Currencies: The investment theme of the next decade?

Introduction

For over a year now, budgetary and public debt issues faced by some European countries deteriorate relations within the Euro zone. Apart from Greece, this crisis has shamed the entire euro zone resulting in a loss of confidence in its own currency from the rest of the world. The debt crisis has thus turned into a euro crisis and painfully reminded us that a monetary union such as ours is fragile and that adherence to its dogma is not granted, but more of a constant leap of faith that rests on the Pact of Stability and Growth. Admitting that today more than ever, trust is key for a fiat money such as the euro, European leaders have happily concluded this year in March a "Pact for the euro" in order to strengthen our economic governance model.

As the 21st century will likely be the scene of a bitter struggle for monetary leadership, and despite acquired international markets’ recognition, the euro will have to fight to maintain its status of second international reserve currency after the U.S. dollar... and maybe one day, after the Chinese Yuan. Since the "subprime" crisis, the U.S. dollar’s supremacy has indeed been challenged while the international monetary system could start a new chapter of its history with the G20, which has made its reform one of its main objectives. G20 leaders are facing the same challenge as the euro zone, which is to increase the international monetary system’s stability so that it cannot be jeopardized by one country’s monetary, fiscal or exchange policies. To achieve this goal, they will promote a smooth transition towards a more diversified international monetary system that better reflects the global economic situation. To understand our monetary system and current foreign currencies related issues, a quick review of past events is essential.

The international monetary system from Antiquity to the present day (see Graphic)

Since ancient times, global supremacy of a currency has always been linked to the issuer country’s economic (and often military) power, but also this country’s ability to protect the currency’s real value by keeping a low and stable inflation.

While modern Greece is going through a bad patch, ancient Greece knew a period of glory between the 5th and 1st century before our era, and its currency, the silver drachma was probably the first to have an international status. Greece was however challenged in early AD by the Roman Empire which, by dint of military conquests, managed to impose its own currency, the gold aureus. In the third century AD, increasing inflation in the Roman Empire led the aureus’ reign to an end, making it a mere commodity, which trading was now only based on its weight and not more on its face value. The Byzantine solidus took then the lead until the 12th century, when the Florentine florin ruled until the end of the Renaissance.

In the 18th century, the Netherlands’ importance in terms of trade and finance is such that the Dutch guilder is the new widely distributed reference currency, especially at a time where the use of bills is spreading. It was in response to the increasing use of fiat money, that central banks began, in the early 19th century, to accumulate gold as a reserve and came up with the gold standard principle, by guaranteeing some commercial papers’ convertibility. The 19th century also coincided with the heyday of the British Empire, which became the first global trading player thanks to the development of its industry, and giving de facto the pound sterling an international status, the currency being then used in more than 60% of global trades.

The beginning of the First World War, however, marks the end of the supremacy of the pound, which has now to deal with the French franc, the Deutsche Mark and last but not least, the U.S. dollar in 1920. A multipolar international monetary system appears, built on the gold standard (first Gold Exchange Standard decided under the Agreements of Genoa in 1922). It does not stand long however, because the Great War is very expensive and many countries find themselves unable to ensure the gold convertibility of their currencies. The depression of 1929 found fertile ground in this fragile international monetary system and most importantly, brought an end to the Gold standard, since many countries decided to formally suspend the convertibility of their currencies into gold. With the victory of the allies during the Second World War, the U.S. became the world’s first economic and military power. Aware of their responsibilities, they decide in 1944 to organize a world conference supposed to lead to the establishment of a monetary system that would be a solid base for the reconstruction and the economic expansion of the free world. The conference gave birth to the Bretton Woods monetary system, which reinstates a "Gold Exchange Standard" based this time on a single currency, the U.S. dollar. All currencies are henceforth set in dollars, based on a fixed exchange rate, while only the dollar is set in gold, on the basis of 35 U.S. dollars per ounce of gold, which forces the United States to maintain the "real" value of their currency.

