In Fun with Currencies we described how currency exchange rates can either add to or detract from the returns for international investors. Specifically, if an investor makes an investment outside his home country, the strengthening of the local currency relative to his home currency during the period of investment adds to the local returns and a weakening local currency relative to his home currency detracts from local returns.
The game plan for international investing is to find an attractive investment opportunity in a country whose currency is likely to strengthen during the period of investment.
We view the currency markets as a swimming pool filled with global currencies. If you want to exchange one currency for another, you dump one currency into the pool and pull out another in the same proportion as they exist in the pool. Your action and the actions of others affect the ratios of the currencies in the pool. When more people pull out a particular currency than put it in, that currency depletes in the pool relative to other currencies. The depletion of a currency in the pool makes it stronger because it takes less of that currency to buy a unit of the other currencies in the pool.
In order to benefit from exchange rate movements, international investors therefore need to look for investment opportunities in countries whose currencies will deplete in the exchange pool during the investment period.
Who, then, are the users of the exchange pool and what actions lead to currency depletion?
While literally millions of users use the exchange pool, four primary uses of the pool largely determine the ratios of currencies in the pool:
Cross-border investment,
Cross-border commerce,
Speculation, and
Government intervention.
Cross-border Investment. International investors use the exchange pool in order to invest in countries with currencies different than their home currency. They have their home currency and need the local currency of the country receiving their investment. International investors dump their home currencies into the pool and pull out local currencies. That action depletes and strengthens the local currency in the exchange pool.
International investors therefore benefit from net inflows of foreign investment into the country receiving the international investor’s investment during the investment period.
Cross-Border Commerce. People and institutions that make or buy product in one country and sell it in another (that is, importers and exporters) use the exchange pool because their revenues are denominated in different currencies than their costs. Exporters receive revenues in foreign currencies and need their home currency to make or buy more product. Importers receive revenues in their home currency and need foreign currency to make or buy more product.
Exporters therefore dump foreign currency into the pool and take out their home currency. Importers dump in their home currency and pull out foreign currency. The actions of importers and exporters offset one another. It is the net exports or net imports of a country that change the ratios of currencies in the exchange pool.
Because exporters dump in foreign currency and pull out local currency, their actions deplete and therefore strengthen the local currency.
International investors therefore benefit when the country receiving their investment is or becomes a net exporter during the investment period.
Speculation. Speculators use the exchange pool in an attempt to make money by accurately predicting the future and positioning themselves to benefit. If a speculator believes that a certain currency will weaken over time, he might borrow in that currency and use the proceeds to buy a currency that he thinks will strengthen over time. If the speculator is right about the two currencies, he can reverse the process after the currency weakens and make a tidy profit.
One important feature of speculative flows in the exchange pool is the speculator, whether right or wrong about the underlying fundamentals of the currency, must at some point reverse his position. If he is wrong, he loses money and eventually has to close out the position. If he is right, he has to close out his position in order to realize a profit. For that reason, speculation does not have an enduring effect on the ratios of currencies in the pool. Temporary effects yes. Permanent effects no.
A second important feature of speculative activity in the exchange pool is if the speculators are right about the underlying fundamentals of the currency in question, their actions tend to accelerate the changes in the exchange pool that would have otherwise occurred in any event. If a speculator believes a currency will weaken, he will borrow in that currency (or create some sort of other liability in that currency) and convert the proceeds into what he believes will be a strong currency. In converting the proceeds, the speculator will dump the currency he expects to weaken into the pool and pull out the currency he expects to be strong. That action alone will weaken the weak currency and strengthen the strong currency. The action of the speculator, in short, accelerates what the speculator believes will happen. When the speculator reverses his position, he will have the opposite effect, which will offset the effect of the underlying fundamentals.
Speculators, if they are right about the future, make the inevitable happen faster.
International investors benefit from “front running” speculators (that is, establishing positions prior to when the speculators establish theirs) that expect the currency in the country receiving the investment to strengthen. In that way, the international investor uses the acceleration feature of speculative capital flows to his benefit.
Government Intervention. Governments meddle in their currencies to effect some sort of macro-economic outcome. Some governments intervene to create a stronger currency, others to create a weaker currency, and still others want to “peg” the value of their currency to the value of another currency. In all cases, the governments wishing to strengthen, weaken, or peg their currencies are participating in the exchange pool: they exchange their home currency for another currency or a foreign currency for their home currency to create the effect they seek.
Government intervention can and does move markets. While government intervention eventually runs into limitations, we have seen some continue for decades.
We try to put ourselves in the shoes of the government and determine their likely motivations. All situations are different and each government has its own motivation.
The Chinese government, for instance, intervenes in order to offset the currency effects of its trade surplus with the United States. The self-correcting nature of cross-border commerce would normally work to close the trade surplus, but China intervenes in the exchange pool to offset that self-correcting feature. The Chinese government dumps in its currency and pulls out U.S. Dollars (USD). That intervention depletes the USD relative to local currency, keeping the local currency weak. Since the exporters are dumping in USD and the Chinese government is pulling them out, the Chinese government is effectively buying USD from the exporters in order to prevent the local currency from strengthening. The Chinese government then takes the USD received and makes USD-denominated investments, traditionally in U.S. treasuries and more recently in U.S. real estate.
The incentive in this case, we believe, is to support Chinese exports.
International investors need to understand the motivations of the host government and, importantly, the limitations inherent in government intervention. The objective of the international investor is to find a situation where the government will either not meddle at all or, if they do, will meddle by depleting the exchange pool of the local currency.
Brazil as an Example. We currently have about 20% of the portfolio invested in Brazil. We like several Brazilian companies first and foremost based on their company-specific fundamentals. We make all investment decisions based on company-specific fundamentals.
We also like Brazil as a destination for our investment dollars based on our analysis of the exchange pool. We believe the net effect of the four users of the exchange pool just described will combine to deplete the pool of Brazilian Reals in the coming years and will therefore strengthen the Real relative to other currencies, including the USD.
First, Brazil is not only a commodity-based economy, but is also the global cost leader in many of the commodities it produces. We believe the world will increasingly rely on the commodities Brazil produces in the coming years. That should increase Brazil’s exports, which should act to deplete the exchange pool of Brazilian Reals.
Second, we believe the global need for Brazilian commodities will attract foreign capital in order to grow and develop the sources of those commodities. That influx of foreign capital will likewise deplete the exchange pool of Brazilian Real in the coming years.
Third, speculators, if they enter the Brazilian market at all, will see a strengthening Brazilian Real on the horizon and will position themselves to benefit. Their actions will only accelerate the appreciation of the Real.
Finally, we believe the Brazilian government is unlikely to intervene in order to weaken the currency more than it has already weakened. Brazil is in the midst of a deep recession and coming off a period of very high inflation. The Real has lost nearly 70% of its value relative to the USD since 2010. The government has no incentive to weaken the Real further. If anything, we believe government will act to stabilize or strengthen the Real over time.
We believe the company-specific fundamentals of our Brazilian holdings and the future activity we see in the exchange pool is a killer combination for our cluster of Brazilian investments. The former should make for good investment returns in local Brazilian terms while the latter, we believe, should deplete the exchange pool of Brazilian Real during our investment period, strengthen the Real relative to the USD, and be additive to our returns as we convert Brazilian Real back to USD at the end of the investment period.
