The world’s most undervalued currency

The world’s most undervalued currency is the Hong Kong dollar. Most of what I said in my previous post about the undervalued Japanese yen applies to an even greater degree for the Hong Kong dollar.

Hong Kong is a special administrative region of China. This means that China is responsible for Hong Kong’s defense and foreign policy while Hong Kong provides its own legal system, law enforcement, monetary system, and other domestic policies. Hong Kong was originally a territory of China that later was taken over by the British in the 1840s and the Japanese in the 1940s during World War II. After World War II, Hong Kong went back to British rule. In 1997, Hong Kong was handed back to China.

According to the Economist magazine’s Big Mac Index, a Big Mac costs an average of $3.41 USD here in the USA and an average of $12 HKD in Hong Kong. If the USD and HKD were at Purchasing Power Parity, $1 HKD would be worth 28.4 cents in USD. Based on the actual exchange rate, $1 HKD is worth 12.8 cents USD. This means that the Hong Kong dollar is selling for only 45% of Purchasing Power Parity against US dollars. That’s a steal! In fact, based on current exchange rates, no other currency is as cheap on a Purchasing Power Parity basis as the Hong Kong dollar.

It is amazing that the Hong Kong dollar is so incredibly cheap given all the factors that should make it sell at a premium to Purchasing Power Parity against the US dollar. Like Japan, the United States, Australia, Canada, and western Europe, Hong Kong is a rich First World economy with a high standard of living, stable government, and high wages. Natural resources are scarce in Hong Kong, and most of its food, energy, and other supplies must be imported.

Land is especially scarce in Hong Kong, especially after you consider that much of its small land area is too rugged for agriculture and other uses. According to the CIA World Factbook, Hong Kong’s population density is 6740 people per square km (7,018,636 people on 1042 square km of land), compared to 340 people per square km for Japan, 33.2 people per square km for the United States, 2.70 people per square km for Australia, and 3.65 people per square km for Canada. Thus, Hong Kong is not a place where you’d expect land, rents, wages, grain, beef, or other costs of running a McDonald’s restaurant to be cheap.

Why is the Hong Kong dollar cheaper than so many Second World and Third World currencies even though it belongs to a First World economy where wages, rents, commodities, and other costs are expensive? Since 1983, the Hong Kong dollar has been pegged to the US dollar at the rate of $1 USD=$7.8 HKD. Without the peg, the Hong Kong dollar would be considerably higher against the US dollar. The Hong Kong Monetary Authority uses Hong Kong dollars to purchase US dollars to artificially hold down the value of the Hong Kong dollar.

This currency peg will not remain forever. Every day that the Hong Kong Monetary Authority maintains the currency peg, it cedes control of its monetary policy to the US Federal Reserve. While the anti-inflationary Paul Volcker was the US Fed Chair when Hong Kong began the peg in 1983, the pro-inflationary “Helicopter Ben” Bernanke is the US Fed Chair today. Something will happen that will make the Hong Kong Monetary Authority to cease outsourcing monetary policy to Helicopter Ben. Perhaps the upward pressure on the Hong Kong dollar will become so strong that the Hong Kong Monetary Authority will no longer be able to hold down the value of its currency. Or perhaps the day will come when the costs of maintaining the currency peg exceed its benefits. Indeed, the Hong Kong economy is becoming increasingly linked to that of mainland China. Hong Kong may decide to drop the dollar peg in favor of a peg to the Chinese renminbi, another undervalued currency (only 46% of Purchasing Power Parity).

Why did I use an Everbank foreign currency CD to buy the Hong Kong dollar? Again, I am avoiding FOREX brokers due to doubts about their stability and lack of insurance as well as the fact that they are geared for hyperactive traders. Unlike the case with the Japanese yen, there is no Hong Kong dollar ETF. The Everbank foreign currency CD is the only way for reasonably conservative investors to purchase Hong Kong dollars. Everbank’s foreign currency CDs are FDIC-insured. Everbank is a conservatively run bank.

