Going Global Why understanding currency diversification within a ...

Going Global Why understanding currency diversification within a global portfolio is important for U.S.-based investors Arnerich Massena & Associates, Inc. December 2007

Contributors: Tony Arnerich Jillian Perkins Travis J. Pruit, CFA M. Lynn Spruill

© 2007 Arnerich Massena & Associates, Inc. All rights reserved. This material is for the general information of clients of Arnerich Massena & Associates, Inc. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. Past performance does not guarantee future results. This material is based on information that we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied on as such. Opinions expressed are our current opinions as of the date appearing on this material. This material may not be sold or printed for distribution without the express written permission of Arnerich Massena & Associates, Inc.

Arnerich Massena & Associates, Inc.

Going Global Why understanding currency diversification within a global portfolio is important for U.S.-based investors

Table of Contents Globalization: the impact on investors • Preparing for a global perspective • What is currency diversification?

Sidebars: • A brief history of currency • BrettonWoods and beyond • Where are we now?

The world’s major currencies • The U.S. dollar and other reserve currencies • Currencies of the Broad Dollar Index • Emerging markets growth • Fixed or pegged currencies What makes a strong currency? • Economic growth and export demand • Fiscal and monetary policy • Trade weights Current trends in international currencies • The growth of the euro • China: will its undervalued currency be allowed to appreciate? • Currency developments in the Middle East • Pressures on the dollar Diversification beyond dollars • The world is your oyster • Recommendations and conclusions



Globalization: the impact on investors The term “globalization” has been tossed about in fields from politics to agriculture. But globalization is not just a catchy word; it is a real phenomenon, with significant impact on the world of investing.We believe that the changing global environment demands a different approach to investing to accomplish our goal as investment consultants of preserving and growing the purchasing power of our clients’ portfolios. Globalization has created two major reasons for increasing the diversification of an investment portfolio outside of the United States, particularly in terms of diversifying currency, that are crucial for investors to consider now. First is the increase in international trade and growth. As free trade expands and trade protections are eased, markets outside of the United States are experiencing rapid growth, and this growth is accessible in an unprecedented way to American investors. The second reason is that the United States dollar is under unique pressures at this time. As the United States has been a world superpower, the dollar has been a “super-currency,” being held as the foremost international reserve currency, acting as the currency of choice for trading commodities like oil and gold, and acting as a stability peg for other countries’ currencies. But the rise of the euro, changes in the oil market, the United States’ troublesome debt, and the declining value of the dollar suggest that America and the American dollar are seeing a shift in their position in the world marketplace. Even with strong returns in U.S. equities, the inflationary effects of a declining dollar erode the purchasing power of earnings; retaining that purchasing power may require that we venture into the world of global investing. We believe that investors are just beginning to recognize the opportunities available in the international community and that to date, the potential depth of diversification across asset classes and currencies has often been overlooked. It is our goal to help investors think not in terms of having an international allocation in their portfolios, but in terms of creating a global portfolio. In this paper, we will begin by providing some historical background; understanding the history of major currencies will lend a context for understanding the state of major currencies today. We MSCI World Index Country Weights1

In 1972, shortly after the inception of the MSCIWorld Index (a stock index that measures developed market equity performance), the United States made up 67.5% of the index’s country weightings. Today (as of December 2006), the U.S. represents only 48.7% of the MSCIWorld Index1.This is one indicator that the shift away from an American-dominated world economy and to a global marketplace is well underway.

1972 Canada 4.4%

2006

Other 2.8%

Canada 3.5%

Japan 8.9%

Other 4.1%

Japan 10.8%

Europe 16.4%

United States 67.5%

United States 48.7% Europe 32.9%

Source: Lazard Investment Management, Inc.

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will then discuss potential ways to add a level of diversification to your portfolio through investing in different types of foreign securities such as foreign bonds, global corporations, and a wider variety of international asset classes. Preparing for a global perspective Representation is the term used in behavioral economics to define human beings’ tendency to represent the future with the present. In other words, we think things will always be the same and act accordingly. Change, however, happens regardless of how much we psychologically seek permanence. The sidebars, A brief history of currency and BrettonWoods and beyond, highlight some of the major shifts in world and economic power; these shifts are strong reminders that change and upheaval are consistent and recurrent themes of history. As today’s world economy shifts, it will take a proactive approach to overcome our natural inclinations to both see the world as unchanging and to be most comfortable investing close to home. This home bias applies to citizens of any country; comfort and patriotism inhibit investment too far abroad. But it may be particularly strong in Americans, who are accustomed to enjoying the elevated status of having dominated as world leader for nearly a century. As an economic and military superpower, both our credit and currency hold particular sway over the international economic environment. However, there are definite signs that the winds of change have arrived and to adapt, we will likely need to look past the dollar for diversification. What is currency diversification? Currency diversification for our purposes simply means buying assets denominated in foreign currencies. Those different assets represent different markets and countries and are purchased in an effort to experience different growth dynamics; spread the risk of currency depreciation, at home and abroad; and to reap rewards from currency appreciation through exchange rate differentials. Currency diversification is an active choice to achieve an additional level of portfolio diversification by investing globally. Currency diversification, in this context, is different from a currency overlay program, in which a portion of the portfolio


