Sunday, March 8, 2009

How George Soros Profited So Much When UK Was Defending Its ERM Position?

Initially, I thought of writing about how people like George Soros & other currency speculators had played the market out back in early 1990s. At second thought, since the Edexcel A-Levels examination is around the corner, thought it will be nice for those taking the examination to know something about UK economic history in brief

What had happened much earlier?

Margaret Thatcher inherited the ‘sick’ British economy from her predecessors Harold Wilson & James Callaghan in 1979. During that period, second oil shock due to Iranian revolution swept the whole world. Oil price increased to another unprecedented level, causing UK economy to face one of the worst recessions in history. Inflation that time was about 27% & was made worse with union militancy. Riots were seen everywhere especially in Birmingham, Bristol, Brixton, Manchester & Liverpool

On coming to power, she pursued a very strict deflationary approach towards the economy. To reduce the inflation rate, she increased interest rates (which wasn’t suitable for cost-push inflation). Simultaneously, all government expenditures were slashed. As a result, she managed to combat inflation by bringing down AD. But there were other repercussions. Increase in interest rates caused pound to appreciate which was deemed unhealthy towards the already-declining manufacturing industry. Exports continued to slide. Current account deficit widens. Through the negative multiplier effect, real GDP contracts further & unemployment was exacerbated, reaching around 3.5 million. It stays that way until 1986

Within the same period, she introduced many legislations that were in favour of firms e.g. giving firms more power to sue their workers, casting a ballot before strike etc. Some quarters argue that Thatcher’s policy was too harsh & stronger than necessary

What happen then?

Things went for a turn in 1986. The Conservative government decided to pursue policies that will inflate the economy. As can be seen (refer diagram) interest rates were cut from 14% to just around 7% to facilitate growth. It was very effective. Even the October 1987 stock market crash didn’t produce any damaging effects to UK economy that time. The bull run continued shortly after that fuelled by high consumer confidence in its housing market. The wealth effect was just too strong. Equity withdrawal increased to record level. It’s a common phenomenon where people borrow more money secured against the rising value of their property.

Source: BBC
Source: BBC
Populist approach like cutting income tax rates for both low & high income also contributed to the fast but unsustainable growth. UK was growing at 5%, twice its normal growth rate. Meanwhile, policymakers were ‘fooled’ thinking that their supply side policies such as the privatisation & trade union reform were a big success and was fundamentally sound. So they did not bother to increase interest rates. The period is called the Lawson Boom. However, rapid growth was followed by high inflation after that. It crept to 11% in 1990. Also current account deficit widens
Is ERM the way out?

Thatcher-led government decided to join ERM (Exchange Rate Mechanism) in 1990 as a way out to combat the horrifying double digit inflation. At that time, pound was pegged against deutsche mark (DM), as Germany was the largest economy in Euro-land that time. The pegged was DM2.95 to £1. In theory, pegging (fixed exchange rates) creates certainty for traders & should not be subject to currency attack by speculators. However, this still depends on how high it is pegged at

Unfortunately, UK government made another costly mistake. The pegging was indeed at too high a level & currency speculators predict that it will not be sustainable. As mentioned earlier, inflation rate was high that time, causing pound to quickly lose its worthiness & weak on the foreign exchange market. Conservative government was forced to increase interest rates to protect its value. Higher rates managed to cool down the economy. But since the main agenda was to maintain the exchange rates more than stabilising the real economy, economist claimed that the increase was overdone. Houses being repossessed hit the headline as many couldn’t afford to pay at such high rate. Consumer confidence decline. UK economy went into deeper recession

However, UK government did not reduced interest rates still. Emphasis was just on stability of exchange rate. At that time interest rates were already at 15%. Speculators, mainly people like Soros predicted that UK will no longer be able to sustain at such high exchange rate & will collapse any time. So he & other speculators persistently sold pound heavily on the market causing value of pound to further fall. UK responded by further increasing interest rates to attract inflow of foreign capital which temporarily led to increase in the demand for pound. Also they intervene in the foreign exchange market to buy pound, using foreign reserves

Somehow, they soon realised that they are fighting a losing battle. There is no way UK alone can contain the market force of continuous selling of pound. It will just worsen domestic recession & drain out foreign reserves in defending sterling. At last it took the decision to leave ERM. That happened on 16th September 1992, popularly known as the Black Wednesday

So how currency speculators played the market?

Soros was well known after the incident, after he sold short more than $10 billion worth of pounds & profited $1.1 billion from the transaction. How it works?

I will present an oversimplified model here:

Say the current market rate is DM 3 = £1. Traders like him borrow say £1000 & with this he obtained DM 3000

Now, let’s say that pound weakens & we have a new exchange rate DM 3 = £1.80. Soros will sell his DM 3000 & gets £ 1800. He returns the £1000 borrowed earlier & still make a clean profit of £800

People like him & many other speculators who successfully predicted the downturn of the pound, will borrow pound in a large quantum & sell it a later date, making profits as shown above. In fact the cycle can get more vicious if he chose to dump the £800 (above) rather than cashing it out

The intention is to further depress the value of pound, & he will again repeat the process, making a larger profit every round

That’s the complexity of financial world! But it’s interesting & I’m amazed how people made money out of thin air!

1 comment:

AmeliaLove said...

"Increase in interest rates caused pound to appreciate which was deemed unhealthy "

I know I deserve to be kicked for asking this, but how does this happen, again?