Investors bet Persian Gulf will loosen dollar pegs

By Joanna Slater
The Wall Street Journal
Tuesday, May 27, 2008

Hedge funds and other investors made bundles of money in the 1990s betting currency pegs around the world would break. They are at it again, only this time they are gambling currencies will soar, not plummet.

Among the prime targets are Persian Gulf nations that link their currencies to the U.S. dollar. An economic boom has touched off rampant inflation in these countries. That is putting pressure on policy makers to allow their currencies to strengthen, something they have said they have no plans to do.

But some investors are so keen on these economies that they think the currencies have nowhere to go but up. Everest Capital Ltd., a $3 billion hedge fund based in Bermuda and specializing in emerging markets, wrote in a first-quarter note to investors that it was betting that Saudi Arabia, Qatar and the United Arab Emirates would loosen the hold on their currencies, allowing them to strengthen.

Trades like that represent a remarkable shift from the 1990s. Then, places like Mexico, Thailand and Russia linked their currencies to the dollar as a way to provide financial stability. As their economies floundered, investors pushed governments to break the pegs, which caused their currencies to tank and sparked broader financial crises.

Now the situation is reversed. Everest was founded in 1990 by Swiss-born Marko Dimitrijevic, who steered his firm through a near-death experience during Russia's 1998 default and currency crisis. His Everest Capital Global fund has posted an average annual gain of 26% over the past three years, despite being down in the first quarter of this year.

Everest wrote investors that as inflation mounted in the Gulf, fixed exchange rates "would be put under significant pressure." One bet already paid off. Last year, it made a wager on the Kuwaiti dinar, which became the first currency in the region to abandon a strict peg to the dollar.

Immediately after the link ended last May, Everest bet that the dinar would strengthen by buying currency forward contracts, which allow buyers to purchase a currency at a set price at some future date. It hedged the trade with options to sell.

The pressures in the Middle East are present in a less-extreme form throughout the developing world. Ukraine announced last week that it would revise its peg to the dollar at a new level that would strengthen the local currency, the hyrvnia. The currency is up about 10% since early April.

Art Steinmetz, who manages a $12 billion international bond portfolio at OppenheimerFunds, likens currencies pegged to the dollar to buoyant rafts dragged underwater by a heavy boat anchor.

"The rope is pretty strained, and once it breaks, the rubber raft is going to shoot to the surface," he says.

A few months ago, Mr. Steinmetz began betting that a number of pegged or heavily managed currencies would strengthen, among them currencies in the Persian Gulf, the Vietnamese dong, the Russian ruble and the Ukrainian hyrvnia. The wagers were made using currency forwards. Mr. Steinmetz's fund had returns of 13% over the past year.

Investors love the Chinese yuan for similar reasons. The currency isn't officially pegged to the dollar, but until recently the government held its rate of appreciation to a slow crawl. This year it has allowed the yuan to strengthen at a faster pace -- 5% so far -- and investors believe there is more to come.

Since these countries are operating from a position of economic strength, it seems unlikely that hedge funds could pressure these governments to abandon their currency regimes. That is unlike the situation in the 1990s, when emerging markets depended on financing from overseas. And in the Persian Gulf, the links to the dollar also serve a broader geopolitical purpose, a priority that may be placed ahead of passing economic pain.

"This is one of those trades where Econ 101 meets the real world," says Kevin Harrington, managing director at Clarium Capital, a San Francisco hedge fund. He says that investors like the trade because there is limited downside and a potentially large upside, but he believes the economic arguments that the pegs will break soon are flawed.

Still, the money pouring into countries in anticipation of stronger currencies is causing inflationary pressures that policy makers can't ignore. Earlier this month, Russia announced a change in the way it manages the ruble against the dollar and the euro, largely to discourage investors who are betting the currency will strengthen.

Governments in the Gulf, too, are trying to quash speculation that their exchange-rate regimes will change. The mere hint of a change can bring in new waves of capital.

Such speculation was rampant last year. Using data from the International Monetary Fund, Deutsche Bank calculated that a narrow measure of money supply in the United Arab Emirates had tripled in November compared with a year earlier and was up 58% from a month earlier, both ominous signs for inflation.

The combination of breakneck growth and inflation in the Persian Gulf means that "by now there has to be significant pressure already to move" on the currency pegs, says Gerard Gardner of North Asset Management, a London hedge-fund firm that focuses on macroeconomic themes.

Mr. Gardner favors investing in local stocks, which are benefiting because the region's central banks have followed the interest-rate cuts in the U.S. If the currency pegs crumble, local currencies will strengthen, swelling the gains from shares when translated into dollars.

* * *

GATA is grateful for financial contributions, which
are federally tax-deductible in the United States.