Bucking the trend

It wasn't long ago that the greenback was the undisputed king of the world currency markets. But that demographic appears to be shifting. And the weakness of the dollar against most world currencies is causing major headaches in the Asia-Pacific region.

Large Taiwanese life insurers, for example - which, in their search for yield, have aggressively invested in dollar-denominated assets in the past decade - are finding it almost impossible to hedge their exposures against a declining greenback. The reason is simple: the market expects further dollar weakening, and the cost of direct hedging is highly prohibitive. As our article on pages 24-26 explains, the largest investors in dollar assets have no choice but to wait it out and move immediately when chances present themselves.

The lessons from Taiwan also serve as a reminder that proxy hedges, which have gained popularly in the past couple of years, are just that: they are merely proxies for real hedges. The assumed correlation assumptions do, and will, break down - a lesson that should have been learnt from the Asian financial crisis.

The reason for the current breakdown is clear. Taiwan's markets are buoyant. Its TSEC Index closed on March 24 at 8,865.35 points, a rise of 6.5% since the start of this year. This increase is in stark contrast with declines of 17.8% and 17.5% in Hong Kong's Hang Seng Index and Japan's Nikkei 225 Index in the same period. And the Taiwan dollar has risen 7.7% against the greenback so far in 2008.

Taiwan's markets have held up where others haven't, due in large part to expectations that March elections in the country would see the Kuomintang, under the leadership of Ma Ying-jeou, returning to power. This duly happened. Ma is expected to forge closer ties with mainland China, a major trading partner.

In the US, meanwhile, the Federal Reserve has cut interest rates to 2.25%, with the expectation of more downward moves that will likely feed more dollar weakness. Taiwan's insurers have already paid a hefty price for their dollar exposures and misjudged hedges - albeit that they are long-duration players. But they are unlikely to be alone.

Weakness in the dollar is playing havoc in other Asian markets. When dollar/yen breached Yen100 in March, investors were forced to unwind vast amounts of carry trades; while dealers performed frenzied hedging linked to long-dated dollar/yen exposures. And, as our cover story on page 10 explains, the ramifications are having an impact well beyond the foreign exchange markets.

Christopher Jeffery.