By guest contributor Kevin Toohey, General Manager, Atchison Consultants
Through trade and capital flows, individuals and businesses can accumulate significant capital in overseas jurisdictions which is held in short-term deposits in foreign currencies. Often the intention will be that the working capital will be held on deposit temporarily in anticipation of future activity.
There are three primary considerations:
- interest rate available
- access to capital
- security of capital
Typically access and security of capital will rank higher in importance to the levels of interest rate received.
Major banks offer term deposits denominated in the major foreign currencies across a range of terms, allowing depositors to balance timeliness of access to capital with generally higher rates of interest.
Nominal interest rates offered in most currencies are currently negligible. By way of example HSBC Australia offer a number of foreign-denominated deposit accounts, all with negligible interest rates:
These low rates are partially a reflection of the consistent reduction in interest rates by the central banks of the US, Eurozone, Japan, Canada and the UK over recent years.
Security of capital is required at two levels:
- Absolute strength of deposit-taking institution (bank)
- Relative strength of foreign currency
Depositors should assess the strength of their counter-party bank to meet the deposit obligations. With credit ratings as a basis, banks rated as investment grade are common.
Particularly for foreign currency amounts that do not have a definitive local denomination purpose, a significant opportunity cost can occur if the relative value of the foreign currency held significantly drops in value.
Security of the relative currency value is dependent on the financial management of nations. History shows an extended track record of governments undermining the real value of currencies, often through inflation. Extreme inflation examples such as the Weimer Republic, Zimbabwe and China through the Yuan Dynasty were disastrous on the relative value of the currency. Similarly, when considered over longer time periods, seemingly mild environments of inflation can have a material impact given enough runway. For example, the real value of the Australian dollar over the past 25 years has fallen by approximately 45% or 2.5% p.a. through inflation.
At least over the given period, Australian nominal interest rates have provided some compensation. At current foreign interest rates level, on an after-inflation basis, foreign depositors can typically expect to lose real value. Currencies offering positive real interest rates are limited to developing economies in Asia and South American such as the Philippines, Brazil, Chile and advanced economies such as Singapore.
Foreign depositors must balance the three considerations of interest rate, access to capital and security of capital as part of their treasury management. In the current environment of negative real interest rates, erosion of future purchasing power is a material opportunity cost of holding foreign denominated working capital on deposit.