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When it comes to planning one's long-term finances, it is worth revisiting the underlying macro-assumptions once in a while. I was reviewing my own earlier blogs in a different forum where I write occasionally. It can be a humbling experience or a satisfying one depending on whether one's beliefs are borne out or not. In a post in a different forum on safe withdrawal rates for early retirees dated Sept. 04, 2009, I wrote:

A complicating factor in this analysis is the theory of interest rate-exchange rate (IR-ER) parity. Broadly, this states that the difference in interest rates (and hence, inflation) between two free-market economies would be reflected in the forward exchange rate movements that run counter to interest rates to neutralize any arbitrage opportunities. The premise is that savvy market operators and arbitrageurs will continually exploit such differential return opportunities and transfer capital between the two countries such that forward exchange rates will neutralize any such advantage compared to spot exchange rates. In an increasingly integrated world where large sums of money move in and out of global capital markets, it is reasonable to assume that the IR-ER parity theory will hold. Sure, for the near term, there are capital controls and restrictions in India where there could be significant anomalies (recall in 2007 and early 2008 where $1 exchanged for as low as INR 37 - well below the average in the last 5 years - and yet, the interest rates in India were much higher than U.S.). I believe these short-term anomalies cannot be taken as guidance for a 30-50 year retirement planning horizon. Still, there remains a nagging question in the minds of retirees (living in emerging markets) with sizable retirement assets in another country. What if, there are significant deviations from this IR-ER parity theory for substantial periods of time (say, 10 years)? After all, IR-ER parity is just another economic theory (like Efficient Market Hypothesis) even though it holds up to logic. Can we pin our hopes on a multi-decade retirement based on an economic theory just because it sounds logical?

In an earlier post in a different forum about hyperinflation dated July 2, 2008, I wrote:

This is why I don't always subscribe to the concept that all or even most of one's assets must be in the country where the retiree lives. This advice, while sound for retirees in many "hard" currency countries, is fraught with risk for retirees in developing markets. I am of the opinion that no more than 50% of one's assets should be in the developing country where the retiree lives (again, invested to generate a return at least on par with inflation) with the rest similarly invested in hard currency assets. Some of you may recall the recent data (of the last 3 years) where the exchange rate(ER)-interest rate (IR) parity relationship broke down between U.S. and India. Interest rates in India were higher than U.S. and yet the exchange rate did not reflect that adequately. Yes, that kind of risk can make one feel "stupid" for not having converted all the money into Indian currency earlier but that is a lesser risk in my view than facing serious currency inflation after converting all the assets into one currency. ER-IR relationships are not mathematically precise, so an investor expecting ER to rise to match IR differentials between two countries may be disappointed in the short term. However, I believe the relationship will hold in the long term because of global trade balances. An implication of the "hard" + "soft" currency strategy of assets is that one's returns would be lower because a sizable portion of the assets are in a 'low yield' country or a 'high inflation' country but that is a price to pay for diversification. The low yield country may also have low relative inflation but this need not translate into quantitative ER adjustments in the short term. Currency markets are not always tightly correlated with relative interest rates, especially when one of the currencies is not freely floated. So, you can partially hedge your risks, but cannot eliminate them. Faced with uncertain probability of two scenarios, one coming first in a race and the other finishing last, a rational investor may choose a middle option where you can be certain of being neither first nor last.

In hindsight, comparing IR-ER parity to Efficient Market Hypothesis (EMH) and labeling them both as "theories" was wrong. IR-ER parity has lots of practicality built in, because it counts on a fundamental human behavior - to seek arbitrage where ever it exists. On the other hand, EMH is a theory based on the rationality of all investors. In my own limited investment history, I have learned that human behavior belies rationality in many instances. As psychologists have long observed, we are mainly emotional creatures with occasional bouts of rational behavior. I now place greater faith on IR-ER parity than on EMH. IR-ER parity holds best between two free-market economies with fully floated currencies (say, U.S. and Japan). Between U.S. and a country with capital and currency controls like India, the IR-ER parity principle may not hold over significant periods (say, several months). But that does not mean that the IR-ER parity principle is wrong, just that it is not efficient but operates with a significant lag between these countries.

When I wrote my previous blogs (referenced above), Indian rupee was trading near a 20-year high against the U.S. dollar. When the USD exchanged for as few as INR 37 in late 2007/early 2008, many predicted the demise of the world's reserve currency and counted on the inevitable rise of INR - along with Chinese yuan - as the future reserve currencies of the world. What a difference just one year made! The Great Recession exposed the vulnerabilities of emerging markets and a massive global "flight to safety" pushed USD so high that even historically strong currencies like EUR, GBP and CHF took a hit.

