Understanding The Risk In The BRICs

When Goldman Sachs economist Jim O'Neil first dubbed the four nations of Brazil, Russia, India and China as theBRICs, back in 2001, he made one of the gutsiest long-term global macroeconomic calls of all time. Featuring the right demographics, vast commodity wealth, growing middle classes and relatively steady fiscal andmonetary policies, O'Neil postulated that these nations would be the biggest drivers for future global growth. So far, the economist's prediction has generally come true. The MSCI BRIC index has risen by more than eight times what the S&P 500 index returned during the past decade, and the BRIC's combined GDP soared to $13.3 trillion last year.

That outperformance has prompted many investors to add the four horsemen of the developing world to their portfolios as a way to cash in on the group's torrid growth. Despite the rosy long-term growth picture for the BRICs, there are plenty of risks, aside from the global macroeconomic pressures in these nations. In the end, these nations aren't called "emerging" for nothing.

With the BRICs continuing to contribute so much to the global economy and with the nations making up a huge portion of emerging market assets, it is critical for investors to understand these risks. Yet, each of the four nations is a completely different animal and comprehending the differences in each of their risk profiles can be a daunting task. Here are some of the internal risks when investing in the BRICs.

A Dragon of Lies
When it comes to emerging market investing as a whole, China remains at the top of many investors' minds. After all, the nation represents the hallmark of the developing market thesis. However, investing in Asia's Dragon economy isn't as easy as buying stock in Germany. 

Perhaps the biggest problem is the lack of GAAP or international accounting standards. That issue has even caught some of the best investors by surprise. For example, billionaire hedge fund manager John Paulson lost a bundle on Toronto-listed Chinese forestry firm Sino-Forest Corp. It was accused of faking land holdings and "cooking the books." Others have been accused of falsifying bank deposits and accounts. That lack of transparency and disclosure of information makes it a lot harder to see the real picture, especially compared with developed market stocks.

That picture gets even muddier when investors are forced to deal with questionable official Chinese data and a heavily regulated/bureaucratic communist government. The majority of the major firms in the nation are in some way owned or controlled by Beijing.

Russia's Corruption Woes Despite the nation's recent entry into the World Trade Organization (WTO), there are still somesignificant investment risks in Russia; corruption and political will are the two biggest. Bribes and organized crime infiltrating legitimate businesses remain standard practices. According to a report by the Information Science for Democracy Foundation, the average amount of petty bribe in the Russian Federation has increased steadily in the last 10 years. Back in 2001, it was roughly 1,817 rubles. By the time 2010 rolled around, it had grown to 5,285 rubles and represented 93% of an average worker's salary.

Then there is the national government to contend with. Voicing an opinion that conflicts with President Vladimir Putin's wishes could lead to your business or investments being seized as well as a potential prison sentence. Just ask Mikhail Khodorovsky, former Chairman and CEO of Russian oil giant Yukos, who was convicted of fraud in 2005 for reasons that are believed to be politically motivated.

LATAM's Commodity King
While outright corruption isn't as big of a problem for Brazil as it is for Russia, the government does have a hand in creating risks for investors that stem from its "protectionist" attitude. The country now has the second-highest number of protectionist measures in Latin America, after Argentina. This includes rules to favor local products, high tariffs on imported goods, tax breaks to encourage domestic production and limiting the access of foreign investors to strategic natural resource assets. For example, investors wanting to tap the nation's vast oil wealth must partner with state-owned energy giant Petrobras. Overall, these policies could derail some investment returns if Brazil decides to go one step further and nationalize various assets.

Asia's Bureaucratic Nightmare
With a democracy as large as India's, you would expect there to be some red tape when it comes to successful investment. However, the nation's bureaucracy has been called the "most stifling in the world." Starting a business in India is incredibly hard, as the local and national governments generally have a hand in the commercial markets. Likewise, enforcing contracts can be impossible, especially when there is a propensity for business partners to enter into undeclared third-party transactions. The Political and Economic Risk Consultancy, a Hong Kong-based think tank, estimates that India's bureaucratic system will prevent it from matching the growth rates of other rival nations.

The Bottom Line
The BRICs offer much in the way of portfolio and economic growth, however, there are some pretty big risks for individual investors as well. Understanding these risks is key to navigating these emerging giants successfully.

