<nettime> Send in the Reserve (how the collapse of Long Term Capital Management saved the Australian economy).

[nettimes_roving_reporter <nettime-l@bbs.thing.net>]

[[moderators note: This story relates to the thread regarding the logic of
financial networks. For international readers, I will outline a salient
point regarding some details of the currency markets: the $A ('the aussie'
in dealer's parlance) is about the 5th or 6th most-traded currency in the
world, and obviously it can still be attacked by currency speculators. Yet
the 'G-7', which does not include Australia and all of the affected
countries undergoing monetary crises this last decade, refused Australia's
proposal that the 'G-22', a slightly more representative group, be
responsible for reforming the investment system.  Nearly half of the G-7
includes countries whose currencies don't figure on any large scale, in
the international currency speculation markets -- Canada, Italy, France to
name them specifically -- yet this club specifically reserves all right to
dictate to the rest of the world the terms on which they will continue to
exploit their currencies on a purely speculative basis. Despite its
'decentralised' features, the network most certainly has a centre.]]


Send in the Reserve

SYDNEY MORNING HERALD 25/09/99
http://www.smh.com.au/news/9909/25/business/business4.html

A high-flying hedge fund's near-death helped the Reserve Bank win a secret
war to save the dollar.  Steve Burrell reports. 

The senior Reserve Bank official had got to his Martin Place office early
on this brisk Queen's Birthday Monday. Although the public holiday meant
foreign exchange trading was thin he was watching his Reuters screen
closely to monitor the progress of the Australian dollar as Asian markets
opened for the day. 

The Reserve had been intervening heavily in the two days going into the
June long weekend of 1998, buying the $A to try to slow its fall toward
lows last seen 12 years before at the height of the Banana Republic
crisis. It had slid further in offshore trading over the weekend. 

The official was nervous about the day ahead. 

At 9.45am the screen showed the first trades in the $A below the
psychological barrier of US60c. 

It marked the start of the toughest day in a secret war against the dollar
that was played out in the world's financial markets for six months last
year. 

It was a battle in which the Reserve Bank went eyeball to eyeball with
some of the most powerful speculative forces in the global financial
system, the hedge funds, and won. 

And, for the first time, those involved are now revealing the
behind-the-scenes manoeuvring in this struggle for the $A, as the hedge
funds targeted a weakened currency and the RBA combined strategic
intelligence gathering and market intervention - buying dollars - to repel
them. 

The team which led the fight for the Reserve included the Assistant
Governor in charge of its financial markets group, Ric Battelino, and the
head of its International department, Bob Rankin, They were up against the
so-called global macro hedge funds, speculators who place massive bets on
world economic trends and which include the likes of George Soros's
Quantum Fund, Julian Robertson's Tiger Management, Paul Tudor Jones's
Tudor Jones group and Moore Capital Management . 

After months of surreptitiously setting up their ambush, the funds
unleashed their frontal attack in the first week of June, selling dollars
aggressively over five days to drive the currency to new lows. The prize:
hundreds of millions of dollars in speculative profits. 

After a tense week in which the $A spiralled down by more than US3c to a
then-record low close, the funds were eventually repulsed. 

But it wasn't until four months later, after the $A had fallen even
further to its lowest level ever of US55.3c in late August, that the
speculative siege was finally lifted by the near collapse, a year ago this
week, of what was to become the world's most notorious speculator. 

The $US3.5 billion rescue of a hedge fund called Long-Term Capital
Management, hammered out in crisis meetings between 14 of Wall Street's
elite investment banks and US Federal Reserve officials, was seen as
essential to preserving the stability of the global financial system
itself. 

It was LTCM's dramatic fall from grace, made public on September 24 last
year, which was a crucial circuit breaker in ending one of the biggest
speculative attacks ever mounted on the Australian dollar. 

If unchecked, it may have eventually forced the RBA, reluctantly, to lift
interest rates to stem an even greater slide, at the risk of driving
Australia into recession. 

The $A had already been on a downward trend from a peak of around US80c
when the Asian economic crisis erupted in mid-1997. Widespread
expectations that the blow to Australia's trade with Asia would have a
severe effect on the current account deficit accelerated the decline. 

The RBA was quite comfortable with a fall which reflected the
deteriorating fundamentals of the Australian economy in the wake of the
East Asian collapse. It intervened only a few times in the following 12
months when markets became particularly volatile. 

But from early 1998 the sharks had been circling the weakened Australian
dollar. 

Slowly at first, and then more rapidly from March, hedge funds started
building huge "short" positions effectively selling forward Australian
dollars which had been borrowed, in the expectation that they would be
able to buy them back at a cheaper price later. 

According to participants in the battle, it was the global macro funds
which mounted the ambush, with one fund particularly prominent. 

Although the Reserve Bank believes "we know who was doing what" in June
last year, it has never revealed precisely who the culprits were. 

