Geopolitical risks and impacts on currency markets

In Depth: What causes the fall in the pound's exchange rate?


What is a “geopolitical” risk?

It is the risk posed to investors and businesses by unexpected developments relating to political issues around the world. As a general principle, if a country’s economy is performing well and the future looks prosperous and – crucially – predictable, investors will be happy to invest in that country and buy its currency. Unexpected events, however, can see them running for the exits, sending the currency down in value. A wide range of geopolitical events can affect currencies, from general elections and major economic policy announcements to natural disasters, rising tensions with other nations, and even wars. At its most extreme, geopolitical risk includes the risk of political violence or regime change that means foreigners’ assets get “expropriated” (i.e. stolen by the government). It also includes unexpected election results, such as the UK vote for Brexit. The greater interconnectedness of markets and supply chains across the globe today means that thinking about geopolitical risk is more important than ever. As such, more business are looking at ways to mitigate the risks - for example, by working with currency specialists like OFX on “hedging” strategies such as forward contracts.

What moves currency exchange rates?

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The foreign exchange, or “forex”, market is the largest and most liquid financial market in the world, with around $5trn traded every day. Its primary function is to allow the world’s businesses and financial institutions to buy and sell different currencies, and so have the means to trade goods, buy assets, or pay for services in countries other than their own. The desirability of a country’s assets and services, and the prospects for its economy (both in absolute terms and relative to other countries), will have a significant effect on the value attached to its currency. As a general principle, if a country’s economy is performing well and the future looks prosperous and - crucially - predictable, investors will be happy to hold its currency. Unexpected events, however, will send them running for the exit. A wide range of events can affect currencies, from general elections and monetary policy announcements to natural disasters and conflicts.

Would it be right to assume that wars have the most dramatic effects on world currencies?

Yes. Wars cost huge amounts of money, destroy infrastructure, and, of course, can lead to political and economic chaos. Currency markets hate them. After the Russian invasion of the Crimea in 2014, both the Russian ruble and the Ukrainian hryvnia more than halved in value against the dollar within a year. For Ukraine, this was principally the result of fears that the country would become a battlefield. In Russia’s case, trade sanctions hammered an economy that was already being crippled by the falling price of oil.

A more recent threat to world peace is the increasingly belligerent behaviour of North Korea. Although the rhetoric from all sides has been extreme, the markets have so far remained relatively sanguine. Remarkably, in the days immediately after Kim Jong Un fired a ballistic missile through Japanese airspace, in August, the Japanese yen actually strengthened, confirming its long-held status as a “safe haven” currency in times of crisis. War in the region would be a severe test of this status, however, and scared money might well then flow towards the US dollar and Swiss franc, also traditionally favoured in times of trouble.

How does politics affect currencies?

Politicians make policy, and policy affects economies. Changes in political landscapes and leadership can therefore have a profound impact on currencies. Brexit is a glaring example. Within 24 hours of the June 2016 referendum result, the pound fell by more than 10% against the US dollar, and continued its downward trajectory until October. And while it has since recovered, it remains well below pre-referendum levels. With doubts about the economic fallout from Britain’s decision to quit the EU likely to remain for many years, continued volatility is to be expected.

The euro was also hit by Brexit and then by the election of Donald Trump - events that appeared to signal a rising nationalism wholly contrary to the ideals of the European project. The currency fell to a 14-year low against the dollar, although it has been rising steadily since the defeat of the far-right candidate Marine Le Pen in the French presidential election in May. As for the isolationist Trump, while his election victory initially sent the US dollar soaring on expectations of a spending binge and tax reform, it has become clear that the only predictable thing about him is his unpredictability. The US Dollar Index, a broad measure of currency, has fallen by 11% since January. Trump recently expressed his dislike of a strong dollar (“lots of bad things happen”), and the president’s choice to replace Janet Yellen as chair of the Federal Reserve, Jerome Powell, is expected to continue her dovish monetary policy, acting as a further brake on the currency. The new Fed chair will be one of the most powerful people on Earth - but he may still struggle to control his nation’s currency in a world where the future is ever harder to predict.

Is there anything on the horizon to compare with the shocks of Brexit or Trump?

Barring nuclear war between North Korea and the US, major geopolitical risk-events seem to have passed for now. A complete collapse in Brexit talks or a deterioration of the situation in Spain, since Catalonia’s unofficial independence referendum, could potentially hit markets however the likelihood of these events transpiring seems remote. The euro’s resilience since the Catalan referendum and sterling’s gains against the dollar over the past six months illustrate this point.

Does Catalan separatism pose a genuine risk to Europe?

It seems unlikely, unless the situation should worsen drastically. There has been no dramatic sell off in the Euro since the crisis began and it seems unfathomable that Spain, and the EU as a whole, will allow the situation to deteriorate to a point that the integrity of Spain would be called into question.

Why is the Japanese Yen seen as a safe haven when its economy is so sluggish?

The Yen has huge foreign asset reserves, the second biggest in the world after China. It is very stable geopolitically and economically (if an underperformer in the latter) like the currency of another traditional safe haven, Switzerland. It’s also embedded in investors psyche, that in times of unrest (even with events that affect Japan directly, such as North Korea’s missile tests and the 2011 Tsunami) you flock to the yen. Whether you are importing from East Asia, or closer to home in euros, at OFX, we recommend forward buying currency as an essential tool for import-driven businesses. It protects profit margins and makes budgeting for international goods more predictable and sustainable.

Do you think it is a good idea to hedge currency risk with gold?

Gold like any other asset is volatile and can appreciate/depreciate depending on geopolitical and economic events. However, gold is a traditional safe haven (like JPY and CHF) and can appreciate dramatically in times of economic woe. Most small businesses who deal with overseas suppliers should be far more concerned with forward buying currencies to pay those suppliers in kind. Involving commodities, like gold, is likely to be far too much effort for small and medium sized business and could be more hassle than it’s worth.

What should you do if you own a property in a foreign country where the currency is falling?

Everything comes down to personal circumstances. If the property is going to contribute a chunk towards your retirement fund into old age then you may wish to consider selling it sooner. Should you be lucky enough to have enough money to see you through retirement, and you’re happy to carry on using it, then there really isn’t an urgency to sell in the short term.

Should investors factor in geopolitical events and act accordingly, or stick to their long-term investment plans and ignore any currency fluctuations?

Investors and businesses need to take into account the potential impact currency fluctuations could have on their profit margins. Those businesses who didn’t forward buy currency before the Brexit vote most likely experienced the cost of importing from overseas increase by 10% overnight. At OFX, we recommend forward buying currency as an essential tool for overseas importers. It protects profit margins and makes budgeting for international goods more predictable and sustainable.

For more information from OFX on currency markets and other matters, please click here