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Tips for the International Investor
From: Columbia University
| By:
Geert Bekaert |
EDITOR'S INTRODUCTION |
In a world in which national boundaries have less importance, is it best to allocate foreign investments across borders or market sectors? In an interview with Fathom, Geert Bekaert, professor of finance at Columbia University Business School and research associate at the National Bureau of Economic Research, discusses pegged exchange rate systems and offers individual investors advice about diversification into European and emerging markets. |
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| Geert Bekaert talks about portfolio diversification. | |
Fathom: In order to diversify among Western European countries, what should an average investor try to do? |
Geert Bekaert: It's very simple. You just buy the European index. So you buy more Germany than Belgium, you buy more Germany than the Netherlands, more of the Netherlands than Belgium, just because of the relative size of these markets. That's what you should be doing. And the question is: How much diversification potential does that give you? That's the capital asset pricing model prediction. |
Fathom: How has the single currency affected European markets? |
Bekaert: In Europe there have been some interesting developments, because we've had the single currency. The single currency is a serious regime shift. Before that, actually, the correlations between European markets was quite high--it was around .5, .6, .65. Nevertheless, there was diversification within Europe, so you bought Germany, you bought France, you weren't buying the same thing. There was correlation between the two, but they were very different countries. What we have seen happening in the last couple of years with the single market and with the single currency is that things are more integrated now. The correlations have shot up. |
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| Geert Bekaert talks about the effect of a single currency on European markets. | |
Now it's useful to think about Europe almost as one global stock market, and to not really differentiate between different countries anymore. In fact, the money managers developing models about Europe have gone away from the typical models in which you look at countries, and they've made it into a sector model. So you say, "I know I want to find out how much I allot to Europe, and then, within Europe, I am actually not going to look at countries but at industries. How much do I want to allot to transportation versus utilities or the media sector?" |
There are a lot of sectorial models being developed now on Wall Street. And the main reason for that is that the countries are not very differentiated anymore, and the correlations between the countries have shot up to over .8, .85, sometimes .9. And one of the reasons, obviously, is that now there is one currency, and there is more integration with the single market. There is a lot of cross-country consolidation going on, companies buying up one another across borders, and so Europe becomes a little bit more like the United States: different states but within one country or one region. |
Fathom: Could the sector model be applied to emerging markets if you have countries like Zimbabwe that are a one-note country? |
Bekaert: That's a big question in finance. The big question is really: How should I diversify? Should I diversify over sectors, or should I diversify over countries? The conventional wisdom of the research that has been applied to this question, and there's quite a bit of it, is: You're much better off diversifying over countries than over sectors. Is knowing what industry the company is in, or knowing what country it is in, the best determinant for how much variation there is in the stock? It is actually the country. So what drives stock returns primarily seems to be country, not industry. So, obviously, you think that if you're a copper stock you are going to be driven primarily by copper prices. But what this academic result would tell you is that while it's still very important to know whether you're in Zimbabwe or somewhere else, country-specific news, whether Mugabe is still in power in Zimbabwe or not, still is very important for the stock market, especially actually for emerging markets. These local market conditions are extremely important. |
What are local market conditions? Macroeconomic conditions; how well GDP is doing in general; is there unemployment or not; is there inflation or not; how is monetary policy doing. These are all prime country-specific determinants of stock prices, not the sector you're in. The sector you're in is important, but it's of secondary importance to what's happening in the country. |
Maybe in Europe that is no longer true, because now in Europe we have only one monetary policy. The different monetary policies are one reason stock markets perform differently across the world. Why does Germany perform differently from the US? Because the business cycle is different, GDP is different; in the US it's going very well, in Europe you may be going into a recession, and Greenspan is doing something different than the chairman of the Bundesbank was doing in the past. |
Now in Europe you have only one central bank, the European Central Bank, so the monetary policies are the same in France, in Belgium, in the Netherlands, in Germany. One thing that was differentiating these different stock markets has disappeared, and this is one reason they are more correlated. |
Fathom: Are there any other geographical sections in the world that an investor would need to know about which have anything even close to that kind of integration across borders? |
Bekaert: Not quite. There are some regions that I think not a lot of people know about which have some kind of monetary-type links that are similar to Europe. One region I'm thinking of is the CFA region in Africa. These represent a whole bunch of West African countries and they are going by the acronym CFA, for Communauti Financiere Africaine. Basically it's a group of former colonies of France. The funny thing about them is that they all have a fixed exchange rate relative to what used to be the French franc and now will be the euro. So in that sense they're linked, because there's only one currency value for all of them. That peg has been holding up for a surprisingly long time up until about six, seven years ago. I think it was in 1994 that they had this one major devaluation of the French franc by 50 percent, which generated a lot of brouhaha, both in France and in West Africa. But that's one of the amazing currency arrangements that you have out there in the real world. |
