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How to Invest in Currencies

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.

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