If you are an American investor, you exchange US$ for EUR to buy EUR stocks - the opposite when you sell. That means a weaker dollar over your investment period would result in you getting back less currency on the exchange and vice versa.
When planning to make an international investment, are exchange rate fluctuations worth considering? Table 1 combines stock market and exchange rate changes from the depths of the recession until today. Consider first an EUR equity investment. Over this period, the EUR stock markets fell by 17%. That means if you bought an ETF indexed on the EUR stock markets, you would have had a 17% capital loss. The dollar increased by 10% relative to the EUR, so you only lost 6%. Not much change in England, but in Japan and China, your equity losses were compounded because the dollar weakened against both the yen and RMB. In India, a lower stock market was more than compensated for by a stronger dollar.
Table 1. - Currency and Stock Market Changes
Jan. 2010 - Nov. 2012
Stk Mkt %*
Sources: OANDA and Yahoo Finance.
* Indices of the country's leading stock market were used for this data.
Table 1 attests to the significance of currency changes. You should most definitely consider what is likely to happen to currency values when making an investment beyond your borders. In what follows, I discuss exchange rate determinants and what can be expected in the next few years.
Factors Affecting Currency Values
- Trade Balances
For many years, conventional wisdom said watch the trade balance (the difference between exports and imports of goods and services). It was believed a trade deficit would cause a currency to weaken because the deficit would increase the supply of the country's currency on world markets. A weaker currency meant your goods became less expensive to foreigners while locals would have to spend more for foreign goods - a self-correcting mechanism (unfortunately not available to Greece and the other weak sister countries locked into the euro).
The U.S. is a case in point. It started running a trade deficit in 1983 and it has been running one ever since. Back then, there was a general belief that Japan would be the next economic power. From 1983 to 2000, the dollar lost 45% of its value against the Yen. Without that depreciation, the U.S. trade gap would have been much larger. And Toyota would not be producing more cars in the U.S. than in Japan.
But something else has also been at work that has allowed the U.S. to run such large deficits for so long - capital flows.
- Capital Flows
For decades, capital flows were viewed as "adjustment items". But the U.S. experience over the last two decades has changed all of this. Just as is the case with the export of U.S. goods and services, there has been a global demand for U.S. government debt and equities. Net U.S. capital flows are presented in Table 2. Several things stand out:
- Net capital flows exceed the current account (mostly trade) deficit.
- While there are large foreign direct investments in the U.S., U.S. direct investments overseas have been larger in recent years.
- Most of the "Other Securities" category is equities, broken out between U.S. purchases of foreign equities and foreign purchases of U.S. equities. Note the heavy purchases on both sides before the recession panic and the heavy liquidation of both in 2009. Since then, foreign purchases have recovered somewhat, but Americans have been investing far less in overseas equities.
- In the panic years of 2009 and 2010, foreign governments bought considerable U.S. government debt while there was a heavy liquidation by the private sector of U.S. equities.
Table 2. - U.S. Current and Capital Account (bil. US$)
U.S. Govt. Securities
Source: U.S. Bureau of Economic Analysis
In an earlier piece, I pointed out that the Beta for emerging country stock markets is far higher than for the U.S. That is, when stock markets fall worldwide, they fall more percentage-wise in emerging markets than the U.S. In large part, this is because the U.S. is the largest trader of emerging markets stocks.
- Red Herrings?
Marc Chandler has pointed out that a number of developing countries are troubled by the Fed's quantitative easing actions. They argue that the Fed buying Treasuries to keep U.S. interest rates low reduces the attractiveness of the U.S. for capital inflows, thereby weakening the dollar. They of course want a strong dollar for their exporters. Of course, Bernanke's primary objective with quantitative easing was to get the U.S. out of the recession. And if you asked him, he probably would have said a fiscal stimulus would have been preferred to the Fed buying Treasuries but Congress would not pass another fiscal stimulus.
China has been heavily criticized for policies to strengthen the U.S. dollar. People point to its large purchases of Treasuries over the last decade. As Table 3 indicates, both China and Japan have been large purchasers of U.S. government paper. Both now hold $1 trillion+ of U.S. debt. There is no question that some of these purchases were made with their exporters in mind. But it should also be recognized that at least until recently, U.S. government debt has been viewed by many as one of the safest assets to hold.
Table 3. - Country Holdings of U.S. Government Debt (bill. US$)
Source: U.S. Treasury
The primary purpose of this article has been to remind readers that when making overseas investments, you should consider what is going to happen to the currency as well as the specific investment. Both have their own unique risks.
But looking ahead, what can we say about currencies? On the U.S. dollar, keep in mind that whenever there is a panic, people buy dollars for safety. As I have written, I am expecting more trouble/panic in EUR countries. It now appears that unlike Europe and Japan, the U.S. economy is on recovery path. That means U.S. import demand should increase, causing the trade deficit to grow which will put pressure on the dollar. However, because of the U.S. recovery, foreigners are likely to increase their purchases of U.S. stocks, causing the dollar to strengthen.
The widely publicized problems in the eurozone have not been resolved. And India has worrisome government and trade deficits. I see both the EUR and the India rupee losing value over the next year.
China and Brazil are interesting countries. The RMB has strengthened considerably against the dollar in the last few years. This strengthening probably won't continue much longer. As a resource-poor country and a growing middle class wanting high end Western products, I would not be surprised to see China's trade surplus become a deficit in the next ten years. Brazil has taken a number of aggressive steps to weaken the real relative to the dollar, and it has succeeded. But I don't think the government will be able to weaken the real further.