Unlike LTCM, which took enormous arbitrage positions on small pricing
anomalies in relatively obscure markets like Russian debt, the global
macro funds specialise in spotting and exploiting big trends in the global
economy. 

These super-speculators use huge pools of funds and enormous leverage
created by borrowings and the use of derivatives to finance their massive
plays. The massive capital flows they spark can overwhelm entire
economies, as Indonesia, Thailand and other Asian nations discovered in
1997, and defeat major central banks, as the Bank of England discovered in
the ERM crisis of 1992. 

The hedge funds plays are complex and executed on a global scale. The
funds themselves admitted to the Reserve Bank during the crisis that their
assault on the $A was a relatively minor skirmish in a much bigger battle. 

Their primary strategy was to drive down the yen in an attempt to force
China to devalue its currency, the renminbi, and break the Hong Kong
dollar's peg to the greenback. 

This strategy reflected their broad view that Asian currencies were
vulnerable as a result of the regional economic crisis and that those that
would come under greatest pressure would be the Chinese currency and, by
extension, the $HK. 

However, there were limited opportunities for the funds to establish big
positions in the region, either because markets in currencies like the
Thai baht and Indonesian rupiah had been so shattered that it was
difficult to find counter-parties to the funds' plays or, in the case of
the reminbi, because it was not openly traded. 

This brought the $A into their sights. A widely traded currency with Asian
linkages, it provided the ideal proxy for their grand Chinese devaluation
strategy. 

But while a secondary target "collateral damage" as RBA Deputy Governor
Steven Grenville has described it their impact on the $A was significant. 

The precise details of their dealings remain in the shadows. The privately
owned and virtually unregulated hedge funds make very little information
publicly available and the banks and dealers who front for them in the
market are reluctant to reveal their clients' secrets. 

The RBA and other central banks, however, have developed ways of tracking
them, gathering intelligence on their trades and strategies through
questioning the big banks that help fund their leveraged positions, the
dealers who conduct their trades in the market and, in June last year, by
confronting the hedge funds directly, by phone, in their New York, London
and Singapore lairs. 

(Although the RBA, and the financial institutions involved, are at pains
to keep these exchanges private, the bank has publicly confirmed meetings
with senior representatives of investment bank Merrill Lynch in June last
year over trading it had conducted on behalf of one if its client hedge
funds, believed to be Tudor Jones.) 

This intelligence network told the RBA that the funds had begun to quietly
build their short positions in the $A early in the year. By May they had
reached around $12 billion. 

At first it had little obvious effect. But as the $A headed toward US60c
in the first days of June, the funds sensed blood in the water. 

They suddenly became much more aggressive, dramatically increasing the
pressure on the currency by taking even bigger short selling positions and
overtly signalling to other players in the market, through their trader
intermediaries, that they were about to attack with enough weight of money
to sweep aside any counter-intervention by the RBA. 

This was deliberately designed to "thin out" the market, driving to the
sidelines players such as Australian exporters who would normally come
into the market to buy up the $A as it weakened to hedge their future
receipts against a recovery in the exchange rate. 

The hedge fund positions were relatively small when measured against
normal turnover in the dollar, which last financial year averaged about
$13 billion a day in the spot market and around $2.5 billion a day in
forward selling. 

But by thinning the market, they increased the impact of their short
selling, maximising the bang for their speculative buck. 

As Rankin has revealed, the hedge funds reinforced this tactic by
concentrating their $A selling in periods when the market was already
thin, such as lunch time in the Sydney market and the "hand over" period
between Sydney and London trading. 

"They were not merely transacting to take advantage of expected events,
but were doing so in a way which seemed intended to try to influence the
course of events, posing a risk to market integrity," Rankin told a recent
internal RBA conference. 

What the RBA was concerned about was not that the funds held a view about
the $A and were prepared to back it, but that they were deliberately
attempting to manipulate the market. 

According to Grenville, this destabilisation strategy was their standard
modus operandi. 

"The tactic is straight forward enough quietly take a short position in a
currency which is already a bit undervalued and then, by a mixture of
highly public additional short selling and vigorous orchestration of
market and press opinion, get the exchange rate to move down quite a bit
further," he said in a recent speech. 

"As it does, a bandwagon forms, with market players anxious to sell the
currency as it becomes cheaper, in the belief that it will become cheaper
still. 

"As the herd moves in the original speculators can square up their
position, at a profit." 

Standard tactics, perhaps, but it worked. In a few wild days the $A
plummeted, as the RBA fought back with market intervention. It bought $2.6
billion in three days at the height of the funds' assault on either side
of the holiday weekend, with much of that concentrated on that crucial
holiday Monday as the $A drifted down through the US60c barrier . 

At least one fund had openly warned the RBA that it aimed to drive the $A
to US54c. With the bank at one stage seemingly the only buyer of $A
standing in the market, many observers thought they might succeed. 

But the intervention eventually forced a stalemate. Although the $A
continued to fall for the next two days, hitting a new record low close of
US58.07c on June 10, it eventually started to turn on the Thursday and
Friday. 

