Commodity-linked Currencies Expose Cracks in Economies

How Currencies Impact Economies

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Crude oil’s dramatic decline from over $100 per barrel in mid-2014 to less than $30 per barrel by early-2016 wreaked havoc on the global economy. While the U.S. may suffer from a spat of energy-related bankruptcies, countries that rely on the commodity to drive economic growth and finance social security programs could suffer worse fates. Russia, Venezuela, and other countries that fall under this category are already buckling under the pressure.

At its core, the decline in crude oil has put downward pressure on gross domestic product (GDP) for many oil-producing countries. The inverse relationship between GDP growth and inflation means that lower economic growth often translates to lower currency valuations. Russia’s ruble and Brazil’s real both hit all-time lows against the U.S. dollar in early-2016 driven by the impact of crude oil prices on their valuations.

Pegs vs. Devaluations

Many countries with floating rate currencies have seen broad depreciations. For example, Peru’s Nuevo Sol has fallen about 20% from 0.36 U.S. dollars per Nuevo Sol in mid-2014 to less than 0.30 U.S. dollars per Nuevo Sol by early-2016. The situation has been far worse in countries like Venezuela that are facing hyperinflation, with the value of the U.S. dollar soaring more than 100% versus the Venezuelan bolivar throughout 2015 and early 2016.

Countries with significant central bank reserves have chosen to peg their currency to the U.S. dollar in order to prevent these kinds of devaluations.

For example, Saudi Arabia’s riyal is pegged at about 3.75 to the U.S. dollar. When the currency deviates from this amount, the central bank intervenes in the global currency market to buy riyals and maintain the peg. Of course, this uses up central bank reserves when there’s strong selling pressure.

Wider Consequences

Falling valuations and inflation pose significant problems for a country’s economy. In general, inflation makes consumer goods more expensive, penalizes savers for holding money, and rewards debtors for having borrowed money. Hyperinflation poses a much greater problem by encouraging a nation’s citizens to avoid holding cash at all costs in order to reduce their risk of loss, which can exacerbate a currency crisis and drive further inflation.

Many Middle Eastern countries also rely on crude oil revenue in order to finance public welfare programs and maintain political stability. If these revenues dry up, these countries could face difficult choices when it comes to maintaining a fiscal budget. These dynamics could create geopolitical risks that may serve to destabilize an economy, which ultimately reduces foreign direct investment as investors avoid investing in excessively risky assets.

Investor Considerations

Investors have a couple different options when investing in commodity-dependent countries in order to mitigate risks and remain diversified.

The first option is to avoid these markets entirely by selling equities and focusing on non-commodity-dependent markets, like the United States or European Union.

While this is certainly a possibility, the downside is that it reduces a portfolio’s overall diversification. Buying and selling sectors also involves market timing, which raises the risk of subpar returns through bad timing – selling during a downturn is generally not a good idea.

A second option is to continue holding these equities, but hedge risks by investing in currency-hedged exchange-traded funds (ETFs) or purchasing put options. By taking these actions, investors can maintain their potential upside exposure while mitigating downside risks. The currency-hedged ETFs help reduce currency-related risks, while put options can accumulate value during a downturn and offset any decline in the underlying equity or ETF.

Investors should also ensure that they’re properly diversified on an aggregate basis by holding a broad basket of industries, asset classes, and geographic regions.

Key Takeaway Points

  • Crude oil’s dramatic fall has taken a big toll on the global economy in 2015 and 2016.
  • Commodity-dependent nations are experiencing the biggest problems with falling oil prices, since it negatively impacts their economic growth and currency valuations.
  • Aside from the economic consequences, these dynamics can have a negative impact on the social welfare and stability of a nation.
  • Investors can mitigate these risks by investing in currency-hedged ETFs or purchasing put options to offset any losses from a downturn.