February 22, 2011

Natural disasters are no laughing matter, for sure. By any measure, the floods experienced around the world in the past year have been pretty horrible. Pakistan, Brazil, and Australia in particular have suffered immensely.

Sadly these are not the only floods occurring. Capital from “rich” Western countries – especially the USA – has been inundating some of the more dynamic emerging and smaller economies in the past year as well. As investors buy into these countries, the resulting currency appreciation directly reduces the country’s export competitiveness. Their citizens may not be stranded on their rooftops, but it feels like a natural disaster in their wallets. Again, no laughing matter. Therefore, a government who finds themselves in this situation needs to balance the positive impact on the development of local capital markets versus the ill effects of the impact on their currency.

La Niña is the term describing the unusual warming in parts of the Pacific Ocean leading to potentially devastating rainfall patterns in surrounding regions. Quantitative easing is the analogous phenomenon at the heart of potentially devastating investment patterns. There may be numerous other factors in each situation, but these are the main culprits. Practically speaking, what is the most effective course of action for those in potentially affected areas?

For rain-related floods, the answer throughout history has been to invest in water management infrastructure even though this can be quite costly to build and maintain. Perhaps there are ways to spread the costs, but basically this is a question of insurance. Since not everybody can afford insurance, some countries are compelled to take the risk.

Countries on the receiving end of unwelcome floods of capital are dealing with the situation in a variety of ways. First, they are increasingly vocalizing their displeasure at US and any other “rich” countries propping up their own economies with measures that have fairly predictable negative outcomes for less well-off countries (sparking the term “currency wars”). The rest of their actions vary between direct interventions in the foreign exchange currency markets to slow the rate of currency appreciation, regulation or measures which are effectively taxes on foreign investment.

One suggestion to governments in this predicament (and this is simplistic for illustration purposes) is to compel certain foreign capital investors in their country, above a certain threshold, to hedge the full investment plus expected profits with forward contracts at the time of investment. There are multiple rationales:

1. The forward contract entails selling the local currency at the same time as it is bought, so the net effect on the FX ‘spot’ rate is zero. This addresses the issue of currency appreciation due to supply and demand factors.

2. If a large project seeking government approval expects to be profitable, the government presumably has the right to know what will be the fate of those expected profits. If they are to be repatriated, then the forward hedging of those profit streams back to the foreign country would result in a net selling of the local currency, weakening it all things being equal.

3. Mandatory forward hedging would also send a signal to would-be speculators that potential surges in FDI flows will not on their own result in an opportunity to make off with short-term profits while the actual investors remain.

4. One dilemma a government is faced with when raising interest rates to control inflation is it may lead to their currency being more attractive to foreign investors which can then conflict with the exchange rate agenda of trying to avoid excessive currency appreciation. Mandatory forwards would reduce this conflict, leaving the government to focus on balancing the positive effects a strong currency can have in reducing imported inflation versus the reduction in the country’s export competitiveness.

5. Other methods include deter investment by imposing some form of financial penalty (whether posting a huge margin with the central bank at 0% interest rates or by a simple levy), whereas a forward contract is a market-based instrument that can be competitively sourced and valued. It isolates the investment from the currency effects.

A Governments policy in relation to their exchange rate may influence the FX strategy chosen for an investment, particularly in emerging and frontier markets. Please call Chatham if you would like to discuss the intricacies of hedging in these markets.