Planting A Currency Hedge

You have decided to invest a small % of your portfolio in emerging markets in one way or another to reduce your exposure to developed economies, or take advantage of emerging market growth. You choose Turkey, and you decide to look to the longer term, in ten year time frames. What about currency?

First of all, there are no cute financial products that you can buy to remove the risk of currency devaluation. Futures, options and derivatives are all designed with the short term trader, investor or speculator in mind. No one will offer you a hedge, or even a strategy, to cope withe longer term devaluations. Can any kind of accurate projection be made, if the experts won’t hedge it?

Man pruning snake-shaped dollar sign hedge --- Image by © C.J. Burton/Corbis                50ytl

It would take a long time to consider most of the factors, internal and external, that contribute to currency movements over a ten year time frame. You might take a close look at economic fundamentals and forces which in the most part apply downward pressure on emerging market currencies, and then see your estimate get blindsided by unforseeble QE in developped economies, which emerging markets react to with currency devaluations and interest rate rises.

For example, the Turkish emerging market Lira devalued 100% against hard currency between 2005 and 2015. Could any investment strategy that projected a 50% devaluation cope with that? Here is a case study of one which began with real estate portfolio acquisitions, the sector that one normally associates with solid but unspectactular peformance.

We take as a sample a 120m2 2 + 1 historic flat in the center of Istabul in an up and coming neighbourhood bought in 2006 for TL 250k, when the USD was 1.3 to the TL., so the flat cost USD 192k, with another USD 58k spent on restoration, so up front a total investment of USD 250k after all currency transactions. It rents out for TL 2,500 p/m (USD 909), that climbs by 10% every year (a fixed annual rise agreed upon by everyone to keep up with inflation, which ran at 5-9%) to TL 5,889 p/m (USD 2,141), which averages out at about USD 150k in rents over ten years after tax and other expenses.

And then, ten years later, you come to sell it. You are surpised that all flats like yours are now quoted and sold in foreign, not local currency, but that doesn’t matter, (as long as you can find a buyer, the market has narrowed to those who operate in USD since you bought in TL) you sell for USD 750k, a ten year profit of USD 500k. You’ve trebled your money after ten years. Add on rent, you’ve turned your original USD 250k investment into USD 900k.

In that investment cycle, a 100% currency devaluation still leaves plenty of profit. There is the opportunity cost of what the money could have been doing elsewhere in developed economy assets or banks, or what it cost in interest rates or loan terms if you borrowed, to compare against. If you had to pay premium rates to attract a lender, you wouldn’t want those to go much higher than double the money you borrowed over ten years, or 10% per year.

In local currency, what you bought for TL 325k with restoration in 2006 brought in rent of TL 477,884 over ten years, sold for TL 2.06m in 2015, for a total income of TL 2.54, an increase of 7.5 times the original investment, with all other costs factored in. Except the currency devaluation! In USD terms, with that taken into account, it is USD 250k in and USD 900k out, an increase of 3.6 times. Plenty slack to pay back up to 15% every year to a loaner.

In real estate, there isn’t a hedge, or any way you can hedge, except by buying and selling well, and catching an area where real estate is Lira or local currency priced and on its way to being Dollar or foreign currency priced. If you hit it just right over the longer term, which is a timing thing connected with risk reward, a 100 % currency devaluation is quite easily absorbed. A dynamic investment in what is commonly seen as a safe if high cost entry asset like property can see off a pretty hefty currency devaluation, as in our case study, as long as growth momentum carries the EM into a new risk reward scenario that attracts buyers at the new risk reward level, for the next ten year outlook.

If we take the same asset category and base and look at a projected doubling of capital value, a 120m2 2 + 1 that costs USD 750k in 2015, at USD 6,250 / m2, sells for USD 1.5m in 2025 at USD 12,500m2 while currency devalues by 50% rather than 100% at the new risk reward level, projected profits will be halved. Risk is reduced, but margins are tighter. There are no guarantees, even with all the extra market intel and experience. The original risk reward investment can only be repeated if more prime historic in a similar area which performs to expectations can be found, with the best prospect long gone.

As the low hanging fruit of prime historic property gets plucked off the branches (not as easy as it sounds!), an investor has to climb right into the middle of the asset tree, and the next asset that appears to offer the best opportunities and rewards over a ten year term that the locals won’t focus on for another five years is brand and business startups, with the added security and natural currency hedge potential of startups being movable assets that can expand locally, regionally, or internationally into other markets.

There are more variables in startups, they are more exciting with higher risks and potential rewards, but equally as was once the case with prime historic property, there is more space and opportunity to move into. A USD 250k investment into a professionally primed startup with the right investment structure and product lines could go all the way, in which case your currency hedge grows naturally, to be trimmed to height and location as required. All an investor would need is market intel and experience, to make the right startup calls. Is that science available? Is there an innovative emerging market investment and brand startup structure that backs up that science?

And the best built in longer term currency hedge investment mix of all? USD 250k into the prime historic property featured here in 2005, and USD 250k into the right brand and investment structure to go into that property in 2015.

Or, as a droll poster on the Bosporus Boutique post remarks, buy gold and stick it into a Swiss Bank.

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