I am confident that when the current peg is dropped, the Hong Kong dollar will at least double in value. It won’t happen right away, but it will happen. Even if it takes a few years, it will be well worth it. A double in 2 years means an annualized return of 41.4%, a double in 3 years means an annualized return of 26.0%, a double in 4 years means an annualized return of 18.9%, and a double in 5 years means an annualized return of 14.9%. A double in 10 years means an annualized return of 7.2%, far better than what US Treasury Bills are likely to return.

Japanese yen

The Japanese yen is undervalued. A Big Mac is cheaper in Japan than here in the USA.

The magazine _The Economist_ uses the Big Mac Index to appraise currencies. The Big Mac Index is an indicator of Purchasing Power Parity. A Big Mac is considered to be representative of goods and services. Although I have been steering clear of the Golden Arches ever since the movie _Supersize Me_ grossed me out, the fact remains that the price of a Big Mac is representative of the cost of many local goods and services, such as land, rent, labor, energy, beef, and grain.

According to _The Economist_ magazine, a Big Mac costs an average of $3.41 USD here in the USA or 280 yen in Japan. Given a current exchange rate of $1 USD = 104.150 yen (10,000 yen = $96.01 USD), an American tourist visiting Japan would only need to convert $2.69 in USD to yen in order to buy a Big Mac. Thus, the tourist would pay 21% less for that Big Mac in Japan than in the USA.

If the US dollar and the Japanese yen were at purchasing power parity, the exchange rate would be $1 USD = 82.111 yen (10,000 yen = $121.79 USD). So the 10,000 yen that currently sells for $96.01 would be fairly valued at $121.79. Again, we can see that the Japanese yen is selling for 21% fewer US dollars than Purchasing Power Parity.

To relate currencies to stocks, the Purchasing Power Parity of a currency is analogous to the book value of a company’s stock. Of course, just as a stock price can remain substantially above or below book value, a currency can remain substantially above or below Purchasing Power Parity. One reason that this disparity can persist is the fact that the real world has substantial currency exchange fees and transportation costs. Additionally, certain countries have persistently higher or lower land prices, rents, wages, and commodity prices.

However, the Japanese yen relative to the US dollar is likely even cheaper than Purchasing Power Parity suggests. Japan has a much higher population density than the US. Land is scarce in Japan, especially after you consider the fact that most of the interior is mountainous and unable to support agricultural, industrial, or residential use. Thus, Japan is a nation with high land prices and high rent. As an industrialized First World nation (like the USA, Canada, western Europe, and Australia) with a high standard of living, Japan has high wages. Natural resources are scarce in Japan, so the nation must import heavily. Thus, one would expect almost everything, including Big Macs, to be more expensive in Japan than in the US. Thus, Purchasing Power Parity provides a very conservative appraisal of the yen.

Why is the Japanese yen so cheap? Because the Japanese economy still hasn’t recovered from the recession and stock market collapse of 1990, most of the the world has given up on Japanese stocks and businesses, and this holds down demand for yen. The other reason is the extremely low interest rates (well below 1%). Low interest rates discourage investment in Japanese debt instruments (bank CDs, corporate bonds/paper, government debt, etc.), also reducing demand for yen. Furthermore, low interest rates encourage both domestic and foreign investors to borrow Japanese yen and invest the money elsewhere for higher yields. Borrowing yen is the same thing as short-selling yen, and this selling pressure also conspires to drive down the yen relative to other currencies. This practice of borrowing money in one currency and investing it in another currency is called the carry trade.

The unwinding of the yen carry trade is a potential triggering mechanism for a rise in the value of the yen. In order to liquidate the yen carry trade, one must buy back yen in order to pay off the loan. Most estimates suggest that at least $1 trillion USD is being gambled on the yen carry trade. If a large number of speculators are simultaneously forced to liquidate their yen carry trades (due to falling financial markets elsewhere or any rise in Japanese interest rates), there will be much more demand for yen. This would boost the value of the yen and force more speculators to liquidate their yen carry trades. This “short squeeze” in the yen would become a chain reaction, like the program trading of US stocks on October 19th, 1987 but in reverse.