The Currency Market Information Edge

The global foreign exchange (forex) market is the largest financial market in the world, and its size and liquidity ensure that new information or news is disseminated within minutes. The forex market has some unique characteristics, however, that distinguish it from other markets. These unique features may give some participants an "information edge" in some situations, resulting in new information being absorbed over a longer period of time. 

Unique Characteristics of the Forex Market Unlike stocks, which trade on a centralized exchange such as the New York Stock Exchange, currency trades are generally settled over the counter (OTC). The OTC nature of the global foreign exchange market means that, rather than a single, centralized exchange (as is the case for stocks and commodities), currencies trade in a number of different geographical locations, most of which are linked to each other by state-of-the-art communications technology. OTC trading also means that at any point in time, there are likely to be a number of marginally different price quotations for a particular currency; a stock, on the other hand, only has one price quoted on an exchange at a particular instant. 

The global forex market is also the only financial market to be open virtually around the clock, except for weekends. Another key distinguishing feature of the currency markets is the differing levels of price access enjoyed by market participants. This is unlike the stock and commodity markets, where all participants have access to a uniform price. 

Market ParticipantsCurrency markets have numerous participants in multiple time zones, ranging from very large banks and financial institutions on one end of the spectrum, to small retail brokers and individuals on the other. Central banks are among the largest and most influential participants in the forex market. On a daily basis, however, large commercial banks are the dominant players in the forex market, on account of their corporate customers and currency trading desks. Large corporations also account for a significant proportion of foreign exchange volume, especially companies that have substantial trade or capital flows. Investment managers and hedge funds are also major participants.

Differing Prices Banks' currency trading desks trade in the interbank market, which is characterized by large deal size, huge volumes and tight bid/ask spreads. These currency trading desks take foreign exchange positions either to cover commercial demand (for example, if a large customer needs a currency such as the euro to pay for a sizable import), or for speculative purposes. Large commercial customers get prices, with a markup embedded in them. from these banks; the markup or margin depends on the size of the customer and the size of the forex transaction. Retail customers who need foreign currency have to contend with bid/ask spreads that are much wider than those in the interbank market. 

Speculative Positions Vs. Commercial TransactionsIn the global foreign exchange market, speculative positions outnumber commercial foreign exchange transactions, which arise due to trade or capital flows, by a huge margin, although the exact extent is difficult to quantify. This makes the forex market very sensitive to new information, since an unexpected development will cause speculators to reassess their original trades and adjust these trades to reflect the new information. For example, if a company has to remit a payment to a foreign supplier, it has a finite window in which to do so. The company may try to time the purchase of the currency so as to obtain a favorable rate, or it may use a hedging strategy to cover its exchange risk; however, the transaction has to occur by a definite date, regardless of conditions in the foreign exchange market. 

On the other hand, a trader with a speculative currency position seeks to maximize his or her trading profit or minimize loss at all times; as such, the trader can choose to retain the position or close it at any point. In the event of new information, the adjustment process for such speculative positions is likely to be almost instantaneous. The proliferation of instant communications technology has caused reaction times to shorten dramatically in all financial markets, not just in the forex market. This knee jerk reaction, however, is generally followed by a more gradual adjustment process, as market participants digest the new information and analyze it in greater depth. 

Information EdgeWhile there are numerous factors that affect exchange rates, from economic and political variables tosupply/demand fundamentals and capital market conditions, the hierarchical structure of the forex market gives the biggest players a slight information edge over the smallest ones. In some situations, therefore, exchange rates take a little longer to adjust to new information. 

For example, consider a case where the central bank of a major nation with a widely-traded currencydecides to support it in the foreign exchange markets, a process known as "intervention." If this intervention is unexpected and covert, the major banks from which the central bank buys the currency have an information edge over other participants, because they know the identity and the intention of the buyer. Other participants, especially those with short positions in the currency, may be surprised to see the currency suddenly strengthen. While they may or may not cover their short positions right away, the fact that the central bank is now intervening to support the currency may cause these participants to reassess the viability and implications of their short strategy. 