This system will last until the early 70s, when the United States are forced to "use the printing press" to finance two major achievements, those of Vietnam and Space. The abundance of dollars fuels inflation around the world, causing distrust vis-à-vis the dollar and requests for conversion of it into gold. Fearing to see their gold reserves disappear, the United States suspend the convertibility of the dollar, which shattered the system of fixed exchange rate, and gives way to a floating rate system as we know it today, only governed by markets’ forces and in which the dollar remains omnipresent

A new international monetary system

It was not until the late 90s that a first serious challenger, the euro, appeared to compete with the dollar on the international monetary system. However, despite the fact the euro managed to capture an important "market share" (see Figure 1), it is now facing its own weaknesses with the debt crisis raging in the European periphery, and therefore cannot fully play its role as an alternative to the dollar.

The latter still represents 60% of global foreign exchange reserves, despite the fact that it has depreciated by nearly 97% [1] since 1944 and that the United States floods the world once again with dollars, widening their deficits to stimulate their economy via the consumption channel. More than ever, the current situation reminds us of United States Treasury Secretary, John Connally’s and his famous quote in the early 70s: "The dollar is our currency but it is your problem".

The international monetary system is therefore in need of a new reform, so that it is more stable but also so it better reflects the reality and diversity of global economic as it has historically always been the case. But today’s global economic reality is the rise of emerging markets and China in particular (see Chart 2).

In this context, the World Bank estimates that a multipolar international monetary system, including the dollar, the euro and the Yuan could emerge by 2025, if China was to agree to let its currency move freely while opening its markets to foreign investors. If such concessions would have seemed unthinkable until recently, China now seems to show more flexibility on the matter. In June 2010 the country loosened the Yuan peg against the dollar while it now allows multinational companies operating on its territory, to issue bonds directly in Yuan to finance their local operations. These changes are still slow and the few percent the Yuan gained against the dollar seem very reasonable in regard of an undervaluation that some estimate to be about nearly 40% [2], but this trend could accelerate in the coming years with the application of the Chinese 12th Five-Year Plan. This plan aims to emphasize "quality" over "quantity" of growth, and the country’s transition from a business model based on "all export" to a model relying more on the domestic market’s strength, by letting the Yuan appreciate.

The Yuan appreciation is undoubtedly a detail considering the fact that the awakening of the Chinese consumer, generated by the increased purchasing power, will have an economic impact that will extend far beyond the borders of China. The country has indeed became the largest trading partner of many countries, from Asia to Latin America, and Chinese concessions regarding exchange rates could cause turmoil in the developing world.

Currencies as an asset class

The currencies environment is currently evolving, which leads to increasing hedging needs for many economic agents, raising investors’ interest and generates a significant increase in daily traded volumes on foreign exchange markets (see chart 3).

The reason investors are increasingly interested in currencies is that foreign exchange markets are still relatively inefficient, understanding that more than half of all trades are done for hedging purposes and not to get a return. Thus they can more easily focus on these markets’ potential yield, which in addition to being attractive, also have the advantage of having a low correlation with other asset classes’ returns [3].

Although highly liquid and offering low transaction costs, these markets have long been neglected by specialist investors such as hedge funds and it is only in recent years that the range of products to address these markets developed. ING Investment Management thus offers funds regulated by Luxembourg laws that unlike many hedge funds have both great transparency and better guarantees in terms of diversification. Beyond the investment vehicle, there are of course various themes of investment opportunities with foreign exchange. Revaluation of emerging markets’ currencies is certainly one of the most promising areas to the extent that they should play an increasingly important within the international monetary system, during the next two decades. While this issue seems to be a rare opportunity, it should not however hide the potential of other themes such as "carry trade" or the use of differential economic fundamentals, which can be addressed simultaneously. Whatever the theme, we believe today that a currency exposure is an added value for any long-term investment.