When Money is Turning into Confetti

Reading about Zimbabwe’s 1,000,000% inflation in recent times inspired the title of this post. I saw a beautiful picture of a 50 billion dollar note printed by the Reserve Bank of Zimbabwe. I have never owned or even seen a currency note with so many zeros. It is currently worth a princely sum of four U.S. dollars. Even if we ignore this extreme case of a sub-Saharan African country, there are examples of larger, more influential countries where inflation has been 1,000%+. They include Russia, Argentina and Brazil. Yes, that Brazil – the ‘B’ of the darling BRIC countries - where the last 5 years of impressive growth and amazing reforms have made it the most stable of all emerging markets, even with the global credit crisis in full swing. A 1,000% inflation results in the infamous long lines for bread, where the price of bread paid by people towards the end of the line is considerably more than what the people at the front pay. In a 1,000% inflation economy, a worker’s salary must increase by a factor of 10 every year, just to keep his standard of living the same. Pretty soon, the central bank printing the nation’s currency and the school children learning their multiplication tables will grow weary with the number of zeros added every month!

When money turns into confetti, what can the residents of a country do? If most of their money is in cash, it is essentially becoming worthless, as even interest-bearing accounts will not be able to keep up with hyper-inflation. Even before the interest rate is revised, the inflation beats the bankers to it. Bonds become practically worthless as the nominal value of the principal is diluted by an order of magnitude in just one year if the inflation is 1,000%. Stocks may hold a little value because the companies that make the essentials that people want will increase prices with inflation while looking desperately for ways to manage the hyper-inflating cost structure. Still, they are not safe havens for the long term because the economic base (i.e. the people’s affordability) weakens so quickly in a hyper-inflationary situation that no company can count on making long term profits in such a country.

So, what can a small investor do to protect his wealth? He can have a sizeable portion of assets in relatively stable “hard” currencies such as USD, EUR, GBP etc. Ah, I can hear some of you complain, these are fiat currencies that are backed by no more than the “full faith and credit” of the issuing countries. Sure, but compared to the faithless currency of a hyper-inflating country with poor governance mechanisms, this is a vastly superior choice. Yet, this option is not always available due to foreign exchange restrictions placed on many residents, especially those living in developing countries that do not float their currencies freely in the global market. The next option is to own “hard” assets like Gold and Real Estate. Both react differently, in my view, during hyper inflation. Gold may preserve its value because it is a globally consistent and tradable asset with universal purity standards. Yet, owning gold physically carries risk and is expensive (due to transaction premiums and security charges) in many developing countries. Gold ETFs are not available in many developing countries but countries like India now offer gold ETFs for resident investors. Owning real estate on the other hand is easier but it is not liquid and it also has some risk, depending on the country’s property rights laws and enforcement infrastructure. Moreover, since all real estate is local, real estate may not offer a safe refuge in a hyper-inflating economy where the real affordability is declining and economic activity is shrinking. Whether real estate will hold its value in the long term in a country where affordability is declining is highly questionable. After all, the value of real estate is dependent on people’s ability to either pay rent or buy the property outright, both of which are dependent on economic prosperity.

Searching for an answer to this question led me to the Oracle of Omaha himself, who addressed this issue in a Q&A session. Warren Buffet said that the best thing an investor can do in a hyper-inflating economy is to invest in himself! This response deserves some careful thought. Regardless of what a currency’s worth is, a competent doctor or engineer or a hair stylist will earn his/her share of the economic output. Even within the same discipline, a highly skilled professional will earn more than his less skilled compatriot. In other words, skills useful to society never become worthless in any economy. In a country where financial investments are worthless, personal skill sets alone will ensure the long term living standards for individuals. This response is of course disappointing if you are, say, a septuagenarian investor, who no longer has the physical capacity for earning wages and so, depends only on income from investments. Well, old age sucks in any country, but it is brutal in a hyper-inflating country. This is why, owning hard currency-based assets becomes crucial for investors who have no other means of earned income.

Does the above apply even to ‘modestly high’ inflationary economies, say India and Southeast Asia, where inflation reached double digits recently? Staying employed is one of the best ways to deal with double digit inflation as incomes rise on par with inflation or better, at least for most skilled occupations. In addition, every year of staying employed is one less year to worry about income during retirement. On the other hand, facing a 15% annual inflation over a 30 year horizon can be brutal to an investor who is unable to earn income through employment. If you were hoping to retire on say, Rs. 50,000 a month ($1200 a month in today’s exchange rates), it is worth only about Rs. 12,000 a month in today’s value 10 years from now, barely Rs. 3,000 a month 20 years from now, and a piddly Rs. 750 a month at the end of your 30-year planning horizon. One way to protect the value of the initial Rs. 50,000 a month is to have it as a safe withdrawal from a well-diversified portfolio (that should have inflation-beating and likely volatile asset classes). This introduces asset price volatility (market risk) into the picture. So, depending on when your 30-year horizon begins, adverse market conditions may prevent you from withdrawing the same amount monthly (inflation-adjusted for future years) or you risk exhausting the portfolio before the 30-year horizon.

This is why I don’t always subscribe to the concept that all or even most of one’s assets must be in the country where the retiree lives. This advice, while sound for retirees in many “hard” currency countries, is fraught with risk for retirees in developing markets. I am of the opinion that no more than 50% of one’s assets should be in the developing country where the retiree lives (again, invested to generate a return at least on par with inflation) with the rest similarly invested in hard currency assets. Some of you may recall the recent data (of the last 3 years) where the exchange rate(ER)-interest rate (IR) parity relationship broke down between U.S. and India. Interest rates in India were higher than U.S. and yet the exchange rate did not reflect that adequately. Yes, that kind of risk can make one feel “stupid” for not having converted all the money into Indian currency earlier but that is a lesser risk in my view than facing serious currency inflation after converting all the assets into one currency. ER-IR relationships are not mathematically precise, so an investor expecting ER to rise to match IR differentials between two countries may be disappointed in the short term. However, I believe the relationship will hold in the long term because of global trade balances. An implication of the “hard” + “soft” currency strategy of assets is that one’s returns would be lower because a sizable portion of the assets are in a ‘low yield’ country or a ‘high inflation’ country but that is a price to pay for diversification. The low yield country may also have low relative inflation but this need not translate into quantitative ER adjustments in the short term. Currency markets are not always tightly correlated with relative interest rates, especially when one of the currencies is not freely floated. So, you can partially hedge your risks, but cannot eliminate them. Faced with uncertain probability of two scenarios, one coming first in a race and the other finishing last, a rational investor may choose a middle option where you can be certain of being neither first nor last.

And, in the remote possibility that you are reading this blog from Zimbabwe, I am told that the special paper and ink used to print currency notes has a decent heat index value, so you can save fuel costs while cooking your meals every day. You now have money to burn.