You do have a lot of countries that do peg their currencies relative to well-known currencies. A very good example for an investor in the US that they probably know about is Argentina. Argentina has a so-called currency board, so there is actually a one-to-one exchange rate between the Argentinean peso and the US dollar. That means that if you look at the Argentinean stock market you can translate it one-to-one into dollars, because the exchange rate is not changing. Now, does that mean there is no currency risk? No, you have to be careful with that, because obviously the currency board will ensure that there's a one-to-one relation between the Argentinean peso and the dollar as long as the currency board holds up. But nothing says that, sometime in the future, maybe because the economy doesn't do so well or maybe because there's an election and a new government comes on, that may be changed, and they go back to a floating exchange rate system or they do a big devaluation. So there's still currency risk. But in the short run it doesn't seem like currency movements are going to drive the returns for US investors. |
These kinds of pegged exchange rate systems, or at least limited flexibility exchange rate systems, are in place in quite a few countries. It's not only Argentina; there's a whole group of Eastern European countries that peg their currencies relative to the euro. As another example, Israel has a band around a particular fixed value relative to basket of currencies. Of course, since the currency crisis that we've had in recent years, both in Mexico and in Southeast Asia, these systems have become a little bit less popular, because we've actually had some instances in which they were clearly not working. |
In Mexico we had a system called the Crawling Peg, where the Mexican authorities were trying to limit the variability in the Mexican peso. It was kept within a band, and the band was kind of moving up slowly with inflation, but it was predictable, so it couldn't go out of the band. And of course in 1994 what happened is that there was this huge attack on the Mexican peso, and they couldn't defend the currency anymore. Basically, the Mexican Central Bank tried to defend the currency, ran out of the money and they had to let the band go. And so the currency was devalued, first by 13 percent at the end of 1994--December 13, 1994. |
Then the speculators said it was not enough, that 13 percent is not where we want the currency to be, and they kept attacking. The government couldn't really support the currency anymore, because that actually meant buying up their own currency with dollars. They had 6 billion dollars left and they had a whole bunch of outstanding liabilities relative to US investors and others that were more than 6 billion, so they were basically running out of money and they had to just let the currency float, which led to the big currency crisis and a big devaluation of the Mexican peso by more than 50 percent. A lot of instability occurred, interest rates spiked up, and there was a big currency crisis in early December. Obviously, that's not a happy event for foreign investors, for the Mexican economy, for the Mexican government. |
Nevertheless, it happened again in '97, this time with the Thai baht. They had a fixed exchange rate system; they were pegging the baht relative to the dollar. They had been doing so for a long time and things had been going very smoothly. They had only had one devaluation in which they had to devalue the baht by about 15 percent, but everything was pretty stable. But then suddenly, in June and July '97, there were currency attacks again. Again the currency could not be defended anymore by the central bank. It went into a free fall. They let it float. After that, other countries in the area, including Indonesia, Korea and Malaysia, went down the tubes. In the Philippines, their currency went down the tubes as well. As so we had a currency crisis in the whole area. |
These systems have been proved to be fickle. It's hard to defend a particular value for an exchange rate. The government authorities probably thought this would bring stability, but what they've learned is that it brings stability for a while and then it could bring a huge crisis. And obviously, if you look at that it's not clear that this is so beneficial. |
If you have a system in which a currency is floating, it's very variable, but nevertheless there is this variability that you know is there and you can deal with it. It's probably better for foreign investors and for foreign businesses, because, don't forget, people doing business in Thailand and doing business in Mexico may be earning money in bahts and pesos and so they're subject to the same kind of risk. If the currency suddenly tanks, if they haven't been able to adjust their prices and so have much less revenue in dollars, this could be a real problem. So this is important both for investors and for actual businesses, multinationals; it's a risk they have to deal with. I would say that actually having a floating exchange rate system, where there's a lot of variability or risk that you have to deal with, may be better than a system in which things are stable for a long time but then they explode and you have these huge movements. |
The same was actually true in Europe. Europe for the longest time had this European monetary system and it was kind of fickle, too. It was working well for the Netherlands, it was pegged to the deutsche mark and doing very well. For a lot of other currencies you had these speculative attacks and the currency had to be devalued. That was true for the French franc, it was true for the Belgian franc, it was true for the Danish krone, it was even more true for the lira and the peseta and the escudo, and we had a big currency crisis in 1992 and in 1993. Now, with the single currency in Europe, we hope that we can avoid these currency crises, because now there's no way to get out. It's just one currency for all, so I think that's a very positive development. |
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