, bank runs, collapse of financial institutions and partial banking crises appeared in Indonesia, Malaysia, Thailand, the Philippines and Hong Kong.

Foreign Exchange and Stock Market Performance in Asia

The Asian Financial Turmoil did deal a huge blow to the Asian economies. Related financial losses even surpassed levels caused by the World War II. Not only did Southeast Asian economies suffer, Hong Kong and Singapore, with more solid economic foundation, were also seriously affected.

Direct attacks become less effective

After the Asian Financial Turmoil and the LTCM Crisis, there have been fundamental changes in international financial supervision, as well as the global economic and financial setting. Concerning financial supervision, more efforts have been made in monitoring short-term capital flows. For those countries having suffered seriously, they have become more alert to international speculators and have studied more thoroughly their domestic structural problems. Efforts have been made to enhance the financial system soundness and supervisory capabilities, striking the balance between market liberalisation and effective monitoring. Loopholes were plugged by strengthening risk management or regulations, e.g. implementation of capital controls, tightening market accession or transaction criteria, so as to curb speculative activities and instabilities due to short-term capital movement.

On the other hand, there have been much fewer speculative opportunities generated by market disequilibrium among worldwide FX, bond, interest rates and commodities markets. This should be attributable to three main factors. The first is the enhanced efficiency and maturity of global financial markets. Second, the birth of the Euro has reduced the number of trading currencies and room for arbitrage, while efforts of the emerging economies to strengthen their monetary system also help to avoid attacks. The third concerns the low inflation environment, accompanied by softer long-term interest rates, that limited the gains from high leverage speculative activities. Overall, it has become more difficult for speculators to generate huge profits from attacking currencies as they did in the 1990s. After the 1997 Asian Crisis, there have not been major direct attacks against currencies or financial systems that caused systemic crises.

Carry Trade - a New Source of Instability

Nevertheless, this does not imply stability from then on. Indeed, there have been huge market fluctuations in the past decade, e.g. the 2000 internet bubble, the 9-11 Incident, the Thai capital control in December 06 and the global stock crises in February and March this year. In addition to the captioned specific reason contributing to the first two incidents, short-term capital movement was the major factor for market volatility. The latter appeared to have replaced attacks against currencies as the major source of instability.

The recent stock market crises can illustrate how capital movement bring about market turbulence. While the Shanghai and Shenzhen stock markets registered the largest single-day decline in the past decade during Feb 27, the New York Stock Exchange also recorded the deepest fall since 9-11. A chain of market plunges then followed. On Mar 5, the Asian markets recorded another "black" day, with the Nikkei tumbled by 3.35%, the Hang Seng recording the largest daily decline in 5 years and collapses in nearly all Asian markets. As the PRC market is still small and remains not-fully-open, and the impacts of the U.S. subprime problem has gradually been reflected, the underlying cause should be capital movements induced by the Yen carry trade.

Carry trade refers to the transactions that take positions in high yield or return assets with borrowed funds of low interest cost. Currencies with low interest rates or weak foreign exchange rates are bound to be funding targets for carry trade, like the current Swedish Krona, Norwegian Krone and the Japanese Yen. Since Japan has maintained low interest rates and a weak FX policy, together with abundant supply, the Yen has been the major global carry trade funding target. Short-term Yen interest rates, though recently boosted to 0.5%, still maintain huge margins of 4-7 percentage points below foreign counterparts, and the Japanese authorities still tend to sustain a weak Yen in order to maintain export competitiveness. Being the funding target of carry trade, the Yen has remained weak. It has been estimated that the borrowings of Yen for carry trade amount to USD200-1,000 billion, close to the overall scale of hedge funds.

Speculative Activities masked by Carry Trade

While interest rates and foreign exchange rates remain steady, carry trade can certainly be lucrative. Nevertheless, potential risks of a rise in interest rates or FX rates would cause abrupt withdrawal of funds to repay the Yen loans, generating even more upward momentum for the currency, and in turn more serious fund withdrawals. The recent stock crises serve as a good example. As the BOJ raise short-term rates to 0.5% on Feb 21, the Yen gradually strengthened from a low of 122 against the Dollar and subsequent massive selling in the FX, stock and gold markets were evident. This crisis mechanism differs from the former direct attacks against particular currency. In fact, it also took place in the second quarter last year when the Yen rose by 9% during early April and mid May, giving rise to position covering in stock and futures markets by the hedge funds, resulting in a 8.3% decline in the S & P 500 index and a 12% correction of the Hang Seng Index.

The Yen carry trade began to emerge in mid 1990s and it has also been associated with speculative activities, particularly by the hedge funds. When Japanese short-term interest rates were reduced to historical lows in 1995 to stimulate the weak economy and create room for banks to make profits, hedge funds began to employ carry trade. According to the BIS, the volume of such trade through offshore centres like Cayman Island reached USD30 billion by Spring 1998. This may be a conservative estimate, given the complexity of such transactions. The Yen rebounded strongly in July1998 and with a change in Japanese monetary policy later in October, it gained further. As a result, investors were forced to cover their positions, leading to huge market volatilities and substantial losses for the speculators.

In recent years, amid the maintenance of low interest rates in Japan that resulted in widening interest spreads against the U.S. and European currencies, growing carry trade were again evident. The U.S. Commodities Trading Commission indicated that net short Yen contracts reached a high of 164,800 by the week ending Jan 23, with the largest participant being hedge funds. As it is difficult to ascertain the scale and direction of fund flows under carry trade, hedge funds are eager to take part in such transactions to mask their speculative activities.

According to market estimates, currently over 1/3 of the speculative funds in the Asian stock markets come from the Yen carry trade. This reflects the major role of Yen carry trade in financial market volatilities in Asia, with hedge funds remained as the major participant. The nature of hedge funds to seek high return through high leverage remains unchanged, only that their means have altered.

Concluding Remarks

The Yen carry trade has become the major source of financial market turbulence. This new form of financial market turbulence would probably take place from time to time, given the Yen's market liquidity and provided that the Japanese authorities maintain their weak Yen policy and keep interest rates low. To mitigate market risks under such new market environment, tight market surveillance, in particular over the hedge funds, demanding regular disclosure of their asset positions, should no doubt be continued. Besides, close monitoring of Japanese economic development, its interest rates and FX trend, as well as capital movement is also deemed necessary.