Dear investors,
Money is something so everyday that it may go unnoticed how ingenious its nature is. Current monetary systems are quite complex and, consequently, little understood by the vast majority of people, even among investors.
In this letter, we bring a brief summary of how the world arrived at the current monetary system, with central banks and floating exchange rate regimes, and some reflections on the consequences of this system for our investments.
Already admitting the strangeness of the topic among the subjects we usually cover, it arose because we recently approved an investment thesis in a company listed on the London Stock Exchange. The need to deal with currency conversions and exchange rate risks piqued our curiosity for this historical perspective.
Brief history of the currency
Before the existence of currencies, any commercial activity was carried out through the exchange of products: a basket of bread for a piece of meat, an ox for two sheep. Each operation negotiated individually and with two major difficulties: the first is that, if you only had an ox to negotiate, you would have to find someone who had the product you wanted to buy and, at the same time, wanted an ox; the second is that you would need to buy a volume of products equivalent to the value of an ox which, at least while alive, is an indivisible unit of value.
The first evolution of this clumsy system was to find some product that was of common interest, easy to store and easy to divide into the quantities necessary for each commercial operation. Various materials assumed this role in antiquity. In the early Roman Empire, salt was used as currency for a period of time. Used by everyone as a seasoning and to preserve meat and fish, easy to store, divisible in any quantity and reasonably valuable at the time, salt met all the requirements to serve as an intermediate product in commercial activities.
Even before the beginning of the Christian calendar, these intermediate products began to be replaced by precious metals, especially gold, which has since become a currency of universal value. A series of characteristics made gold the material chosen as a universal currency of exchange. It is universally desired and rare enough that small quantities represent significant value. It is divisible into any quantity you want and is eternally durable. Despite the possibility of creating metallic alloys by mixing it with other metals, as a way of falsifying what should be pure gold, methods for testing its purity have been known since ancient times, as proven by a story about Archimedes, a famous ancient mathematician.
In the 3rd century BC, the Greek king Hiero II hired a goldsmith to forge a gold crown, providing him with all the gold needed to create the piece. When the crown was handed over, suspicions arose that the goldsmith had stolen some of the gold for himself and replaced it with silver. The crown weighed exactly the same as the gold bar dedicated to its creation, but the purity of the metal could be compromised.
Unwilling to destroy the new crown to test his suspicion, King Hiero II asked Archimedes to find a way to test the purity of the gold without damaging the object. After weeks of thinking about the problem, while bathing in a bathtub, Archimedes noticed that the volume of water displaced when entering the bathtub was equal to the volume of the body of the object immersed in it, regardless of the material the object was made of. According to legend, it was at that moment that he understood that he could use this principle to solve the king's problem and, in his enthusiasm, he ran naked through the streets shouting “Eureka!”, the Greek term for “I discovered!”
The test developed by Archimedes is quite simple. With gold having a density about twice that of silver, an object made of pure gold has a smaller volume than if it were made of gold and silver. Thus, Archimedes placed the crown of King Hiero II in a container filled with water and measured the volume of water displaced. Then, he took a bar of pure gold with the same weight as the crown, placed it in another container and made the same measurement of the volume of water displaced. Comparing the two measurements and seeing that the crown had displaced more water than the pure gold bar, the crime was proven and the goldsmith punished.
This story also illustrates how old gold's position is as a symbol of material wealth. Interestingly, to this day the main use of gold is in the manufacture of jewelry and decorative objects. Its value remains high not because there is such a massive industrial use, but because it continues to be desired by people around the world. Note that it is not the condition of currency that made gold valuable, but it became a means of storing value precisely because it was already valuable before. Some primordial instinct makes him admirable and associates him with wealth.
Until the 18th century, coins containing predetermined quantities of precious metals remained the main form of money used for everyday commerce. From then on, they were gradually replaced by paper money, printed banknotes that have no value in themselves, but that represent a certain value and are widely accepted. The paper money still used today follows this same concept.
The gold standard
Paper money replaced metal coins in everyday life for practical reasons. The purity of the metals needed to be tested, the transfer of significant sums meant having to transport heavy loads of metal and there was the issue of security, both in the transport and storage of metal coins.
