wealtharticles-hopping_onto_higher_interest_yielding

Hopping onto Higher Interest Yielding Currencies - By Ivan Ng

One perennial question many Singaporeans might be asking would expectedly be: Why are banks giving such low interest rates for my Singapore dollar deposits compared to deposits in other countries? A good question considering the fact that inflation in Singapore measured by Consumer Price Index (CPI) rose to 4.4% yoy in Dec 2007.

Currently, bank deposit rates for the mass market Singapore dollar savings accounts would range from 0.25% to 1.5% per annum. By and large, this varies with different banks, the deposit size, the tenure, and the type of deposit account. Even if one can negotiate a better rate with banks, it seems unlikely that they will be able to beat the mounting inflation figures.

How about converting some of my savings into higher-yielding currency time deposit? Now a quick check on some of the local bank’s website shows that a 6-month NZD50,000 time deposit would yield interest rates ranging from 7.2% to 8% per annum as at 15 January 2008.

The logic appears surprisingly simple. Assuming an exchange rate of SGD1.13 to NZD1.00, buying NZD50,000 would cost an investor SGD56,500. For the Kiwi-dollar deposits, we have assumed an interest rate of 7.6% per annum for a six-month time deposit. While care has been taken to ensure realism to the detail, all figures represented herein are only for illustrative purposes only.

Forex Movements Threaten Yields
Most of us, however understand that even this seemingly simplest of strategies to make money work harder for us is not without its risks. To the majority of us who earn and consume in Singapore dollars, movements in the exchange rate of the Kiwi dollar against the Singapore dollar 6 months down the road would be a key concern. A depreciation in NZD against SGD within the following 6 months would mean the principal amount and interest placed in NZD when converted into SGD, will be less. The reverse is true as well.

Let me assume ½ year down the road, the NZD has weakened to a point where it costs only SGD1.09 to buy NZD1.00. After the conversion into SGD, the outlay of NZD50,000 plus interest of NZD1,900 would leave us with SGD56,571. This deposit, in spite of the higher interest rates on the NZD, would have been better off if he had just left the money in a Singapore dollar 6 month time deposit, sitting on a cushy SGD56,923.75 at the end of the 6 month tenure.

Of course, some may wonder if currencies could depreciate or appreciate against one another that rapidly after all. Don’t the huge differentials in interest rates provide some sort of a buffer towards downside risks as well? From the above example, is a 3.7% depreciation of the NZD against SGD considered a drastic move for the currencies? Is placing money in higher-yielding currencies not such a good idea in the long run ultimately? We shall examine some recent currency movements as well as finance theory to attempt to answer these questions.

In the 2^nd half of 2007, the Singapore dollar appreciated by about 6.5% against the USD; this shows that currency movements could be volatile and move in large magnitudes within a short span of time. More importantly, this means that investors who have placed their monies into foreign currency deposits with higher yields than the Singapore dollar deposits may not be securing a good deal, if the foreign currency in concern depreciates against the Singapore dollar.

Let us take another case of a typical Japanese yen (JPY) interest rates are currently among the lowest in the world, and many Japanese have been trying to improve their yields on their home currency by placing them in higher-yielding currencies, such as NZD; in fact, this is the very basis of the carry trade strategy employed across global markets today.

Nonetheless, the currency market has always been an extremely volatile one. On 23 July 2007, NZD1.00 could still be exchanged for JPY97.58; but just 3 weeks later, on 16 August 2007, an investor only receives JPY78.39 for NZF1.00. This is a huge 24.5% depreciation of the NZD against JPY!

While this volatility is probably an anomaly, owing to the massive unwinding of the yen carry trade, it offers an idea of the risks of getting caught on the wrong side of a massive currency movement which could have been translated into huge capital losses for investors in the base currency terms. The interest rate differentials would have barely compensated for the capital losses suffered from such a single movement in the exchange rates.

Knowing What Interest Rate Parity Means
It is also important that investors understand the theory of interest rate parity. While 2 versions of this theory exist, that is, covered and uncovered interest rate parity, we will only be focusing on the former.

This theory attempts to conclude that spot and forward prices for currency pairs have already incorporated the interest rate differentials; as a result, the possibility for additional gains, owing to higher interest rates on one currency over another, is minimal. Theoretically, the market would also take the opportunity to earn an arbitrage profit if the relationship between the spot and forward prices did not already include the interest rate differentials, eventually closing the window for profits.

To explain, spot rates are the rates at the point in time when the buying or selling of one currency for another occurs; forward rates as the name implies, are the current traded prices for an asset which 2 parties have agreed to buy or sell to each other at a specified future date. For foreign currencies, forward rates could be predetermined for a range of 1 week to more than a year in advance.

Do Forward Rates Necessarily Determine Future Prices?
Truth is, forward rates do not determine the price 6 months from today; they are but a reflection of the market’s expectations of future price levels, at the current point in time. This means that, technically, a depositor may still be able to enjoy the additional interest earned on higher-yielding currencies, as spot prices upon the conversion of the foreign currency into his home currency may be beneficial to him in the short run. Nevertheless, the theory of interest rate parity does illustrate how the interest rate differential has already been incorporated into the market expectations for future currency movements.

Investors should also realize that, by using foreign currency time deposits to earn higher yields, they are effectively giving up their autonomy over those sums of money for that particular length of time. Should high volatility in the exchange rates of these foreign currencies occur, owing to the changes in monetary policy by their respective governments, investors will not be able to do anything until their deposits mature. They risk paying penalty charges or suffering a freeze on the interest payable on their money if premature termination occurs.

Higher-Yielding Currencies Not A Sure-win
Ultimately, to attempt to take advantage of higher-yielding currencies is not as simple as it seems, owing to the potential adverse currency movements between your base currency and the foreign currency in concern. The theory of interest rate parity has given us simple examples of how interest rate differentials have already been factored into the market’s expectations of future exchange rate movements.

Generally, keeping deposits in other currencies would only prove to be more useful, if one expects inflows into that particular currency, or when he has future needs for the currency for a child’s education or investments in that foreign country. We believe that investing through higher-yielding currencies may not necessarily be profitable in the longer term, due to interest rate parity, even as investors may be able to enjoy the effect of higher yields in the short run.

Ivan Ng (iFast Insights Feb - Apr 2008)