Like a second-hand car salesperson, international currency markets can play bait and switch with sound investments. A few years ago, when the dollar cost R10, an investor would have paid R1Â 000 for a $100 share in the United States. The same share would only be worth about R750 today, assuming the share did not rise.
Anyone playing on the world market and conducting transactions in foreign currencies is exposed to this kind of foreign exchange rate or currency risk. Speculators might seek to make a buck from predicting movements in foreign exchange rates, but investors are more concerned that the value of their assets might fall if the currency takes a tumble.
Currency forecasting may depend on number crunching and surveys of local economists, but it is ultimately educated guesswork — it is not a science. Nedbank chief economist Dennis Dykes said that currency forecasting has one of the worst records of any economic forecasting.
Despite this uncertainty, financial analysts often make the case for moving money offshore. The underlying logic is that it is never a good idea to put all your eggs in one basket, said Dykes, although he said that currency movements are not the basis upon which to make foreign investment decisions.
Considering that the South African economy accounts for about 1% of the world’s GDP, he said that one would not necessarily want to invest 100% in such a small share of the global economy.
Some economists and the trade unions, however, point to low national savings and raise concerns that moving money into foreign markets reduces the available funds at homes.
Standard Bank economist Dr Elna Moolman said that it would make sense to diversify to get around the risk of currency fluctuation in the value of the rand. She identified key risks to the rand as fluctuations in commodity prices and a possible decline in American demand for commodities as the United States market slows.
Many offshore funds diversify to hedge currency risk. One such fund manager for a local investment group was reported as comparing his fund’s currency strategy to an approach to the stock market. John Stopford was quoted in a South African newspaper as saying that Investec does not try to forecast currencies, but views currencies like it views shares. This means that it seeks characteristics that are attractive, such as yield, value and momentum, he said.
Several factors in the real economy, especially interest rates, contribute to the risk of a currency.
A currency’s performance is linked to interest rate differentials, said Hugh-David Hutcheson, a financial risk specialist at FRisk Consulting. The United Kingdom has lower interest rates than South Africa, making the latter a relatively attractive market to invest in.
However, the UK recently raised interest rates, narrowing the differential. Unless South Africa raises its rates correspondingly, the UK interest rate increase will reduce the relative attraction of the South African markets for capital and lower demand for the South African rand, devaluing it relative to the UK currency.
Monetary policy is another factor that could affect foreign exchange rates, said Hutcheson. In South Africa, for example, the central bank has an inflation-targeting strategy, which means that it tightens monetary policy when inflation approaches the upper limit of the target. Raising rates can appreciate the currency because it widens the interest rate differential. Yet Hutcheson said that he did not expect the reserve bank to continue its tightening bias in the long term and thought it would ease off to a more neutral stance.
Current account deficits are another consideration because they can have a weakening effect on currencies, he said. The theory here is that unless South Africa can finance its trade imbalance, where the country imports more than it exports, the currency will devalue.
Localised factors are also important, said Hutcheson, such as the labour markets and demand and production in different countries. In South Africa, an event such as the World Cup in 2010 might appreciate the currency as capital inflows grow, stimulated by an expected rise in tourism.
Political risk is another element of currency risk. The form of government is important, said Dykes, who said that a system like a dictatorship that gave rise to unexpected policy changes was potentially risky. He also said that there is more political risk associated with countries where the president’s remarks can lead to market swings. Although there are formal risk ratings, he said that most people are governed by their impressions of the political situations in other countries.
Dykes recommended that the best thing for a personal investment strategy would be for an investor to make this type of an investment with a fund manager who had a good grip on currency markets and personal investment.
Currency consumer review
Economists take several factors into consideration when trying to judge where currencies are moving. And they often get it wrong. But to give an idea of some of the factors involved in evaluating a currency for risk, the Mail & Guardian spoke to some economists and analysts to review some of the top currencies on the market today.
From the perspective of a South African investor, the best route might be to invest in rand-denominated global unit trusts, recommended Equinox analyst Peter Digby. These funds are generally diversified across markets and currencies, he said.
“My thinking is to say, don’t try to take on currency speculation yourself,” said Digby, “You can get your fingers easily burnt.”
We chose to look the United States dollar, the Japanese yen, the euro, the British pound and the Australian dollar.
United States dollar
Central bank lending rate: 6,25%
Consumer price inflation: 2%
Formerly considered a “safe haven” for investors, the US dollar has been weakening in recent times. One analyst maintained that its economic performance is not as weak as expected and that expectations that the dollar will decline may only be seen in the longer term. Reasons for weakening include a large current account deficit and high budget deficits.
Euro
Central bank lending rate: 3,5%
Consumer price inflation: 1,9%
The euro has been performing more strongly than the US dollar. One analyst said that it tends to outperform the dollar. Some analysts point to budget deficits in France as a worrying sign and Germany is also said to be battling to keep its macroeconomic fundamentals in a reasonable shape.
British pound
Central bank lending rate: 5,25
Consumer price inflation: 2,7%
The pound is said to take the middle road between the US dollar and the euro. The central bank recently hiked rates as rising housing prices and credit extension pushed up inflation. If Gordon Brown succeeds Tony Blair as prime minister, the United Kingdom is unlikely to join the euro.
Japanese yen
Central bank lending rate: 0,25%
Consumer price inflation: 0,4%
The yen is expected to appreciate as the Japanese economy recovers from its lows in the 1990s. The economy is export-oriented and is running a current account surplus. In this future this structure may make it vulnerable to US economy weakness. Yet Japanese industry has also improved ties with China, raising interest in this sector.
Australian dollar
Central bank lending rate: 6,25%
Consumer price inflation: 3,9%
Like the rand, the Australian dollar is strong during commodity price booms. It is con-sidered to have performed relatively well, to some extent off of a weakening dollar. The central bank follows a strict inflation-targeting regime in the face of the inflationary impact of rising housing prices and credit extension. — Tumi Makgetla