From the Mind of Trevor Stone

Over a month ago, clarsa asked

I figured, when the Freddie Mac/Fannie Mae thing hit the tarmac, the best place to be would have been in foreign currency, particularly the yuan which had been held artificially low for quite some time in order to facilitate international trade. But for the last few days, I've been reading that Asian stocks were flailing wildly and Asian currency is losing ground against the dollar. How can that be?

I've been late in answering in part because I was busy and in part because I haven't learned as much about currency markets in the past few months as I have about other markets. But here's a stab at an answer.

First, some background. Most countries have their own currency. When one country's economy isn't doing well, their currency doesn't buy as much of other currencies. Equivalently, people with currency from other countries can buy that country's currency for cheap. For example, in the middle of summer, one U.S. dollar could buy half a British pound and one British pound could buy two U.S. dollars. Today, one U.S. dollar can buy 67 pence and one British pound can buy $1.50. In the former situation (a strong pound, a weak dollar), American goods are cheap for Brits and British goods are expensive for Yanks. In the latter situation, Americans find it "cheap" to visit castles and Brits find it "expensive" to visit Disneyland. (Traveling in Western Europe and America is almost never cheap when you compare the price of food and lodging to third world countries, but in currency exchanges it's relative prices that matter.) The Europeans weren't particularly happy with their high-valued currencies this summer because it resulted in fewer U.S. imports of European products. So they could buy more stuff, but they had a harder time selling stuff.

Some countries use currencies which aren't freely traded in this way. In some cases, they use another country's currency directly; for the last several years El Salvador's official currency has been the U.S. dollar. In other cases, the country keeps their currency, but assigns a fixed (or barely-fluctuating) conversion rate to another country. For instance, the Hong Kong dollar is always worth 103 Macau patacas. (That way you don't have to change money when you go from Hong Kong to Macau for a day, but the Macanese merchants get a few cents advantage.) The Chinese currency* is "pegged" to the dollar. In the middle of the summer, one U.S. dollar was worth about 6.83 Chinese yuan. Last week, one U.S. dollar was worth about 6.83 Chinese yuan. China just recently announced it would lower the value of the yuan, making one dollar buy 6.88 yuan. Not a big gain, but a significant sign.

* There are several ways to refer to Chinese currency. Its official international name is the Chinese yuan (CNY). In China, the official name is the Ren Min Bi (RMB), "The People's Currency." But if you ask someone how much a half-kilo of fruit or a plastic dingle-dangle costs, they'll answer in kuai. "Kuai" is a count word meaning "units," so "Er shi kuai" is short for "Er shi kuai ren min bi," "Twenty units people's currency." A loose translation of "Er shi kuai" is "Twenty bucks."

So there's part of the answer to your question: Since the exchange rate of the yuan with the dollar is fixed, investing in yuan doesn't give you any advantages over investing in the dollar (unless you want to buy a lot of goods and services priced in yuan). It's sort of like betting on the weight of a sack of flour. You won't lose any bets, but you won't make much money either.

What about other currencies? Since every day we hear news about how terrible the U.S. economy is, wouldn't it have been wise to invest in some other currency in the middle of the summer? Not really.

The U.S. dollar is sort of the de facto world currency. Barrels of oil, for instance, are bought and sold in dollars. And remember all those mortgage-backed securities and collateralized debt obligations that blew up earlier this year? They were all in dollars. When Lehman Brothers went bankrupt, everyone who'd sold (the equivalent of) an insurance policy against Lehman going bankrupt had to pay the policy holder. That meant they all needed dollars they could spend. They sold off oil and other commodities and foreign currencies so they'd have dollars to cover their investment positions.

Furthermore, the U.S. economy is seen as the most robust in the world. If the U.S. Federal Reserve collapses, the world will be near the point where we need to start trading cows for beans and searching our hard drives for funny pictures. So while holding pounds and euros was sensible when the U.S. economy was falling alone, now that the whole world's economy is collapsing, dollars are seen as the safe bet.

That's the theory anyway, but I wanted to be sure. Are there any currencies that have done better than the dollar lately? I grabbed data for 13 currencies vs. the dollar and graphed their value against the dollar. (Values are normalized so the currency's value on the first day of the graph, July 30th, is 1. That lets pounds at 0.5 to a dollar appear on the same graph as yen at 100 to a dollar). The Chinese yuan held steady (I skipped other currencies pegged to the dollar). 11 currencies lost value, ranging from the Thai baht which is 94% of its previous value to the Brazilian real and Australian dollar which are 67% of their previous value. The lone winner was the Japanese yen, now at 116% of its late-July value.

I don't know why the Japanese yen is doing well while everything else is tanking. Japan went through its own fiscal crisis in the mid- to late-90s so its financial system has some recently-created safeguards that Obama's economic team is probably studying. There are probably other factors too, but I've heard very little about Japan lately (other than references to their 1990s collapse).

( 54K graph )On the plus side, now would be a great time to visit Australia or Brazil. It's even summer!