ESG Currency Investing

• The importance of responsible investing has been growing rapidly, but currency’s unique role has so far gone largely unnoticed. As Record announces that it is seeding an innovative ESG currency strategy, we ask: how exactly does currency fit into the existing ESG investment landscape?
• We argue that ESG currency investing can be used to incentivise responsible policy decisions at the national level, and to direct capital towards institutions that can promote efficient and sustainable economic development; particularly in Emerging Markets.
• Through currency markets, we believe that investors can help reduce a pro-ESG country’s cost of capital, fund its current-account or fiscal deficits, or provide it with greater scope for accommodative policy.

A unique proposition

Record has recently announced that it is seeding an innovative ESG currency strategy (Record Currency Management develops ESG database and currency strategy, November 2018). The strategy harnesses “a range of currency-relevant environmental, social and governance (ESG) factors related to the United Nations Sustainable Development Goals”, in order to divert currency investments towards pro-ESG countries and improve an investor’s ESG credentials.

But what exactly is ESG currency investing? What does it achieve, and how does it fit into the existing ESG investment landscape? This blogpost serves as an introduction to the topic of ESG currency investing, and breaks down some of the key questions that investors may need to tackle.

The drive towards responsible investing

In recent years, the market’s interest in “responsible investing” has been growing with increasing momentum. According to a 2017 McKinsey & Co. study, more than a quarter of assets under management globally are now managed according to ESG principles; around 22 trillion US dollars. And this growing interest is not only reflected within the investment community itself; but industrialised society more widely is increasingly scrutinising investor behaviours, and holding the investment industry to account for any part it may play in supporting unethical or unsustainable practices.

Thus far, the primary focus has been on corporate practices, and the phenomenon of ESG investing led by the equity space. By refraining from investing in businesses that act inappropriately, the investment community can incentivise more responsible corporate behaviours. And if a large enough proportion of investors turn their back on a badly behaved company, reducing its supply of capital, the cost of that company’s capital could increase, hindering its ability to maintain those negative practices.

There are similar examples in the credit space, too. Green Bonds, for instance, offer a more direct way for responsible investors to provide capital for climate and environmental projects. Again, by increasing the supply of capital, the cost of capital for such projects can be reduced, improving their feasibility.

Yet, responsible investing in the currency space remains a relatively undeveloped theme. The fundamental questions around the role that currencies play in driving pro-ESG outcomes have gone, so far, largely unanswered.

Country-level ESG outcomes

So, first, why would an ethical investor be tempted by ESG currency investing? What outcomes might she hope to achieve at a national level?

The United Nations Sustainable Development Goals (UNSDGs) offer a good starting point. This set of 17 goals arguably embodies the gold standard of sustainable development objectives, focussing on issues such as poverty, hunger, health & well-being, education, inequality, clean energy, climate action, justice, institutions and global partnerships. Where an investor can positively impact any combination of the above, at a country level, this is undoubtedly a worthwhile consideration to add to her investment process.

The goal

Next, what might be an appropriate set of objectives for ESG currency investing?

If ESG equity investments can incentivise better corporate behaviour through lowering a company’s cost of capital, what can ESG currency investment achieve? In practice, it can be thought of in a very similar way; pro-ESG currency investments can incentivise more responsible policy decisions at the national level, and direct capital to where it can be better used:

• Incentivising better policy. By tilting currency investments towards countries that are making good ESG progress in a number of areas, the investment industry can help those countries’ economic development. The channels and mechanisms by which this takes place are explored in further detail below, but the objective is to provide incentives for governments to pursue pro-ESG initiatives.
• Efficient allocation of capital. By directing investments towards ESG-friendly countries, an investor implicitly reallocates capital towards countries with stronger institutional frameworks, which are likely to be better equipped to effectively support long-term productivity growth. These countries are therefore likely better able to take advantage of the additional capital inflows to boost productivity. And thus, over the long run, capital investment should be put to better use, helping to improve both the efficiency as well as the sustainability of economic development.

These objectives are of particular importance for emerging market (EM) economies, where there is wider variability in the strength of institutions. So by applying an ESG framework within EM currency investing, investors can simultaneously incentivise countries to adopt ESG behaviours, whilst also supporting EM productivity convergence towards developed economies.

Currency channels for affecting change

But, unlike ESG equity investing, the mechanical effects of investing in a nation’s currency are much more nuanced. Specifically, we foresee four primary mechanisms by which currency investment can affect ESG outcomes over the long run:

• by reducing a country’s cost of capital;
• by helping to fund deficits in the current account and/or fiscal balance;
• by allowing the central bank more room for accommodative monetary policy; and
• by allowing greater scope to increase foreign currency reserves, reducing perceived sovereign credit risk.