A brief history of currency Since the advent of money, there has been a struggle to create a universal currency standard so that trade between nations would be both possible and facile. At times, various empires have managed to establish their currencies as reigning candidates, but to date, there has never been a true universal currency. Which currencies are dominant fluctuate with global political and economic changes. The first widely-used currency was the coinage of the Roman Empire; Roman military power ensured that its currency was utilized throughout the Mediterranean region. However, as Rome consumed the land it claimed conquest over, an increasing need for money caused the Romans to begin debasing their currency. It went from silver coins to fiat money, silver-coated coins whose value relied on government decree. Eventual economic and political instability — partially caused by the currency debasement and rising inflation (which is equivalent to a tax on citizens) — resulted in the currency’s and the Empire’s demise. Medieval China’s Tang dynasty also had a long-running currency that was used throughout the Chinese Empire.Political and monetary stability made it possible for paper money to be introduced in China during the Kao-tsung dynasty of 650-683 A.D., nearly a thousand years before it appeared in Europe. (Taylor)


is engaged in currency trading as a strategy separate from international security investing. It is an inherent aspect of holding foreign assets to be also indirectly invested in the foreign currency necessary to purchase those securities; some currency diversification is a natural aspect of international investing. As an investor buys and sells a foreign currency in order to invest abroad, the exchange rates of both the dollar and the foreign currency impact investment returns. A strong dollar is beneficial when purchasing foreign currency. However, after selling securities and exchanging a foreign currency back into dollars, the return of an investment will be enhanced if the other currency has appreciated against the dollar and can thus buy more dollars. The following example outlines this process: Vodafone stock- Purchase of one share for one year 2006-2007 Dollars invested

Stock price 9/28/2006


Stock return in local currency

Dollars at 2006 exchange rate

Return with exchange to USD in 2007

Total dollars after investment

$228.39

£ 120.75

£ 176.50

46.2%

$333.84

56.2%

$356.64

Source: finance.yahoo.com If you bought a single share of Vodafone stock on 9/28/2006, it would have cost £120.75, or $228.39 at the then exchange rate. A year later, Vodafone’s price increased 46.2% and the stock share was worth £176.50. At the 9/28/2006 exchange rate, that would amount to $333.84. But if you sold your share of stock and exchanged your British pounds back into U.S. dollars, you would have earned an additional 10.0% return because the pound appreciated against the dollar during that time. Your total dollars after investment would have been $356.64.

Vodafone stock- Purchase of one share for one year 2004-2005 Dollars invested



Stock return in local currency

Dollars at 2004 exchange rate

Return with exchange to USD in 2005

Total dollars after investment

$353.07

£ 184.16

£ 163.59

-11.2%

$313.63

-19.8%

$283.03

Source: finance.yahoo.com If you bought a single share of Vodafone stock on 12/30/2004, it would have cost £184.16, or $353.07 at the then exchange rate. A year later, Vodafone’s share price decreased 11.2% and the stock share was worth £163.59. At the 12/30/2004 exchange rate, that would amount to $313.53. But if you sold your share of stock and exchanged your pounds back into U.S. dollars, your return would have been further reduced to -19.8% because the pound had depreciated and couldn’t buy as many dollars. Your total dollars after investment would have been $283.03.


However, political problems during the Yuan Dynasty created inflationary pressures and the currency failed. Bullion, gold and silver, reigned in Europe throughout the Middle Ages, with no unifying or dominant currencies. Although different nations had their own printed currencies, none were widely accepted outside of their own borders until in 1865, the Latin Monetary Union was established in France, Belgium, Switzerland, and Italy. Coins minted to the LMU standard were accepted legally by member countries untilWorldWar I. The gold standard was perhaps the closest to a unifying currency the world has ever had. Currencies were fixed against the value of gold, and a country’s gold standard currency could be exchanged for gold bullion. England was using a gold standard in the early 1700s but it did not spread to the rest of Europe until later, becoming widespread by the 1870s. The United States began to adopt a gold standard in the early 1800s. While not universal, the gold standard was widely used until World War I. The period of the gold standard was one of smooth international trading. Currency exchange was greatly simplified because of the fixed rates; furthermore, long-term prices were stabilized. However, having fixed currencies limited governments’ ability to use monetary policy to counteract short-term economic volatility.


