TAKE NOTE COVER STORY
A World of Currencies
Many of the world's major currencies have experienced large swings in value over the past two years. Our investment professionals explain the latest trends and what they mean for the world's leading currencies—as well as the possible impact on your portfolio.
The U.S. dollar, long the world's primary reserve currency, recently reached its lowest level against the Japanese yen since World War II. And the European debt crisis has the potential to send the euro on a decline of its own. The weakness of these two currencies and the ascent of China's economy have opened the door for the Chinese yuan, which many analysts expect to join the dollar and the euro as one of the world's reserve currencies by decade's end.
Investors may hold different currencies through stocks and bonds that trade internationally. T. Rowe Price's fund managers closely monitor currency risks and trends, while maintaining a careful focus on the fundamentals that could affect economies, sectors, and their holdings. Their teams monitor factors such as capital flows, inflation forecasts, trade policies, and interest rate projections. Managers use that information to project how currency values are likely to change—and how those changes are likely to affect the values of foreign assets for U.S. investors.
The Dollar's Future
The dollar has long dominated world currency markets. Oil, copper, and nearly every other internationally traded commodity are almost exclusively valued in dollars. And, as of April, 60% of the world's foreign exchange reserves consisted of dollars, compared with 27% held in euros and 4% in yen. But the dollar has been gradually weakening, prompting questions about whether it will lose its dominance in the next 20 or 30 years.
Several short- and long-term trends have contributed to the dollar's decline. In recent years, foreign institutions made efforts to diversify away from the dollar in the wake of the U.S. financial crisis, which was followed by a long period of low interest rates and slow economic growth that further eroded the dollar's value. At the same time, emerging market economies grew, which boosted their currencies relative to the dollar and other developed markets' currencies.
T. Rowe Price analysts believe that the U.S. dollar's value will continue to decline relative to foreign currencies over the long term. Foreign governments have begun—and are likely to continue—to diversify their currency exposure by moving some of their reserves into currencies other than the dollar. And strong economic growth in emerging markets will likely continue to strengthen the currencies of those countries, according to Ju Yen Tan, a London-based portfolio manager with T. Rowe Price International.
Ultimately, however, the dollar's decline is likely to continue at a manageable pace that will not soon challenge its status as the world's dominant reserve currency. The history of foreign reserves held in U.S. dollars shows that, adjusted for foreign exchange rate moves, the proportion of foreign institutional reserves has declined only modestly. Moreover, there are few signs that foreign governments are becoming cautious about the dollar. Notes Tan, "Dollar—denominated U.S. Treasuries remain the global premium low-risk asset, with none of the barriers to entry that foreign investors often face when buying the debt of countries like China and Brazil."
The Weakening Euro
The euro has lost 20% of its value against the U.S. dollar since its peak in 2008 and, according to T. Rowe Price relative valuation models, still appears to be modestly overvalued on a trade-weighted and historical basis. In practical terms, this means that the euro needs to correct further to make European goods cheap enough to spur significant external demand. Moreover, T. Rowe Price analysts believe that a European economic recovery will require a weaker euro.
European countries have very diverse economies with varying degrees of efficiency. All of those economies stand to benefit from a continued decline in the euro, which would allow foreign consumers to buy their goods more cheaply. German manufacturers, for example, are among the most competitive in the world and are already benefiting from the weaker euro, especially in consumer goods sectors such as luxury cars.
Conversely, several other countries—among them, Greece, Italy, Spain, Portugal, and, to a lesser extent, Ireland—suffer from a severe lack of competitiveness due to lower productivity, rigid economic structures, and relatively high wages. If these nations had their own currencies, those currencies would have experienced significant devaluations. As things stand, the euro will have to fall further to make goods and services from these nations more competitive, in turn spurring improved foreign demand.
The Euro in Danger?
The euro is likely to continue to correct moderately against the U.S. dollar over the next six to 12 months. At the same time, we do not anticipate that the euro will collapse and see the euro as retaining its status as the most widely used currency in trade exchanges across the world.
