Stanislav, now an analyst on our Canadian equity team, was fifteen when his family decided to move from Kazakhstan to Russia.
A tall, thin boy with dark hair and a focused expression, he belonged to a family of Russian restauranteurs.
Growing up in post-Soviet Kazakhstan and later Russia, Stanislav received an education in money that would seem alien to North American children. As a child, he overheard stories of shortages in currency, rapid inflation and people’s savings becoming worthless overnight due to valuation. It was not uncommon where he lived for people to buy electronics and food (whatever was available) as soon as they were paid because no one wanted to risk keeping it in savings. Few trusted that money would keep its worth in the future…because it rarely did.
As Stanislav recounts in one story:
“I remember that my family never played the lottery but one time my mother did and she won, to our surprise.
The crazy part was that the amount printed on the ticket was meant to be a big sum, enough to buy a refrigerator, but since it coincided with a period of rapid devaluation, the ticket became almost worthless by the time my mother received it.
She said it was not even worth the trouble to cash it in because of its meager value and the trouble of doing so.”
Imagine winning the lottery and not even bothering to cash it in because it wouldn’t be worth your time! That’s quick erosion of purchasing power.
Currencies play a major role in our lives. They impact what and how much we can buy, how we think about savings, and even where we go on vacation. Currencies impact us day-to-day and over the long run. And as the experience of post-Soviet Russia illustrates, they can have a big impact on our lives at times.
Unfortunately, the topic of currency is also one in which there is a great deal of confusion and indifference. Many people think about currency risk about as often as they do their appendix, i.e., never, unless there is a problem. And even those who do care about currency risk often struggle to wrap their heads around the topic given its complexity.
However, currency risk is important enough that everyone should have some understanding of it. It is important to know what it is, the ways it can impact us, and what, if anything, we can do about it.
Currency Risk
Coincidentally, the year that Stanislav’s family moved to Russia was also the year of Russia’s 1998 financial crisis. In 1998, Russia’s economy was in a precarious position. At the time, Russia maintained a fixed exchange rate, and was struggling to maintain it at its lofty levels. Chronic fiscal deficits and low productivity undermined the country’s creditworthiness and stalled growth. Meanwhile, foreign exchange (FX) reserves were running painfully low, a result of the 1997 Asian financial crisis and a global weakening of crude oil prices. The situation was worsened when President Boris Yeltsin suddenly dismissed PM Victor Chernomyrdin and his entire cabinet on March 23, 1998, sparking a political crisis and further inflaming investor concern.
Capital began to flow out the country, gradually at first and then at an alarming rate. The central bank of Russia soon found itself unable to keep the ruble propped up and, on August 17, 1998, was forced to accept a massive devaluation. The ruble fell over 50% and Russia defaulted on most of its debt. As a result, inflation soared to over 80% for many goods. Asset prices collapsed. Overnight, it became much more costly to live in Russia.
Russia’s 1998 financial crisis is a good example of the potential pain that can be caused by dramatic shifts in exchange rates. When currencies fall precipitously, individuals lose their purchasing power, many companies go bankrupt because they can no longer pay their foreign-denominated debt, and countries can fall into recession. Conversely, when currencies spike dramatically, companies can become uncompetitive globally because similar foreign companies become cheaper to do business with, individuals can lose jobs, and whole industries can be hollowed out. In short, sharp moves in currency often bring about painful adjustments.
This is currency risk: the potential loss due to shifts in exchange rates. Theoretically, currency risk is the probability of any event that causes pain or loss because of fluctuating exchange rates. It could relate to the risks faced by an individual, a company or a country. For the purposes of this discussion, we will focus solely on the risks that can accrue to the individual.
Currency risk can negatively impact individuals in two important ways: (1) the loss of purchasing power, and (2) the impact on one’s investment portfolio. We have already seen the devastating results that can be caused from the loss of purchasing power in the example of 1998 Russia (and, as Canadians, we know how painful a low Canadian dollar can be when we want to plan a trip to the U.S.), so let’s take a closer examination of how it can affect an investment portfolio.
Let’s imagine that at the start of 2015 you, a Canadian investor, owned a portfolio comprised of equity investments in Canada, the U.S., and the U.K. Assuming an annual return equal to the index for each investment, your portfolio would have looked like this were the impact of currency to be excluded” :
Clearly, the quotational impact would be significant. In 2015, the dramatic fall in global commodity prices drove the Canadian dollar lower relative to the U.S. dollar and the British pound. An investor would have benefited from investing in U.S. and U.K. equities, in part because the returns generated in these markets outperformed the performance of Canadian stocks, but also because the U.S. dollar and the British pound outperformed the Canadian dollar.
Since currency fluctuations can have an impact on our portfolios, and more importantly, can constitute a risk to our purchasing power over time, how can we go about managing our exposure to exchange rates?
Know Your Ingredients
Just as a chef is much more likely to concoct a new recipe that is flavourful by understanding how ingredients work together, an investor will be materially better served by understanding some of the fundamentals of how exchange rates work.
In our team’s experience, it is helpful to view currency markets as systems: they have underlying structures, they contain players, and they are impacted by events. They even have forces that interact to drive the outcomes (price levels) we see.
The currency market system is both massive and decentralized. It is by far the largest market system in the world, dwarfing stock and bond markets in comparison (the market for USD is 27x larger than the U.S. stock market).1 At the same time, it is decentralized; there is no one global currency bank that clears all currency transactions. Instead, currency transactions happen among millions of players, all over the world.
Another observation we can make on this system is that it iscomplex. The currency market system is made up of millions of interactions. The agents that participate in this system include banks, corporations, investment funds, hedge funds, and central banks, among others. These players have their own individual purpose for transacting and usually hold a unique viewpoint on the market.
This system is also adaptive. Actors in the system react to other micro events that occur and also react to what other actors do. This results in collective and emergent behaviour. As an example, consider the adaptive qualities that emerged in the 1998 Russian financial crisis. When investors saw that capital was starting to flow out of Russia, many became nervous that the country would have a currency crisis. In turn, they began to sell their investments which put further pressure on the ruble, thereby increasing the likelihood of an actual crisis.
In summary, the currency market system is massive, decentralized, complex and adaptive. These important characteristics influence the way we must think about the system.