This gave the RBA breathing space until, as one participant described it,
"something else happened". 

That something else was a sharp rebound of the Japanese yen against the
greenback in mid-June. Many funds had placed bets running the other way
and in this situation they were unwilling to add further to their short
positions in the $A. The currency recovered, eventually reaching US63c in
mid-July. 

But although the RBA had won this round, the big bets the funds had placed
against the $A had not been withdrawn. This overhang of short positions
weighed on the currency and kept other players in the market on the
sidelines, fearing another speculative raid that would again send the
Aussie plunging. 

Through the rest of July and August the $A slid again, falling eventually
to its record low of US55.3c after the Russian devaluation and debt
default on August 17 sent world markets into a spin and worsened the
fundamentals for all commodity-based currencies. 

It recovered some ground, but by late September it still hovered, battered
and vulnerable, around US58c. 

At this point the turmoil which had roiled the markets for weeks
threatened to turn into a genuine global financial crisis after the LTCM
revelations. 

But for the Australian dollar the hedge fund's near death experience came
as a godsend. 

The huge shocks being felt in the international markets had turned these
Masters of the Universe into hostages to the very forces of financial
instability they had helped create. 

One by one, the funds' hugely leveraged bets turned sour, producing
massive losses and forcing them to liquidate positions to survive. 

The turmoil had its epicentre in Russia's decision on August 17 to open
the rouble to a sharp devaluation and impose a 90-day foreign debt
moratorium in a desperate attempt to restore its disintegrating finances. 

Although Russia is a financial midget in global terms, there were fears it
could trigger a round of declines in other emerging markets. These fears
triggered a wholesale rejection by investors of risk and a "flight to
quality" from emerging-market debt into the safe haven of US Treasury
bonds. 

This drove US bond interest rates towards record lows and blew out rates
on emerging-market debt, slashing its value. This in turn triggered a
meltdown for the hedge funds like LTCM, which, among other positions, had
placed big bets on the gap in bond prices between the US and other markets
narrowing. 

The problem was made worse by the massive leverage underpinning their
plays. 

Funds were forced to liquidate profitable positions such as their $A plays
to cover their losses. 

Then, on September 24, the rescue of LTCM became public, setting alarms
bells ringing around the world. A string of major banks had lent the hedge
fund money and lost it. 

The US Federal Reserve's close involvement also suggested it had deep
concerns about risks to the financial system itself if the well-connected
hedge fund collapsed. 

This intensified fears about the viability of other hedge funds and of the
banks lending to them. 

As European and American banks revealed LTCM losses and rumours swept the
markets of possible further hedge fund collapses, the focus of fear
shifted to the commercial banks and the risk of a global liquidity crunch. 

It was a fatal blow for the hedge funds. The exposure of LTCM's woes
prompted the world's banks to cut off the lending which had underpinned
the massive edifice of leverage they had built up. 

Without the credit needed to maintain their short positions, the funds
were forced to cover themselves by buying in the market the very assets
they had conspired to drive down. 

Even though the global macro funds which had attacked the $A relied more
on derivatives than bank loans for their leverage, they were indirectly
hit by this global "deleveraging', forcing them to crystallise big losses
and prompting investors to pull their money out. 

Then came the next shock. It was mid-afternoon in Asia on October 7, and
as traders watched their screens it looked as though the US dollar was
falling off a cliff. 

An unprecedented realignment of the $US/yen relationship, which saw the
biggest one-day fall in the greenback in a quarter of a century, had
begun. 

Virtually every fund was effectively short the yen because they were up to
their eyeballs in the "yen carry trade" borrowing at ultra-low interest
rates in Japan and reinvesting in high-yielding assets, ranging from US
and European bonds to riskier emerging market debt. 

The yen carry had been the closest thing in the global markets to a free
lunch, but the weakening $US was pushing these previously highly
profitable plays closer and closer to the red. 

The funds, which had massively leveraged their yen plays, were also facing
margin calls on their borrowings and derivatives positions. The result was
a rush for the exits as they unwound their positions, selling dollars and
panic-buying yen. 

In the space of six hours, the greenback lost more than 6 per cent, taking
it from around 131 yen to around 123 yen. 

It had already slid from 135 yen the previous day. 

After a short rebound, the carnage continued in New York trading. 

Then, in afternoon trading in Asia on October 8, an even more precipitous
plunge began. The greenback plummeted from around 122 yen to as low as 112
yen in the space of a few hours. 

The battered $A climbed nearly US4c on the back of the burgeoning yen as
the hedge funds plays disintegrated. 

The combination of the Russian crisis, LTCM and the yen's rise had saved
the $A. 

The funds were forced to back out of their short positions, liberating the
$A from its speculative trap and driving it up to around US64c by
mid-October roughly where it had stood in early May. 

It was the final defeat for the funds in their six-month assault on the
$A. 


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