The solution found was to store the precious metals in bank vaults, specially built for this purpose, and replace the circulation of the metals with banknotes issued by the institution responsible for their storage. Each note represented a certain value, and could be converted back into precious metals in kind, usually gold or silver, upon request to the institution issuing the notes. In the beginning, private banks even issued gold-backed currencies with widespread market acceptance. Later, the central banks of each nation began to act as exclusive issuers of paper money, a condition they maintain to this day.
Initially, central banks maintained the backing of currencies in gold as a general practice. In other words, they guaranteed the convertibility of the paper currency issued by them into gold. This mechanism, called the gold standard, had two main advantages. The first was to guarantee that central banks could not issue paper money indiscriminately to cover public spending, indirectly imposing fiscal discipline on governments. The second is that gold functioned as an international currency of exchange. Because the currencies of major countries were convertible into gold at a fixed rate, the exchange rates between these currencies were also fixed. In this system, trust in central banks was not necessary and negotiated prices for imports and exports were, in practice, determined in gold.
Even under the gold standard, governments and central banks committed occasional excesses, suspending the convertibility of their paper currency in times of fiscal deficits that weakened the position of gold reserves actually available in the central banks' coffers. The acid test came during the First World War, a period in which several countries financed war expenses with currency printed without adequate gold backing and unilaterally suspended the convertibility of their currencies. As an inevitable consequence, this movement caused a sharp rise in inflation.
The decades following the First World War were marked by instability in the international monetary system, with several countries oscillating between adopting and abandoning the gold standard. The excessive issuance of unbacked currency caused crises of confidence in currencies which, in turn, caused bank runs in search of the right to convert paper money into gold bars. When this happened and central banks found themselves without sufficient reserves to satisfy cash gold withdrawals, the right of convertibility was suspended, further contributing to the distrust surrounding central banks as guardians of the value of their currencies. This climate of instability remained until 1944, when the Bretton Woods agreement was signed.
Bretton Woods (1944-1973)
The United States, having already achieved its position as a world power in the post-war period and holding two-thirds of the world's gold reserves at the time, led the negotiation of a new international monetary system to regulate trade relations between 44 countries. Under this agreement, each country's central bank would guarantee the convertibility of its currencies into US dollars at fixed rates and the dollar would be convertible into gold at a fixed rate of USD 35 per ounce. In practice, it was a return to the gold standard with the US dollar as an intermediary currency, with the United States in the privileged position of issuing the currency that would serve as an international store of value.
The great motivation behind the agreement, which guaranteed the adherence of several countries and sustained it for a long period, was the understanding that fluid international trade was essential to maintaining world peace. This lesson had been learned in the two world wars, both motivated by economic conflicts amplified by protectionist measures seen as unfair by countries prevented from accessing certain markets. In turn, for dynamic international trade to exist, an organized and stable system of conversion between different currencies was necessary. The international monetary system created by the Bretton Woods Agreement achieved this objective, offering some protection against manipulation of the value of currencies by central banks, one of the tools traditionally used to manipulate export and import flows.
The Bretton Woods Agreement remained in force for a few decades, but began to show signs of weakness at the end of the 1960s. In the post-war period, the United States maintained a continually deficit trade balance, largely due to financing to allied countries and American military actions around the world. To maintain this deficit, the American central bank printed more and more dollars, despite the obligation of convertibility into gold established by the Bretton Woods agreement. In 1970, American gold reserves were sufficient to cover the conversion of only 22% of the dollars in circulation in the world, encouraging the search for the conversion of dollars into gold to intensify. In response to this movement, which would soon make convertibility unsustainable, in 1971, American President Richard Nixon unilaterally announced the abandonment of the gold standard. From then on, the American central bank would no longer convert dollars into gold.
Floating exchange rate regime
After the United States broke convertibility into gold, there were some attempts to return to a fixed exchange rate system based on the gold standard, but these efforts were not successful. In 1973, Japan and European countries decided to adopt a floating exchange rate regime, in which the value of their currencies would be freely determined by supply and demand. The end of the Bretton Woods Agreement was made official in 1976 and, in the following years, most developed nations adopted the floating exchange rate regime. Brazil still took some time to adapt to the new standard. It adopted the floating exchange rate only from 1999 onwards.
