* WHAT TO DO NOW: Learn currency fundamentals. In this lesson we continue our review of why currencies move.
* EZ CURRENCY DIVERSIFICATION: Find countries with low debt. Their currencies are likely to be strong. See case study on page eight.
* EZ PROFIT: See funds in top performing currencies on page nine.
This is dawn’s first illusion. Faint glimmerings that are pale curtains of subtle pink and salmon cast upon a darkened sky. Then rainbow blends of color cast brighter shades and early morn. Black dots become sea gulls growing in the fullness of an orange rising sun that shimmers over maritime mists in the early dawn.
Islamorada, the Florida Keys, late August 1993. I am with my wife, Merri, and children Jacob, Francesca and Eleanor riding in a boat out into the dawn. We are going fishing but as is often the case, I brought a little work along. In this instance, work consisted of an economic bulletin published by one of the large Swiss banks. I read it on the trip and learned that the three major countries with the lowest national debts as a percentage of GNP were Finland-first, Australia-second, and Switzerland-third. I mentioned that fact in my September 1993, WORLD REPORTS investment letter.
In 1994 the two strongest currencies in the world were the Finnish mark first and the Swiss franc second. The Australian currency was not strong. However based on one simple currency fundamental, I was able to spot two of the three strongest currencies in the year ahead. We will look at this in more detail in this case study. In this lesson we will begin to look at fundamentals such as this, which make currencies move.
If the prime reason we invest internationally is to gain greater economic opportunity and to protect wealth and purchasing power, the most important place where we should invest is in investments that are denominated in strong currencies.
With this in mind, let’s look at the fundamentals of international currency fluctuation. This will help you understand why currencies gain and lose strength against one another, why some currencies are fundamentally weak and why others are fundamentally strong, and how you can simply (and with as much accuracy as possible) use these fundamentals to forecast upcoming currency movements.
Foreign Exchange/Currency Fluctuation
When gold and silver coins were used internationally, trading between countries was fairly straightforward. If a person in Persia, for instance, was given as payment a solid gold coin minted in Greece, he could, if he chose, melt it down and either use the gold for barter or make a Persian coin out of it.
But today paper (and plastic) fiat money is used worldwide, and every country has its own currency. This makes international financing of trade much more complex. When goods are exchanged between Japan and the United States, for example, dollars and yen are also exchanged. You can’t melt a dollar to make a yen, so some means of determining exchange value between these two units of currency has to be decided. This is the role of foreign exchange. In fact, foreign money is called foreign exchange, because a relative price between currencies must always be determined.
The term “forex” is short for foreign exchange. When a person talks about a forex profit or loss, he is talking about the increased or decreased value of an investment caused by currency movements.
For example, if an investor bought a share listed on the London Stock Market that cost 100 pounds, and the pound is worth US$1.50, he invests 100 pounds or US$150. If the share value rises to 200, the investor has made 100% profit on the investment — in terms of British pounds. His profit in terms of U.S. dollars depends on how the value of the pound has moved versus the dollar.
If the pound maintained its parity with the dollar (i.e., did not change in price vs. the dollar), the profit in U.S. dollar terms is also 100%. The original investment of $150 is now worth $300. But if the pound drops in value to US$1.35 (a 10% currency drop), the profit in U.S. dollar terms is only 80%. The investment, worth 200 (100 original value plus 100 profit), is worth only US$270. Although the investor has a 100% gain on the investment itself, the forex loss was 10% on the original investment and 10% on the profit. If the value of the pound rose to US$1.65 (a 10% currency gain), the investment would be worth US$330. In U.S. dollar terms the gain would be 120% — 100% investment profit plus 20% forex profit.
Historically, the parity of the British pound has varied from US$2.20 to US$1.00 in the past ten to fifteen years, so you can see why forex moves can be so important to business and investing. These same factors determine changes in price between all currencies. They affect us daily, often in ways we cannot immediately see. But the big question we as investors ask most must be, “Why do these currencies move?”
Technical vs. Fundamental Currency Analysis
No one knows totally why the value of a currency moves. However, there are many factors that have a definite influence on the value of currencies. We will learn these factors in this lesson and Lesson Eight.
We will also learn how to analyze these factors, so we can form our own view about which currencies will rise and which will fall.
