How Currencies can Impact your Investments

The purpose of investing is to make a profit but when your investments are in different currencies, these currencies can fluctuate in value and affect your return on

investment.

A loss in the value of a currency can lead to negative real returns for foreign portfolio investors. It also affects the local businesses & domestic demand in many ways.

US Dollar being the world’s reserve currency, and dominant in Global trade, a strong US Dollar or a weaker currency against the USD could have an impact on your investments.

With hawkish Federal Reserve in the US indicating few interest rate hikes in 2022, this could have an impact on the Dollar strength & emerging African economies. So, you should position yourself if this could impact you.

Expected Rate Hikes in the US in 2022

US Fed have indicted four rate hikes in 2022, and many analysts on Wall Street believe that there could be as high as seven interest rate hikes by the US Fed in this year to control the high inflation.

This will likely have an impact on the global stock markets & forex markets, which could impact African economies too.

How this could Affect Tanzanian Investors & Businesses?

Rahul from Forex Beginner explains that “Higher Interest Rates in the US & strong US economy would mean a strong US Dollar. This could affect other weaker currencies in the short term.”

“The only way to make the local currency stronger in the longer term is by increasing the exports or by being attractive to foreign investors.”

Even before in 2014, the Greenback strengthened against other major & emerging market currencies. Strong US economy, weaker growth in Europe & the expectations of an Interest Rate hike caused the Dollar to strengthen. Many currencies including the Tanzanian shilling (Sh) went over the roof. The exchange rate went from Sh1600 in 2014 to Sh2300 in 2015.

Certainly, an appreciation of the US dollar affects African currencies.

A stronger US Dollar would mean that the imports will be more expensive, which could lead to a higher inflation.

But if global consumer spending & demand slows down, this would mean the demand for Tanzanian and other African country exports such as agricultural commodities, textiles, Gold, Copper Oil etc. could be affected.

A reduced demand for exports means less foreign exchange will come in, leading the currency to depreciate against the Dollar. A weaker currency means importation by companies in Tanzania becomes more expensive since they pay in foreign exchange. This increased cost of production leads to increase in the price of goods demand drops.

A drop in demand for goods means less profit declared by the companies producing them and lower return on investment for investors in those companies.

What is Currency Risk?

Also known as exchange rate risk, it is the probability an international investor or a business would lose money due to fluctuations in exchange rates.

Let’s look at an example below:

Tracy runs an import business. She has heard about xyz cars company in a foreign country and she does some study and arrives at the conclusion that she wants to import it to sell locally.

She plans with details below:

Price of the car is = $5000.

1USD exchange rate = Sh2250

Tracy plans to import 2 cars calculated as $10,000 x 2300 = Sh22,500,000 for which the buyer will pay her Sh. 25,000,000

But as she’s negotiating the price with the exporter in the other country & arrange for the shipping, the exchange rates of Shilling drops to Sh2300. So, now she will need to pay Sh23,0,00000 or approx. 2% more.

Now her profit has been reduced from Sh2,500,000 to Sh2,000,000.

Well, the bad news for Tracy is, she ends up paying higher for the same goods because the Shilling has depreciated in value against the Dollar so that currency conversion from Sh. to US dollar for imports made her costs higher.

A classic example of currency risk faced by global businesses.

In the perspective of a foreign investor investing in a local company, even if a company is doing well and making good profits in Shillings, the exchange rate depreciation can still cause the investor to have a zero or negative return on investment. This is one reason foreign investors don’t like to invest in economies they are not confident in.

What Causes These Currency Fluctuations?

Monetary Policy

This is a tool for a central bank to control the amount of money in an economy. It can be divided into two

Expansionary- designed to stimulate spending in the economy by reducing interest rates.

Contractionary – designed to reduce spending in the economy by increasing interest rates.

Monetary policy changes in big economies like the United States can affect other countries as discussed in above.

One of the main monetary tools for Central Banks is the Interest Rates. And it is one of the notorious factors that causes currency fluctuations.

Interest rates are like the sail in the economic ship of an economy. They influence the exchange rate, return on investment, cost of lending, earned interest on savings accounts etc.

Since the US have the biggest economy in the world, and the bulk of global trade is in US Dollars, any fluctuation in their interest rate & Dollar Strength could have a ripple effect on the other economies.

Inflation

Inflation is the increase in the price of goods and services over a period of time due to a weakened purchasing power of the currency or due to increase in demand.

It can be studied from the Consumer Price Index which is an average of the price increase of major goods and services in the market.

When there is a rise in inflation, the demand for goods and services decreases resulting in less demand for the currency, lower sales by the companies producing these goods and lower return on investments (ROI). A lower ROI drives foreign investors away to countries offering better returns hence the value of the currency drops.

As published on the Bank of Tanzania website, inflation in Tanzania is at 4.2% for December 2021.

Politics

Investors like predictability in a country. It builds confidence to know their investments are safe.

If a country has political leadership that formulates policies that are not investor friendly, foreign investors might pull out or reduce their investments in the country resulting in less foreign exchange inflow and a depreciation of currency.

For example, let's say there is a dispute between a Global Company & the Government, and the company is fined in Billions by the government. This dispute leads to the company shutting down operations in the country.

A dispute of this nature can scare foreign investors away from a country.

The Impact on Investments & Businesses

A sudden depreciation in a domestic currency leaves businesses vulnerable. Some of the effects are -

• Imported raw materials become more expensive
• Imported finished products become more expensive
• Businesses pay more fees to banks to convert domestic currency to foreign currency
• Businesses may not be able to pay staff salaries due to increased production cost

How to Minimize the Impact of Currency Risk?

As an investor, let us discuss how you can hedge the against exchange rate fluctuation.

Using future contracts to hedge currency fluctuation risk

A futures contract is an agreement between two parties to buy or sell a predetermined quantity of an asset at a predetermined price and predetermined date.

Example

A business wants to import goods from China. The owner realizes the Shilling may weaken against the USD in 3 months’ time so he calls his broker and arranges a Currency Futures contract.

Let’s say this contract allows him to buy 10,000 USD by selling Shilling in 3 months’, time at a predetermined forward rate or price.

With this even if the Tanzanian Shilling depreciates against the US Dollar during that 3-months period, the investor can still sell the Sh at the predetermined forward rate and cover his loss if the forward rate is estimated correctly.

Using FX Options to hedge Currency Fluctuation Risk

A Foreign exchange options contract gives the holder the right but not the obligation to buy or sell a predetermined quantity of an asset at a predetermined price and time in the future.

The price is called the strike price. A contract to buy is called a call option and contract to sell is a put option.

The investor in example above may choose to buy an option by paying a premium to the option seller which generally is your bank. This gives the investor or option holder the right but not obligation to buy the 10,000 USD at a predetermined price and time.

In 3 months if the currency depreciates, he/she can choose to execute the option, but if the USD depreciates, he can choose not to exercise the option. By choosing not to exercise the option he will forgo the premium paid to the option seller.