Currency Strategy A Practitioner s Guide To Currency Investing Hedging And Forecasting Wiley_2

56 Currency Strategy Table 2.1 Currency decision template using a risk appetite/instability indicator Asset managers Currency speculators Corporations Risk-seeking/stable (<40) • Raise currency exposure to high carry currencies • Buy high carry currencies • Short low carry safe haven currencies • Hedge high carry currency strategically Neutral (40–50) • Reduce currency exposure to high carry currencies • Close positions • Only hedge high carry currency exposure tactically Risk-aversion/unstable (>50) • Eliminate currency exposure to high carry currencies • Short high carry currencies • Buy low carry safe haven currencies • Only hedge high carry currency exposure tactically long high carry/short funding currency positions are reduced. Finally, when market conditions deteriorate to the extent the index moves into “risk-aversion/unstable” territory (above 50), high carry currencies are cut across the board, to the increasing benefit of safe havens such as the Swiss franc and the Japanese yen. The relationship between risk appetite and specific currency performance has been proven statistically within academic research using correlation analysis. From this, we can come up with a rough template for currency trading, hedging and investing decisions using the index (Table 2.1). Note that this is not meant to be an exact list of recommendations. As with any model,therewillbeexceptions.Rather,itismeantasatemplateagainstwhichspecificcurrency exposures should be measured on a case-by-case basis. There is actual fundamental grounding for using a risk appetite indicator for currency hedg-ing, trading or investing. Since the end of the Cold War, there has been much greater emphasis on tightening fiscal and monetary policies in order to bring inflation down. As a result, real interest rates have been rising. In the developed markets, capital flows over the medium to long term to those currencies with high real rates. The discipline associated with membership of the EU and the Euro has exacerbated this process, and the same should happen in Central and Eastern Europe ahead of accession to the EU. As a result of such global macroeconomic forces, the trend has been to hold high carry currencies in all conditions—risk-seeking/stable and neutral—apart from risk-aversion/unstable. The link between risk appetite or instability and currencies comes through capital flows and therefore through the balance of payments. Countries with high current account deficits are dependent on capital flows and therefore dependent on high levels of risk appetite. Conversely, countries with current account surpluses are not dependent on capital flows or risk appetite. Therefore, during periods of risk-seeking, it should be no surprise that currencies whose countries have current account deficits tend to outperform. Equally, during periods of risk-aversion or avoidance, currencies whose countries have current account surpluses tend to outperform by default as capital flows are reduced or even reversed. Inthedevelopedeconomies,currenciessuchastheUSdollar,UKpoundsterling,Australian dollar and New Zealand dollar are seen as risk-dependent currencies because of their current account deficits. Conversely, currencies such as the Swiss franc and the Japanese yen are not dependent on risk appetite because they have current account surpluses and therefore are seen as “safe havens” in times of risk-aversion. This is not an exact science, because there are Currency Economics 57 exceptions such as the Canadian dollar, which tends to prosper during periods of risk-seeking despitethefactthatCanadahashistoricallyruncurrentaccountsurpluses.Generally,however, within the developed economies the relationship between risk appetite and the current account tends to hold. The principles that we have described here work for the developed market currencies. They also work very well within emerging market currencies, albeit with some caveats. Emerging market economies and currencies have some specific characteristics which need to be consid-ered when using a risk appetite or instability indicator: Most emerging market economies have current account deficits—Because of high cap-ital inflows, most emerging market economies run trade and current account deficits. As a result, most are risk-dependent, though one would assume this anyway. Emerging market economies tend to have structurally high levels of inflation—Due to economic inefficiencies and higher growth levels, emerging market economies have tended to be characterized by higher inflation levels. Emerging market interest rates are more volatile—Capital inflows to the emerging marketsarefrequentlysubstantiallylargerthantheabilitytoabsorbthemwithoutconsequent major financial and economic imbalances. Such inflows artificially depress market interest rates until such time as economic imbalances become unsustainable, at which point the currency collapses and interest rates rise sharply. Thus, such inflows can cause substantial interest rate volatility. Political, liquidity and convertibility risk add to emerging market volatility—Politics is no longer seen as a primary risk consideration within the developed markets, but it still is within the emerging markets however, given higher levels of political instability. Emerging marketsarealsoconsiderablylessliquidandsomearenotconvertibleonthecapitalaccount, both of which affect market pricing. These caveats notwithstanding, asset managers, leveraged investors or corporations can use a risk appetite instability indicator as a benchmark for managing or trading emerging