Forex Hazards to Look Out For

Before the collapse of the Bretton Woods accord, currency exchange rates were largely fixed. However, countries were still able to officially devalue their currencies at specific points, making changes to the fixed exchange rates in response to changing economic fundamentals. These devaluations – or revaluations in rare instances – had major economic impacts. 
Rapid devaluation can happen even in today’s floating rate environment While currency exchange rates now operate under a floating regime and move in response to market forces, a significant change in exchange rates over a relatively short period of time can still have a dramatic impact. One example of this is when the UK left the European Exchange Rate Mechanism (ERM) in 1992 after the British pound came under heavy attack from currency speculators. Another is the Asian currency crisis of 1997, where currency woes in Thailand led to contagion that spread throughout the region. 

Quickly falling exchange rates damage the economy  

Investors need to be on the lookout for significant currency movements, since these still have a major impact on the affected country’s economy. In the short term, the country sees a surge in exports and an improved current-account deficit as the country becomes more competitive abroad. However, this export growth quickly stalls and is followed by more expensive imports, causing the current-account deficit to grow rapidly. At the same time, rising prices from imported goods drive inflation, causing further economic decline. In some cases, the devaluation causes foreign investors to pull the money out of the country, resulting in further economic pain. 

Why is this a problem for investors? 

For investors, one obvious problem with a rapidly declining exchange rate is that they get dramatically lower returns. For instance, if they hold the country’s bonds, then any returns they get may well be wiped out by the lower currency value. For example, if the bonds are yielding 5%, then a 20% drop in the currency’s value will yield an effective loss of 15%. Another problem is the slowing economic growth and increasing inflation in the country. This usually leads to falling corporate profits, which in turn translate into plummeting stock prices. 

What should you watch out for?

It’s important to detect early warning signs that rapid exchange rate changes could affect your portfolio. First of all, keep an eye out for cases where rates are being manipulated – for example, China’s suppression of the yuan. Second, while emerging markets can offer spectacular profits, they also pose real risks when fundamentals deteriorate. Because of this, you should avoid emerging economies that have high account deficits and high inflation rates. Finally, look at the historic direction of currency rates – even if a currency is in slow decline, this can have a significant impact on the real returns that you get from investing in the country.