paulbissett.com

Another post resulting from a request to comment on a particular financial market.  This one is from the currency markets.  Life’s been crazy, I’ve got to reuse as much material as possible.

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Currency trading is a difficult business, and it always takes me some work to understand it.

In the absence of government intervention in the currency markets (Central Bank), monetary policy (Central Bank), and internal fiscal policy (Government Budgets), the value of a countries currency should fluctuate based on the import/export ratios and perceived future productivity growth relative to other currencies.

In the real world, Central Banks and Governmental Budgetary policies tend to cause (wild) variations around the long-term trends.

In the case of the Iraqi Dinar (IQD), there does not appear to be an active exchange in the currency, cleared by a central bank.  This means it is closed to currency traders.  However, there does seem to be rampant speculation in the currency by individuals.  These individuals buy actual dinars in limited quantities.  They hold this currency in hopes of selling it back for more dollars in the future than what they paid.

Playing the currency market in this fashion has some higher costs than through the currency spot and futures markets mediated by foreign exchanges and central banks.  The first risk is that the bid/ask spread is likely to be much higher.  If $1 buys 1000 Dinars from a local Bank, then it may take >1500 Dinars to buy back that same dollar at the same Bank.  Playing in real currency is typically very expensive in currency investing.

The bigger risk is that one day, the Central Bank and/or Government decides that the current currency is worthless and that they are printing new currency.  All holders of old currency must exchange this currency for new currency at an official exchange rate.  This is called a revaluation.  South North Korea did this last year at the end of 2009 and limited the amount of old currency one could exchange, effectively wiping out the savings of millions of residents.  Oh and by the way, foreign owners of the currency got nothing.

It is unclear that the Iraqi government would take such a drastic measure as limiting the amount of currency that can be exchange, or who may actually exchange the old currency for new.  But this is a risk that must be acknowledged in currency trading.

The most highly discussed possibility with the Dinar is a revaluation without limitation (do a Google search on Iraqi Dinar).  This means that all non-counterfeit currency will be exchangeable at the new exchange rate.  The non-counterfeit qualifier here is important because there seems to be rampant counterfeiting occurring in the Dinar.  If you are buying actual currency and have no way to assure that it is non-counterfeit, you run the risk of losing your investment on the revaluation.

A “clean” revaluation is simply exchanging one set of old notes for a fixed set of new notes, i.e. 100 old Dinars = 1 new Dinar.  In such a revaluation, there is no change in the relative value of dollars that will be purchased after the exchange, i.e. there is no appreciation in the currency investment in dollar term.  If $1 buys 1000 Dinars before the revaluation, then $1 will buy 10 Dinars after the revaluation.

The point here is that currency revaluation is very different that currency appreciation.  It is akin to a stock split, or in this case a reverse stock split.  If the underlying fundamentals of the currency are not likely to change then the relative value of the currency is not likely to change on a revaluation (assuming the other currency is stable).

The official exchange rate from the Iraqi Central Bank appears to be 1170 IQD to $1 (http://en.wikipedia.org/wiki/Iraqi_dinar).  However, this may not represent the actual “street value” of the Dinar, which may factor into any revaluation.  In reviewing a possible investment in actual dinars, let’s look at a commodity price comparison for implied exchange rates.

A quick look at sugar prices in the commodity markets from December suggests that the “real” exchange rate of Dinars is close to 1,755 IQD per $1 (This comparison is quick, dirty and suspect because I just used data that I found on the web.  Your results may vary.) –

Refined White Sugar (RWS)
50 kg (Dinars, IQD)               65,800
1 kg (Dinars, IQD)                  1,316

Spot Market (RWS)
1 kg ($)                                   0.75

Implied Conversion 1,755 Dinars per $1

Local Bank Sold 1,250,000 (IQD) for $1307.50 (December 14, 2010)
or
Local Bank Sold 956 (IQD) for $1

The purchase of Dinars at a local bank with US$ would buy approximately 54% of the Dinars that could have been purchased on the streets of Baghdad.  This does not appear to be a good exchange rate from which to make currency investments, and is probably a function of the bid/ask spread problems I mentioned earlier, as well as the fact that Florida Bank probably has to work off “official” exchange rates in acquiring the currency for a customer.

Outside of revaluation, official exchange rates, and bid/ask spreads, there are other risks in Iraq that must be considered.  These include civil war and continued problems with oil exports.  At the same time the county needs to rebuild its infrastructure, elevating imports.  These will hurt the long-term trends in Iraq’s internal productivity growth as well as its expected import/export ratios.  This would suggest a flat to decreasing Dinar relative to other more stable currencies.

Buying Iraqi Dinars from a local bank using dollars is a bet on Iraq versus the U.S. with some extreme bid/ask spread and high risk.  It appears to be a poor investment choice at this time.

But that’s just my opinion…