market as well as developed market currency risk. High carry currencies such as the Polish zloty, Hungarian forint, Brazilian real and Mexican peso tend to outperform when market risk ap-petiteconditionsareinrisk-seeking/stablemode,whileequallyunderperformingwhenmarket conditionsareinrisk-aversion/unstablemode.Similarly,lowcarryemergingmarketcurrencies such as the Singapore dollar and the Czech koruna tend to underperform during periods of risk-seeking/stable market conditions and outperform during periods of risk-aversion/unstable market conditions. Neither the speculative cycle of exchange rates nor the risk appetite indicator is meant to represent exact science in terms of predicting exchange rates. They do however have the advantage of focusing on capital account rather than trade flows, in line with the elimination of barriers to free movement of capital. In addition, they are specifically useful for focusing on short-term exchange rate moves, an area where the traditional exchange rate models fall down. Finally, the results can be used specifically rather than just generally and tailored to the individual currency risk needs of asset managers, leveraged investors and corporations. 2.2 CURRENCY ECONOMICS Sofarinthischapter,thefocushasbeenontryingtocreatenewexchangeratemodelsbasedon capital flows to try to improve forecasting accuracy. As necessary as this is, it does not mean 58 Currency Strategy we abandon the traditional exchange rate models. Classical economic theory has provided the foundations for exchange rate analysis. The purpose of establishing a framework known as currency economics is to be able to combine the new with the exchange rate models and use both in a more targeted and focused way. Any major differences between this framework of currency economics and classical economics are more methodological than ideological. The traditional exchange rate models, focusing as they do on such factors as trade, productivity, prices, money supply and the current account balance, help provide the long-term exchange rate view. Capital flow-based models are considerably more helpful and accurate in terms of predicting short-term exchange rate moves. However, these two types of exchange rate model should not necessarily be viewed as polar opposites.Theverypurposeofestablishingaspecificframeworkknownascurrencyeconomics is to create an integrated approach to exchange rate analysis, which is capable of answering theriddlesofshort-,medium-andlong-termexchangeratemoves.Thetwosidesdohavesome common ground, and it should be no surprise that this common ground is to be found in the balanceofpaymentsmodel—giventhatitfocusesbothontradeandcapitalflows.Withinthis, there are three specific analytical tools which should be of use to currency market practitioners in bridging the gap between short- and long-term exchange rate analysis: The standard accounting identity for economic adjustment The J-curve The REER 2.2.1 The Standard Accounting Identity for Economic Adjustment We looked at this briefly in Chapter 1, but to recap it is expressed as: S − I = Y − E = X − M where: S = Savings I = Investment Y = Income E = Expenditure X = Exports M = Imports This can actually be expanded by breaking down “savings” into public and private savings such that: (Sp + Sg) − I = X − M where: Sp = Private savings Sg = Government savings Here, government “dis-saving” reflects having a budget deficit. Thus, from this, we can see immediately that there is a possible link between a budget deficit and a trade deficit. If a country’s budget deficit continues to rise, this is reflected on the left-hand side of the equation by an increasingly negative value for Sg. Unless this is offset by a rise in private savings or a fall in investment, this will eventually mean that the left-hand side of the equation turns Currency Economics 59 negative. Of necessity in this circumstance, the right-hand side of the equation must also be negative, which in turn means that the country has a trade deficit. Thus, a budget deficit can lead to a trade or a current account deficit. The link is not necessarily automatic. However, it should be assumed that widening budget deficits, if sustained over time, lead to widening trade and current account deficits. If we extend this, we see that at some stage widening currentaccountdeficitswillbecomeunsustainable,requiringarealexchangeratedepreciation. Thus, widening budget deficits may eventually require real (and thus nominal) exchange rate depreciation. Economists are not generally thought of as prone to high emotion. Yet, one has to say that the accounting identity is like a work of great art, hiding great intricacy and complexity behind the veneer of apparent simplicity. From this accounting identity, we can see how economies adjust to changes in fundamental conditions and therefore how exchange rates should adjust to those conditions. Again, this is probably best shown through an example. Example 1 For the purpose of this exercise of showing how the accounting identity can work in practice, imagine a purely theoretical example whereby you are the corporate Treasurer of a South Africanminingcompany.Forargument’ssake,thecompanyminesandexportspreciousmetals to Europe, the US and Asia. Of course, those precious metals are for the most part priced in US dollars. However, the company is based in South Africa, thus its export revenues are in US dollars and its cost base is in South African rand. This may be an oversimplification but let’s assume for the sake of this example that it is the case. In terms of currency risk, the Treasurer’s main decision is whether to hedge forward receivables or alternatively