Example – Forex Market Reaction to News All financial markets react strongly to unexpected news or developments, and the foreign exchange market is no exception. Consider a situation in which the U.S. economy is weakening, and there is widespread expectation that the Federal Reserve will reduce the benchmark federal funds rate by 25 basis points (0.25%) at its next meeting. Currency exchange rates will factor in this rate reduction in the period leading up to the expected policy announcement. If, however, the Federal Reserve decides at its meeting to leave rates unchanged, the U.S. dollar will in all likelihood react dramatically to this unexpected development. If the Federal Reserve implies in its policy announcement that the U.S. economy\'s prospects are improving, the U.S. dollar may also strengthen against major currencies.

The Bottom LineWhile the massive size and liquidity of the foreign exchange market ensures that new information or news is generally absorbed within minutes, its unique features may result in new information being absorbed over a longer period in some situations. In addition, the hierarchical structure of the forex market can give the biggest players a slight information edge.

Ways You Can Short Europe

It's well known that the European Economic and Monetary Union (EMU) is in dire straits. Insolvency plagues the region, with countries like Portugal, Ireland, Italy, Greece and Spain (colloquially called the PIIGS) facing massive budget deficits relative to theirGross Domestic Products (GDP) and rising unemployment. Furthermore,impotent monetary policy as well as a prolonged lack of unified fiscal policy have dampened growth prospects and exacerbated the EMU's problems.

Before considering a specific investment, an experienced investor will make it a point to thoroughly understand the macroeconomic panorama at hand. Solutions addressing the woes of the eurozone are varied. Proposed reforms to the Maastricht Treaty include banking and fiscal union; all the while, eurozone leaders debate the effectiveness of economic stimulus programs. To a certain extent, any legislation to bolster confidence in the EMU would be healthy for the global economy. Inaction is the eurozone's greatest enemy.

Financials and the Euro
From a traditional standpoint, the Financial Services industry is typically a bull-market sector, suffering most when Mr. Market experiences a downturn. Accordingly, European banks have struggled to remain solvent throughout the euro crisis, as their loans have had difficulty performing and their assets have depreciated in value. These symptoms are most evident in the nations hit the hardest by the euro crisis, namely the PIIGS nations. Within the economies of Ireland and Spain, where housing bubbles popped in 2008, the banking system has had an especially hard time getting back on its feet.

Shorting banks in these in high debt-to-GDP ratio countries is an interesting move - if you can do it. While the P/E multiples of European financial stocks, such as Banco Santander or Deutsche Bank, are currently low, the exit of any PIIGS nations from the EMU would trigger a massive sell-off within the industry across Europe. Other industries would surely suffer as well, but a devalued currency would challenge banks with eroding balance sheets and cash flows. More specifically, the inevitable devaluation of an exited nation's instituted currency would result in the further lowering of equity multiples for domestic Financial Services firms. 

Exchange traded funds can make capitalizing on this bearish outlook on European financials easier, such as the iShares MSCI EMU Index. For individuals predicting further decline in the euro against the greenback, leveraged ETNs like Market Vectors Double Short Euro ETN are an option.

Shorting Government Bonds 
Generally, it's difficult to short a bond, especially one in a continent beyond your borders. Moreover, bond-land is not customarily as volatile as the stock market, making it harder for a short to perform well. In Europe, bond auctions in PIIGS nations are seeing all-time low prices and all-time high yields. Throughout the euro crisis, the results of these bond auctions have been an indicator of investor confidence. Even a cursory examination of the yields in PIIGS nations shows that investors are wary of the risks associated with the eurozone's worst economies. Clearly, the time to short debt offerings in these nations has come and gone.

However, in a more economically robust country, such as Germany, the exit of any PIIGS nation from the EMU would render a short play wildly profitable. If any nation left the eurozone, German national debt offerings might suffer disastrous consequences. Germany's treasury bonds have already been propped up by a "flight to quality." Furthermore, if a PIIGS nation split ways with the euro, confidence in the system as a whole would waver and German bonds would conceivably plummet in price, while yields would skyrocket. A flight from quality, so to speak, can be significantly more rampant and contagious than its inverse. Shorting ETFs, such as WisdomTree Euro Debt Fund, with holdings in German and French bonds might make for one way to profit from this ordeal.

The Bottom LineAs European leaders flounder to reach a consensus on fiscal, monetary and economic stimulus policies, investors can capitalize on the EMU's systemic weakness. While the economic turmoil in Europe opens opportunities for short selling, be advised that some European nations have temporarily imposed bans on short selling individual securities.