There are two types of currency analysis: technical and fundamental. Technical analysis is based on the actual movement of a currency. A technical trader buys a currency just because it is going up. He doesn’t care why it is going up — he just buys because it is going up. Similarly, a technical trader sells a currency when it is going down.
Thus, if someone says that the “technical position” of a currency is strong, it means that the currency’s value is rising. If the technical position is weak, it means the currency’s value is falling. This school of thought does not care what the underlying fundamental reason for a currency’s moves are. A technical trader believes that there are too many diverse factors that affect currencies and that one can never truly know why currencies move. This “technical school of thought” believes that the movements of the market are a true reflection of all these forces and thus currency movement is the only factor worth studying.
There also is another school of currency traders which prefers to make judgements on more basic, fundamental factors about each currency. “Fundamental” refers to the underlying reasons that a currency rises or falls. A fundamental trader invests in a currency because he believes the underlying fundamental factors indicate that the currency is strong and will rise in value. These underlying factors can be divided into short and long term factors as below:
Long Term Factors
1) Productivity 2) Trade Balance (Surplus or Deficit) 3) Government Debt and Government Deficit 4) Nature of Government Spending 5) Tax Rate
Short Term Factors
1) Interest Rates 2) Inflation 3) Real Return on Investment 4) Velocity 5) Money Supply
Knowing how to examine fundamentals of a currency’s strengths and weaknesses is invaluable. When charting an investment course, it is important to have an overall currency plan based on these underlying factors and fundamentals. For this reason, we will examine in detail each of the fundamental and short term underlying factors that determine currency strength and weakness.
Long Term Factors
The global investor today has several long term trends staring him in the face. First, the U.S. dollar seems weak in the long term. Every possible indication is present that the dollar will continue to fall long term, especially against more disciplined currencies like the German mark, Swiss franc, and Japanese yen. Does that mean the dollar will fall next month vs. these currencies? Or throughout the coming year? Certainly not. Even in long term falls or rises, there are peaks and valleys that can unpredictably extend over long periods. But indications are present that the dollar will lose value in the long-term.
A Game Plan Gives Emotional Strength
Even when an investor studies the long and short term fundamentals of currencies, there will be times when the currencies do not move as predicted. However, the inevitable rises and falls of marketplaces can be more easily tolerated emotionally, if you understand the forces that make them move. Also by understanding underlying currency fundamentals and making investment decisions based on such knowledge, the chance for success is increased.
The Instantaneous Movers of Currency Value: Fear and Greed
The reasons that currencies do not always move as expected can be many. First, one may incorrectly understand fundamentals. Second, the statistics (normally government provided) that reflect currency fundamentals may be slanted or incorrect. Third, there may be factors that are unseen and unknown.
However, the greatest reason why currencies do not move exactly based on short and long fundamentals is because the ultimate value of a currency is determined by the currency markets. These markets are driven not only by the fundamentals, but by the traders’ opinions.
Important Point to Remember: A currency’s future value can never be totally known because it is affected by all of the opinions of the market. All these opinions can never be known and they are volatile because they are in turn driven by two underlying motives-to make a monetary gain and to avoid a loss. We could call these forces-fear and greed.
Although foreign exchange is ultimately based upon foreign trade (as payment for trade between countries), the day-to-day and moment-to-moment price of a currency is driven by currency traders, many of whom do not look at the underlying fundamentals of a currency’s value.
These traders represent buyers and sellers around the world, all of whom are driven by the two most prominent motives when it comes to any type of investment: fear and greed. Currency traders, buyers and sellers, are continually afraid that they are holding currency that is about to fall in value — even if the currency is going up in value. But of course at the same time, they do not want to miss out on any appreciation they might receive. Which of these two motivators is the strongest? The answer is, by far, fear of loss.
Benjamin Franklin once said that a tired man would never get out of bed and go downstairs to earn a dollar. But the same man would jump out of bed and dash downstairs to save the loss of a dollar he had already earned.
Important Point to Remember: Many investment psychologists believe that the motive of fear outweighs the motive of profit by about two to one. A look at most bull and bear markets will show that a strong bear will normally fall at a rate that is twice as fast as a strong bull market will rise.
And so it is with currency traders. The price of currencies rise and fall in relationship with each other, based ultimately on the fundamentals we shall discuss. But underlying the movement are investors’ fears of loss and potential gain.