allow them to be translated at designated intervals depending on exchange rate developments. In this specific example, it has to be pointed out that South African exporters have a regulated limit of a period of 180 days with which to repatriate export receivables. If we look back at the first half of 2001, South Africa was recording tremendous trade surpluses, which is to say that the balance of exports to imports was robustly positive to the tune of over 20 billion rand in that period. Using our accounting identity, this can be expressed by: (Sp + Sg) − I = +ZAR20.5billion Just as the right-hand side of the equation is strongly positive, so the same must be the case for the left-hand side. Thus, the inescapable conclusion from this is that the sum of (Sp + Sg) must ofnecessitybeconsiderablyhigherthan I.Atthesametime,SouthAfricawasactuallyrunning a budget deficit of around 2% of GDP. This represents government dis-saving, meaning that Sg is actually negative. Thus, we can in turn extrapolate from this that either South Africa’s private savings (Sp) had become extraordinarily high or investment (I) was either low or negative. Those familiar with the South African economy know that low private savings has been a perennial structural weakness of that economy. Thus, the first suggestion is extremely unlikely. If we accept this, then in turn we must conclude from the accounting identity that low or negative domestic investment (I) in South Africa was the reason why the left-hand side of the equation was also strongly positive. While precious metal exports have declined as a percentage of total South African exports in recent years, they still make up a considerable proportion at around 15%. Thus, the rising 60 Currency Strategy overall trade surplus may also reflect rising precious metal exports. Our corporate Treasurer, seeing mounting export receipts in US dollars, may presume that the sheer weight of the rising trade surplus may cause the rand to appreciate. If he or she does so, they may in turn decide to sell US dollars forward for rand to lock in at favourable levels and avoid having to hedge forward later at slightly less favourable levels. However, this may not in fact be the right decision to take. If we look again at the accounting identity in this specific example, we see a picture of low or negative domestic investment in the economy. Domestic investment in an economy is not the same concept as inward portfolio or capital investment. However, we may assume that if domestic investment is low or negative, inward investment is also likely to be low or negative. A currency market practitioner thinks not just in terms of trade or capital flows,butratherintermsoftotalflowsgoingthroughthemarket;thecommongroundbetween the new capital flow-based and the traditional trade flow-based exchange rate models. Thus, in this example capital flows may be low or negative, potentially offsetting the positive impact on the rand of trade flows. As a result, the corporate Treasurer should think twice before hedging by selling US dollars for rand until such time as they have to since any trade-related benefit to the rand may be offset by investment-related losses. In practice, the dollar–rand exchange rate traded in a relatively tight range through the first half of 2001, apparently confirming that net positive trade flows were offset by net negative investment outflows. Subsequently, of course, South Africa’s trade balance swung from a sub-stantial surplus to an even more substantial deficit due to the combination of strong domestic demand, boosted by loose monetary policy, and weak external demand. With domestic in-vestment rising but inward investment still weak, those net negative trade flows became the dominating factor in subsequent rand weakness. From August 2001 through to the end of the year, the rand fell from around 8 to the US dollar to a low of 13.85. Ill-informed people have said it was due to speculation. The truth is somewhat less sinister, which is that it was due to fundamental factors at work that were evident within the standard accounting identity for economic adjustment. This is an example of how a corporation can use the accounting identity to analyse their currency exposures. For good measure, we should try the same exercise for an investor. Example 2 An institutional investor may also be concerned with currency risk, albeit from a slightly different perspective. Instead of mining precious metals out of the ground, our investor may be buying a portfolio of international equity and fixed income securities. Whether our investor likesitornot,theveryactofinternationalinvestmentautomaticallyassumesnotonlycurrency risk but also a specific currency view. What do I mean by this? If an investor in the UK decides to buy a 10-year US Treasury note, in order to do that they have to buy US dollars. In market parlance, they are whether they like it or not “long dollars, short sterling”. If during the time in which they hold the investment, sterling falls against the dollar, this is a very favourable development which should help enhance the total return of the investment. Why? Because when the US dollar proceeds are translated back into sterling, a fall in sterling against the dollar means that the dollar is worth more sterling. The ensuing currency profit should thus boost the total return. Say, however, that sterling actually appreciates significantly against the US dollar. In this case, any profit earned on the original investment in the US Treasury note may be reduced or even eliminated when the proceeds are translated back into sterling. The rise in sterling @Team-FLY ... - tailieumienphi.vn