Currencies are often seen as safe stores of value, not as the investment they really are. For this reason, most people do not have a currency strategy in place. This leaves them vulnerable to future changes in valuation and policy. In this article, I explain how to build such a strategy.
The times they are a changin’
Humans have been using currencies as stores of value and tools of trade for thousands of years. Ancient currencies were nothing like their modern counterparts however, they were nearly all backed by precious metals or were actually made of precious metals. Their supply was thus dictated by mining outputs and their value was linked to that of the metals they were made of or represented. This all changed in the seventies when Richard Nixon (the 37th president of the United States) initiated a series of reform that we now refer to as the Nixon shock. The most important of those reforms was the unilateral cancellation of the direct convertibility of the US dollar to gold. This effectively ended the Bretton-Woods system and led to the creation of the free floating fiat currency system that remains in place to this day.
Since then the world of currencies has been an interesting place to say the least. A more complicated place too. Against many prediction, the US dollar has remained the dominant global reserve currency. New currencies have also risen (and fallen). There has been a major shift in how monetary policy is conducted. We have also witnessed how financial crisis can impact currencies and in reverse, how currencies can start financial crisis. More importantly, currencies have become a much bigger part of our lives. For some of us, they have even become a defining factor in how we live, do business and invest.
As we continue down the road to globalization, the importance of currencies will only grow and so will the need to have a proper strategy in place. Not only to protect purchasing power but also to benefit from changes in valuation, interest rates and from arbitrage strategies.
A strategy for the future
A good strategy should always take into consideration your own personal circumstances and goals. Where do you currently live? Where do you plan to live in the future? What is your home country? Where is your family based? Do you plan on having kids? If yes, would you possibly move to another country to offer them better prospects? Where would you like to retire? Those are all questions you should ask yourself. For example, if you plan on living in China in the future, you should hold some Renminbi. If your family members all live in Germany and you think you may possibly have to help them out one day, you should hold some Euros. If you plan on retiring to the Cayman Islands, you should hold US dollars as the Cayman dollar is pegged to it but the US dollar is easier to hold and more liquid. Even if you plan on living a sedentary lifestyle, it is important that you plan and implement a currency strategy. You never know when your government will change its monetary policy or how your home currency’s value will hold into the future.
A good strategy is one that also allows you to not only to protect your purchasing power but benefit financially from future changes in currency valuation and monetary policy. Look for currencies that are currently undervalued, high interest rate currencies (for carry trades) and the currencies of countries whose economic policy is sound and development prospects good. For example, if you plan on living in Australia, you should hold both US and Australian dollars. The reason for this is that when the US dollar rises, the Australian dollar tends to fall and vice versa. As such, holding both ensures that your purchasing power is protected. It also gives you the opportunity to profit from the difference in interest rates and from valuation moves.
How does one get started? In most cases, by opening a multi-currency bank account. Is is also possible to use term deposits, bonds or a brokerage account. You can learn more about how to open an offshore multi-currency bank account here. In some circumstances, it may not be possible or practical to hold some currencies even if they tick all the boxes. In such a case, you should look for more practical alternatives. A good way to do that is by picking highly correlated currencies. Another way is to use currency pegs. For example, someone who wishes to hold US dollars could instead hold Hong Kong dollars as it is pegged to the US dollar. As a last resort, it may also be possible to hold currency futures.
It is important that you revisit your currency strategy on a yearly basis. Update it so that it reflects changes in your circumstances and in the currencies themselves. Make sure that each currency can be readily accessed in case of need.