Natural Uncertainty Amidst Geopolitical insecurity

Discussion and Analysis by Charles Porter

Whilst the media has abounded with talk of a risk off environment precipitated by numerous central bank announcements and geopolitical threats, natural disasters are embedding themselves upon our radar. Our thoughts and concerns truly rest with those affected, either directly or indirectly. This article addresses the financial legacy and currency purchasing power that those emerging from these terrible natural geographical events will awaken to.

The North American continent has been subject to severe natural disasters over the past couple of weeks. The United States is now recovering from hurricane Harvey and Mexico this morning incurred a record breaking, catastrophic, earthquake. Looking forward, Florida braces and prepares for what appears to be an immense hurricane, potentially Category 4, ‘Irma’. We discuss the logic of natural disasters upon the exchange rate and then, in a subsequent article, test these hypotheses to identify whether these trends are perceptible within empirical charts.

Expectations regarding natural disasters, such as those described above, can be divergent. For example, if the natural disaster is forecasted, such as the forewarning of a hurricane, the concomitant expectation, ceteris paribus, is for a devaluation of the affected currency. This is because investors or individuals with liquid assets held or exposed within the threatened geography, will attempt to limit, or eliminate entirely, their exposure to the disaster. The extent of the capacity for the reallocation of assets will depend upon the very nature of the assets. For example, if the elasticity of a particular national product is highly inelastic, particularly if there are few substitutes, the depreciation effect will be necessarily diminished.

The overarching mechanical expectation behind a currency devaluation preceding the impact of a natural disaster (post-forecast) is an increase in the supply of money, assisted by a decrease in the demand for it. The supply increases whilst investors and individuals attempt to liquidate exposed assets in favour of others, likely denominated in another currency. Money demand would likely be comparably reduced through similar actions of prospective investors, delaying or reorienting their investments. The clearing rate of the affected currency pairs should therefore precipitate a weaker affected currency.

For an unforeseen natural disaster, such as that which has hit Mexico overnight, there is no warning time and thus no pragmatic flight of capital. Given that investors will have few available options to liquidate their assets, particularly if the incident occurs at an adverse hour, we might expect the currency to continue to trade closer to its previous rate. This is because both the demand and supply of the affected currency is unlikely to relatively fixed in the ultra-short, immediate, term. However, whatever assets are liquid and whatever capital is active to speculate against the currency, will be used to result in smaller, unstained, movements around the time of the crisis.

In the days following the incident, however, the value of the affected currency may be thought to increase for two reasons. Firstly, insurance flows following the disaster may amount to a sizeable repatriation of the currency. These flows, comparable to the order of the damage and thus severity of the natural disaster, will create a force that attempts to restore and increase the strength of the domestic currency. Secondly, the fear and worst-case scenario character of risk evasion from a natural disaster may suggest a bias towards an excessive pre-impact devaluation. Therefore, once the damage to the economy becomes known and more tangible, the eschewment of the affected currency should end. This will restore a significant portion of the demand for the domestic currency.

There may, however, be a counter-force to this currency revaluation. If the response to the crisis comes not from externally denominated reserves, but from governmental new state money, then the currency supply should de facto increase. This axiomatically reduces the strength and purchasing power of the currency by pushing down the clearing rate of the supply and demand for the currency. If, instead, foreign reserves are sold off in order to purchase aid in the domestic currency, this effect can be inverted. Although uncommon, this option has been invoked in the past.

Part Two of this article tests the hypotheses generated within this article.