The Currency of the Times

A year ago almost every economy in the world was in trouble. In the developed economies, output plunged while in China and some other emerging economies, growth merely slowed sharply. The slump was synchronized and severe.

However, the opposite seems true of the recovery. China’s rebound began earliest and has been the most spectacular. The US economy began growing in the middle of 2009 and accelerated sharply in the final months of the year. News from the euro zone and Japan is rather gloomier. Germany emerged from recession before the US, but growth fell back to zero in the fourth quarter. The Japanese recovery also seems to be fading.

This diversity has caused big moves in the currency markets. The market’s confidence in a currency reflects both an appraisal of a country’s fiscal and monetary policies and its prospects for economic growth, so shifting growth patterns can have big consequences for asset prices and exchange rates. And those exchange rates have an important effect on the competitiveness of a country’s exports and the costliness of its imports (part of an overall inflation calculation).

Aspiriant’s investment team monitors these currency relationships in order to reconfirm our current (unhedged) approach to currency exposure and to identify direct currency strategies which may be profitable. The following sections describe the current currency exposure in client’s portfolios and offer some thoughts on the flap over manipulation of the Chinese currency.

Currency exposure in clients’ portfolios

Aspiriant-managed portfolios have a currency component as part of their foreign investments; consequently exchange rate movements have an important impact on our clients’ investment returns. Conceptually, when a U.S. investor buys a foreign investment, the investor exchanges dollars for the foreign currency; the foreign currency is then used to buy the investment. At the end of the investment period, the U.S. investor sells the foreign investment and receives foreign currency, which is then exchanged for dollars. If the foreign currency has appreciated, it will purchase more dollars than it did at the beginning, thus adding to the return, and making the US dollar return greater than the “local currency” return. Conversely, if the foreign currency has depreciated, it buys fewer dollars and the local foreign currency return is lower than the US dollar return. The graph below illustrates this dynamic with the 2009 local currency and US dollar returns for two broad international equity indices, and a Japan equity index.

Source: Bloomberg

During 2009, many major currencies appreciated against the dollar. The appreciation was most marked for the Australian dollar and New Zealand dollar, which strengthened by 42% and 41%, respectively. The UK pound sterling also appreciated against the dollar last year, though it has fallen 7% in the first quarter of 2010. Several other developed market currencies, like the Swiss franc and the euro, have also fallen against the dollar since the end of last year. Emerging market currencies such as the Russian ruble, the Indian rupee and the Polish zloty have all appreciated against the dollar over the same period.

What should a long-term investor make of all this currency movement? We have made the intentional decision not to hedge the currency exposure in Aspiriant client portfolios for several reasons: hedging is not free, we value the additional diversification away from the dollar, and we think that, on balance, currencies in the rest of the world will likely strengthen relative to the dollar over the next 20 years. To be sure, there will be periods when the dollar strengthens against the major currencies, but we don’t expect that to be the dominant trend. As a result, those portions of our clients’ equity portfolios that are invested in foreign equity markets are also exposed to exchange rate movements. Generally, we think that exposure will be beneficial; consequently, we plan to stick with our decision not to hedge currency in client equity portfolios.

Having said that, the economic scenarios which result in good equity market returns are not always consistent with a strengthening currency; in certain environments it might make sense to engage in specific currency investments. The Aspiriant investment team is therefore evaluating ways to separate the currency exposure from the underlying capital market assets, in order to increase exposure to currencies with characteristics (such as high interest rates) which have, in the past, preceded strong currency returns.

Is China a Currency Manipulator?

Over the past year, currency relationships have exacerbated tensions between the major global economies, especially the US and China. Nobel prize-winning economist (and currency expert) Paul Krugman estimates that China’s undervalued currency, the yuan, is costing America roughly 1.4 million jobs. Its cheap currency gives its exporters a pricing edge selling into the American marketplace. Because of its high savings rate and state ownership of businesses, these dollar earnings are invested in US securities rather than being spent on US goods. For many years, these asset purchases resulted in lower interest rates, and helped enable higher US borrowing and spending rates. In fact, many economists point to this dynamic as part of the reason for the bubble in US mortgage securities.

But today, interest rates in the US are as low as they can go. So by saving dollars rather than spending them, the Chinese are draining demand from the world economy. China’s foreign-exchange reserves now total $2.4 trillion, of which about 70% are thought to be in dollar-denominated investments.

In mid-March, 130 members of Congress signed a letter to Timothy Geithner, the US Treasury Secretary, calling for a surcharge on imports from China. The tariff is intended to force China to strengthen its currency, which is pegged to the dollar. This proposed tariff is similar to the Nixon Administration’s 1971 surcharge that prompted America’s trading partners to renegotiate their exchange rates four months later.

The main difference is that, in 1971, the currency markets were locked into a system of fixed relationships. By pegging to the dollar, a currency was automatically fixed to everything else. China currently pegs the yuan to the US dollar while allowing it to float in value against the currencies of its trading partners and competitors. Relative to a basket of currencies weighted by the amount of trade with China, the yuan’s value is back to where it was when the financial crisis started. In fact, according to a measure (the “third-country” effective exchange rate) calculated by the Hong Kong Monetary Authority, the yuan is about 12% more expensive today than it was before the collapse of Lehman Brothers, relative to China’s emerging market competitors in its big export markets. By this indicator the value of China’s currency is about 25% above its 2005 level. So the evidence is mixed – while many economists feel that the yuan is too cheap relative to the US dollar, it has appreciated relative to a number of other currencies.

The second difference is related to the first: because all major currencies were pegged to the dollar in 1971, everybody had to pay the surcharge. Nixon dismayed everyone but discriminated against no one. China’s critics today, on the other hand, urge the Obama administration to impose tariffs on Chinese goods alone. They argue that doing so would reduce the demand for Chinese imports, which constitute about 15% of the US total. But there is no guarantee that US consumers would switch from Chinese goods to those made in the US. If US consumers bought from producers elsewhere in the world, or China relocated production, a US surcharge would change the composition of the trade deficit without necessarily changing its size. So the effect of a tariff is far from certain.

And while China is the most prominent currency market manipulator, it is not the only one. Even countries whose currencies have appreciated, such as Switzerland and Japan, have intervened to stop further strengthening of their currencies while the stigma associated with a weak currency seems to be gone completely. Given the desperate scramble for growth that has followed the credit crunch and the global recession, the interests of exporters seem to be paramount.

To some, the lesson of all this is clear. If all the issuers of paper money want to see their currencies depreciate, then the only answer is to own an asset that central banks cannot debase — gold. Part of the rise of the price of gold, to more than $1,100 an ounce this year, must be attributed to the conviction that governments will try to inflate away their debts by allowing rapid growth in the money supply resulting in a weakening of their currencies.

Currency debasement is a long-term concern. Over the next couple of years, it is hard to see how sustained rises in inflation will be generated given the amount of spare capacity in the global economy. We argued as much in last quarter’s Insight. And given the generally short average maturity of government debt around the world (less than five years in the US), a deliberate strategy of higher inflation would be met with an offsetting increase in the yield demanded by the market. So while gold is a small part of most Aspiriant client portfolios, we do not think it appropriate to overweight gold given its lack of yield

Dr. Jason Thomas, PhD

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