Currencies, Inflation, and Foreign Investments

Inflation is the cancer of the economy. Rising inflation is a sign that the economy is operating less efficiently, it means that business is allowed to raise prices rather than improve productivity to improve its profitability. Rising inflation has a negative impact on productivity as business finds it easier to raise prices rather than investing to improve productivity in order to increase margins. Rising inflation means that people who rely on fixed income have their source of livelihood depleted by external forces and they are forced to live with smaller resources. ,p>Rising inflation creates discontent in the economy and in the population as people see their money worth less and less. The quality of goods purchased declines as business cuts cost to improve profitability and raises prices. The whole economic process becomes distorted.

The financial markets, as inflation rises, reflects this uncertain state of affairs and they act very poorly as they did in the 1970s. Rising inflation is really a cancer of the economy and that's why the Federal Reserve and the central banks around the world are committed, at least on paper, to keep inflation under control and achieve price stability. Price stability really means that with prices growing slowly, business is forced to improve margins by increasing productivity and this increased productivity creates a stable business cycle, sound growth and high real income as wages rise above the inflation rate.

Rising inflation also is usually associated with an overwhelming role of the government in the workings of the economic process. A definitive example is what happened in the 1970s in the United States. Inflation soared from 3% to 15% as the federal government aggressively expanded social programs and at the same time was fighting the war in Vietnam without raising taxes. Spending was funded by keeping very low interest rates relative to inflation, causing inflation to soar, thus indirectly raising tax revenues as income was artificially inflated by inflation. This influence forces the economy to operate at inefficient levels. It is not a coincidence that the Soviet Union, where the bureaucratic apparatus was 100% of the economy, collapsed because of the inefficient Soviet economic system. Other countries in Europe have shown that the more socialistic governments have been associated with an economy growing more slowly. This is the reason why Europe grew slowly in the 1990s. Japan itself was in a long recession in the 1990s due to the close control of government and cartels on the way their economy operates. The United States has proved that by maintaining some freedom in the marketplace, one can achieve solid economic growth and a low unemployment rate. As we have seen in chapter five, rising inflation is eventually associated with high unemployment rates as business cuts employment and recessions are usually the rule, not the exception.

Of course as inflation rises, interest rates also rise. Lenders ask for a higher return for their money being lent to keep into account the inflation risk. When inflation rises, everything seems to be going wrong. On the other hand, the 1960s and the period following the 1980s showed quite clearly low inflation is accompanied by stable economic growth. The currency of a country reflects this state of affairs and is a delicate mechanism measuring the imbalances of one country relative to the others. A strong dollar reflects the fact that the US economy is performing well, with stability and low inflation. A weak currency reflects a country that has economic problems, inflation problems, and productivity problems - a country that lacks stability and conviction to solve the issues.

Currencies, over the long term, reflect the inflation differential between two countries. It measures the relative efficiencies between two countries. A country with low inflation is more efficient and more stable than a country with higher inflation. Therefore, the country with a weak currency reflects a country that is relatively worse off than the country with lower inflation. This is an important fact to recognize because when investing in foreign stock markets or in foreign assets, one has to assess the impact that the currency has on the performance of the investment.

For instance, if one invests, let's say in Japan, and the Japanese market rises 20 percent, it provides the investor with a 20 percent capital gain. However, if the Japanese Yen declines 20 percent, the total gain for the US investor is zero. Although the investor has a 20 percent profit from stocks, it takes 10 percent more Yen to buy dollars to repatriate his investment, therefore, net net the gain is zero.

Foreign investments should be made in countries with a strong currency to avoid the currency risk because a currency loss takes away from the gain of the investment in that foreign country. Since the long term trend of a currency is determined by the trends of inflation in that country, before investing, one should do a cursory check of the level of real interest rates for that country. It will provide the investor with a very simple way to recognize what the currency risk involved is in that investment. Inflation in a country depends mostly on the level of real interest rates.

For instance, in 2000 South Korea had short-term interest rates of close to six percent and inflation of one percent. Clearly, South Korea monetary authorities were following a sound monetary policy. Short-term interest rates were low, close to the norm of 5-6%, real interest rates were high with short-term rates higher than inflation, and inflation was low by many standards. Clearly, all this information suggests that South Korea is a country that has a firm or strong currency.

However, let's say the United States has short-term rates of five percent and inflation of two percent, and for example Venezuela and Mexico have short-term interest rates close to 35 percent and inflation of 30 percent. In this example, the currencies of Venezuela and Mexico offer a currency risk. The first reason is because high short-term interest rates well above the five percent norm tell the investor that the country has serious structural problems. The second reason is that real interest rates are extremely low relative to the US. In this example, interest rates are more than two times inflation in the U.S. However, in Venezuela and Mexico real interest rates are only 1.2 times the inflation rate. This means that monetary policy in Venezuela and Mexico is conducive to a weak currency relative to the U.S. dollar since monetary policy in these two countries is likely to produce higher inflation than in the US. Therefore, these two countries offer a very high currency risk and should be avoided. By the way, these numbers are available on the Internet or any weekly edition of the Financial Times or The Economist.

(From Chapter 7 of my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China. The book is available at Amazon.com).

George Dagnino, PhD Editor,
The Peter Dag Portfolio.
Since 1977
2009 Market Timer of the Year by Timer Digest
Portfolio manager

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