Ken Orchard, T. Rowe Price's sovereign credit analyst, believes the euro will remain supported, given that troubled countries will be able to restructure their debt. Portugal's debt likely will be addressed sometime between 2014 and 2015, with no further actions afterward. In addition, any restructuring will not produce the same levels of uncertainty seen in the markets last year during talks over the Greek debt.
However, political turmoil and unpopular fiscal austerity measures in Greece or the other peripheral nations could trigger renewed breakup fears if new governments were elected into power and threatened to drop out of the eurozone. In this scenario, Orchard believes there would likely be a flight to quality from the bonds of periphery nations to the bonds of core European nations such as Germany. This would likely prompt European leaders to try to relieve bank-funding stresses and restore market order by injecting more money into the financial system. Survival of the eurozone at this point would depend on political solidarity between the periphery and the core nations. The euro would likely fall in value, as investors would be wary of holding the currency during any uncertainty surrounding the eurozone.
The Yuan's Ascendency
The weakness of the dollar and the euro has created an opening for the Chinese yuan to emerge as a global reserve currency. China's leadership has supported its economic growth for decades by keeping its currency low against the dollar so that Chinese-manufactured goods would be very competitive on world markets. Now, China has gradually begun to let its currency float, leading to a 30% gain of the yuan against the dollar since 2005.
The emergence of the yuan as a global reserve currency would have far-reaching effects for both the world economy and investors. But most estimates suggest it will take some time for that to happen. History indicates that changeovers in world reserve currencies are rare and occur gradually. The dollar eclipsed the British pound, but only after the U.S. surpassed that of Great Britain. China's economy is about half the size of the U.S. economy—although it is catching up rapidly.
For the yuan to become a reserve currency, China also must meet two critical prerequisites that are still years away. "First, the country will need to open up its capital account, which will require it to develop its domestic financial markets and implement financial reform," says Christopher Kushlis, an emerging markets sovereign analyst with T. Rowe Price. "Second, it must establish a deep, liquid, and investable government bond market that provides an anchor of value as a risk-free asset."
The Attractiveness of Emerging Markets Currencies
Emerging markets currencies offer economic and geographic diversification away from the U.S dollar and other developed markets currencies. A great part of the opportunity in emerging markets currencies lies in the attractive valuations offered by these currencies, providing potential for significant exchange rate appreciation against the dollar over the medium- to long-term as these economies become more advanced. Developing markets are generally net exporters of basic commodities such as raw materials, precious metals, oil, agricultural, and meat products. As prices of these commodities rise, local currencies generally benefit and appreciate against the dollar, providing investors with a very effective hedge against the erosive effects of inflation on savings.
Large currency fluctuations can be very disruptive to markets and affect exporters and importers, as well as severely dent investor confidence. Emerging markets governments have taken great strides to minimize currency market disruption by amassing large quantities of foreign exchange reserves, which can be deployed to smooth or halt currency depreciation. This is especially relevant in times of market stress; central banks use the foreign exchange reserves to buy back sufficient quantities of their home currency to provide support, keeping markets orderly and increasing investor confidence. Governments with notable large foreign reserves include Russia, Brazil, China, and Malaysia.
Implications for Investors
Strategies with unhedged or managed currency exposure are beneficial for investors looking for diversification away from their domestic market and can provide potential for enhanced returns—especially in an environment where the dollar is likely to lose value versus other currencies. If, for example, you own shares on the Tokyo stock exchange and they rise 10%, and the yen appreciates 10% against the dollar, your investment has gained 20%.
The easiest and most effective way to gain access to foreign currencies is through mutual funds that invest in local currency—denominated bonds from developed or emerging markets or equity funds that buy shares of locally listed companies. Such investments have risks, of course. Currencies can be volatile and trade with valuations above or below the levels that fundamentals suggest. Sudden corrections can be triggered by disappointing economic data, a flight to liquidity, or political instability. While these characteristics often present tactical investment opportunities, they can also lead to short-term losses for investors.
Investors holding foreign bonds and foreign equities should have a long-term investment horizon. Equally important, investors can reduce currency risk by diversifying with foreign currency—denominated investments in several countries and regions.