The discussion of which is the best monetary system is not trivial. In the gold standard, the founding premise is that the world's gold reserves would establish how much currency is available for economic activities. As gold is finite, if the world economy grew at a higher rate than the expansion of gold reserves, the result would be deflation, as we would have a greater quantity of material goods produced by the global economy being represented by the same quantity of gold. This would lead to a constant appreciation of gold, which makes no sense per se.
About half of the gold in the world today is in jewelry and decorative objects and about a quarter is in bars and coins. Less than a fifth is in official reserves of value. If gold were constantly valued not for the value attributed to the metal itself, but for its use as backing for currencies, the inevitable consequence is that the value of gold would, at some point, be greater than its actual usefulness to people and we would leave from using gold for these purposes to simply storing it in central bank vaults, so that bars and bars of gold would just sit there, at all the cost of the security necessary to keep them safe.
In the floating exchange rate regime, the premise is that the backing of the value of a country's currency is made up of the assets existing in its internal economy. Although it is more difficult to measure than the amount of gold in the Central Bank's coffers, it makes sense that a country's economic production has value per se, regardless of the amount of gold the country possesses. The point is easily understood by imagining a country that has huge oil reserves, but no gold. Making it impossible for this country to issue currency due to the absence of gold in its coffers is against common sense.
However, the problem remains of how to determine the value of currency issued by a Central Bank that has the power to print currency indiscriminately. The solution to this regime is to leave pricing to the market. In the same way that the price of any commodity is defined by the momentary balance between supply and demand, motivated by any factor whatsoever, the exchange rate price is also defined in the same way. Indirectly, the value of a currency depends on the strength of its country's economy, the results of its international trade balance and its government's public accounts, since the main assets held in foreign reserves are typically public fixed income securities. Despite being less objective than the gold-backed fixed exchange rate regime, this floating pricing model is the standard in capitalism.
Impact of the system on investments
The first point of attention to consider is that in any international investment, there will be a risk of exchange rate fluctuation. In the short term, the rate may fluctuate without any justification derived from fundamentals. A momentary imbalance in international trade accounts, problems in other economies that require repatriation of resources or simply speculative movements around the currency can cause variations in the exchange rate. Therefore, there is always a certain randomness around exchange rate risk.
In the long term, currencies should maintain a certain parity relationship, with exchange rates varying depending on the difference in inflation in each currency. The basic concept is that the exchange rate must be defined by the real purchasing power of the currencies, because if it were possible to buy a gold bar in currency A and sell it in currency B and the exchange rate between this pair would allow the generation of profit , this would represent an arbitrage opportunity that would be exploited by investors until the conversion flow from currency B to currency A was sufficient to rebalance the exchange rate to the neutral point. With inflation being the quantitative measure of how much each currency depreciates, if currency A suffers inflation while B does not, the exchange rate needs to change so that more of currency A is needed to buy the same amount of B.
This parity relationship does not solve the exchange rate projection problem because the task remains of projecting inflation levels for the two countries in the currency pair. The estimate is difficult because each country's inflation depends heavily on the amount of currency issued by its Central Bank, which in turn has a strong relationship with the country's fiscal balance (government revenues subtracted from its spending). As we Brazilians know, the level of spending in a country is greatly influenced by political issues that are difficult to predict.
In addition to the difficulty in inflation projections, exchange rates can spend years outside the theoretical equilibrium point determined by the parity relationship that considers inflation differentials, in the same way that a share can spend years with a price far from its fair value. Therefore, investments abroad add an extra layer of risk: in addition to the fluctuation in the price of an asset, there is the fluctuation in the exchange rate. As a result, the ideal time to sell an asset abroad may not coincide with the best time to repatriate the capital, that is, convert the sale value in foreign currency back into Brazilian reais.
The choice left to investors is to accept this risk as an increase in the price volatility of foreign investments in the local currency or to enter into foreign exchange purchase or sale contracts in the opposite direction of the investment flow to neutralize the effect of currency fluctuation (hedge). , an arrangement that, in practice, involves paying a small fee to protect against exchange rate fluctuations.
When the investment thesis has nothing to do with the exchange rate, generally the best option is to carry out the hedging operation and insert the extra cost into the safety margin required in the purchase price. This is what we will do in the case of our investment in England, which we mentioned at the beginning.
Check out the comments from Ivan Barboza, manager of Ártica Long Term FIA, about this month's letter in YouTube or in Spotify.