Contrarian Trading Tactic
There is another school of thought that thinks most investors (in the long run) are always wrong. Most investors are captured by greed and buy at the top of a currency’s strength and then panic and sell in fear at the bottom of its weakness. Contrarian investing philosophy suggests that we should always invest in currencies that are relatively very weak and avoid those that are relatively very strong.
One must understand fundamentals to understand when a currency is really relatively weak and when it’s relatively strong. So for the rest of this lesson we will concentrate on the long term fundamentals.
Long-Term Factors of Currency Movement
* Long-Term Factor #1: Production and Consumption. The ultimate mover of a currency’s value is the age old give and take between production and consumption.
It follows the natural law that governs all work and economic productivity: a person cannot consume what he does not produce. If a person does consume more than he produces, he has two choices and two choices only: One, he must increase income to meet or exceed consumption, or two, he must borrow to meet the discrepancy.
Ultimately, of course, the choice comes down to #1, because for an individual, borrowing can go on only so long before reckoning takes place. Governments, however, sometimes think they can borrow indefinitely, bolstered by their ability to create money from thin air and by their power to tax (and raise taxes) on citizens.
What is production? It’s the creation of goods and services, the creation of new ideas that improve goods and services, and the distribution of these goods and services. Production involves the entire range of a country’s economic activity: from the development and distribution of raw materials, to the formation of these raw materials into desirable, useful products, to the development of stable banking and insurance networks that finance and protect investors’ capital outlay.
When a country has little actual growth in production, theoretically it should not increase its money supply. Unfortunately, this is the very time governments need money the most. Few can resist the impulse to print a little extra to tide them over.
If a government does not impose discipline to assure that no money is produced unless some production takes place, that currency will eventually fall in value compared with currencies that are based on more productive, stable values.
This is especially so of governments that use fiat currency. If a currency is based on gold, silver, or another hard asset, it is not possible to simply print whenever more is needed. The gold or other hard asset represents productivity, because no person or government is going to give away gold unless some productive value is exchanged. Fiat currencies have no base of hard assets, and the printing presses can churn it out unencumbered by small details. There is no worry such as is the currency really worth anything.
Fiat currencies are very sensitive to the emotions of fear and greed in the foreign exchange markets, because the only real value these currencies have is confidence. If an investor is confident that a Fiat currency will rise, he will buy it. If the investor fears that the currency will fall, then he will sell.
If all currencies were tied to a hard asset, there would not be so much fear that a country is creating more currency than productivity warrants. Nor would there be as much desire to speculate for profit on a currency’s parity motion. Value would always remain steady.
What would this do for the world? It would ensure that governments would be more honest with its citizenry. Governments would not be able to expand beyond their citizens’ desires to pay for governmental services. Governments would issue money based only on production. Certainly they could still borrow, and certainly they could adjust taxes from time to time. But overall, basing currency on hard assets would force governments to maintain fiscal discipline.
However, such discipline is something that few governments in history have maintained for any reasonable length of time. We must assume that the U.S. government will not suddenly gain this discipline and that growing U.S. debt will eventually destroy the remnants of the world’s currency system as we now know it.
Important Point to Remember: Most governments today are accustomed to a system of borrowing far more then they can ever repay. This is a trend that has been promoted since the 1940s. Politicians have become hooked on budget deficit spending. Until this trend reverses itself, currency turmoil is almost certain because all the governments are spending more then they produce.
*Long-Term Factor #2: Government Debt. The fundamental basis for international currency movement may be trade and the resulting surplus or deficit in a country’s balance of payments. However, the real world involves real governments, run by real people with real needs, short and long term. For this reason, the most fundamental basis of currency movement is government discipline (or lack of).
Governments today produce money out of thin air to fund their activities (as seen in the previous section on the U.S. Federal Reserve and fractional reserve banking). If governments produce money that is not backed by precious metal or by the productivity of their own people, the money created will eventually become weaker versus money issued by governments that produce money backed by precious metal or productive work.
The most fundamental law of money is that something cannot be consumed unless it is first produced. This simple, common sense law seems so obvious that it hardly needs stating. Yet ignoring this law has led (and will continue to lead) currency after currency to destruction!
Money, above all, is a form of discipline. In its most pure form, this discipline is aimed at stopping members of a community from taking more than they have produced.