For many international investors, historically, currency risk has been a secondary consideration; something to be aware of but not a primary concern. Foreign accounting practices or political instability have been considered the major risks associated with international investing. Additionally, with the dollar entrenched as the world’s major currency and having a long history of stability, seeking out international investments specifically to diversify currency may not have seemed particularly important to many American investors. The environment now, however, requires a new look at the opportunities afforded by diversifying across currencies. With a depreciating dollar and a number of other economies growing rapidly, in addition to the wider distribution of the world’s market capitalization, currency diversification may become a key consideration in developing a portfolio of international investments. The world’s major currencies The U.S. dollar and other reserve currencies

Britain abandoned the gold standard in 1914 because it needed its gold to fund the war effort. An attempt to return to the gold standard after the war caused economic difficulty for all countries using the pound sterling, as the currency adjusted to the inflated value of gold. The collapse of the gold standard in 1931 went hand in hand with the end of the British Empire’s hegemony and may have contributed to the economic troubles of the Great Depression. As the United Kingdom ceded its status as world superpower to the United States, the position of the pound sterling also lost its place as reserve currency to the U.S. dollar.

Since shortly after World War II, the U.S. dollar has been the foremost currency of international trading. As U.S. dollars represent the primary reserve currency, governments around the world hold most of their reserves in dollars. This has a few important effects. Commodities, such as gold and oil, are usually denominated and traded in U.S. dollars for the simple reason that it is more convenient to trade in a currency everyone holds. Because demand is always high for a reserve currency, the United States is able to borrow money at a slightly better rate than otherwise. The dollar’s status as reserve currency is one of the main reasons we are able to sustain such a large trade deficit, provided other governments are willing to continue to hold dollars. “In a very real way, the dollar has assumed the status that gold bullion used to have as a repository of value trusted worldwide. This special status gives the dollar considerable protection from the potential consequences of the huge U.S. trade deficit.” (Davis, 2004) Reserve currencies are selected by countries based on the stability and strength of the underlying economies, which historically have also often been backed by military power. At the beginning of the twentieth century, the British pound sterling was the world’s foremost reserve currency. This was a result of Britain leading the world in the gold standard, but was strongly supported by British military hegemony. The dollar replaced the pound at the same time that the United States established its military dominance through World Wars I and II. The table on the following page shows the major reserve currencies of the world and how the percentage of reserves held in each currency has shifted over the last thirteen years. The euro is clearly gaining popularity as a reserve. British pounds sterling are currently the third largest reserve currency. Up until the last few years, that place was held by the Japanese yen, but it has recently declined.



Currency Composition of Official Foreign Exchange Reserves 1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

U.S. dollars

59.0%

62.1%

65.2%

69.3%

71.0%

71.1%

71.5%

67.0%

65.9%

65.8%

66.7%

64.6%

64.2%

pounds sterling

2.1%

2.7%

2.6%

2.7%

2.9%

2.8%

2.7%

2.8%

2.8%

3.4%

3.6%

4.4%

4.5%

Deutsche mark

15.8%

14.7%

14.5%

13.8%

-

-

-

-

-

-

-

-

-

Japanese yen

6.8%

6.7%

5.8%

6.2%

6.4%

6.1%

5.1%

4.4%

3.9%

3.9%

3.6%

3.2%

3.1%

euros

-

-

-

-

17.9%

18.3%

19.2%

23.8%

25.2%

24.9%

24.2%

25.9%

26.1%

other*

16.3%

13.8%

12.0%

8.0%

1.8%

1.8%

1.6%

2.0%

2.2%

2.0%

1.9%

1.9%

2.1%

*Includes French francs, Swiss francs, Netherlands guilder, and european currency units source: International Monetary Fund

Currencies of the Broad Dollar Index There are also major world currencies that are not reserve currencies. The Federal Reserve Board considers seven currencies to be “major” and includes them in the Major Currencies Index, a subindex of the Broad Dollar Index. The currencies of the Major Currencies Index, which in addition to reserve currencies include the Canadian dollar, the Australian dollar, and the Swedish krona, are considered major world currencies because they are widely traded outside of their country of origin. The rest of the currencies in the Broad Dollar Index are part of another subindex, dubbed the OITP Index (other important trading partners). These are selected for the Broad Dollar Index based on their shares of U.S. imports and exports. (See next page.) Emerging markets growth As today’s advanced economies become a shrinking part of the world economy, the accompanying shifts in spending could provide significant opportunities for global companies. Being invested in and involved in the right markets — particularly the right emerging markets — may become an increasingly important strategic choice. (Wilson & Purushothaman, 2003)


Emerging markets economies are growing rapidly and a number of economists project that they will become larger than advanced economies within the next few decades. In a 2003 paper entitled, Dreaming with BRICs: The Path to 2050, Goldman Sachs researchers posited that “over the next 50 years, Brazil, Russia, India, and China — the BRICs economies — could become a much larger force in the world economy.” (Wilson & Purushothaman, 2003) The largest emerging market economies are often referred to as the E7: China, India, Brazil, Russia, Indonesia, Mexico, and Turkey. (Hawksworth, 2006) As emerging markets tend to experience more rapid economic growth, the currencies of these nations may present valuable opportunities for currency diversification.


