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Category: Money

The price of ignorance when it comes to FX

As fintech gives us all the ability to play the currency markets on our smart-phones, Hinde Capital’s CFO, Mark Mahaffey, w...

22 July 2017

Mark Mahaffey

As fintech gives us all the ability to play the currency markets on our smart-phones, Hinde Capital’s CFO, Mark Mahaffey, writes on the need to understand foreign exchange variables and, with the pound at a historic low, details how you can cash in and avoid the bear traps.

Everywhere we seem to turn, there is an advertisement for a new card promising the best rate for exchanging into multiple currencies which can then be held electronically on that card. Most of us are now painfully aware of how costly banking services are, especially when it comes to getting cash to take abroad. The outrageous exchange rates at Gatwick airport are notorious for impoverishing the hapless traveller before they even get on the plane.

While electronic money, banking or online currency exchange seem to be the new game in town, the history of such products can be traced back to 1982 when a research paper by David Chaum, an American inventor, introduced the idea of digital cash. He set up a company called DigiCash and in 1994, the first electronic payment was made. The secure triarchy of blind signatures, undeniable signatures and group signatures were all developed under Chaum’s guidance. However, despite Paypal emerging as long ago as 1998, the evolution of electronic money had been relatively slow until recently.

In the next few years we are likely to see total acceptance of electronic multiple currencies being held in digital wallets. They will cease to be the preserve of the younger, tech literate generations but become the norm, allowing users to escape the high costs of yesteryear’s banking and rip-off exchange rates. The regulatory agencies, hopefully free of the 2008 crisis of banking bashing mandate, will embrace the new world and work to protect the users of the new technology.

As more and more people gain the ability to take charge of their personal finances electronically, there will be a premium on comprehending the inherent variables of money and foreign exchange, I hope to illustrate the need for than comprehension here.

Currency management

The importance of understanding currencies, the level of valuations and the driving forces behind potential moves, is, more or less, dependent on where you are on the scale. For example: Perhaps at one end is a farm worker in Scotland who never leaves the country, has little in the way of disposable income for goods or investments and can match his income with his liabilities in his home currency. At the other end is an international businessman who spends a reasonable amount of time overseas with assets in property and global investments.

Most of us are likely to be somewhere in the middle and, as such, should have some understanding of currency levels. One of the reasons I am bringing this up today is for people to understand exactly where we are in the UK with respect to our currency and its competitors.

The respective trade rates of key currencies

In any measurable way, the pound (GBP) has performed poorly over the short and long-term. On a trade-weighted basis (as above), it is 25% lower than at the turn of the century, while the dollar (USD) is 15% stronger.

As you can see below, against the USD, the GBP is now back to 30-year lows.

The historic pound to dollar exchange rate

Arguably, it was only a matter of time because the UK is an import-skewed nation with the largest twin deficits of budget and trade and has been living way beyond its means for years. Brexit brought that home to roost and we now sit as the poor man of the world, in currency terms at least.

Hopefully, as we are not an emerging market, we will not face a complete currency collapse, as you might see in Turkey or Russia. Many ‘academics’ with government-defined pensions welcome this drop in GBP to ‘rebalance’ the economy, but it is not as helpful to the less well-off who are facing inflation of food essentials.

Just like any business, understanding your income versus expenses and your assets versus liabilities are key in currency management.

  • What currency does your income come in? What are your expenses?
  • What currency are your assets in? What are your liabilities?

Earning money in the strongest currency, while paying your expenses in the cheapest is understood clearly by businesses who sell into the US and have their factories in China.

The same goes for holding assets in the cheapest currency and having your liabilities in the strongest. Many people who invest abroad, either in financial investments, property or business, often fail to think currency first or even at all, but it can be exceptionally profitable to make astute investments with timely respect to:

  • Currency
  • Investment merits
  • Earning yield

In recent years with the extraordinary monetary policies employed globally since the 2008 crisis, many currencies now yield either next to nothing or negative, but historically that has not been the case. In time this will regain its significance, and, with inflation heating up in most countries, it might be sooner than most people think. A crucial part of any currency management is the interest rate that deposited cash receives and vice versa the interest paid out on liabilities.

