Will China be sucked into the currency wars?

Currencies are fast becoming 2015’s big investment risk. A factor once largely ignored can now make or break performance. Already, sharp moves this year in the Swiss Franc and Euro have hit some funds hard. But, do investors get enough information from managers about the risks being run? Although many funds do not hedge, monthly investor updates rarely focus on currency calls. For many, currency is an invisible risk

Indeed, managers themselves may not even fully understand the potential for loss. The apparent stability of currencies for extended periods can create an illusion of control, blinding investors to the danger. Currencies do not always move smoothly, and the risks are hard to model.

The confidence that central banks had in their ability to control currencies was shattered when the Swiss Franc/Euro peg snapped in January. In the hours immediately following the defeat of the Swiss Central Bank, a number of funds breached risk limits; the Swiss Franc soared 30%, but few were able to trade. In a chaotic market, managers short of the currency could do little to mitigate losses.

Yet, it would be wrong to think of the event as a black swan. Borrowing Swiss Francs has been dangerous for over 40 years. In the early 1970s, a number of investment trusts were hit when the Bretton Woods system ended. Since then, the Swiss Franc has risen seven-fold versus the Pound, but funds still keep returning to borrow an outperforming currency. Memories are short. This year it was hedge funds that repeated the mistake, in what they thought was a low risk trade.

The currency wars may also be creating systemic risk. The “carry trade” as a source of cheap leverage is a financing tool widely used by traders and investment banks. Emerging market governments and businesses readily borrow US Dollars, even if it does not match their cash flows. When Dollars were cheap, this funding boosted growth and profits. Now, a strong Dollar is deflationary. Emerging market exporters of Dollar-denominated commodities can afford to cut the Dollar price as their own domestic currency weakens. Brazilian exporters of sugar and orange juice, for example, have slashed prices as the Brazilian Real has fallen to an 11 year low. It seems likely that these deflationary pressures will be transmitted into emerging economies, and embedded in expectations. Currencies have become a weapon of economic destruction in many parts of the world.

Governments and central banks may not stand idly by as they lose control of their currencies. Capital flows and hot money moving around the world can wreck economies, creating problems for exporters and importers. More aggressive responses by the countries affected could be the next development. Investors need to assess the risks of exchange controls, should governments decide to prevent capital flight. The financial world currently has more freedom of capital movement than in any previous currency war; an experiment without precedent. The freedom is a privilege that could be withdrawn if it ceases to help growth.

Markets are currently gripped by the possibility that the Euro could be the next peg to go. Yet, just a fraction of this attention is focused on China’s currency peg, largely fixing the value of the Renminbi in terms of the US Dollar. This has encouraged flows into China, often based on Dollar borrowing, and typically ending up in the Chinese shadow banking system. It is clear this has reversed now, with China attempting to stabilise outflows. But China may not be able to stand idly by if Japan’s devaluation spreads across Asia. China simply cannot achieve the pace of productivity growth that would be needed to restore competitiveness. Instead devaluation looks a likely option. The consequences of this are hard to model, and so it seems simply much easier for investors to ignore.

Neither central banks nor investors have control over currencies, despite the illusion they have. The Swiss Franc may not be the last of this year’s nasty currency surprises. Investors should ask more questions about the bets funds are making, currency risks now demand more attention.

A version of this article was published as in the Behavioural Finance Series in Citywire on April 2 2015.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. The information presented in this article has been obtained from sources believed to be reliable; however, I make no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material. Articles and information do not represent investment advice.

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