Knowing which precise stocks, bonds and other structured products to short is difficult; an understanding of the macroeconomic issues at stake is of the utmost importance. Only when equipped with this knowledge can an investor confidently make investments, especially during tumultuous financial times.

The Credit Crisis And The Carry Trade

Broadly speaking, the term "carry trade" means borrowing at a low interest rate and investing in an asset that provides a higher rate of return. For example, assume that you can borrow $20,000 at an interest rate of 3% for one year; further assume that you invest the borrowed proceeds in a certificate of deposit that pays 6% for one year. After a year, your carry trade has earned you $600, or the difference between the return on your investment and the interest paid times the amount borrowed. 

Of course, in the real world, opportunities like these rarely exist because the cost of borrowing funds is usually significantly higher than interest earned on deposits. But what if an investor wishes to invest low-cost funds in an asset that promises spectacular returns, albeit with a much greater degree of risk? In this case, we are referring to the currency, or forex, markets, where carry trades quickly became one of the most important strategies. These trades allowed some traders to rake in big profits, but they also played a part in the credit crisis that struck world economic systems in 2008. 
A New Millennium for Carry TradesIn the 2000s, the term "carry trade" became synonymous with the "yen carry trade," which involved borrowing in the Japanese yen and investing the proceeds in virtually any asset class that promised a higher rate of return. The Japanese yen became a favored currency for the borrowing part of the carry trade because of the near-zero interest rates in Japan for much of this period. By early 2007, it was estimated that about U.S.$1 trillion had been invested in the yen carry trade. 

Carry trades involving riskier assets are successful when interest rates are low and there is ample global appetite for risky assets. This was the case in the period from 2003 until the summer of 2007, when interest rates in a number of nations were at their lowest levels in decades, while demand surged for relatively risky assets such as commodities and emerging markets. 

The unusual appetite for risk during this period could be gauged by the abnormally low level of volatility in the U.S. stock market (as measured by the CBOE Volatility Index or VIX), as well as by the low-risk premiums that investors were willing to accept (one measure of which was the historically low spreads of high-yield bonds and emerging market debt to U.S. government Treasury Bills (T-Bills). 

Carry trades work on the premise that changes in the financial environment will occur gradually, allowing the investor or speculator ample time to close out the trade and lock in profits. But if the environment changes abruptly, investors and speculators could be forced to close their carry trades as expeditiously as possible. Unfortunately, such a reversal of innumerable carry trades can have unexpected and potentially devastating consequences for the global economy. 

Why the Carry Trade WorksAs noted earlier, during the boom years of 2003-2007, there was large-scale borrowing of Japanese yen by investors and speculators. The borrowed yen was then sold and invested in a variety of assets, ranging from higher-yielding currencies, such as the euro, to U.S. subprime mortgages and real estate, as well as in volatile assets such as commodities and emerging market stocks and bonds. 

In order to get more bang for their buck, large investors such as hedge funds used a substantial degree of leverage in order to magnify returns. But leverage is a double-edged sword - just as it can enhance returns when markets are booming, it can also amplify losses when asset prices are sliding.
As the carry trade gained momentum, a virtuous circle developed, whereby borrowed currencies such as the yen steadily depreciated, while the demand for risky assets pushed their prices higher. 

It is important to note that currency risk in a carry trade is seldom, if ever, hedged. This meant that the carry trade worked like a charm as long as the yen was depreciating, and mortgage and commodity portfolios were providing double-digit returns. Scant attention was paid to early warning signs such as the looming slowdown in the U.S. housing market, which peaked in the summer of 2006 and then commenced its long multiyear slide. 

Example - Leverage Cuts Both Ways in Yen Carry Trade Let\'s run through an example of a yen carry trade to see what can happen when the market is booming and when it goes bust. Borrow 100 million yen for one year at 0.50% per annum.  Sell the borrowed amount and buy U.S. dollars at an exchange rate of 115 yen per dollar. Use this amount (approximately US$870,000) as 10% margin to acquire a portfolio of mortgage bonds paying 15%. The size of the mortgage bond portfolio is therefore $8.7 million (i.e. $870,000 is used as 10% margin, and the remaining 90%, or $7.83 million, is borrowed at 5%). After one year, assume the entire portfolio is liquidated and the yen loan is repaid. In this case, one of two things might occur: Scenario 1 (Boom Times) Assume the yen has depreciated to 120, and that the mortgage bond portfolio has appreciated by 20%. Total Proceeds = Interest on Bond Portfolio + Proceeds on Sale of Bond Portfolio = $1,305,000 + $10,440,000 = $11,745,000 Total Outflows = Margin Loan ($7.83 million principal + 5% interest) + Yen Loan (principal + 0.50% interest) = $8,221,500 + 100,500,000 yen = $8,221,500 + $837,500 = $9,059,000 Overall Profit = $2,686,000 Return on Investment = $2,686,000 / $870,000 = 310%

