What should my base currency be?

Mar 2017

BY Jonathan Marriott, CIO LGT Vestra

“Forecasting exchange rates has a success rate no better than that of forecasting the outcome of a coin toss.”(2) Alan Greenspan, Chairman US Federal Reserve November 2004

Over the years entrepreneurs who have sold their business and are contemplating an investment portfolio have asked me, what should my base currency be? They have realised more money than any single generation is likely to use and they often see themselves as citizens of the world not permanently tied to a single country or region. As Alan Greenspan observed, currency forecasting is not easy and predicting long-term changes can be particularly hard. The post Brexit devaluation of Sterling by over 20% demonstrates how dangerous it can be to be tied to a single currency.

Entrepreneurs who have realised substantial sums often want to preserve what they have made for future generations. They have worked hard to create their wealth and do not want its value to dissipate over time. A sterling based investor who spends his time travelling the world will have a nasty shock this year when he looks at how far his sterling has stretched over the year. The base requirement for this person is to preserve the real spending power of his portfolio over time. We can debate what inflation rate to use, whether it is the cost of property in the south of France or a new yacht, but what we can be fairly sure of is that expenditure in years to come will be in multiple currencies.

Predicting currency moves is hard, predicting how and where currency may be spent is harder. A mix of major currencies would appear to be sensible but without a clear picture of the future what do we base this on? To reduce market view bias we should look for a mix that has been sourced independently. One option is to look at the weighting of currencies in the Special Drawing Rights (SDR) unit of an account used by the International Monetary Fund (IMF). The SDR weightings are reset every five years and calculated by the IMF based on their estimated importance, relative to a set of currencies in the World’s trading and financial systems.

As of October last year, the SDR basket is made up of 41.7% US Dollar, 30.9% Euro, 10.9% Chinese Renminbi , 8.3% Japanese Yen and 8.1% Pound Sterling. The Chinese currency exchange rate is to some extent managed by the state and may be difficult for some people to include. If this is excluded, the simplified basket is 46.8% US Dollar, 34.7% Euro, 9.4% Yen and 8.1% Sterling. This is a starting point for discussion and some investors may still wish to have some home bias. In any event, this is a long-term basis and weightings may vary around this base. If sterling investors had taken this allocation last year then their international spending power would have been preserved.

The down side of this approach is that investors tend to think and account in a single currency. If you account in Sterling and the currency recovered the loss of last year, the accounts would show a loss but the international spending power could be unchanged. To overcome this it may be easier to account for each currency allocation separately.

As Alan Greenspan observed, making currency predictions is not easy and currency moves may be a source of risk rather than return. Therefore, it is important for global entrepreneurs to consider their long-term base when devising an investment plan.

(2) “The inability to anticipate changes in supply and demand for a currency is at the root of the statistically robust finding that forecasting exchange rates has a success rate no better than that of forecasting the outcome of a coin toss.”

“Nonetheless, despite extensive efforts on the part of analysts, to my knowledge, no model projecting directional movements in exchange rates is significantly superior to tossing a coin. I am aware that, of the thousands who try, some are quite successful. So are winners of coin-tossing contests. The seeming ability of a number of banking organizations to make consistent profits from foreign exchange trading likely derives not from their insight into exchange rate determination but from the revenues they derive from making markets.” Alan Greenspan November 2004 source: US Federal Reserve