Fixed or pegged currencies There are a number of emerging markets currencies that are pegged to the dollar, meaning that their countries’ governments maintain the currency at a fixed exchange rate relative to the dollar. In order to maintain a dollar peg, the country must hold a large quantity of reserves in both dollars and the local currency which it can use to manage fluctuations in the market. When the local currency appreciates, the government floods the market and brings the currency’s value down; conversely, when it depreciates, the government buys back excess currency with dollars and restores the balance. A country might choose to fix its currency in order to aid in stability. A currency pegged to the dollar won’t provide a diversification opportunity, since the exchange rate with the dollar fluctuates only slightly; however, currency regimes shift, sometimes frequently. Currencies currently pegged to the U.S. dollar include the Venezuelan bolivar (as of July 2007), United Arab Emirates dirham (as of July, 2007), Saudi riyal (as of September 2007), Qatar riyal (as of September 2007), and Lebanese lira (as of March 2007). Currencies may also be pegged or fixed, but to a basket of currencies rather than to the dollar alone. For instance, the Russian ruble is fixed against a basket that includes the U.S. dollar and the euro. China’s yuan, recently unpegged from the dollar, is now pegged against an undisclosed basket of currencies. Singapore, also, manages its dollar against a basket of currencies of its major trading partners. Some believe that a pegged currency is an intermediate step toward a floating regime, and so is likely a temporary situation. What makes a strong currency? There is no single criterion by which a currency is deemed a strong currency. The strength of a currency may fluctuate with market cycles, economic trends, and local and world politics. A variety of factors contribute to a currency’s standing in both the world market and in the markets of trading partners. A country’s economic growth definitely affects its currency, but healthy GDP growth does not necessarily translate into a strong currency. Fiscal and monetary

Currencies in the Broad Dollar Index Major Currencies Index Euro area Canada Japan U.K. Switzerland Australia Sweden

Weighting in 2007 17.6% 16.5% 9.5% 4.5% 1.4% 1.2% 1.1%

source: Federal Reserve

Currencies in the Broad Dollar Index OITP Index (other important trading partners) China Mexico Korea Taiwan Hong Kong Malaysia Singapore Brazil Thailand India Philippines Israel Indonesia Russia Saudi Arabia Chile Argentina Colombia Venezuela

Weighting in 2007 15.1% 9.6% 3.6% 2.5% 1.9% 2.1% 1.9% 2.1% 1.4% 1.3% 0.7% 1.0% 0.9% 1.0% 0.8% 0.7% 0.5% 0.5% 0.5%

source: Federal Reserve



policy, trade weights, current accounts (trade surplus or deficit), strength in exports, political stability, interest rates, and inflation — all of these play a role in establishing the value of a country’s currency. “Short-term movements in exchange rates can be extremely volatile and hard to predict, largely because speculators play a major role in day-to-day currency trading. On occasion, too, a government will intervene unexpectedly to prop up its own currency or manipulate the flow of other currencies. Still, over periods longer than one year, trends in exchange rates will reflect international differentials in trade balances, productivity growth, interest rates, and inflation.” (Davis, 2004) Economic growth and export demand Broadly speaking, exchange rates are determined by supply and demand as the world’s currencies are traded daily on foreign exchange markets. Changes in a nation’s exchange rate are closely scrutinized because they affect the relative value of foreign and domestic goods, services, and investments. As with other asset prices, the impact of exchange-rate fluctuations on mutual fund returns depends on a number of complex and interrelated factors.

A country’s economic growth affects its currency in several ways. The value of a given foreign currency relative to other currencies is based on supply and demand. A country experiencing rapid economic growth presents investment opportunities for which interested investors will purchase the foreign currency, driving up demand and appreciating the currency. However, many countries rely on export trading as a major source of economic growth, and when a currency appreciates, exports become more expensive and demand declines. For nations that depend on (Davis, 2004) exports, continued economic growth may be predicated on maintaining a cheap currency and thus providing inexpensive exports. For example, China has been accused of keeping the yuan artifically low in order to continue to export goods and services at a low price: “Even after Beijing agreed to a gradual appreciation of the yuan in 2005, China’s current account surplus has surged to record levels, fueling speculation that the currency needs to appreciate even further.” (Wingfield, 2007)


Bretton Woods and beyond From the late 1800s until World War I, international trade relied upon the gold standard; exchange rates of local currencies were fixed to gold, which served as the international reserve currency. Having this international standard of value simplified international trade, making it relatively easy and straightforward. However, after World War I, the gold standard broke down. With a great deal of flexibility in currency valuations, international trade became more complicated. There were a series of issues, such as nations manipulating a devaluation of their currency in order to sell exports and related uncertainty about the value of money.The resulting decrease in international trade may have contributed to the severity of the Great Depression. Following the Great Depression and World War II, the international community recognized the need for formal agreement and order in the international monetary system. The Bretton Woods conference, held in July 1944 in Bretton Woods, New Hampshire, included representatives from 45 different countries. The conference resulted in the creation of the International Monetary Fund (IMF), an institution charged with the responsibility of overseeing the international monetary system, monitoring economic policies, and providing advice and assistance to government and central banks. The BrettonWoods Conference also resulted in the adoption of the “Bretton Woods System.” With the United States having