Scenario 2 (Boom Turns to Bust)Assume the yen has appreciated to 100, and that the mortgage bond portfolio has depreciated by 20%. Total Proceeds = Interest on Bond Portfolio + Proceeds on Sale of Bond Portfolio = $1,305,000 + $6,960,000 = $8,265,000 Total Outflows = Margin Loan ($7.83 million principal + 5% interest) + Yen Loan (principal + 0.50% interest) = $8,221,500 + 100,500,000 yen = $8,221,500 + $1,005,000 = $9,226,500 Overall Loss = $961,500 Return on Investment = -$961,500 / $870,000 = -110%

The Great Unraveling of the Yen Carry TradeThe yen carry trade became all the rage among investors and speculators, but by 2006, some experts began warning of the dangers that could arise if and when these carry trades were reversed or "unwound." These warnings went unheeded. 

The global credit crunch that developed from August 2007 led to the gradual unraveling of the yen carry trade. A little over a year later, as the collapse of Lehman Brothers and the U.S. government rescue of AIG sent shockwaves through the global financial system, the unwinding of the yen carry trade commenced in earnest.
Speculators began to be hit with margin calls as prices of practically every asset began sliding. To meet these margin calls, assets had to be sold, putting even more downward pressure on their prices. As credit conditions tightened dramatically, banks began calling in the loans, many of which were yen-denominated. Speculators not only had to sell their investments at fire-sale prices, but also had to repay their yen loans even as the yen was surging. Repatriation of yen made the currency even stronger. In addition, the interest rate advantage enjoyed by higher-yielding currencies began to dwindle as a number of countries slashed interest rates to stimulate their economies. 

The unwinding of the gigantic yen carry trade caused the Japanese currency to surge against major currencies. The yen rose as much as 29% against the euro in 2008. By February 2009, it had gained 19% against the U.S. dollar.
Carry Trade CasualtiesThe carry trade pushes asset prices to unsustainably high levels when the global economy is expanding. But rapid and unexpected changes in the financial environment can result in the virtuous circle quickly turning into a vicious one. In 2008, global financial markets suffered record declines after being hit by a deadly combination of slowing economic growth, an unprecedented credit crisis and a near-total collapse of consumer and investor confidence. 

Large-scale unwinding of the carry trade can also result in plunging asset prices, especially under tight credit conditions, as speculators resort to panic liquidation and rush to get out of trading positions at any price. Numerous hedge funds and trading houses had to contend with huge losses in the aftermath of the unwinding of the yen carry trade. 

Banks may also be affected if their borrowers are unable to repay their loans in full. But as the events of 2008 proved, the broad decline in asset prices had a much larger impact on their balance sheets. In 2008, financial institutions around the world recorded close to $1 trillion in charge-offs and write-downs related to U.S. mortgage assets. 

The global economy was also severely affected, as the collapse in asset prices affected consumer confidence and business sentiment, and exacerbated an economic slowdown. Nations whose currencies were heavily involved in the carry trade (such as Japan) would also face economic headwinds, as an unusually strong domestic currency can render exports uncompetitive. 

The Bottom LineCarry trades involving riskier assets are successful when interest rates are low and there is ample global appetite for risky assets. When boom times turn to bust, however, these trades have proved devastating for traders and for the broader markets.

Fundamental Speed: The "Duck-And-Jab" Approach To Forex

Wouldn't it be great to increase the probability that your trade will be successful while simultaneously spending less time analyzing chart patterns? By putting the forex market in perspective and realizing your role as an individual trader, it is possible.