The holy grail is to find, not just a cheap currency but a high yielding currency as well.

Let’s look at a straightforward example of this: Brazil, a long-term emerging country is still experiencing booms and busts, both with its financial markets and its currency.

If you had made the timely decision to exchange £10,000 into Brazilian Real in late 2015 at 6 Real to £1 you could hold those Rs 60,000 in a one-year bond at 14%. Fast-forward to December 2016, and if converted the now Rs 68,400 (after interest) back into GBP at 4 Real to £1, you would receive £17,100 – a whopping 71% return in just one year.

Maybe Brazil is too far from home, so how about buying a ski chalet in Switzerland in 2007 with the GBP-CHF at CHF2.45 to £1? Spending £300,000 would have got you CHF 735,000 back then. Today, even assuming zero price appreciation in property in Swiss franc terms, which is not the case, those CHF 735,000 at today’s FX rate of 1.22 makes it worth £600,000 – a 100% return on the currency alone.

Deposit rates by country

                            1990          1995          2000          2005          2010          2015

 

US                          8.2%       5.75%          6.5%          2.6%          0.25%         0.25%        

UK                         14.0%     6.75%          6.2%          4.75%       0.75%         0.55%

JAPAN                   8.0%       0.50%          0.1%          0.05%       0.25%         0.1%

Germany                               3.8%           4.5%          2.1%          0.5%          -0.04%

CHF                        8.7%       3.5%            3.6%          0.75%       0.20%        -0.80%

Brazil                                      60%            17.3%        19.7%       10.2%         12.6%

 

In other investment cases, we have seen over the years, when there was a widespread belief that Japanese equities would recover from the lows of the 2010-2012 period, many invested in the standard broker route of first converting their GBP into yen. By 2015, the Nikkei, the Japanese main index, was up over 100% in yen terms but, unfortunately, the GBP-JPY had weakened dramatically cutting that return to less than 25% in GBP terms. The difference between a currency-hedged Japanese equity and a non-hedged fund became all too apparent.

A similar situation occurred in gold when UK investors bought gold in USD terms in 2000. This is referred to as ‘The Gordon Brown low’ in gold circles because Gordon Brown, the UK chancellor at that time, auctioned off most of the UK’s gold reserves at the cheapest price in years. Gold was at $257/oz and GBP-USD 1.40. By 2007, gold had reached $650/oz, a rise of 150% in USD terms. Unfortunately, the rise of the GBP-USD rate to 2.00 had limited the unhedged UK investors to a GBP return of 75%.

So understanding your purchasing currency as well as the asset you’re buying does matter, sometimes dramatically so. To make the best of your business and investments, currency is just as important, if not more than the asset/business itself. Of course, like most potential profitable events in the future, it is not obvious why a currency should move and in what time frame. We can make some relative assessments on ‘cheapness’ or ‘richness’ based on history, but the fundamentals that provide the impetus for movement are harder to define. Most people understand that both real interest rates (rates after inflation) and some purchasing power parity argument, (think Big Mac index) are good starting points. In the long-term, the theory goes that money will flow to those higher interest rate currencies whose purchasing power parity (PPP) is low, but there are many other short-term factors. If it were easy, everyone would be doing it!

Unfortunately, UK investors or UK earners currently find themselves in a cheap currency; in fact, the cheapest it’s been in a long time. As a result, any money earned buys the least in international terms, whether it is ski chalets or US equities. In business, the vast array of importers are getting crushed while the few UK non-service exporters are doing better; meanwhile the poor consumer is facing higher prices for food, Apple products and foreign holidays. If you have benefitted by holding assets in other currencies, maybe this is the time to cash in and move your money back into sterling. If you are looking for a new business venture, think first about an export business where your sales are in rich currencies, but your production is in ‘cheap’ sterling. And if you are looking to buy overseas assets, property or equities, certainly consider taking out a currency hedge.

Mark Mahaffey is the CFO of Hinde Capital. This article is based on a piece originally published in Hindesight Letters.

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