Fiscal and monetary policy Fiscal policy can enhance or detract from fiscal stability, also a determinant of currency strength. For example, real GDP growth in the European Union has been relatively modest — 3.1% in 2006 (CIA, 2007) — yet the euro has been appreciating steadily against the dollar. Hans Martens, Chief Executive of the European Policy Centre, believes this is due to fiscal stability: “...looking at economic growth and job creation alone will not explain why exchange rates change in the way they do. What is required is a holistic view that takes into account the fiscal performance of the economy.” (Martens, 2006) A country’s monetary policy affects the status of the currency as well. A country experiencing high interest rates will attract investors and drive up demand for the local currency, causing the currency to appreciate. On the other hand, a risk of high inflation causes investors to worry about currency devaluation. Trade weights Trade weights, which reflect the amount of trade one country does with another, determine in part the demand for a foreign currency. The U.S. Broad Dollar Index is based on trade weights. As an example, the Chinese yuan was only 6.6% of the Broad Dollar Index in 1997 when Chinese imports were 7.8% of the total imports to the U.S. By 2007, Chinese imports had grown to 18.3% of total imports and the weight of the yuan in the Index grew to 15.1%. (Federal Reserve) Current trends in international currencies According to the International Monetary Fund Research Department, “Financial globalization, measured by gross external assets and liabilities relative to a country’s GDP, has approximately tripled since the mid1970s.” (Mauro and Ostry, 2007) Along with the increase in globalization have come changes in the currency landscape as well. Among these are the rise of the euro as an international currency, the fluctuations in the yen and yuan, developments in the Middle East, and more recent pressures on the U.S. dollar as America’s debt and trade deficit grow.


emerged as the world’s strongest economy, the international community agreed to fix their currency relative to the United States dollar,keeping their values within a narrow band of parity. The dollar continued to be backed by the gold standard, in which not only was it valued relative to gold, but could be exchanged by a bank at any time to the U.S. government for actual gold. However, dollars had the advantage of greater liquidity; thus did the dollar become the world’s reserve currency. This system was in place until the late sixties, when it became evident that there was not enough gold in the world to sustain the growth in world trade. In 1971, under economic pressure, the U.S. abandoned the gold standard and the BrettonWoods system collapsed. Since then, most major governments have had a policy of floating exchange rates, allowing them the most flexibility in terms of monetary policy. The IMF continues to serve its members with macroeconomic monitoring and crisis prevention. And the U.S. dollar continues to serve as the world’s international reserve currency, backed now by America’s force as an economic and military superpower and the convenience of tradition. There are advocates today of a universal fixed currency, as well as those who favor a completely open-market floating system. Alan Greenspan was famously in support of returning to the gold standard. (Luskin, 2003) The only certainty is that, as in the past and especially in light of shifting trends in globalization, monetary regimes are likely to continue to change. 10


The growth of the euro The European Union is the largest single economic entity in the world... Its presence in the world economy is powerful: it is the largest exporter and the second largest importer (behind the U.S.) of goods; the largest exporter and importer of services; the largest importer of energy; the largest donor of foreign aid; the second largest source of foreign direct investment... (Sapir, 2007)

The euro made its debut in 1999 as an accounting currency, with actual euros in circulation in 2002. The European Union is made up of 13 member countries; the euro is also used by several other non-member nations. The European Central Bank (ECB) and the European System of Central Banks (ESCB) manage the euro based on a set of fiscal rules established by the European Growth and Stability Pact. Before it went into circulation, the euro struggled, but since 2002 has strengthened steadily in relation to the U.S. dollar and other currencies. Economists disagree on whether having a unified currency constitutes an advantage or disadvantage for the individual countries of the European Union. It certainly restricts their ability to use fiscal and monetary policy for anything other than maintaining the strict terms of the ECB, and holding a common monetary ground while maintaining independent democratic politics is a challenge of the highest order. However, the system seems to be proving its worth, as the euro has quickly become the world’s second-largest reserve currency after the U.S. dollar.

As noted earlier, it doesn’t seem that the euro’s recent strength is predicated on economic growth in the European Union, which has been modest. Rather, the strength seems to be founded on a strong fiscal policy: “It has puzzled many that the euro within a relatively short time rose from an exchange rate of 0.85 U.S. dollar to over 1.30 U.S. dollar, not least because the U.S. economy has been performing much better than the euro-zone as [far as] economic growth and employment [are] concerned in the same period. However, in the same period the euro-zone economies have performed much better than the United States when looking at the fiscal side of the economy, i.e. the public budgets and — not least — the current accounts.” (Martens, 2006) The Economist reports that the European Union is economically powerful but lacks the will and organization to have equal strength in global politics: “Half the G-8 group of rich countries come from the EU, as do nearly a quarter of the executive board members of the International Monetary Fund.” However, “...a Brussels think tank, Bruegel, constructs a careful case that the EU is a ‘fragmented power,’ in which institutions, member governments and citizens do not agree on how to exploit or defend Europe’s economic strengths.” (The Economist, 2007) The euro-zone has economic stability and shows signs of strong and consistent continued growth; how the euro will fare compared to more rapidly growing emerging markets is uncertain.