SEE: Getting Started In Forex

Most traders don't realize that the money they contribute to the spot market has virtually no impact on price movement, so playing by the same rules as the "big players" may not be your most profitable option. When you jump in and out of the market quickly on a calculated and highly economic regimen - a strategy called fundamental speed - you can make an impact on your own investments.

Who Are the "Big Players"?Banks and governments are the big players that make the forex market move.

• Banks transfer money to and from global institutions and stock reserves of every major currency. 
• Governments set the interest rates that determine bank lending power, and have the ability to sway the market by releasing key economic information.

SEE: Get To Know The Major Central Banks

The role of a forex trader is not to trade to move the market, but to realize the relatively undecipherable impact his or her trades make. Keeping this in perspective, a trader can profit through the timing of his or her trades - the fundamental speed process.

Fundamental Speed: The What and the HowFundamental speed is the process of keeping an eye on key economic indicators that impact the currencies you trade, placing your trade and then exiting in a systematic way. Here is a rundown on how the process works:

1. Pick high-impact economic releases only 
Each day dozens of economic releases are made globally but only a few - if any - are worth trading. Currencies tend to make big movements when an economic release is tied directly to their rate of transfer in relation to another country's currency 

SEE: Interest Rates Matter For Forex Traders
Here are a few releases you should keep an eye on: 

• CPI
• Trade balance
• Interest rate statement
• Retail sales
• Home sales
• Consumer confidence
• Unemployment claims

Most economic calendars online show the high-impact releases in red, with a basic explanation of how they move the market. This can be a handy tool when deciding which releases to trade.

2. Set a time limit to move in and out of the market 
Realizing that the money you put in the foreign-exchange market will not make a substantial impact, you should have an exit strategy that is based on a system, not emotion. 

After an economic release, a reliable price movement occurs for one to two minutes. Depending on whether the release is hawkish or dovish you will see that the price typically goes in the expected direction - but many times it spirals out in what seems to be a random direction after the first 60 to 120 seconds. 

This is not so much a random movement as it is a government trying to steady its currency or a bank pushing money through to get the best transfer rate - things that are out of your control. If the release points in the direction of the daily moving average, you may feel comfortable staying on the trade for up to five minutes. Treat this on a trade-by-trade basis however.

3. Do nothing in a neutral situation 
If the predicted or forecasted figure is accurate to the actual, don't jump into a trade just to put money down. Trading the fundamental speed process only gives you a few trade options on any given day (less if you trade specific currencies) and there is a temptation to risk money in a neutral situation. It is important to keep your emotions in check.

More Probable, More ProfitsAs a trader it is important to emphasize increasing the probability of a successful trade. The higher percentage of profitable trades you make typically gives you a higher rate of overall return - that is, more cash in your pocket. By sticking to a system, you will be trading in a fashion that allows you to track the probability of your trades and to gauge which ones are profitable and which ones are not. A few more benefits of the fundamental speed process include: 

• Less time analyzing charts: Technical trading can be a complex arena for beginning traders and, although it is systematic, it can be difficult to use successfully. As you grow as a trader you can merge technical trading with fundamental speed to maximize your exit strategy. But if you are just starting out, you can avoid charts altogether by focusing on the fundamentals, which are black and white.
  
• The ability to set a forex schedule: The forex market is a 24-hour-a-day operation, but obviously you cannot expect to trade nonstop. For many traders the most difficult part of trading is figuring out the best time to trade. Some traders work day jobs and must trade after-hours; others are full-time traders but realize the importance of sticking to a regimen. By using the fundamental speed process you know the exact times you need to trade.

The Bottom LineMany traders learn forex through instruction manuals that treat individual traders like the "big players." Individuals trade with limited capital, meaning their impact is far less than the governments and banks that run the market. By harnessing this knowledge and trading in a way that uses it effectively, a trader can maximize his or her potential.

America's Loss Is The Currency Market's Gain

The historic Smithsonian Agreement of 1971 can be credited with the end of fixed exchange rates, the end of the gold standard and a realignment of the par value system with 4.5% trading bands. However, the agreement was disastrous for the United States and mostly benefited European and Japanese economies because of the agreed upon stipulation that the U.S. would devalue its currency. While the Smithsonian Agreement may not draw memorable historic attention, the fact that a nation can willfully sign an agreement to devalue its currency has lasting ramifications for an economy because a devaluation is a guarantor of deflation and enormous budget and trade deficits.

