Exchange rate movements can greatly affect the spending power of foreign assignees. A leap in the value of a host country currency, for instance, combined with high inflation in the location, can cause significant shortages unless salaries are adjusted accordingly.
ECA's cost of living indices and changes in living costs (CLCs) are designed to make it easy for such adjustments to be made. However, they still need to be explained. All things are relative – never more so than with cost of living. If the same inflation movement is also occurring in the assignee’s home country, it will offset the effect in the host location and produce a smaller CLC than might otherwise have been expected. Furthermore, inflation rates, which assignees might read in local newspaper headlines, are not the same as the price measures used by ECA to produce its indices. These are based on specific baskets of goods and services, devised and weighted to reflect lifestyles of foreign assignees.
Explaining salary adjustments can be tricky, therefore. Gaining a good understanding of recent global exchange rate and inflation trends can provide a useful starting point.
Since the last Cost of living survey in September 2010, there have been many substantial exchange rate movements. One would always expect numerous smaller currencies to have lost or gained to a large degree over such a period, but what has perhaps been unusual this time is the number of major currencies undergoing seismic shifts.
The dollar recovered a little in May, but has still depreciated by more than 10% against the euro since the September survey. Many assignees could be affected, because of the widespread use of the dollar around the globe and the numerous currencies pegged to it.
United States dollar
The dollar recovered a little in May, but has still depreciated by more than 10% against the euro since the September survey. Many assignees could be affected, because of the widespread use of the dollar around the globe and the numerous currencies pegged to it. Reasons for the dollar’s loss of value include:
- depreciation suits the US currently – it is lowering debt values and making exports more competitive which in turn is creating jobs; the authorities are not supporting dollar, therefore;
- quantitative easing (pumping money into economy to stimulate lending and spending), which cuts the value of dollar in real terms;
- investor confidence higher, so assets riskier than the dollar are more appealing;
- recovery slower in US than in many other economies;
- continuation of long-term downward trend (dollar down 19% on real, trade-weighted basis since March 2009; down 30% since May 2001) and no fundamental reason for change;
- dollar may be losing some of its appeal as a safe haven;
- countries holding big dollar reserves are diversifying towards other assets.
Some analysts are calling a trend change at the moment and forecasting dollar appreciation, basing predictions on the worrying state of the global economy and the possibility of another recession. They expect nervous investors to head for safe havens, which the US dollar has been considered for decades. However, unusually, it was not valued as such during the early weeks of the Arab Spring, so it may be losing its lustre in this regard. Other havens may appear safer, given the US budget deficit problems, although Japan (whose currency is another traditional haven) has even worse debt problems. The Swiss franc is the other favoured safe-haven currency. It is no surprise that it has appreciated rapidly in recent months.
Quantitative easing is due to end on 30 June, but most of the other factors above will still apply, so there could be further dollar losses to come.
Euro
The euro has moved the other way, appreciating by more than 10% against a very long list of currencies. With the US dollar so weak, investors have had to look elsewhere. The strong economic recoveries in Germany, especially, and France, have made the euro attractive, especially as they have forced the European Central Bank to raise interest rates from record lows before most other central banks have done so. Recurring issues relating to sovereign debt crises in various member states and the future viability of the single currency itself have tempered euro gains, but they have still been formidable. They will have impacted on assignees in many parts of the world because lots of countries have either adopted the single currency or pegged their currencies to it.
Economic prospects remain bright for most of northern Europe. Conditions in Germany, where inflation has risen sharply, tend to dictate monetary policy, so further interest rate rises are likely and will support the euro. If the sovereign debt situation can be stabilised, the euro is highly likely to continue on its upward curve. On the other hand, a default by Greece could cause rapid depreciation, and any contagion to other troubled states, such as Portugal or even Spain, could have such major consequences that the survival of the euro itself could be under threat.
Huge demand from China has brought a commodities boom to Australia. Job creation has been impressive, forging solid growth in domestic demand and pushing up prices. Interest rates have been raised in response, prompting more buying of the currency and more appreciation, though slowing inflation. Indices involving Australia have seen big changes.
