There has been a good deal of volatility in international currency markets this fall and some discussion in the press about the possibility of an international currency war. Changing international currency values won’t affect all of your clients equally, but there is a very good possibility that they will have some effect on nearly all of your clients.
In a perfect world, changes in currency values would reflect nothing more than changing international trade and financial relationships among individual countries. The currency of a country with a big trade surplus should go up and the value of a currency of a country with a big trade deficit should go down. Of course, it’s not a perfect world. Currency values are also affected by economic policies, investor perceptions of the economic prospects of different countries and sometimes, by direct intervention in currency markets by governments or central banks.
As international trade has increased exponentially in recent decades, currency values have become more and more important because more and more countries have come to depend on exports for a substantial part of their economic growth. Canada has long been in this position, while China is a relative newcomer as a major exporter.
Currency values matter to exporting countries because they have a lot of influence on trade. The lower the value of a currency, the lower the price of that country’s exports to its customers, and the more exports the country is likely to sell. Conversely, if the value of a currency moves up, so too will the price of the country’s exports, and its exports are likely to fall. Think, for example, of the damage to Canada’s exports caused by the rise in the Canadian dollar. In the context of a generally weak economic recovery in North America and Europe, and rising currency values in a number of Asian economies, international currency values have become a major international issue.
So, how does all of this affect your clients preparing for retirement and those living in retirement? There are at least three ways.
The most obvious is the potential effect on portfolio values of the clients who invest outside of Canada. A falling Canadian currency raises the value of a client’s portfolio when translated into Canadian dollars. But, as you and at least some of your clients are well aware, a rising Canadian dollar does the opposite. That doesn’t mean clients shouldn’t invest outside of Canada. It does mean that you should ensure they are aware of the potential for currency fluctuations, pick portfolio managers who are capable of picking securities whose potential for growth can more than offset potential currency fluctuations, and have the discussion with clients as to whether a currency-hedged investment would be more appropriate than not.
The second way currencies can affect your clients is that currency levels around the world affect economic performance. There seems little question, for example, that the Chinese currency’s value being held down by way of the government’s control of currency markets has enhanced China’s economic performance. That can be of benefit to your client’s investments either by being invested directly in China, or in Canada where some of our natural resource sectors benefit quite directly from economic growth in China. In a somewhat similar vein, the relatively low U.S. dollar should help U.S. exports, a welcome boost in an economy whose consumers are still too loaded with debt and worried about jobs to be leaders in the economic recovery.
While I have just cited two examples of the benefits of a low currency, this shouldn’t suggest the rule of thumb that a low currency is always best. As China matures, a good deal of its economic focus will shift from business investment to consumer expenditures. As that shift happens, a higher currency that would encourage imports of consumer goods is what most investors will wish for.
The third way that currencies can affect your clients (but hopefully won’t) is by way of currency volatility and, in the worst case, currency wars. The term “currency wars” refer to competitive devaluations among exporting countries. In order to attempt to gain a larger share of global exports, country A devalues its currency. In retaliation, country B devalues its currency. At first glance, it appears somewhat similar to retail price wars. It is to the extent that if all retailers in a segment continue to cut prices, none of them will achieve the increased market share that was the aim of the price cuts. What can be different about currency wars is that we are dealing with a currency market that, like all financial markets, hates uncertainty. In the worst case, if competitive devaluations were large and widespread enough, one could envision currency markets having real problems in functioning – somewhat like some credit markets during the 2007-2008 financial crisis. I want to stress that I am in no way predicting global currency wars. However, I think it is useful for advisors to be aware of the worst-possible situation.
Clearly, there has already been some currency manipulation, both direct and indirect. The Japanese central bank has intervened directly in the foreign currency market to attempt to reduce the value of the Yen, which has climbed rapidly this year. Some Asian countries have imposed impediments to capital inflows (which have been driving up the value of their currencies) in an effort to restrain foreign-currency values. The United States Federal Reserve has indirectly driven down the value of the U.S. dollar through its announcement that it would implement a second round of quantitative easing. And, typical of currency market conditions these days, the U.S. dollar rose on a day when markets concluded that perhaps the Fed wouldn’t do quite as much quantitative easing as was first expected.
Despite the events in currency markets so far, there is a very good chance that things will settle down. The G-20 group of nations has made an initial pledge that its members will not manipulate currencies. That does not amount to a binding commitment, but the fact that the member countries are discussing the matter and are prepared to make a public pledge on the matter is encouraging.
What would be even more encouraging would be if there was more attention paid to a recent proposal by U.S. Treasury Secretary Timothy Geithner. His suggestion is that countries target their international current account balances rather than their currencies. This gets right to the heart of the matter because the big surpluses in countries such as China and the big deficits in countries such as the United States are definitely an impediment to the global economic recovery. If current account balances were targeted, countries might be encouraged to pursue the internal policies that would improve their economies rather than manipulating currencies. Even though changing currency values can be powerful, the gains from these changes are one-time gains. Internal changes such as making labour markets more flexible, encouraging business investment and a host of other possibilities require much more effort but are likely to provide a much higher return down the road.
What we have at the moment is a good deal of currency market volatility and a good deal of currency market uncertainty. Obviously, we don’t need another area of uncertainty and volatility. But for the near term, it is likely to be that way. If some common sense and logic prevail in the world, currency markets will eventually begin to settle down. In the mean time, it is much better for advisors to deal with these uncertainties – and the related client concerns – head on.