The U.S. dollar declined approximately 8% during the years following the agreement, causing the gold price to top out at $800 an ounce by the late 70s because of its deleverage with the dollar and a commodity boom that would also last well into the late 70s. Both are modern day ramifications of a declining dollar. To fully understand the Smithsonian Agreement and its implications, a brief walk through Bretton Woods may help. 

Bretton WoodsThe 1930s saw a laissez faire, free-floating currency market that threatened not only destabilization and economic warfare for smaller nations, but exchange rates that were unfairly discouraging trade and investment. Along came Bretton Woods, in 1944, and stabilized the system through a new monetary order that would peg exchange rates set at a par value with a gold exchange. Government intervention was allowed if 1% of a nation's balance of payments fell into disequilibrium. Convertible currencies were pegged to $35, with the U.S. buying and selling gold to maintain the price.

Since the U.S. dollar was the only stable currency, the States managed the system through theInternational Monetary Fund (IMF) and became its major financier. This led to major outflows of dollars in financing world economies, causing massive deficits in the U.S. The reason for this was because the U.S. owned a majority of official gold reserves in the 1940s. How much could a dollar be worth with massive deficits backed by gold and a world dependent on the United States for its growth? What a predicament.

The Smithsonian Solution
To fix deficits would limit dollars and increasing deficits would erode dollars, and both instances would be highly detrimental to European and Japanese growth. So, dollar confidence waned causing 1930s-style currency speculation, except for the U.S., whose currency was backed by gold. Adjustments were needed because the U.S. couldn't stop the deficits, while the European and Japanese economies were threatened by massive surpluses. The answer to these problems was the Smithsonian Agreement. 

Nations again realigned the currency system, agreeing to a devalued dollar, a new par value and trading bands of 4.5%, with 2.25% on the upper and lower side of trading. One year after signing the agreement, Nixon removed the U.S. from the gold standard because of further dollar depreciation andbalance of payments erosion. So, the U.S. started interventions through the swap market, and then through Europe, to support its currencies. This was the first time interventions were used after the Smithsonian Agreement breakdown. Almost two years after the Smithsonian Agreement, currencies free floated because the U.S. refused to enforce the agreements, after raising the gold fixed price twice within this two-year period.

Free Floating CurrenciesFree floating is a misnomer because trading bands ensured that a nation's exchange rates did not fall outside of the agreed upon range. Nations didn't have gold or an amount of currencies to pledge on their own to the IMF, and the U.S.'s gold and dollar supply had to be implemented to finance the system. This allowed the American dollar to become the world's reserve currency, a permanent financing currency. But the U.S. only had so much gold and dollars, so with post WWII economic growth on the horizon, it was inevitable that Bretton Woods would break down. If not, then the United States would have destroyed its own economy for the sake of growth in Europe and Japan.

Bretton Woods and the Smithsonian Agreement were not monetary systems to allow currencies to trade like a fiat currency based on supply and demand through an open market. Instead, Bretton Woods - and later, the Smithsonian Agreement - was a monetary system designed for trade and investment managed by the IMF, but financed by the U.S. 

As the U.S. pledged its gold and dollars, it was gaining Special Drawing Rights trade credits and using those credits against other nation's currencies to finance trade. In this respect, the U.S. had to fix its currency price so other nations would have a peg to the dollar and get access to credits. For larger growth states, this was perfect, but detrimental for smaller states because they didn't have enough gold or dollars to gain trade credits. So, a currency pricing imbalance existed for many years through economic growth years after WWII. The time for real tradable, market-driven exchange rates for retail traders would still be many years away. What would come later to assist poorer nations lacking access to the world's trading system was trade-weighted dollars to be used for trade. But this would take many more agreements before actual implementation.

The IMF
The need for the IMF in this equation was substantial. The IMF ensured that the world's central bankers did not dominate the exchange rate market on their own or in conjunction with other nations; it prevented against economic warfare. The par value system allowed trade to equalize through the use of trade credits. This equalization meant basing the price of a currency on its balance of payments. If balance of payments fell into disequilibrium, the IMF allowed a nation's current price to be adjusted up or down.

The Bottom LineWhile the Smithsonian Agreement was not perfect and actually hurt the U.S. in the short term, it was an instrument needed to further our path toward real market-driven exchange rates.