Knowledge is Power

Currency Concerns

Over the last year, the rising cost of oil has seemed to dominate the news and play a primary role in the direction of the financial markets. The escalating price of crude oil has been a dark cloud hovering over a market that would have liked to take advantage of positive economic news. Certainly, the price of oil will have implications for consumers, on production costs and the financial markets, but another issue will have significant impact on all of those issues – the value of the U.S. dollar versus other major currencies. The dollar fell over 7% versus the euro in 2004 and nearly 5% against the yen. If you examine a longer period of time, the difference appears more drastic. Since the end of 2001, the euro has appreciated almost 37% versus the dollar. The yen – 5.7%. Not close to the significant appreciation of the euro. That may be why currency traders and investors throughout the world are beginning to make bets on Asia, anticipating the impact of a declining dollar to those currencies.

As the dollar seemed to be in a prolonged freefall against the euro, Asian central banks in countries such as Japan and China did all they could to keep their currencies down against the dollar. These actions are driven by a desire to keep their own export industries competitive on a worldwide basis. Most Asian central banks have followed the lead of the Bank of Japan. In the past when the Bank of Japan has intervened in the currency market by buying U.S. Treasuries to hold down the yen, others have made similar moves. After the first quarter of 2004, the Bank of Japan stayed on the sidelines of the currency market. That move has led many to believe that intervention may be at minimum in 2005, spurring a rally in the currencies of the Far East.

If an upward move occurs for currencies in countries such as Japan, South Korea and Taiwan, the ramifications would be felt beyond the currency market. The Asian stock market would be a benefactor of the declining dollar versus Asian currencies. Over the last few years, U.S. investors experienced increased returns as their euro denominated investments were converted back to dollars. The same effect could amplify returns of Asian stocks.

Businesses and lawmakers in the U.S. would like to see appreciation from Asian currencies, most specifically in China. To this point, China has refused to allow their currency to fluctuate against the dollar. The U.S. feels that policies such as the pegged currency have served to intensify the trade deficit with China, which ballooned to $150 billion in 2004. In order to make U.S. exports more attractive and curb the deficit, the U.S. has applied pressure through both rhetoric and policy (tariffs imposed by trade authorities) in hopes that China will allow the yuan to strengthen sooner than later. If policy does change in the future, other currencies in that region may also move higher on the coattails of the yuan. Even if the currency does appreciate up to 20% against the dollar, as some experts anticipate, low labor costs in China should allow the country to remain competitive in the global trade market.

Whether China revalues it currency or not (and it looks doubtful for the remainder of 2005), Asia appears to be a region where further appreciation against the dollar is most likely. The euro has already seen significant gains and European finance ministers would work to prevent significant upward movement going forward. The Canadian and Australian dollars have moved considerably higher since 2002 as well. Intervention has held Asian currencies (specifically the yen) down in comparison, increasing the attractiveness of those countries to their counterparts around the world. Two strategies that would capitalize on these dynamics would be to purchase companies domiciled in Asia or using international managers who have a greater focus on the Asian markets. Even if the appreciation is not realized, this kind of shift may temper a portfolio in the event of a strengthening dollar as European companies possibly surrender some of the large gains enjoyed as the Euro rallied in recent years. Just remember, even if oil continues to dominate the news, currency dynamics may have a much greater effect on your portfolio in the long run.

Sources: Baseline, Barron’s