For example, any government can add a new department and staff it, paying for the expenditure by simply printing (or creating) new money. But when a currency is tied to gold or silver, the government cannot simply manufacture it out of thin air. The government must first produce or earn the gold, then print the money. This keeps a government honest. It disciplines a government not to consume until it has produced. Gold or silver, in themselves, are merely representative of production accomplished.
If a government does not impose discipline on itself to assure that no money is produced unless some production occurs, that currency will lose its purchasing power versus currencies whose governments do maintain discipline. Some governments impose less discipline than others. The less discipline there is, the weaker the currency will be and the faster it will fall versus other currencies.
There are numerous ways to spot future weakness in a currency.
First, look for deficits in a government’s annual budget. If a country has a deficit, it is producing money without discipline. As a rule, the larger the percentage of the debt compared with the country’s gross national product, the more likely the country’s currency will fall vs. other currencies.
Second, spot potential weak currencies by looking at a country’s accumulated debt. If a country has a debt it must start running a budget surplus before it can pay down the debt. This can only be accomplished by either a slow down in spending or by an increased income. In either case, such discipline balances the budget. If a government does not balance its budget, it has to borrow to meet payments.
Third, look out for a government with both an accumulated debt and a deficit in its annual budget. This country is already in debt and the debt is increasing!
Unfortunately your task of finding such governments will be all too easy. Government deficit financing is now a normal part of most economies. Huge debts are being created by governments all over the world.
These debts create all kinds of economic problems. They interfere with private industry. This was one factor that seriously hurt bond prices in 1994. The huge demand by governments for financing of their debt attracted funds that once went to private bond issues. When governments borrow more and more money, this pushs up the yield on treasury issues, competing with bond issues and making them less attractive.
Government debt affects currency values in many ways. Some countries, especially developing countries, create so much debt that they cannot produce enough goods to service their debt (principal or interest). In these cases, the currencies of the countries are seriously affected. Even major nations are affected. The numbers below show the huge debts that major governments around the world have taken on.
CURRENCY RESERVES (November 1993) COUNTRY GOLD TONNES GOLD $ TOTAL RESERVES GOLD % NATIONAL IN US DOLLARS RESERVES DEBT AS % OF GDP USA 8,146 86,434 147,559 58.6% 63.0% Canada 318 3,369 13,175 25.6% 82.3% Japan 754 7,996 79,439 10.1% 64.9% Australia 247 2,617 13,609 19.2% 29.7% Germany 2,980 31,409 116,965 26.9% 44.0% Switzerland 2,590 27,482 56,984 48.2% 30.0% France 2,546 27,011 54,252 49.8% 50.1% Italy 2,074 22,001 47,974 45.9% 108.4% Netherlands 1,357 14,395 34,567 41.6% 78.3% Belgium 779 8,263 19,545 42.3% 134.4% Austria 616 6,537 18,621 35.1% 52.1% UK 581 6,161 43,838 14.1% 41.9% Spain 486 5,155 47,723 10.8% 48.4% Greece 107 1,132 4,811 23.5% 84.3% Sweden 189 2,003 21,409 9.4% 54.4% Finland 62 660 7,650 8.6% 29.0% Denmark 52 548 9,242 5.9% 62.2% Norway 37 389 16,694 2.3% 43.9% Ireland 11 119 3,522 3.4% 98.1%
The amount of debt in relation to gross domestic product is an important factor to help us determine the value of a currency. For example, Australia has a very low percentage of debt to GNP, and its currency is now appearing stronger. Switzerland has a low debt to GNP ratio, and its currency is very strong.
This low debt is a factor that adds strength to a currency. However, this is not the only factor. For example, you would think that the Belgian franc would be weak because its debt ratio is so high. Surprisingly, the Belgian franc has been strong. We will learn why when we look at the next factor (the nature of government debt).
However, first let’s look at the Case Study.
In 1993 I read a Credit Suisse economic report that gave me the government debt figures like those shown on the last page. From this simple chart, I concluded that the Finnmark, Swiss franc and Australian dollar would be strong currencies. I mentioned that fact in my September 1993 WORLD REPORTS investment letter and over the upcoming months suggested to investors that they invest in these three currencies.