Taking each of these in turn…

First, investment in a country’s currency can reduce the local cost of capital, incentivising investment and improving long-run productivity. This is because purchases of that currency are likely to lead to net capital inflows to the local money markets; an effect that should occur even via derivatives market trades, such as FX forwards, because marginal increases in market positioning should lead other market players (usually banks) to hedge those positions via the spot market.

For instance, if a significant shift were to occur in the Turkish Lira (TRY) FX forward market, increasing the demand for long TRY positions, the banks that provide liquidity to meet this demand would likely hedge those positions by buying TRY outright in the spot market and depositing those funds in TRY-denominated money markets.

This capital inflow into local money markets can then put downward pressure on local interest rates, reducing the overall cost of capital, both for the government as well as the private sector. In turn, this should incentivise economic investment – both by the private and public sectors – which can help improve productivity in the longer run. The lower cost of capital means that lower hurdle rates are required before investment projects are initiated; leading to investments being made that might otherwise have been marginal or too costly.

Second, and closely related to the first channel, purchases of a country’s currency can help fund deficits in the current account and/or fiscal balance, reducing the country’s need for higher interest rates to attract capital. In particular, a strong relationship exists between a nation’s current account and real interest rates, suggesting that a premium is implicitly offered to investors by countries with large current account deficits that need to be financed, in order to attract capital. By supporting the financing of these current account deficits, an ESG investor can help reduce the market premium for capital, and reduce long-run equilibrium real rates.

Third, currency purchases supporting exchange rate stability can create room for more accommodative monetary policy, providing further incentives for productivity-boosting investment. By supporting the level and stability of a country’s exchange rate, the local central bank is less likely to come under market pressure to tighten policy in order to support the currency. In Turkey, for example, recent relief from downward pressure on the TRY, is gradually reducing the need for the CBRT to continue hiking interest rates to fight inflationary pressures.

By providing more accommodative monetary policy, the local central bank can then provide the conditions necessary for greater investment – again, for both private and public sectors – which can boost long-term productivity.

Fourth, in certain cases, currency appreciation can afford a country greater scope to increase its foreign currency reserves (e.g. in an effort to offset currency strength). This, in turn, can reduce the market’s perceived level of sovereign credit risk for that country, and thus reduce the sovereign interest rate burden. Again, through lower interest rates, this can lead to more expansive national investment.

Ultimately, we believe that well-organised institutions and governments are better prepared than poorly organised ones to undertake the necessary actions for the above mechanisms to take place effectively. And they are also more likely to make the appropriate national investment decisions. Therefore, by tilting currency investments towards these countries, an investor can not only provide incentives for ESG progress, but also direct her investments towards countries with greater productivity-growth potential.

Critiques and considerations

Of course, the above mechanisms are not impervious to critique or limitations.

For one, some may argue that ESG investments could lift a pro-ESG country’s exchange rate, reducing the competitiveness of its export industries. Perhaps some would go on to postulate that it could actually be more beneficial to help weaken pro-ESG currencies. After all, it is indeed true that a weaker exchange rate could, in some cases, lead to increased export volumes in the short term. But this would not directly facilitate investments to improve long-run productivity. And, in any case, it is quite likely that the currency would subsequently appreciate due to increased demand, offsetting the initial increase in competitiveness. The inverse is also true, meaning that a slight appreciation in the currency will not necessarily have prolonged effects on a country’s exports. Finally, any benefit to export competitiveness would be offset by the negative effects of monetary policy and cost of capital described in the sections above.

Ultimately, although there are naturally some benefits to a weaker currency, investors’ attempts to encourage currency weakness would not necessarily help improve a country’s productivity, and would be unlikely to support an EM’s trend of convergence towards developed markets in the long run.

It is also true that the impact of any ESG investment practice is likely only marginal when implemented on a small scale. So the expected impact of ESG currency investing accumulates with the number of investors and currency managers applying it, as well as the scale of capital behind such investments. Perhaps no single investor or manager will ever be able to discern her own precise impact but, in aggregate with her peers, she will likely incentivise countries to improve their ESG credentials, and will deploy capital where it is most likely to foster productivity growth.

The future for ESG currency investing

There may yet be some way to go for the ESG currency movement to reach the maturity of the ESG equity space, but the catch-up process is underway and currency offers some distinct advantages. For example, through currency, participants can increase their ESG credentials and promote sustainable development outcomes on a much wider scale than through equity investing alone. What’s more, as currency tilts can be traded as an FX overlay with very low transaction costs, currency ESG can be implemented without the additional cost or corresponding disruption of trading the existing assets in an investment portfolio. Finally, by reflecting ESG factors across all asset classes (not just bonds and equities), investors can now create more balanced portfolios, which continue to focus on risk-adjusted outperformance but equally reflect an investor’s values and a responsible approach to investment.