...the U.S. dollar is no longer the world’s only real reserve currency. Although the euro cannot yet match the universality and global use of the dollar, it is a valid alternative as a global reserve currency. (Martens, 2006)

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China: will its undervalued currency be allowed to appreciate? China’s GDP is second only to that of the United States (as an individual country) and is experiencing rapid growth — 10.7% in 2006 and 11.1% in the first quarter of 2007. (Treasury Department, 2007) China managed its currency (the renminbi, of which the yuan is the major unit) pegged against the U.S. dollar until 2005, when it announced a switch to a floating exchange rate. Officially, the renminbi was to be managed against a new basket of undisclosed currencies, but in fact has remained closely tied to the U.S. dollar. This has caused concerns: “China’s tightly managed exchange rate regime is a substantial obstacle to the resolution of economic imbalances that foster China’s high savings, high investment, and large trade surpluses.” (Treasury Department, 2007) China’s current account surplus is at a record $249.9 billion in 2006 (Treasury Department, 2007) and the current sentiment is that the Chinese renminbi is significantly undervalued relative to the dollar.

GDP of the 15 largest economies Country

GDP (U.S. $B)

U.S.

13,130

European Union

13,060

China

10,170

Japan

4,218

India

4,156

Germany

2,630

U.K.

1,930

France

1,891

Italy

1,756

Russia 1,746 It has been suggested that this is due to a purposeful manipulation, orchestrated to keep the yuan artificially low and thus continue to grow Brazil 1,655 China’s booming export trade. Forbes magazine reports: “On Capitol South Korea 1,196 Hill, Sens. Charles Schumer (D-N.Y.) Canada 1,178 and Lindsey Graham (R-S.C.)... [have “Will all this turn the been] arguing that China has continued Mexico 1,149 yuan into a super- to manipulate its currency and engage in Spain 1,109 currency soon? No, but illegal trade practices in the past two years, Data based on purchasing power parity (this means to be a true global player and that stronger action on the part of the that foreign currencies are expressed in dollars not according to their actual exchange rate, but accordyou need economic power, administration to bring China into line in ing to their ability to purchase a comparable basket of global ambitions, and the order to protect U.S. workers.” (Wingfield, market goods.) willingness to trade your 2007) Although Chinese officials state that source: Central Intelligence Agency currency freely. China has they are working to correct the imbalances, the first two requirements the process has been slow. “While China has in spades. Slowly, it is taken some steps to increase the flexibility of the renminbi, the pace of appreciation that the authorities have allowed is much too working on the third.” slow and should be quickened.” (Treasury Department, 2007) If the Chinese do begin to (Bremner, Dawson, Shameen, Ihlwan, 2005) manage their currency floating on the open market, it may propel China’s economy even further to the forefront of the world’s stage.


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Currency developments in the Middle East The Middle East, because of the oil trade, has a strong influence in currency markets: “Saudi Arabian and other Middle Eastern investors pack a punch in currency markets that is disproportionate at times to the thin slice of global foreign exchange reserves they hold.” (Parry, 2003) One of the reasons the dollar holds such prominence as a reserve currency is that commodities such as oil are priced and traded in U.S. dollars. However, Bloomberg reports that Iran, the world’s fourth-largest oil exporter, has begun to trade oil in other currencies, particularly euros: “The Tehran Times said today Iran has started substituting euros for dollars in oil sales, citing an unidentified person at the Oil Ministry. Iran Daily reported Iran wants to cut its dollar-based transactions to a minimum, citing Minister of Economy Davoud Danesh-Ja’fari.” (Wolfensberger, 2006) There are rumors of the possible opening of an Iranian oil exchange that uses euros to trade oil, but the various scheduled launches have not yet materialized. Further, when Kuwait unpegged its dinar from the dollar in 2007, there were rumors that other Middle Eastern nations, such as the United Arab Emirates, would follow suit. The Gulf countries are looking at developing their own currency, with an arrangement similar to that in the euro-zone. “The six Gulf Arab monarchies of Saudi Arabia, the United Arab Emirates, Kuwait, Qatar, Oman and Bahrain plan to form a single currency by 2010.” (Sharif & Brown, 2007) If this move is successful, it may further dilute the dollar’s position in the oil markets, as well as reduce demand for reserve dollars. Pressures on the dollar The dollar has been depreciating for several years against many of the world’s major currencies, including the euro, yen, and yuan. A depreciating dollar increases the risk of inflation; as the dollar is worth less and less versus foreign currencies, imports cost more and more.While depreciation makes our exports less expensive and drives up demand, the U.S. only exported $1.4 trillion in goods and services in 2006, whereas we imported $2.2 trillion in goods and services. (U.S. Census Bureau, 2007) With the size of the U.S. import trade, the inflationary impact of a depreciating dollar may be difficult to contain. Also, the pressure on the world’s foremost reserve currency is mounting as the United States continues to set records in its trade imbalance and national debt. One of the biggest questions is whether the dollar can maintain its status as a reserve currency under the weight of these twin deficits. As dollars lose value, the international community will likely want to hold fewer and fewer of them. The subsequent question is whether the dollar will experience a “soft landing,” in which a slow depreciation along with an increase in exports and lowering of the trade deficit ultimately balance out, or whether a “hard landing” will cause recession and other economic troubles for the United States. Joseph Davis, Ph.D., an investment analyst with Investment Counseling and Research, favors the soft landing theory: “This process will takes years, not weeks, and so will be accompanied by a secular depreciation in the U.S. dollar that should be generally beneficial to both the U.S. and global economies.While this more pallid long-run scenario is still bearish for the U.S. dollar, it surely need not be so for insitutional and individual investors holding portfolios well diversified not only among asset classes, but also between domestic and international mutual funds.” (Davis, 2004)


