Whilst there is plenty of press coverage on the impact of QE on bond yields, very little attention is paid to the impact on currencies and global imbalances. Earlier this month the US Treasury released its Semi Annual Report to Congress on the Foreign Exchange Policies of Major Trading Partners of the US as part of a review of the exchange rate and externally-oriented policies of its major trading partners. Germany, China, Japan, Korea, Taiwan and Switzerland are all on a monitoring list having at least 2 of the following 3 traits: a material bilateral trade surplus with the US, a material current account or exhibiting persistent one sided foreign-exchange intervention. That said, at this juncture none of the named countries exhibited all 3 traits or were considered currency manipulators.
Germany has a sizeable current account surplus at just over 9.4 percent of GDP (1H’16) and it runs a significant bilateral surplus with the US. As the EC itself notes ‘While current account surpluses in countries with an ageing population like Germany are to be expected, and recent oil price and exchange rate developments had a favourable impact on the trade balance, the current value of the surplus appears well above what economic fundamentals would imply.’
Germany’s situation is exacerbated by the euro: combining creditor and debtor nations in a currency union can be problematic. In the case of the euro area post GFC, the highly leveraged, deficit running members notably Greece, Spain and Portugal have been forced down the route of austerity to adjust and now run current account surpluses. Germany, a strong creditor nation, has become locked into a relatively weak euro exchange rate (than had it retained the deutschmark) and is by default pursuing a mercantilist model. The IMF’s 2016 External Sector Assessment notes that the German REER is undervalued by 10-20% and using their current account regression model with standard trade elasticities it is 10-15% undervalued. For Europe: ‘On balance, staff assesses the euro area average real exchange rate in 2015 to be undervalued by 0-10%. The REER gaps are large in many member countries, ranging from an undervaluation of 10-20% in Germany to an overvaluation of 5-10% in Spain.’
The EC established the Macroeconomic Imbalances Procedure (MIP) after the crisis ‘to identify and address imbalances that hinder the smooth functioning of the economies of Member States, the economy of the EU, and may jeopardise the proper functioning of the economic and monetary union.’ The MIP uses a range of indicators including ‘a 3-year backward moving average of the current account balance as a percentage of GDP with thresholds of +6% and -4%.’ The latest review notes that the euro area current account surplus ‘is higher than the surplus implied by economic fundamentals’ with the bulk contributed by Germany and the Netherlands; the euro area current account reached 3.7 percent of GDP in 2015. Thus, one of the areas of debate has been about bringing the excessive surplus for Germany to a more sustainable level to avoid the current account surplus for the Eurozone as a whole reaching unsustainable levels. The obvious ways to try and do this involve trying to boost domestic growth through policies that encourage private investment, infrastructure investment and aim to boost wages and domestic consumption.
Adjustments do happen and perhaps given the low growth environment have become important subjects for discussion at G-7 and G-20 meetings and IMF review reports. Indeed the Trans-Pacific Partnership incorporates provisions to address unfair currency practices. Ultimately, trading relationships, economic or currency unions have to bring benefits to all to prosper. As an example, China’s current account surplus reached an excessive and unsustainable level of 10 percent of GDP in 2007 but has now adjusted back to a reasonable level in the range of 1.9-2.7 percent for 2011-2015. In the case of the euro area there has been some progress, helped by five rounds of the MIP, but really as the 2015 Five Presidents’ Report notes a deepening of the fiscal union also ultimately needs to happen with a euro area treasury and a common macroeconomic stabilisation fund for rebalancing and redistribution to be more effective.
Our Next Generation Global Bond Fund uses our projections for Net Foreign Assets to help us identify not only the countries likely to be upgraded (or downgraded) owing to current account imbalances, but also the currencies that are likely to see upward pressure over the long run. Needless to say, the euro, yen and Chinese renminbi score strongly under this type of analysis. For the past few years the US dollar has been very strong, partly as a result of being further ahead in the interest rate cycle. However, with December looking like a near certainty for a Fed rate rise, one has to wonder how many more rate hikes we will see when the global economic backdrop remains so weak. At a point that investors believe that we have reached the end of the US tightening cycle, the dollar is likely to come under significant pressure. Under those conditions, the Bank of Japan and the ECB in particular are likely to find it difficult to keep the yen and the euro from appreciating against the dollar.