In 1994, two of the strongest currencies in the world were the Finnish mark-first and the Swiss franc-second. Later in 1994 they became the two strongest currencies. The Australian dollar was not quite as strong but also fared well in a year of great turmoil. Investors who invested in Finnmark Money Market Funds made 20.6% (on average in U.S. dollar terms). Swiss Franc Money Market Funds returned 18.32% and Australian Dollar Money Market Funds 11.38%.
This case study shows us two important points. The first is that government debt has an influence over a currency’s value. Based on one simple currency fundamental, I was able to spot two of the three strongest currencies in the year ahead.
The second point is that debt is not all that counts. Why was the Australian dollar not as strong? The fact is that all of the fundamentals add an influence on a currency’s value. None of them is the one contributing factor. We, as investors, rarely will be able to know exactly which factor is most important at any time.
To understand this better we’ll look at the third fundamental factor after we have reviewed contacts for this lesson.
Listed below are mutual funds that invest in Finland, Switzerland and Australia.
Listed below are Nordic and Scandinavian mutual funds that are likely to have a portion of their portfolio invested in Finland and banks that can assist you in investing in Finland.
Unibank Scandinavian Fund, 19-21 Circular Road, Douglas, Isle of Man. Telephone: 011-44-1624-629420. Fax: 011-44-1624-627515.
CMI Nordic Equity Fund, 203 Route d’Arlon, L-1150 Luxembourg. Telephone: 011-352-458825. Fax: 011-352-458821.
Den Norske Bank, Nordic Fund, 11 Rue Aldringen, 2960 Luxembourg. Tel: 011-352-468191.
Skanifond Nordic Equity Fund, Banque Scandinave a Luxembourg, 16 Boulevard Royal, L-2449 Luxembourg.
Hypo Foreign & Colonial Nordic Fund, Exchange House, Primrose Street, London EC2A 2NY, England. Tel: 011-44-171-628-8000. Fax: 011-44-171-6288188.
Jyske Bank, Private Banking International, PO Box 133, DK-1780 Copenhagen V, Denmark. Tel: 011-45-33-78-78-78. Fax: 011-45-33-78-78-33. As Denmark’s fourth largest bank, these investment managers are familiar with the Finnmark and the Finnish Stock and Bond Market. They can purchase the Finnish equity mutual fund, Evli Select.
Listed below are funds that invest in Swiss equities, bonds and money markets. Also listed below are funds that invest in Australian equities, bonds and money markets.
Baer Multicash Swiss, PO Box 36, Bahnhofstrasse 36, CH-8010, Zurich, Switzerland. Tel: 011-41-1-228-5111. Fax: 011-41-1-211-2560.
Gartmore CSF AUD Deposit, PO Box 278, La Motte St., St. Helier, Jersey JE4 8TF. Jersey, CHannel Islands, Britain. Tel: 011-44-1534-27301.
JF Australia Equity Fund, 44th Floor, Jardine House, Hong Kong. Tel: 011-8522-843-8813. Fax: 011-44-8522-845-2421.
CS Equity Portfolio Growth SFR, 58 Grand rue, L-1660, Luxembourg. Tel: 011-352-460-0111. Fax: 011-352-475541.
Pacific AUD Bond Fund, PO Box 45, Port Vila, Vanuatu, South Pacific. Tel: 011-678-24106. Fax: 011-678-23405.
Pictet U.F. Valbond SFR, 29 Boulevard George Favon, CH-1204 Geneva, Switzerland. Tel: 011-41-22-705-2211. Fax: 011-41-22-781-3131.
What To Do Now
Write to these fund managers. Look at the details in their funds. See the performance they obtained through 1993, 1994 and recently. Look at how much impact currency strength in their country had on the performance of these funds in terms of the currency where you live.
*Long-Term Factor #3: Nature of Government Debt. Just looking at government debt is not enough. One must look deeper, beneath the actual debt vs. GNP figures, to see the whole picture of how a government is spending. The nature of the debt, or the “quality” of the debt, as it is sometimes called, can influence the strength of a currency.
One aspect is whether the deficit is growing or shrinking. If the deficit grows year after year, investors worry more than if the budget is being balanced and the deficit is shrinking. Also one must see if the reduced deficit is enough to matter in relation to the entire debt.
