The framework for understanding the relationship between currencies and the balance of payments (external balance) is relatively simple. Where a country has a rising trade deficit (meaning the value of the country’s imports is greater than the value of their exports), its home currency needs to weaken to boost the competitiveness of its exports or spend less to reduce the trade deficit. Reduced domestic spending is unlikely in most developed economies, given plenty of pent-up demand and loose fiscal policy. Therefore, the natural adjustment mechanism for countries running wide trade deficits will have to be the exchange rate.
The Real Effective Exchange Rate (REER)is an indicator of the external competitiveness of a country’s currency. It is the weighted average of a country’s currency against a basket of other major currencies after adjusting for inflation differentials. When comparing the dollar against a wide range of currencies on a REER basis, we note that the dollar is overvalued. See Figure 1.
Figure 1
Very often these valuations mean little until a trigger point is reached, usually following a significant imbalance. In the US there are signs of these imbalances beginning to appear. For one the US trade deficit continues to deteriorate, with components such as the goods deficit reaching record lows. It is becoming more difficult for the US to finance this trade deficit via the foreign purchase of US Treasuries (such as bills, notes, and bonds). Equity inflows into the US have also started slowing, and so overall the basic balance is deteriorating. See Figure 2.
Figure 2
The US current account deficit (that occurs where a country sends out more money than it receives) for Q3 of 2021 was $214.8 billion, the widest in over a decade. The dollar tends to decline on a multi-year basis when the basic balance peaks and starts deteriorating. See Figure 3.
Figure 3
Given the volatility in currency markets, a consistently managed foreign exchange policy is essential for all businesses exposed to currency risk. Assisting our clients to determine and apply such a policy is what we do. Contact us for an exploratory discussion.
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