Between 2000 and today Australia saw its ‘terms of trade’ nearly double. That is to say, the things Australians buy from overseas have halved in price relative to the things we sell. The key reasons are a decrease in the price of the manufactured goods we import and an increase in the price of the mineral and food resources that we sell. Both of these are related to the growth of China and other developing countries. This terms of trade increase is effectively free money for us and it has been a boon for consumption here. Mining royalties have swelled government coffers, higher wages have filled consumer bank accounts and asset prices have to continue to rise despite our lacklustre productivity growth since 2004. This episode demonstrates both how volatile terms of trade can be and how dependent the standard of living of a small country can be on them.

But what the terms of trade can give us, the terms of trade can take away. One possible scenario that has attracted attention lately is Europe experiencing an ongoing downturn and taking trading partner China with it. Perhaps China’s state-owned banks will experience financial problems due to an asset bubble burst. Who knows. Either way, this could send the value of our exports plummeting. The Australian dollar might fall as much as 30-40%, as it did during the nadir of the global financial crisis in 2007-08. An ongoing decline would presumably reverse many of the gains a higher terms of trade brought. Tax revenues would fall, potentially triggering government austerity or higher taxes. Real wages would fall and take asset prices (read: house prices) along with them. Depending on how effective our monetary stimulus and floating exchange rate were in response, and how robust our financial system remained, employment could fall as well.

I’m not saying that scenarios like this are more likely than macroeconomic soothsayers or the market are saying. I don’t know that. Nobody really knows. All I want to suggest is that you can insure yourself against this kind of risk with a very simple financial instrument: a bank account.

As our terms of trade move, the Australian dollar moves roughly in proportion. [1] So what asset increases in value for an Australian when the global economy is going poorly and dragging down our export values? Foreign currencies! [2] If a terms of trade crash causes a recession in Australia it would be sad to see your purchasing power and wages fall, or worse, your job disappear. But it would be some welcome compensation for your holdings of US dollars to suddenly be worth a third more in Australian dollar terms.

Holding a variety of currencies is just an instance of the most mundane piece of investing advice around: diversify. [3] It also obeys another simple investment strategy: buy assets whose values are negatively correlated with one another. That is, organise your portfolio so that when some of your investments go unusually badly, others go unusually well. If you live and work in Australia you are highly ‘invested’ in the Australian dollar, Australian taxes and Australian wages. When those things take a turn for the worse, foreign currencies do unusually well, so they function as a form of insurance.

Fortunately holding foreign currency is relatively cheap. You can get savings accounts in Australia with HSBC that attract no fees apart from a two-way exchange rate spread of around 0.9% (i.e. if you move your Australian dollars to US dollars and back again you’ll lose about 1% of your holdings). [4] If you have an account overseas and more than a few thousand dollars to transfer it would be cheaper to move them with OzForex. Though you won’t earn much interest on Euros or US dollars relative to Australian dollars at the moment, the ‘interest rate differential’ should be factored into the expected movements in the exchange rates, so on average you won’t miss out on any interest (though how much you receive will be variable).

So is anyone else going to join me and start converting a share of their savings into foreign currency?

[1] When Australian exports are valuable, foreigners have to buy more Australian dollars to purchase them. Their higher demand for Australian dollars drives up their value. And when the value of our exports declines, the value of the dollar falls for the same reason.

[2] And other assets that have relatively stable value in foreign currencies.

[3] If you wanted to even out the purchasing power of your money, to a first approximation, you would want to split your cash between different currencies in proportion to what share of your consumption came from each country (in the form of holidays and TVs and so on). As about 30% of Australia’s GDP is traded, that would suggest holding a third of your wealth overseas.

[4] An alternative way to ‘hedge your bets’ without actually having to tie up large amounts of wealth in foreign currency (or other assets) is to buy foreign exchange ‘options’. These give you the right to buy foreign currency in the future at a given rate. If the Australian dollar declines in value you can exercise the ‘option’, buy foreign currency at the above-market rate and take a profit. Westpac among others offers this service for those with substantial sums of money. I haven’t gone into this in detail to avoid confusing people.

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