For example, U.S. deficits in 1993 and 1994 have fallen. This would add strength of the dollar, if investors perceived that the government was ready to reduce its debt. Yet, at this writing, the dollar was weak and falling. This shows that this factor has not influenced investors. The deficit reduction has not been enough to matter.
Another important factor in the quality of a government’s debt is how the money is spent. Imagine how investors might view Germany’s debt, which is also large (though not as high a percentage to GNP as the U.S.).
A tremendous amount of debt has been accumulated by the German government, one might say. However, much of this debt has been “invested,” in unifying East and West Germany. This German investment will hopefully create a larger, more unified economy with a vast new labor market of potential consumers. In essence, Germany is buying its own cheap labor market.
Or imagine how investors look at Japan’s debt, which historically invested to build industry, promote exports, and build up the internal infrastructure of education, highways, sewers, airports, bridges, etc. Japan has as high a debt to GNP percentage as the U.S., but compare Japan’s and Germany’s investing with the U.S.’s and Canada’s spending.
Over half of all government expenditures in the U.S. and Canada are on debt interest costs and social entitlements such as welfare and social security. In other words, the U.S. and Canadian governments are spending the money they borrow, even with todays’ publicity abot surpleses in the US, while Germany and Japan are investing their loans. This is not the way it should be.
First, the country must pour a substantial amount of its own GNP back into the development of its own citizens and internal infrastructure. Japan and Germany have continued to do this during the last decade; the United States has not. Certainly public debt must be held as low as possible, but the nature of the debt is also important when considering the future strength of a nation’s economy.
Second, a country must maintain a steady economic growth coupled with a low population growth. When a country’s population grows faster than its GNP, the per capita standard of living falls. In general, the emerging countries today have a significantly higher birth rate than developing countries. This will make it harder for these countries to raise their standard of living.
Birth rate per 1,000 people for sample countries:
U.S. 15.2 U.K. 13.4 Angola 45.4 Germany 11.0 Japan 10.5 Spain 11.1 Nigeria 55.0 France 13.1 Belgium 11.7 Switz. 12.2 Haiti 49.7
The ten largest countries in the world by population:
China 1,190 million India 919 million U.S. 260 million Indonesia 200 million Brazil 158 million Russia 150 million Pakistan 129 million Bangladesh 125 million Japan 125 million Nigeria 98 million
Internal Versus External Debt
Another very important factor in determining quality of debt is whether the government is obtaining its financing from its own citizens or from investors abroad. This has a major impact on the potential value of a currency.
Take Belgium for example. We can see that Belgium has a high percentage of debt to GNP, but one reason that this has not affected the Belgian franc to such a high degree is that most of the debt is financed by Belgians.
This internal financing of debt is important for two reasons.
The first reason internal financing is important is that this shows that the citizens of Belgium save a high percentage of their income. The rate of savings is an important factor in determining the strength of a currency. If a nation saves (and invests) a large percentage of its income, this makes the country’s currency stronger. The savings are used to increase productivity in the country.
The second reason is that if investors decide to take their money out of government investment they won’t necessarily take their money out of the local currency (which would decrease its value).
Imagine the difference in Belgium and the U.S. and what this difference could make to the value of the two currencies. In Belgium, the savings are high and if investors suddenly decide to take their money out of government bonds or treasury bills, they might put their money into Belgian stocks or Belgian banks. The money stays in the country to help finance its economy.
Even if the money is pulled out of Belgium for investment, most will eventually return to Belgium (when the Belgians wish to spend it) so there will always be an underlying strength.
Now imagine the U.S. where the public has one of the lowest savings rates. The government finances much of its debt by borrowing from Japanese and Arab investors. If these investors pull their money out of government bonds, the money is not only much more likely to leave the country but the outward flow will mean that many dollars will be sold at once (which would drive down the dollar’s value).
This is exactly what happened in the recent Mexican peso collapse. Much of Mexico’s debt was held by foreign investors. When they all wanted to pull out, the flood of pesos sold caused its value to collapse.
The length of government debt is also important! In the case of Mexico not only was much of its debt owed to foreigners, but the debt was due right away. A government does not have to repay its debt (and hence create an outflow of money) until the debt is due. Thus the shorter the terms of debt are, the lower quality the debt will be perceived to be.
We have learned in this lesson that there are many fundamental factors that cause currencies to rise or fall. We have not learned all these factors yet and continue to examine them in the next lesson.