How to Invest in Currencies: Look for Growth, Understand the Risks

Currencies can be a good investment due to their low-cost of entry and virtually complete liquidity .

The main argument against investing in currencies is that most investors don't know when it's time to move out of a specific currency. So here is a way to help you identify when to enter and when to leave a currency.

For the long-term investor, as with commodities (see "Want to Invest in Commodities? Be a Proactive Economist"), "long-term" for currencies is not 20 to 30 years, but three to five years.

Why three to five?

As Bill Clinton once said, "It's the economy, stupid." Fundamentally, the strength of a currency reflects the strength of its underlying economy. All else being equal, a strong economy means its currency is strong.

Our ability to predict the strength of an economy -- limited to begin with -- does not carry over a period longer than several years. Why? There are just too many factors in play, such as inflation and interest rates, job market, stock market, political dynamics, laws and regulations and major geo-political events (think Sept. 11, 2001).

Furthermore, the relationship between those factors and the performance and strength of an economy is not straightforward to analyze and understand. Not to mention that some events are simply unpredictable.

Therefore, at best, we can see where an economy is headed three to five years into the future. Longer than that, all bets are off. Shorter than that is pure gambling. Of course, even predicting an economy's strength for the next few years can be difficult, but it's the "sweet spot" in which you are most likely to make good currency bets. Investing, after all, is about consistently making "good enough" decisions.

Another Twist

When you invest in a currency you are making a statement not just about one economy, but about two. For example, if you live in the U.S. and you are investing in the euro via foreign exchange (Forex or FX), you are making a statement about the relative strength of the European economy vs. the U.S. economy.

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Essentially, you are selling U.S. dollars and buying euros. Then, to capitalize on your profits, you sell the euros you bought and buy U.S. dollars again. By going through this process you are saying, "I expect the European economy to do better than the U.S. economy."

That said, the following are the key issues you want to think about when evaluating an economy to invest in. It may not surprise you that these factors are quite similar to the ones you should think about when investing in a company.

High growth. Overall, this is the most critical factor. When an economy is growing, its assets (like companies and real estate) rise in value. When this happens, investors -- both internal and external -- invest in the country, and this results in greater demand for its currency, and hence the rise in its value.

Having grown its economy 10% to 11% annually from 2004 to 2006, China is often cited as a "high growth" country. In the same region of the world, you'll find Vietnam growing at around 8% annually and Singapore at 6%.

Think of China as a large-cap stock and Vietnam and Singapore as small-cap stocks .

With a high growth large-cap company, you "expect" its stock price to rise. Similarly, when a country is experiencing big economic growth, its currency (like China's yuan renminbi) is expected to go up. And generally, small-cap stocks rise more than large-caps because the new players have "more room" to grow. However, with "small-cap economies," the size of the country can be a fixed constraint that limits growth, increasing the risk of owning currencies like Vietnam's dong or Signapore's dollar.

Low risk. Higher risk offers higher returns, right? If a country poses high risk, investors in its economy would require a high return, which means they have to pay less for what they buy, and this translates to lower currency prices.

There are several groups that provide risk ratings for countries, usually from the perspective of credit insurers. Examples of such organizations are A. M. Best, the French export credit underwriter CoFace (that offers good, if short, descriptions of the risk issues, as well as numerical data hard to come by on bankruptcies in a given country) and the Belgian ONDD, with its wonderful graphical interface.

The following are the risk factors that most matter for an economy.

Inflation. Inflation means the country's currency can buy less over time. The reason inflation is a major risk factor is that high growth often generates inflation, and balancing the two is not easy. Yes, you want the high growth, but you want to see signs that the country is not facing very high inflation and is going to take steps to control inflation, by raising interest rates, which increases the attractiveness of its currency.

To evaluate how a country is going to behave, look up past statements of the country's leaders. Take, for example, the situation in China. Zhou Xiaochuan, the Chinese central bank (the People's Bank of China) chief, recently said, "There is definitely room for further [interest rate] increases, in my personal opinion." But Xiaochuan added, "The timing and the scale of the adjustment are also critical factors to consider."

He also admitted that the rate cuts in the U.S. restrict his ability to raise rates.

Overall, taking into account China's objectives in developing its domestic consumption and its capital markets (both of which require low interest rates) and its general appetite for growth (as seen in the past decade), it is likely that China will keep its rates low enough to achieve the above objectives, but above the U.S.' rate in order to attract foreign capital .

Diversification. A growing country such as Cambodia, with its concentration in farming (dependent on the weather) and textiles (the majority of exports, dependent on China), poses a higher risk than one like Singapore, with its diversification across products, and growing diversification across countries it exports to.

Additionally, before investing in a foreign currency, examine whether it is highly dependent on goods or services that are affected or tied to the economy of the country that you're betting against. Singapore, for example, is very tied to the U.S., even though now 60% of its exports go throughout Asia. Therefore, investing in Singapore's currency means you are not necessarily hedging against the U.S. economy as much as you think. Also, you can probably expect Singapore's growth to slow down due to the slowdown in the U.S.

Balance of payments. If a country carries a trade deficit for a lengthy period of time, it means it would be beneficial for it to lower the value of its currency, so it effectively owes less on its debt, and its deficit is smaller. The U.S. had pressured China for several years to free the yuan-U.S. dollar exchange rate, and allow the yuan to become stronger comparatively, in order to reduce the trade deficit between the countries.

Geo-political risk. A country that has an unstable political situation -- either internal or external -- poses a greater risk for investments. Cambodia and China, with their communist-party-controlled governments, actually offer more stability than many democratic countries, where economic policy can change radically with a change in government. Higher geo-political risk, as any other risk, makes a country less attractive and investors would require higher returns, thereby resulting in lower currency exchange rates.

Currency markets are extremely volatile -- more so than stocks and bonds -- because they respond to interest rates and other dynamic factors that change constantly, and in multiple countries. The result: a great temptation to gamble and play on the spreads . However, that's short-term speculation. This article was a lesson in long-term investing.