Currency ‘Protectionism’ Boosts Dollar as Banks Lend at Home

March 2 (Bloomberg) -- John Taylor says three decades of currency trading taught him financial turmoil prompts large banks to favor local lending, and that’s why he’s buying U.S. dollars for the biggest foreign-exchange hedge fund.

“Whenever a banking system realizes it’s in big trouble, it says, ‘I have to take care of my next door neighbors and the businesses down the block,’” said Taylor, who manages $11.4 billion as chairman of New York-based FX Concepts Inc. “Then that currency of that country, if its banks are big in international lending like in the U.S., will strengthen.”

Evidence of so-called financial protectionism surfaced last week. Stephen Hester, chief executive officer of Royal Bank of Scotland Group Plc, said Feb. 26 that the U.K.’s largest government-controlled bank will cut back or withdraw from 36 of 54 countries where it operates to focus on its “heartland.”

The pound and franc will also benefit from such moves, while currencies of New Zealand and other nations dependant on international banking will suffer, said Hans-Guenter Redeker, BNP Paribas SA’s chief currency strategist in London. He predicts the dollar will strengthen about 5.6 percent to 1.20 per euro by June 30.

Concerns about home-lending favoritism follow pledges by governments around the world of more than $10 trillion to prop up banking systems. More than $1.1 trillion of writedowns and losses created the worst financial crisis since the 1930s and triggered a global recession.

Protectionist Measures

U.S. President Barack Obama’s $787 billion stimulus plan, enacted last month, includes “Buy American” provisions. French President Nicolas Sarkozy created a fund in November to protect “strategic” companies from “foreign predators.” Russia increased duties on automobile imports in December, while India limited steel imports and imposed tariffs on soybean oil.

Historians blame a trade war during the Great Depression, starting with the U.S. passage of the Smoot-Hawley Tariff Act in 1930, for deepening the worldwide economic slump. History also shows that exchange rates are vulnerable to protectionist threats, said Derek Halpenny, the London-based European head of global currency research at Bank of Tokyo-Mitsubishi UFJ Ltd. The dollar slid to a record low in April 1995 of 79.75 yen after the U.S. threatened to impose tariffs on Japan.

Redeker said financial protectionism adds a layer of danger to foreign exchange markets, where trading increased to $3.2 trillion a day as international banks expanded.

Royal Bank of Scotland

“The problem is that many banks that operate internationally have received government funds,” Redeker said. Those banks will be pressured into “prioritizing local markets and withdrawing from abroad at an increasingly rapid rate. This will be quite negative for those countries that don’t have a strong enough banking system on their own and have in the past relied on banking from abroad.”

After posting the biggest loss in U.K. history, Edinburgh- based Royal Bank of Scotland plans to boost lending to U.K. homeowners and businesses by 50 billion pounds ($71.7 billion) as part of an agreement with the government to shift 325 billion pounds of investments into a state insurance program.

Declines in the shares of financial companies helped push the Standard & Poor’s 500 Index to a 12-year low last week, on concern the deepening recession will force banks to seek more government aid. The premium banks charge each other for short- term loans, a barometer of willingness to lend known as the Libor-OIS spread, was 1.02 percentage points Feb. 27, about 10 times the average for the decade before August 2007.

Dollar Index

The dollar rose to the highest in almost three years against the currencies of six major U.S. trading partners on Feb. 27 as investors sought refuge in the world’s preferred reserve currency. The Dollar Index, which the ICE exchange uses to track the U.S. currency versus the euro, yen, pound, Swiss franc, Canadian dollar and Swedish krona, reached 88.490, the highest level since April 2006. It’s up 8.2 percent this year.

Last month was the worst for the yen against the dollar since 1995 as Japan’s currency weakened 7.85 percent and ended the week at 97.57 to the dollar. The euro depreciated versus the dollar too, losing 1.2 percent last week to 1.2669. The New Zealand dollar lost 2.1 percent against its U.S. counterpart.

For Taylor of FX Concepts, who worked at Citibank until 1979, today’s markets are reminiscent of the late 1970s and early 1980s. Oil prices more than doubled and the Federal Reserve lifted its target rate for overnight loans to 20 percent by March 1980 from 10 percent at the beginning of 1979, leading the U.S. into a recession that lasted from January to July 1980. The Dollar Index surged 22 percent between the end of 1979 and the close of 1981.

‘Road to Disaster’

Damage caused by past bouts of trade restrictions may limit barriers from rising. After a January gathering in Rome, policy makers from Group of Seven nations said in a statement that they were “committed to avoiding protectionist measures, which risks exacerbating the downturn.”

“World leaders recognize that any kind of protectionism leads us down the same road to disaster,” said Ward McCarthy, a former Fed economist who is now a principal at Stone & McCarthy Research Associates in Skillman, New Jersey. “Even though this ugly word -- protectionism -- has cropped up, it doesn’t seem to be gaining any momentum as far as government economic or financial stability programs are concerned.”

Citigroup Inc. CEO Vikram Pandit said in a Jan. 16 conference call that the U.S. wasn’t pressuring the bank to restrict international lending. The government ratcheted up its effort to save Citigroup on Feb. 27, agreeing to a third rescue attempt that will cut existing shareholders’ stake in the New York-based company by 74 percent.

Helping the Economy

Kenneth D. Lewis, CEO of Bank of America Corp., the largest U.S. bank by assets, acknowledged that helping the U.S. economy goes hand in hand with accepting federal funding.

“With expanded investment in our company by the federal government, we intend to play a major role in restoring the economy of United States to a healthy rate of growth,” he said during a Jan. 16 conference call. “We will do this by providing credit to consumers, small and large businesses and state and local governments. Bank of America acknowledges the responsibilities of the company in the use of public funds.”

The World Bank, the European Bank for Reconstruction and Development and the European Investment Bank said Feb. 27 they will provide as much as 24.5 billion euros ($31 billion) to help central and east European banks and businesses cope with the global financial crisis and refinance foreign-currency loans.

Ratings Cuts

Shares of eastern European banks touched six-year lows and the Polish zloty, Hungarian forint, and Czech koruna slid after Moody’s Investors Service said in a Feb. 17 report that it may cut the debt ratings of western European banks exposed to mounting bad debts in the continent’s developing economies.

The South Korean won, Australian&cls; dollar&cle;, and currencies of smaller countries dependant on trade are most at risk from a rise in protectionism, said David Woo, the London-based global head of foreign-exchange strategy at Barclays Plc.

The International Monetary Fund cut its estimate for world growth to 0.5 percent in January from 2.2 percent, the weakest pace since World War II. South Korea’s economy will shrink 4 percent this year, the IMF forecasts.

“As governments direct significant amounts of public money to shore up the banking system and in an attempt to stabilize domestic job markets, there is increasing political pressure to appear to focus on domestic problems,” said Mark Konyn, Hong Kong-based chief executive officer of RCM Asia Pacific Ltd., which oversees $11 billion in assets. “Protectionism is a threat to the recovery.”