When it comes to currency, there's no shortage of places for expats to hold their savings. Many offshore banks offer multi-currency accounts and market high-yielding forex or dual-currency deposits to their expat clients. Concerns regarding the viability of some currencies as well as recent government interventions can complicate the decision about which currency to hold. Since even a relatively small foreign exchange move can have a significant impact on expats' personal finances, it's important to choose wisely. In this article, we'll try to provide a framework to help make the decision about which currencies to hold easier.
What Moves Exchange Rates?
When deciding where to put your money, it's important to first understand what forces move exchange rates, and how what happens in the short-term can be quite different from what happens over the long-term.
As professional currency traders will note, unpredictable factors often drive short-term currency movements. Most important is the "ebb and flow of risk aversion," which could also be described as changes in investors' collective greed or fear. Since greed and fear are related to emotion rather than reason, short-term movements are not predictable.
Government intervention is another unpredictable short-term factor. Even when government action might be foreseen, its timing is probably not predictable.
Over the long term, exchange rates are driven by the fundamentals of the underlying economies, with the most important factor being the difference in relative price levels and inflation rates. To understand how this works, first assume free movement of goods across borders, low transaction costs, and freely trading currencies. If an item such as sports shoes has a significantly different price in one country versus another, then logically there will be more demand for the cheaper shoes. Higher demand will eventually result in either a change in the relative price (inflation of the cheap shoes or deflation of the expensive ones), or a move to equilibrium in the exchange rate between the two countries (if the currencies freely trade). Similarly, if the shoes start out identically priced in both countries but high inflation exists in one, then inflation in the price of the shoes in one country will lower relative demand for it, and equilibrium will eventually be realized through the exchange rate.
One way to look at relative currency value is to compare the size of a country's economy as measured at its official USD exchange rate [GDP at Official Exchange Rate (OER)] versus the size of that country's economy if all goods were priced in the United States at U.S. prices [GDP at Purchasing Power Parity (PPP)]. This comparison has some similarities to The Economist's famed Big Mac Index, except that instead of comparing the value of just a McDonald's Big Mac hamburger, PPP compares the relative price levels of the entire economy.
Neither The Big Mac Index nor PPP comparisons are perfect, so they cannot be taken as absolute predictions of future long-term exchange rates, in part because moving goods across borders comes with transaction costs and because governments do intervene in the trade of goods, services, and currencies. However, an expat whose living expenses are denominated in Thai baht may want to think carefully before "investing" in a currency that is more expensively priced, such as Australian dollars. Even a small move towards equilibrium in the exchange rate could negate a high deposit rate and then some.
Fundamental Currency Values
Comparing 2012 GDP at Official Exchange Rates Versus PPP (USD bn)
^GDP at official exchange rates is the home-currency-denominated annual GDP figure divided by the bilateral average U.S. exchange rate with that country in that year.
^^ GDP at purchasing power parity (PPP) exchange rates is the sum value of all goods and services produced in the country valued at prices prevailing in the U.S. in that year.
Source: The World Bank, UN International Comparison Program, Creveling & Creveling estimates.
Which Currencies Should Expats Hold?
As pointed out above, short-term movements in currencies are unpredictable. And while long-term currency movements are driven by fundamentals such as inflation, the timing and the role that fundamentals play are also difficult to predict. Over the short-term, taking a position in a currency is a speculative bet. Over the long-term, inflation adjusted, it's a zero-sum game with high volatility along the way. Therefore, it's important to understand that currency in and of itself is not an investment like stocks or bonds, which generate cash flow and positive long-run returns.
For funding short-term goals such as emergency funds, current-year living expenses, or a known expenditure within the next few years (such as a business investment or house deposit), the best place for you as an expat to hold your savings is in the currency you intend to spend it. There's no more point in putting funds you need for a business start-up on deposit in a foreign currency than there is in investing those funds in stocks―the short-term volatility of either makes the risk that you won't have enough too high.
For longer-term goals, instead of trying to "invest" in a currency, a better approach is to ensure you match your portfolio's bond or fixed-income currency exposure with the currencies of the ongoing or future liabilities you intend the portfolio to fund. So if in seven years your child plans to attend a university that charges in USD, you should ensure that the bulk of the fixed-income assets intended to fund those college expenses are denominated in USD. You don't want to be holding AUD assets while the AUD drops by 10% against the USD just as your child gets ready to head off for university. Similarly, if your portfolio is for funding retirement living expenses in Thai baht, then you'll want to have fixed income assets in Thai baht rather than in British pounds sterling or Swiss francs.
Hopefully, this article helps to explain what's behind currency movements and what role currency should have in expats' savings and portfolios. By coordinating the currency of your funding and spending goals you can avoid one of the major mistakes expats make with their money and improve your overall financial security.
Find more articles by Peggy Creveling, CFA on Google+
About Creveling & Creveling Private Wealth Advisory
Creveling & Creveling is a private wealth advisory firm specializing in helping expatriates living in Thailand and throughout Southeast Asia build and preserve their wealth. Through a unique, integrated consulting approach, Creveling & Creveling is dedicated to helping clients cut through the financial intricacies of expat life, make better decisions with their money, and take the steps necessary to provide a more secure future. For more information visit www.crevelingandcreveling.com.
Our firm has been featured in the folowing:
Copyright © 2013 Creveling & Creveling Private Wealth Advisory, All rights reserved. The articles and writings are not recommendations or solicitations, and guest articles express the opinion of the author; which may or may not reflect the views of Creveling & Creveling.