13


Currencies that have recently unpegged from the U.S. dollar Argentine peso

2001

Egyptian pound

2003

Chinese renminbi 2005 Malaysian ringgit 2005 Kuwaiti dinar

2007

Syrian pound

2007

Further, a number of countries have shifted their currencies from a dollar peg to a managed float regime. As part of this shift, those countries will need to hold fewer dollars as reserves. Some suggest that this may be a negative sign: “Global central banks’ ongoing reserve diversification has been a main factor weighing on the U.S. currency and Treasury market in recent years. Many people argue because foreign central banks have played a vital role in financing U.S. borrowing by buying U.S. debt, a diminished appetite for dollar-denominated reserves could have a significantly negative impact on the dollar and the U.S. economy.” (Zhou, 2007) These issues should serve as a warning to investors. As events continue to develop and unfold, currency diversification will only become more important. An investment portfolio that includes a significant international component will be better prepared to take advantage of future global growth and weather shifts in the exchange market.

Where are we now? The 2006 NACUBO Endowment Study found that higher education endowment funds held an average of 17.9% of their portfolios in non-U.S. securities: 12.8% in developed equities, 3.9% in emerging equities, and 1.2% in international fixed income securities. (NES, 2007) Of the largest 200 pension plans in the Pensions & Investments 2006 survey, international equities made up 18% of their asset allocations. Corporate plans had a slightly higher allocation — 19.2% — compared with public plans at 18.3% and union plans at only 10.6%. (O’Connor, 2007) Two of the largest collectors of 401(k) participant data — the Employee Benefits Research Institute and the Vanguard Group — do not separate international equities from the equity asset class when reporting participant-directed asset allocations. This probably suggests that the percentage of participants’ assets invested internationally is likely quite small; we estimate it at between 10-15%. The pie charts on page 3 show the makeup of the MSCI World Index. In 2006, the U.S. made up less than half of the index; the United States represents less than half of the world’s market capitalization. But it is common to see investment portfolios in which U.S. securities make up 70, 80, 90, or even 100% of the portfolio. Our research suggests that a weighting of 20% or less to international securities may not be sufficient to capture the broad range of growth opportunities available, as well as manage market risk and currency risk.


Diversification beyond dollars The world is your oyster We believe that expanding investors’ horizons to include global perspectives will increase the opportunities for risk management, diversification, return premium, and growth, as well as help to maintain the purchasing power of assets in an inflationary environment.We also believe that currency diversification is particularly important at this stage in U.S. history but that guidance on the subject is limited at best. At this time, the most important goal for an investor is to maintain an open mind and strive to look at global investing objectively. A bias toward U.S. investments is natural for U.S. investors, both because of a certain degree of nationalism and because the United States has been a dominant world force for such a long time. And while

14


it is possible that the United States could retain some of its economic power with strong leadership and economic policies that address our deficits, a broader outlook for investors takes advantage of growth opportunities outside of the country while hedging against the risk that the U.S. dollar may be facing a struggle. Recommendations and conclusions How do we recommend achieving a global portfolio? Given that everyone has individual goals and investment requirements, we would recommend giving careful consideration to what will be most appropriate for any given portfolio. Again, key at this point is an open mind and the willingness to consider opportunities as they become available. However, the following are a few strategies we believe would be well worth consideration in incorporating currency diversification into an investment portfolio: •

Be open to increasing your portfolio’s international allocation. For many of our clients, we are recommending allocations of up to 50% in international and global securities, depending on their individual situations.

•

Consider overweighting your portfolio in U.S. large cap. Many U.S. large cap funds incorporate global multinational companies. An overweighting to U.S. large cap in a portfolio may help capture some of the domestic growth to come out of the globalization trend, without currency risk.

•

Broaden your international asset classes. Most investors separate their domestic equity portfolio among large cap, small cap, and other sub-asset classes. Consider including large cap international, small cap international, and even international specialty funds.

•

Include foreign bonds. This may be an excellent method for achieving currency diversification while minimizing risk.

