Foreign investment with inflation-linked securities: A natural hedge under Fisher theory?

Abstract

All foreign holders of U.S. dollars currencies face significant risk of unfavorable currency exchange movements, proportional to the amounts they hold. Some of these risks can be hedged to an extent, but the costs of doing so can be significant, and errors in execution or maintenance of the hedges can cause serious capital losses. Today the vast holdings of China and others creates currency risk on an unprecedented scale. China alone now has a total in excess of a trillion (1 × 10 12) U.S. dollars, which makes traditional approaches to hedging problematic at best. 1 1 At this writing, China has a reported $1.07 trillion in reserves: Batson, Andrew (2007), “China May Get More Daring with Its $1.07 Trillion Stash”, The Wall Street Journal, February 15, 2007, C1. A year earlier it was reported that “[China] will soon release statistics showing it has passed Japan as the biggest holder of foreign currency the world has ever seen. Its reserves already exceed $800 billion and are on track to reach $1 trillion by the end of the year, up from just under $4 billion in 1989.” Keith Bradsher, The New York Times, Sunday, February 26, 2006. http://www.nytimes.com/2006/02/26/weekinreview/26bradsher.html?_r=1&pagewanted=all&oref=slogin. This paper analyzes the potential hedging effectiveness of investing foreign dollar holdings in U.S. inflation-indexed securities under Fisher's Identity. To the extent that Fisher's Identity and its derivative theories hold, foreign investors can effectively protect the purchasing power of their dollar balances, and earn an assured rate of return. Investment in inflation-indexed securities does not incur the additional expenses that swaps and currency hedges do.