In a bold but perhaps necessary move, the Central Bank of Brazil recently announced an injection of $50 Billion into forex markets intended to stem the 30% fall in the value of the Brazilian Real that has taken place so far this year. Unfortunately for Brazil, the forces tugging on emerging market currencies far exceed the potential counter-efforts that such a country is capable of waging. Call it a lack of confidence, or a sudden aversion to risk. Either way, investors are fleeing regions that only months ago, they were still flocking to in droves. High interest rates, strong economic fundamentals, even capital injections and liquidity initiatives are no match for the financial tsunami. In addition, it's not as if the Brazilian economy is necessarily in a good position to emerge from the crisis unscathed, as its neighbor Argentina could soon default on its debt...again. Bloomberg News reports:

The real has sunk 31 percent from a nine-year high of 1.5545 reached on Aug. 1 as the global crisis has driven down prices on the country's commodity exports and eroded demand for higher- yielding, emerging-market assets. Only the South African rand, down 35 percent, has fallen more over that time.

Read More: Brazil to Pump $50 Billion in Currency Market to Shore Up Real

The Australian Dollar has lost nearly 1/3 of its value (relative to the USD) over the last few months, as the credit crisis continues to drive investors away from areas perceived as risky. In other words, the best (and perhaps the only reasonable) explanation for its fall has very little to do with Australian economic fundamentals. Then again, the rise in the currency that took place over the last decade was also rooted in technical and financial trends, although rising commodity prices were also a factor. The Australian Dollar (as well as the New Zealand Kiwi) was one of the prime beneficiaries of carry-trades, due to unusually "generous" interest rate levels. Now that investors are chasing stability/capital preservation instead of yield, however, the currency has seriously fallen out of favor. The Australian reports:

Equity markets would continue to drive currency markets, while being influenced by the ongoing financial crisis. "These are unprecedented times in volatility for the Australian dollar and currencies," said [one analyst].

Read More: Dollar crashes to five-year low

While the Dollar rally may ultimately prove beneficial to US consumers (due to cheaper imports), it is certainly not helping US-based multinational corporations. Companies that earn a significant portion of their revenue abroad would normally be considered stable investments during times of economic uncertainty, since their exposure to individual economies is minimal. In the context of the current crisis, however, such companies have struggled; since they must report earnings in terms of USD, a strong Dollar is equivalent to lower earnings on foreign sales. Some companies have turned to hedging their exposure, while others have opted to either ride out the fluctuations and/or hope that they cancel each other out, banking on the notion that forex is ultimately a zero-sum game. Dow Jones reports:

To be sure, such global currency fluctuations are hard to manage and even those companies that do have hedges in place may only be able to limit and not completely offset the pressures of a strengthening greenback and oscillating exchange rates.

Read More: Multinationals Turn To Hedging To Manage Rising Dollar

The G7 Industrialized Nations met today in Tokyo to discuss the credit crisis, with a focus on its impact on forex markets. The Japanese Yen, specifically, has exploded in recent weeks, as nervous investors have fled emerging markets and other risky sectors, and have unwound carry trades (funded with Yen) in the process. Evidently, this is wrecking havoc on the Japanese economy, which has a notoriously frail domestic sector and is heavily reliant on exports to drive growth. The Central Bank of Japan has recently threatened intervention, and now that the G7 is presumably on board, it may do just that. The New York Times reports:

The statement, which said the G-7 would "monitor the markets closely and cooperate as appropriate," came as countries in Asia, spooked by the relentless sell-offs in the stock markets, scrambled to support their economies.

Read More: Group of 7 Meeting in Tokyo Tackles Yen’s Rise

One can usually assume that any talk of the carry trade is in reference to the Japanese Yen. In this case, however, it is the Dollar that is being driven by a shift away from the popular strategy of borrowing in one currency and investing the proceeds in assets dominated in another. In explaining the recent Dollar rally, analysts have tended to focus on the pall of risk aversion that has descended upon global capital markets, coupled with the spread of the credit crisis from the US to the rest of the world. While these are certainly contributing factors, perhaps they should also look at the repatriation of Dollars that were initially sent abroad over the last decade in search of loftier returns. Hedge funds and other institutions, including those based outside of the US, took advantage of record-low interest rates to borrow Trillions of Dollars and invest them abroad. Due to a combination of margin calls and client "withdrawals," however, such investors have been forced to not only unwind such positions, but return the proceeds of the US. The Guardian UK reports:

Data collected by the Bank for International Settlements shows that European and UK banks have five times as much exposure to emerging markets as US and Japans banks, with surprisingly big bets in Latin America and emerging Asia - where they rely on dollar funding rather than euros.