•

Include emerging markets. “In our base projections, the E7 economies will by 2050 be around 25% larger than the current G7 when measured in dollar terms at market exchange rates (MER), or around 75% larger in PPP [purchasing power parity] terms. In contrast, the E7 is currently only around 20% of the size of the G7 at market exchange rates and around 75% of its size in PPP terms.” (Hawksworth, 2006) That’s a great deal of potential growth.

•

Consider currency diversification opportunities in private equity and real estate investments.

It is our hope that the information in this paper serves as a spark to ignite conversation with your consultant. Our job is to look ahead for our clients and address trends and events that may influence their investment strategies. We believe that globalization is having a significant impact on the world’s markets, changing the risks and presenting opportunities. By providing education to our clients, our primary goal is to open the door to a dialogue about specific ways to take advantage of these market trends and changes.


15


Endnotes: 2006 NACUBO Endowment Study; National Association of College and University Business Officers and TIAA-CREF, January 22, 2007 Carry on Living Dangerously; The Economist, February 8, 2007 China’s Currency Problem, by Brian Wingfield; Forbes.com, May 3, 2007 Currency Composition of Official Foreign Exchange Reserves (COFER), International Monetary Fund Currency Risk and the U.S. Dollar by Joseph H. Davis, Ph.D.; Journal of Financial Planning, March 2004 Currency Weights: Broad Index of the Foreign Exchange Value of the Dollar; Federal Reserve Statistical Release, January 2, 2007 Dreaming with BRICs:The Path to 2050, Global Economics Paper No: 99, by Dominic Wilson and Roopa Purushothaman; Goldman Sachs, Inc., October 1, 2003 Euro-Dollar - A Holistic View of The Economy by Hans Martens; paper presented at The Euro and the Dollar conference organized by the Jean Monnet Chair of the University of Miami with the support of the European Commission, April 25, 2006 The Evolution of Exchange Rate Regimes Since 1990: Evidence from De Facto Policies by Andrea Bubula and Ínci ÖtkerRobe; International Monetary Fund Working Paper, September 2002 Foreign lands look good to investors by Cecily O’Connor; Pensions & Investments, January 22, 2007 Fragmented Power: Europe and the Global Economy, edited by André Sapir; Bruegels, July 2007 Gold Standard by Michael D. Bordo; The Concise Encyclopedia of Economics Greenspan Comes Home to Gold, by Donald Luskin; National Review, January 31, 2003 Hegemony and Decline: Britain and the United States by Andrew Gamble in Two Hegemonies: Britain 1846-1914 and the United States 1941-2001 edited by Patrick Karl O’Brien and Armand Clesse; Aldershot: Ashgate Publishing, Ltd., 2002; pp. 127-140 A History of Universal Currencies by Dr. Bryan Taylor; Global Financial Data Indexes of the Foreign ExchangeValue of the Dollar, Federal Reserve Bulletin 2005 Iran May Reduce Use of Dollar,Tehran Papers Say by Marc Wolfensberger; Bloomberg.com, December 6, 2006


16


Kuwait ends dollar peg, pressuring region to follow by Arif Sharif and Matthew Brown; Bloomberg.com, May 21, 2007 Kuwait unhooks dinar and dollar, signaling a possible trend, by Wanfeng Zhou; MarketWatch, May 21, 2006 Lebanese Pound to Stay Pegged to Dollar, Central Banker Says by Massoud A. Derhally and Dania Saadi; Bloomberg, March 6, 2007 Mideast accounts help drive euro’s rise and fall by John Parry; Forbes.com, July 17, 2003 Overweight but underpowered; The Economist, September 6, 2007 Report to Congress on International Economic and Exchange Rate Policies, U.S. Department of the Treasury, June 2007 Riyadh rules out revaluing currency; The Peninsula, Qatar’s Leading English Daily, September 27, 2007 Saudi Plans to Keep Riyal Pegged to the U.S. Dollar, King’s Adviser Says by Arif Sharif and Zainab Fattah; Bloomberg, September 20, 2007 UAE rules out dirham revaluation in ‘foreseeable future’ by Shakir Husain; Gulfnews.com, July 6, 2007 U.S.Trade in Goods and Services- Balance of Payments Basis; U.S. Census Bureau, Foreign Trade Division, June 8, 2007 The Venezuelan Economy in the Chavez Years by Mark Weisbrot and Luis Sandoval; Center for Economic and Policy Research, July 2007 What is the IMF, International Monetary Fund, September 2006 Who’s Driving Financial Globalization? by Paolo Mauro and Jonathan D. Ostry; IMF Research Department, August 16, 2007 TheWorld Factbook; Central Intelligence Agency, August 16, 2007 The World in 2050: How big with the major emerging market economies get and how can the OECD compete? by John Hawksworth; PricewaterhouseCoopers, March 2006 The Yuan Grows Up by Brian Bremner, Chester Dawson, Assif Shameen, and Moon Ihlwan; Business Week, August 8, 2005


17

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