The banks tried to hush things up – and then came Northern Rock. The fact is, things are going to get even worse...

On the rocks: why capitalism isn't stable

WORKERS, NOV 2007 ISSUE

The recent volatility in Britain's financial markets was first sighted in May when the debt from the Boots Chemist sale was offered as a yield-bearing product by investment banks. The offer had to be pulled within days, as there were no takers, meaning that the £10 billion debt had to remain on the investment banks' own balance sheets.

Hitherto such debt had easily been sold on but investment banks were suddenly unable to do so, meaning their available liquidity for the next deal had disappeared. The lack of take-up on the Boots debt was so worrying that the banks tried to hush things up but the news crept out and the jitters had set in.

For the past seven years the ability to raise capital for such deals as Boots had been straightforward. Interest rates worldwide had remained at forty-year lows but the cycle started to change at the beginning of this year. For example Japanese interest rates that had previously been at levels of 0 per cent to 0.25 per cent moved to 0.5 per cent and the Japanese yen soared on the currency markets.

The reason why this had a significant impact was because of a practice called the "carry trade". This is where capital at say 0.5 per cent interest is borrowed in Japan and then converted into for example sterling to invest for a rate of interest of 5.75 per cent. Much capital for private equity is raised this way not only in yen but also from other currencies, such as the Swiss franc for the same interest rate benefits.

Canary Wharf: still building, but how solid are the financial foundations? Photo: Workers

But deals of this nature only work when interest rates are low. What is less well understood is the risk that if the currency that has been borrowed against revalues, the relative value of the original sum borrowed mushrooms. A rise in the value of the yen means the huge-scale "carry trade" borrowers will have to pay back a lot more than they thought. Will they be able to pay? Wondering, the markets catch the jitters; banks hesitate to loan money or, as it is now often called, "buy debt".

Currency wars
Currency risk is also inherent in the little-recorded battle that has been taking place between the USA and China. China has built up a $1,400 billion trade surplus but the US has allowed the dollar to slide against other currencies with the aim of devaluing China's dollar-denominated surplus. At the same time the US has been trying to force the Chinese yuan currency to be revalued, which in turn would further erode China's surplus when repatriating its dollars back into yuan. The EU ambassador to China, Serge Abou, has also joined the attack by saying, "Apparently China's trade surplus has no limit and we do not see efficient measures. These facts are considered with a certain bitterness in our leadership." In fact the risk of worldwide currency volatility is at present considered so great that gold prices have soared due to gold being considered the only safe haven.

All this sheds some light on the Northern Rock situation, where pictures of people queuing to get their money out of the bank were having such an effect on sterling that international financiers were also beginning to think that a run on British institutions might prevent them from exiting with their wedge of cash.

The interesting thing about the day Alistair Darling at 5pm announced the government guarantee on Northern Rock, is that the pound had slid quite significantly against the euro. Those pictures of the British people queuing needed to be taken off the screens as quickly as possible, because suddenly the exchange rate was at risk. We are now heading for even more difficult times with Britain generally being viewed as a previously rich uncle who has yet to work out where all his former wealth has gone.

top