My daughter-in-law’s mother lives in Taiwan. She would like to borrow against a house she owns in Taiwan $120,000 and invest in fixed interest in Australia. Is this possible? Is this risky? Would she earn enough extra money to make it worthwhile?
I have been asked this question numerous times, and again just recently. It would seem to be very smart to borrow in a country with low lending rates and then re-invest †the money in another country where investment rates as are much higher as a money-making scheme. There are many risks involved including exchange risk that might make it less attractive once you delve further.
Economist Frederic S Mishkin in The Economics of Money, Banking, and Financial Markets (8th ed.) hypothesised that “the real interest rate in an economy is independent of monetary variables. If we add to this the assumption that real interest rates are equated across countries, then the country with the lower nominal interest rate would also have a lower rate of inflation and hence the real value of its currency would rise over time”. This is now known as the “International Fisher effect” named after another economist Irving Fisher (1867 – 1947).
So in effect you would expect a country with higher interest rates to have higher inflation, and subsequently its currency would be steadily stgaluing compared to a country with a lower interest rate (and lower inflation). A mathematical formula was derived to show using spot rates and interest rates of each country that you would end up in a neutral position if you exchanged cash from one country to invest in another, and then exchanged back again at the end of a period. And you could still be disadvantaged slightly by exchange rate commissions and fees both ways as well as lending versus investment rate margins differentials.
The above theorem is what you would expect in the ideal world. But our world is far from ideal and rates are not constant, and exchange rates can be influenced by large flows of money from one currrency to another, counter to each country’s economic strength.
In many cases we see the opposite of the “International Fisher effect” occuring and opportunities do exist to make a profit from moving cash from one country †to another. There is also the issue of taxation on either side of this transaction to further complicate the matter.
I would say that transactions of this type contain very high levels of risk, and operators seeking some margin with this strategy should look at their ability to effect transactions quickly and efficiently, minimising risks of rapid currency stgaluations by hedging with spot prices (the premium reduces your profit potential). Most of all you would need a very good understanding of all the potential risks and extent of their damage to your hard-earned capital should it all go wrong. It would certainly not be for the faint-hearted.
Paul Jackson is a Brisbane-based Financial Planner with MacDonnells Financial Services, which is licensed under FYG Planners.
Disclaimer: This article is general in nature and is not intended as investment advice. Readers should always seek further advice before making any financial decisions.