Ambrose Evans-Pritchard: A scramble for exposure to global inflation

Hedge Funds Target Currency Pegs

By Ambrose Evans-Pritchard
The Telegraph, London
Monday, October 15, 2007

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/10/15/ccview...

The wolf packs are circling. Fifteen years after George Soros smashed the sterling and lira pegs of Europe's Exchange Rate Mechanism, central banks have invited hedge funds to pounce again -- this time on a global scale.

Sitting ducks are on offer across Eastern Europe, the Middle East, and emerging Asia, each offering an irresistible one-way bet for speculators with deep pockets.

What the candidates all have in common is inflation, the ever-higher penalty they pay for chaining their destinies through currency pegs and dirty floats to the dollar and the euro, the currencies of two enfeebled blocs -- one a fat roue at the end of his credit, the other a stooped old gentleman with a stick.

The global M3 money supply is growing at 10.6 percent as stimulus from America, Europe -- and Japan, through the carry trade -- leaks out to the vibrant parts of the world economy.

Money is expanding at 18 percent in Saudi Arabia, 19 percent in China, 24 percent in India, 36 percent in the United Arab Emirates, 41 percent in Russia, and 69 percent in Venezuela.

With the usual lag, inflation has at last hit. Prices are rising at 6.5 percent in China, 9 percent in Russia, 9 percent in Vietnam, 11 percent in the UAE, and 12 percent in Qatar -- to name a few.

Only nations with very rigorous monetary regimes seem able to resist this tide of liquidity. Most are floundering. Hence the rush by investors to profit from these unrestrained bubbles by piling into their stock markets.

The MSCI emerging markets index has risen by 30 percent since the credit crunch hit in August and triggered a reflationary rescue by the Fed and the European Central Bank.

The easy way to play the game is through multinationals that generate a big chunk of their profits in the boom zones. Citigroup has advised rotating from "mid-cap" to "uber-cap" stocks, which on average generate 23 percent of sales in emerging markets. They cite AXA, BAT, Lafarge, Henkel, Nokia, Philips, and Siemens, among others.

This scramble for exposure to global equity inflation explains the force of the rallies on Wall Street and Europe's bourses since August. The Dow has vaulted to new records; the small-cap Russell 2000 has not. Bears read that as an ominous "non-confirmation."

At some point East Europe, the Gulf, and Asia must jam on the brakes or kiss goodbye to economic stability. Fifteen or 20 countries are already on the cusp of an inflationary spiral. If they don't act, hedge funds will do the work for them.

The easiest prey are in the Baltics and Balkans, where EU newcomers have let rip by importing an ECB monetary policy designed for the slow barges on the Rhine. All are overheating.

Inflation is now 11pc in Latvia, and 7 percent in Estonia and Lithuania. Property prices in the capitals of all three are more expensive than Berlin. Inflation is 12 percent in Bulgaria and 6 percent in Romania.

The ECB has now invited the wolves to kill.

Board member Lorenzo Bini Smaghi said East Europe's pegs had pushed interest rates too low for the needs of fast-growing catch-up economies. "This might lead to boom-and-bust cycles, with potentially very severe adjustments costs that may delay real convergence," he said.

Was this his way of saying the ECB will not defend the region's ERM exchange bands? He is an old hand. He must know that the ERM crisis in 1992 was triggered by Bundesbank hints that "one or two currencies" should be devalued. In 1992 the target currencies were too weak. Now they are too strong. Speculators are happy either way.

For the petrodollar sheikdoms and Asia's tigers, the curse is the dollar, not the euro.

The inflation pressures were bad enough before the Fed slashed rates a half point to 4.75 percent.

These countries are now having to import a loose money policy designed to stave off a US recession. It is pouring gasoline on the flames.

Kuwait became the first Gulf state to ditch its dollar peg. Others are hanging on, but inflation has reached 10 percent in the United Arab Emirates and 11.8 percent in the gas-rich neighbour of Qatar.

They have balked at cutting interest rates in lockstep with the Fed. So have the Saudis. This makes pegs untenable over time. Matt Vogel of Barclays Capital says a riyal "carry trade" has already begun in Saudi Arabia. Speculative flows are surging into the kingdom.

The Gulf region has $3,500 billion under management in reserves and wealth funds. It has the firepower to shoot wolves, but does it make any sense to do so? Buying dollars leads to even more inflation. In any case, Qatar has already slashed the dollar share of its $50 billion investment fund from 99 percent to 40 percent. The game is up.

Further east, Vietnam is throwing in the towel as inflation hits 9 percent. It said it will no longer hold down the dong by massive purchases of US bonds. Singapore, Taiwan, and Korea have begun to change tack, slowing dollar accumulation before inflation gets out of control. "There is evidence that foreign-exchange intervention strategies are changing across the region," said Goldman Sachs.

China too is a target. Its crawling dollar peg is held too low, driving inflation to levels last seen just before the Tiananmen protests.

Reserves of $1,430 billion are no help. They are the problem. As Nomura's chairman, Junichi Ujiie, told me in Tokyo: "We're all trying to get money into China any way we can because we know the renminbi has to rise. It's a one-way bet. It's wonderful."

We face a new kind of currency crisis. Post-war bust-ups have usually been on the fringes.

This time the capitalist core is rotten. Neither Western Europe nor the United States is strong enough to support the twin pillars of the world's currency system. Nobody else is ready.

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