Read More: Dollar roars back as global debts are called in

Emerging Market currencies are becoming the latest victims of financial derivatives, proving Warren Buffet's claim that such contracts represent "financial weapons of mass destruction." Apparently, companies throughout the developing world (although predominantly in Latin America) had used derivatives to bet on the strength of their home currencies, relative to the US Dollar. Given their record appreciation over the preceding few years, such bets probably appeared risk-less. As investors have fled emerging markets en masse, however, such currencies have tumbled. This has forced companies that had bet against the Dollar to rapidly unwind their derivative positions, which only caused their currencies to decline further. The Mexican Peso and Brazilian Real, to name the most prominent examples, are now in a virtual tailspin. Another "short squeeze" is probably not far away. The Wall Street Journal reports:

[Investors] had begun pulling money out of Mexico and other emerging markets. Since Aug. 1, the peso has dropped 24% against the dollar, and in October careened through its biggest daily drops since a 1994 currency crisis.

Read More: Big Currency Bets Backfire

Last week, China revealed that in the most recent quarter, its economy grew at the slowest pace in nearly five years. It also revealed that its foreign exchange reserves crossed $1.9 Trillion, due to a record monthly trade surplus. How can this seeming contradiction in economic peformance be reconciled? In my opinion, the Chinese economy will continue to slow as a result of a generalized post-olympics slowdown and falling export demand brought on by the global economic crisis. The consequent collapse in risk appetite will bear negatively on investing in Chinese assets. Its stock market has already lost 50% of its value this year, and foreign direct investment (which is more difficult to monitor) is certainly sliding. In other words, there will be less foreign capital for the Central Bank to soak up, and less pressure on the RMB to appreciate. AFP reports:

The various factors at play could actually be causing some capital outflows as troubled foreign firms and investors may need the money overseas.

Read More: China's forex reserves pass 1.9 trillion dlrs: central bank

The word "confidence" has become ubiquitous when talking about the credit crisis. Policymakers talk casually about the lack of confidence and offer solutions for its restoration. But wasn't it a surplus of confidence that was responsible for the credit crisis? Banks confidently extended loans to less-than-credit-worthy borrowers, who confidently took on more debt than they could repay, which was then confidently repackaged and underwritten by Wall Street, and sold to unassuming Central Banks abroad, who confidently believed that the Dollar was tantamount to gold. Ironically, their confidence has been (falsely) confirmed by the recent Dollar rally, as investors flocked to the eye of the global financial storm because of the perceived safety of investing in the US. If confidence is indeed restored, it will not be cheap, as the US government bailout will probably be highly inflationary. Central Banks may soon catch on and realize that if they are to continue financing an annualized current account imbalance of $700 Billion, they will need to be compensated accordingly. The Wall Street Journal reports:

Our foreign creditors accepted dollars in payment for their goods and services -- and then obligingly invested the same dollars in America's own securities. It's as if the money never left the 50 states.

Read More: The Confidence Game

Policymakers are once again uttering the dreaded D-word. Not "depression," but rather "deflation." Food and energy prices have retreated from record highs, and the economic downturn is threatening to crimp demand further. In addition, the deleveraging brought about by the credit crisis has sent asset prices (real estate, stocks) tumbling, and it's not clear when they will stabilize. Economists are also forecasting that a tightening labor market and decreasing demand could force workers to accept pay cuts in return for job security. In short, a sustained period of deflation, such as that which plagued Japan in the 1990's, is becoming a very real possibility. Last week's coordinated interest rate cut was motivated by financial and economic factors; it was aimed at providing liquidity to financial markets and stimulating aggregate demand. Future rate cuts, however, may be driven by monetary concerns. One thing to keep in mind is that deflation can be kind to currencies; witness the strength of the Japanese Yen despite its long-term economic malaise. If the entire world experiences falling prices simultaneously, however, its not clear how forex markets would respond. Bloomberg News reports:

The deflation scenario might go like this: Banks worldwide, stung by $588 billion in writedowns related to toxic assets -- especially mortgage-related securities -- will further reduce the flow of credit, strangling growth. As the credit crisis worsens, businesses will find it almost impossible to raise prices.

Read More: Deflation Threat Returns as Asset Markets Decline

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The credit crisis has not been kind to emerging market currencies. Virtually all of them have declined by double digits (in percentage terms) against the USD. Such currencies may receive a boost from the International Monetary Fund, which recently announced plans to make more cash available, especially on a short-term basis. Previously, many analysts and policymakers had written off the IMF as irrelevant, since private sources of capital had gradually become available to countries that previously depended on the IMF for funding. However, as investors flee emerging markets en masse, such countries once again find themselves in dire straits. Iceland, for example, is likely to take advantage of the offer, as it has exhausted most of its other options for shoring up its ailing economy and currency. Bloomberg News reports:

The IMF has been at the center of some of the biggest financial bailouts of the past three decades, helping broker solutions to the Latin American debt crisis in the 1980s and rescues for Mexico, Russia, Brazil and Asia in the 1990s.

Read More: IMF Speeds Access to Funds as Emerging Markets Buckle