Australian dollar
The Australian dollar has gained no less than 15% against the US dollar since September. Huge demand from China has brought a commodities boom to Australia. Job creation has been impressive, forging solid growth in domestic demand and pushing up prices. (Note the combination of currency appreciation and relatively high inflation here.) Interest rates have been raised in response, prompting more buying of the currency and more appreciation, though slowing inflation. Indices involving Australia have seen big changes. Other commodity-based currencies, such as the Canadian and New Zealand dollars and the Norwegian krone, have also appreciated markedly against the US dollar.
Nearly all commodity types have witnessed soaring prices since the global economic recovery began. Grain and other food costs have been affected by extreme weather episodes, supply problems, expanding middle classes – and populations in general – pushing up demand, and the increased use of corn for ethanol production. Coal has soared on rampant demand from China and elsewhere. Oil too has seen growing demand from emerging economies, while production has been falling in several countries and supply hampered by unrest in north Africa and the Middle East. Copper is also up, while precious metals have been attracting buyers hoping to hedge portfolios against inflation.
The future direction of the Australian dollar will depend to a large degree on whether the commodities boom continues. It has gone into reverse in the past couple of months. Warnings about the Chinese economy potentially overheating may have been overdone, but if Asian growth were to diminish significantly, Australia’s currency could also see a sharp change of fortunes.
Global inflation trends
The average official annual inflation rate from the 170+ countries covered by ECA’s Cost of Living survey is currently 5.8%. That is historically high and constitutes a major increase on the 4.6% recorded in September 2010 (and an even bigger one on the 4.3% of a year ago). Inflation continues to rise across much of the world and there are several reasons for this:
- high food prices;
- rising oil and other commodity prices;
- growing demand because of economic recovery;
- quantitative easing;
- sales tax increases as governments balance books.
Food prices tend to affect foreign assignees less than local people, at least in the developing world, because assignees generally spend a lower proportion of spendable income on food. High fuel and energy prices impact similarly, because they are usually necessities and again tend to take a bigger percentage out of local national spendable incomes than those of more wealthy assignees. However, the cost of living has undoubtedly been rising for nearly everyone to some degree. What degree exactly is better determined in the case of foreign assignees by ECA’s indices than by looking at general inflation, although the latter can still provide a useful guide between surveys.
Food prices tend to affect foreign assignees less than local people, at least in the developing world, because assignees generally spend a lower proportion of spendable income on food.
Surging prices for gold, silver and platinum are evidence of serious concerns about the soaring cost of living, because precious metals are used to hedge against future inflation. However, metals prices declined in May as investors realised they might have overdone it. Pressure on food prices is abating, while energy prices too seem likely to fall – they are already doing so – now that markets are coming to terms with political trends in the Middle East. Inflation in the developed world is generally not being caused by domestic factors, such as consumer demand growth, but by external and probably temporary influences, such as food and oil costs, which are notoriously volatile. With unemployment high in many Western countries, labour markets struggling and wage growth moderate, once short-term factors are removed from the equation, it may well be that deflation provides a bigger threat than inflation.
Whatever happens to exchange rates and inflation over the next few months, you can be sure they will still be strongly influencing Cost of Living indices near you.
Cost of Living Survey March 2011 – some movers and shakers
Argentina to Australia: price inflation in Argentina tempers Australian dollar’s appreciation
Despite the Australian dollar appreciating by over 15% against Argentina’s peso between the September 2010 and March 2011 surveys, the cost of living index for an assignee being sent out of Argentina to Australia moved by just 2.5% to 207.3. The effect of the strong Australian dollar was largely cancelled out by price increases in Argentina: prices of items in ECA's basket increased almost 15% in Argentina between surveys while prices in Australia moved approximately 2%.
Hungary to Turkey: weak Turkish currency main influence on index movement
In September 2010 the index for a move from Hungary to Turkey was 169.3. In March this fell just over 15% to 141.5. The similar price movements measured in Hungary and Turkey did little to temper the effect of the Turkish lira’s depreciation by 15.6% against Hungary's florint between surveys.
Japan to Caracas: index move mainly a result of Venezuela price increases
Between the September 2010 and March 2011 Cost of Living Surveys, Venezuela's currency fell just 3% against the Japanese yen. However, prices in Caracas rose by more than 16% during that period while the price of like-for-like items in ECA’s cost of living basket for Japan fell slightly. The index for an assignee out of Japan to the Venezuelan capital in this year's March survey is 115.1, up over 13% on September's index of 101.4 largely off the back of the price movement.