The global economy is showing signs of increased strength, and conditions in most major international financial markets have improved significantly in the past 12 months. Would-be investors should be wary, however, owing to some important issues including policy challenges posed by emerging asian economies, the existence of unsustainable international trade imbalances, and the potential for a further realignment of the world’s major currencies. Portfolio allocation and currency hedging strategies which allow investors to anticipate and react to these global forces in a timely manner should prove invaluable in such a volatile environment.

The impressive growth of China and India since 1990 has elicited both fear and fascination on the part of international investors. While their performance is not unprecedented and mirrors that of many other Asian countries during the last 30 years, there is one notable difference: the two countries together account for roughly 40 % of the world’s population. In the long run, their remarkable performance should benefit the entire global economy. In the short run, however, many of their trading partners may find it difficult to adjust to the new economic reality.

The macroeconomic tensions noted above have been exacerbated by a rising US trade deficit and growing US indebtedness. The sharp depreciation of the US dollar through most of the 2002-2003 period reflected growing unease over the size of these global imbalances. Unfortunately, much of the exchange rate movement thus far has been against countries such as Japan and continental Europe, which have relatively low growth rates and a limited ability to cope with large exchange rate appreciations. Other countries, primarily in Asia, have been resisting these exchange rate pressures but will eventually have to give way.

Simulations conducted by the IMF and the OECD suggest that a further sizable depreciation of the US dollar will be required in order to put the US current account on a sustainable track. Even if these predictions prove correct, however, they do not indicate exactly when the adjustment might occur, which currencies are likely to be most affected, or how far they are likely to move.

While investors can realize significant gains from international diversification, they also need to be aware of some important forces changing the world economy. One of the most significant of those is currency risk. Some models have recently been developed that might provide assistance in this regard. Unfortunately, they do not come with any user guarantee.

<B>Nitish BENIMADHU

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