Why did I choose to buy FXY (Currencyshares Japanese Yen ETF) to bet on a rising yen? I do not recommend opening a FOREX brokerage account to trade currencies. Unlike the stock brokerage industry, the FOREX brokerage industry does not have SIPC insurance. FOREX brokerage firms are notorious for going under without warning and taking customers’ money down with them. Also, FOREX brokerage firms are geared towards extreme speculators. Given that leverage ratios of over 100:1 and multiple trades an hour are popular among FOREX traders, they make the Dot-Com daytraders of 1999-2000 look conservative in comparison. Everbank offers Japanese yen CDs, but the FXY ETF (which holds 10,000 yen per share) is much more liquid and convenient because it trades like a stock and is not subject to early withdrawal penalties.

Model Portfolio update: bought Hong Kong dollar CD

The Doppler Value Model Portfolio purchased a 3-month Hong Kong dollar CD from Everbank on Thursday, May 15th. According to http://www.exchange-rates.org, the exchange rate was $7.9950HKD/USD. So the $10,000 USD investment was $79,950.00 HKD. The currency conversion fee was 1%, or $100 USD. The interest rate is 1% for the current term.

To conform with the terms of a CD, the CD will roll over every 3 months unless I specify otherwise. Also, any interested earned will be reinvested in the new CD. If I decide to liquidate rather than roll over the CD, I will announce that on this blog at least a week in advance. The fee for converting the CD back into US dollars or into another currency will again be 1%. Interest will be earned in Hong Kong dollars and will be credited upon maturity. As is the case with the regular cash balance, interest will accrue daily.

The current CD will mature on Friday, August 15th, 2008. Assuming that I continue rolling over the CD, the subsequent maturity dates will be:
Friday, November 14th, 2008
Friday, February 13th, 2009
Friday, May 15th, 2009
Friday, August 14th, 2009
Friday, November 13th, 2009 (Yes, that’s Friday the 13th. I hope to get away from Jason on that day, but the only way I can do that is to have an out-of-body experience. Well, I’ll just have to deal with Jason myself.)

The $10,000 USD used to purchase the Hong Kong Dollar CD and the $100 USD currency conversion fee bring down the cash balance from $71,736.58 USD to $61,636.58 USD. The Doppler Value Model Portfolio now consists of:
$61,636.58 USD cash
$79,950.00 HKD Everbank CD
2 shares of Berkshire Hathaway Class B
222 shares of DFJ
103 shares of FXY

Model Portfolio Update – purchased DFJ and FXY

DFJ (WisdomTree Japan SmallCap Dividend ETF) closed at $44.95/share today. FXY (CurrencyShares Japanese Yen Trust) closed at $96.84/share today. So the Model Portfolio has just bought 222 shares of DFJ for $9978.90+$40.00 in commissions and 103 shares of FXY for $9974.52+$40.00 in commissions.

So the Model Portfolio now consists of:
$79,966.58 in cash
222 shares of DFJ
103 shares of FXY

Model Portfolio: buying Hong Kong dollar CD

I am buying an Everbank Hong Kong dollar CD for 10% of the model portfolio. To simulate the time it takes to open an account at Everbank, this transaction will take place at the close of business next Thursday, May 15th at the prevailing exchange rate. The transaction cost of the currency exchange will be 1%.

Model Portfolio: buying Japan

The Doppler Model Portfolio is purchasing Japanese investments – DFJ (WisdomTree Japan Small-Cap Dividend ETF) for 10% of the portfolio and FXY (CurrencyShares Japanese Yen ETF) for another 10% of the portfolio. In keeping with the rules I set, these purchases will take place at the closing price tomorrow (Friday, May 9th).