Even those who intend to live in another country are better off keeping a significant portion of their hard currency assets invested in the same currency (say, USD or EUR or GBP or CHF) where they earned it. That recommendation had an underlying belief that IR-ER parity, no matter how weak it appears in the short term, must hold good in the longer term. In India's case, from INR 37 to a USD, we are now at INR 63 as of this writing, a massive depreciation of 70% over the past 5-year period. Put in dollar terms, the value of INR 1000 today when converted to dollars would fetch you 41% less dollars than the same amount in 2007.

If we put all the ''growth' that occurred in the Indian economy over the last 5 years in the above context, the picture is not pretty. An annual salary growth of 10% (not unusual in India) over the last 5 years is equivalent to a 5.5% net loss (in USD terms) over the same period ((1.1^5) *(1-0.41) = 0.945, i.e. 5.5% loss). A 2% annual raise earned by a US-based professional over the same 5 year period puts his income at 10.4% over the starting point (2008). In other words, he is ahead in same currency terms by ~16% over his Indian counterpart. Note that we are talking about growth, not absolute values, so the comparison across countries can be made. Now the paltry 2% annual raise in USD looks great, right? The situation looks downright ugly when assets are compared. A globally balanced USD-denominated stock portfolio from the same period would have yielded a 15% annual return (Nov. 2008 to Nov. 2013), or a compounded total return of 101% over the same period. When the same return is compared in INR terms, it balloons to 342% of starting asset value, i.e. 242% growth in assets (i.e. more than triple the starting value in INR terms).

In just one 5-year period, a retiree's decision to leave all his assets in USD equity funds in 2008 rather than bring them to India (based on rapidly appreciating Indian currency in 2007-08 period) would have made for a happy outcome indeed. He would be far ahead than his peers in India as the Indian equities or even debt fund performance over the same period pales in comparison, especially when converted back in USD. For those who vouch by India's booming real estate, even a 20% annual growth in a given real estate purchase (let's say you picked the right place at the right time) over the last 5 years would have given you a 150% appreciation, i.e. 2.5 times your investment value. Great performance, but benchmarked in USD, the cumulative return is only 46% or about 8% annual growth. Still good, but nowhere near the salivating 20% you thought you had. Compared to debt funds across U.S. and India over the same period, which would be most appropriate for IR-ER parity study, the annualized return of about 10% in India (aggregated bond fund) versus say, 5.16% in U.S. (refer AGG - iShares Aggregate US Bond Fund trailing 5-year returns) shows that Indian bond investors are worse off than U.S. bond investors over the same period (using USD benchmark). This is a classic case of ER not only neutralizing IR differential between 2 countries but has even gone beyond.

Though the preceding paragraph expands on the Indian example, the same logic applies to retirees or wage-earners in Brazil and Indonesia as well over the last 5 years. The exchange rates between USD-Brazilian Real or USD- Indonesian Rupiah have changed so much over the last few years that much of what is written about India in the preceding paragraph would apply to prospective 'settlers' in Brazil or Indonesia as well. This also applies to those planning to retire in Thailand and Philippines though the figures would vary obviously for each country based on how their own currency performed vis-a-vis USD and how their domestic economies grew in the last 5 years.

Conclusion

The bottom line is that IR-ER parity principle works even in emerging markets, but it can overshoot significantly in either direction in the near-term. From a Brazilian or Indian resident's perspective, the overshoot was in the favorable direction in 2007 and in the adverse direction in 2013. These variances don't undermine the principle, but rather highlight the complexity of predicting IR-ER movements in any given short-term period. Evidence of IR-ER parity principle runs counter to the financial planners' common advice that one should have most of their assets in the country of residence, especially if you choose to take residence in an emerging market. If the last 5-year period is any guide, evidence suggests that those wishing to retire in an emerging market from North America/Europe should still keep significant percentage (say, no less than 40%) of their assets in US or EUR denominated assets.

For Americans or Western Europeans with relatively modest assets, their "early retirement" dream may be realized in a country that offers significantly lower cost of living. However, the decisions they take on currency asset allocation to finance their living in an emerging market can have a major impact on the success and potential lifestyle during retirement.

Source: Role Of Interest Rate-Exchange Rate Parity In Asset Allocation