It’s that time of year when friends and colleagues are asking about summer vacation plans. Interestingly, this question happens to dovetail with the requests we get on where we potentially see value. For those tourists who are stuck on ideas, a first logical step may be to identify favorable exchange rates to help narrow down potential destinations.
This value-seeking behavior resonates with us as a global bond manager in a couple of ways. First, we are always conducting our own currency analyses, in which tourism plays a role. We are always looking for undervalued currencies, supported by underlying economic fundamentals that will eventually help those valuations revert to their means—the bedrock of our approach to active currency management. Secondly, we want to identify the secular and cyclical trends that will actually help a country’s economic fundamentals improve. Tourism is one of those factors—it’s a micro event illustrative of the macro impact that human behavior can have on something like a country’s current account, and eventually the currency. Let’s take a look at Mexico, which became a perennial vacation destination following two notable events that coincided in 1994: the Tequila Crisis and the North American Free Trade Agreement (NAFTA).
The Mexican peso ailed from the Tequila Crisis—a perfect storm of Federal Reserve tightening, falling crude prices, weak domestic infrastructure, and general political instability. Yet, the weaker currency became a crucial part of Mexico’s growth trajectory over the next two decades. Mexico’s NAFTA membership opened the floodgates to inbound foreign direct investment (FDI), thanks in large part to the cheap peso. In one respect, Mexico saw improvements to its capital account due to the inflow of FDI in the form of fixed capital investments concentrated in manufacturing sectors. New factories brought in new jobs and all the benefits that come with it—better infrastructure, an increase in government revenues from a bigger taxable base, and an increase in consumption. Historically, FDI levels in Mexico peaked three times following the Tequila Crisis, in 1997, 2001, and 2013—the most recent spike showing a sharp rebound off of a 20-year low.
Mexico’s current account also benefitted from increasingly prolific exports to the U.S. and the improving services needed to accommodate foreign tourists. Americans really played a pivotal role in Mexico’s growth story, either by importing comparatively cheaper Mexican-made goods, or planning a trip to a country that increasingly offered better hotels and infrastructure to attract tourists. As Chart 2 shows below, tourism has steadily increased over time in Mexico. The overall improvements to Mexico’s current and capital accounts were reflected in the country’s overall balance of payments.
So why are we telling you a story that’s over 20 years old at this point? It’s a tale as old as time—actually, more like when most currencies around the globe became free floating. Currencies are an economic regulator; the peso illustrates how a combination of currency valuations and consumer behavior can serve as favorable tailwinds for an economy and support long-term economic expansion.
This story isn’t exclusive to emerging markets either. The U.K.—a notoriously expensive vacation destination—has enjoyed a surge in tourism following a weaker pound sterling, which fell after the June 2016 Brexit referendum:
London’s enviable high end shopping has particularly been a draw for foreign tourists looking to buy luxury goods discounted by the pound’s depreciation. To substantiate this trend, foreign credit card transactions in London jumped 22% in December 2016 from the previous year.1 England’s national tourism agency, Visit Britain, even announced plans to court Chinese tourists in an effort to infuse £1billion into the services sectors.
The trend in the U.K. hints at who is leading the charge in global tourism. While a broadly strong U.S. dollar over the last couple of years—particularly in 2015-16—drew Americans to various international destinations, the previously dollar-pegged renminbi also gave the rising Chinese middle class international mobility. The effects of Chinese international travel on the country’s balance of payments are striking, as shown in Chart 4 below. Over 84 million Chinese tourists traversed the globe in 2016, and their expenditures are reflected in China’s balance of payments relative to gross domestic product (GDP):
Therefore, the results of tourism are positive-sum for both the destination and home countries of visitors—the benefits can be seen in both current accounts. The relationship between cheaper currencies and a rise in tourism have the potential to notably improve a country’s balance of payments—a metric that gauges the health of an economy. Eventually, sustainable economic growth should help the currency appreciate over time—and may boost the total return of unhedged sovereign bond investments. Behaviorally, an influx of foreign tourists into a country can indicate an undervalued currency. That flow of tourist spending and portfolio and FDIs then create a demand for a country’s currency.
In the complex world of currency valuation there are all kinds of sophisticated models that money managers use to determine valuation. Many of the indicators fall under the category of theory—money supply, inflation differentials, leading economic indicators, central bank balance sheets—and the list goes on. However, a lot can be said about observing the action of millions of consumers who often respond in a rational way to enlightened self-interest. We believe it would be foolish not to recognize the practicality of observing the human response to currency valuation.