Currency Risk Is Your Worst Enemy

3 mins. to read

Economic analysis by Filipe R. Costa

Mark Mobius, the “father” of emerging markets investments (featured in this month’s upcoming SBM magazine edition), is delighted with the large number of countries in which his funds can invest today. In 1987, when the name emerging markets was introduced, Mobius created the first emerging markets fund, picking equities from just six countries. At that time, emerging economies were already offering great growth opportunities but the existing barriers to capital flows prevented funds from freely entering these countries. Add political risks to the framework and you end up with only a handful of potential investments.

Thirty years later, the number of potential countries in which to invest has grown to 50, ranging from emerging to frontier markets, where money can be sent freely and where political risks are bearable. Globalisation has turned the world into a large village without borders, allowing production to be split and allocated across the world and investment to flow freely across borders, in search of the highest rewards. Investors can now reach almost any country and diversify their portfolios while reaping some extra profits promised by smaller, fast-growing economies. At the same time, ordinary people like me can even take loans in foreign currencies to benefit from lower interest rates and enjoy lower interest expenses.

But free capital flow is bidirectional. It allows capital to either enter or leave a country at investors’ discretion. In a world where distances have been overcome via the advances in computers and communications, free capital flows are a free pass for hot money to flow from country to country, seeking the best yields and escaping any signs of problems. A click on the screen of your tablet is all you need to move your money from one place to another. As you may guess, this readily available money is an ingredient for both growth and currency crisis.

So, easier access to emerging markets is a nice feature to add to your portfolio, but also a dangerous one. You now have access to the Russian and Turkish equity markets, which may help achieve some large profits at the end of the year. Let’s say Russian equities rise 20% in a year. That amounts to quite a nice profit but may very well turn into a nightmare at the time of converting the rouble back to the pound or the euro. A mix of free money flow and expected lower growth due to declining oil prices led to a massive outflow of money from the country last year, halving the value of the rouble. Had you invested in the country, currency risk would have eroded your profit.

Now think about all the Germans and Italians living near the Swiss borders. They found it enticing to borrow in Swiss francs instead of euros; lower interest rates and a peg to the euro made the franc unbeatable in terms of interest expenses. Let’s say someone living and working in Germany was paying 2,000 francs per month on a loan, which at the 1.20 peg was worth around 1,670 euros. Then, suddenly, the central bank decided to abandon the peg, and at some point during the night, the 2,000 francs were turned into 2,325 euros. Oh dear!

Central banks compete with each other for inflation and growth.

As we have seen lately, they are willing to do whatever it takes to accomplish their main goals, using conventional tools like interest rates, unconventional measures like quantitative easing, and desperate measures like setting negative interest rates. Adding central bank activism to free international capital flows is like adding water to sulphuric acid. Both can result in severe damage – the second to your health, the first to your wealth. Currency games are now at elevated levels, posing a threat to international investment and forming the basis for the next big crisis.

Currency risk is an investor’s worst enemy and investors should insure their portfolios against it, no matter how low the risk may appear. In fact, the lower the risk, the cheaper it is to insure against. Relying on stable currencies is not a good strategy… Just wait for the Fed to hike interest rates and you will see what happens to emerging markets… And what about the Swedish and the Danish? Will they keep the peg?

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