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By Joseph Cafariello
Tuesday, February 12th, 2013
A nation’s currency is much like a company’s stock. In the simplest of terms, the value of a company’s stock is derived by cutting up the company’s total worth by the number of shares in circulation.
This same simplistic principle can be applied to the valuation of a nation’s currency, where cutting up the nation’s wealth by the number of units of currency in circulation gives you the value of each unit of money.
But there arise circumstances that can temporarily see a company’s stock—or country’s currency—trade below its ‘calculated’ value. Entire investment funds are based on such disparities; value funds, for example, focus on buying stocks that are trading below their companies’ book value.
Extend this idea to currency trading, and you can see why there is so much excitement around Iraq’s currency, the dinar. Investors consider the Iraqi dinar grossly undervalued, given the tremendous potential of Iraq’s oil-based economy, and are thus buying the dinar with great expectations.
Just how tremendous is the potential of Iraq’s economy? The International Energy Agency summarized Iraq’s promising prospects, as reported by the Wall Street Journal not long ago:
“Iraq's oil output is on track to more than double in the next decade, supplying almost half the growth in world oil supply and making the country a driver of future crude prices, the International Energy Agency said.”
Citing an IEA forecast, the article noted, “Iraq's oil production could hit 6.1 million barrels a day by 2020 and 8.3 million barrels a day by 2035, compared with just over 3 million barrels a day now, … [which would] make Iraq ‘by far the largest contributor to global supply growth’ over the next 20 years, taking the place of Russia as the world's second-largest oil exporter.”
The same article quoted Fatih Birol, chief economist at the IEA, in an interview: "Production growth in oil and even in natural gas will provide the chance to transform Iraq's economy.” “Oil revenues can provide solid foundations for a prosperous country."
And isn’t that what every value investor is counting on? The opportunity to buy a stock or currency while it is still cheap, before the company or country reaches its full economic potential?
Indeed, it is going to happen eventually for Iraq. Many war-torn nations of the past emerged as economic power-houses after those initial rebuilding years; Japan and Germany among the best known. But how long does it take?
Time is certainly one very important factor any investor needs to consider. Sure, Iraq’s oil revenues will likely double over the next decade. But what will the U.S. stock market do over the same period? How will a well-diversified portfolio of dividend stocks, growth stocks, and some precious metals perform? Is the dinar really worth such risk when there are so many safer choices right here at home?
And even with a great appreciation in the value of the dinar over the coming years, the costs associated with jumping in and out of the trade are not of little consequence.
A recent Reuters article noted that “buying the dinar is a task in and of itself. The currency is only traded in Iraq, so it can only be purchased by U.S. customers through a handful of dealers around the U.S. who get their dinars from Iraqi banks. If a customer wants to sell his dinars, the dealer will only buy it back at a 30 percent discount - so no quick trades here.”
The safety of the transaction is also a concern, given the dinar’s small and illiquid market. Writing for Forbes, John Wasik cautions, “When there’s exclusively a private market for any security or vehicle, valuations can be highly speculative. If there’s no open system with transparent pricing and clearing systems, the investor safeguards are minimal.”
Essentially, the quote you are getting could be highly skewed in your disfavor.
Yet there is another very critical factor at play in trying to determine the soundness of the dinar as an investment, or of any currency for that matter: political uncertainty.
A highly recommended read on the effects of political uncertainty on currency stability is the 2005 paper Politically Generated Uncertainty and Currency Crises by David Leblang of the University of Colorado and Shanker Satyanath of New York University.
Of particular interest to our discussion here is their paper’s first section, “Causal relationship between political variables and currency crises”, where the pair examines two hypotheses, the first of which is that a new government increases the likelihood of a currency crisis.
After walking us through a number of theories, the duo reasons “that an increase in the range of beliefs across speculators about the state of economic fundamentals, raises the probability of a currency crisis.”
They go on to explain why there would be a “range of beliefs across speculators” in the first place, saying, “When a government has already been in office for an extended period, speculators have a relatively common basis for forecasting the government’s likely response to a given set of statistics; the government’s recent track record. When there has recently been turnover in government, the government does not have a recent track record…”
“Recent turnover in government,” they conclude, “increases the probability of a currency crisis.”