Fiscal face-offs offer a silver lining to pound’s feeble state

Kathleen Brooks
ONE lasting impact of this recession is that it has named and shamed those economies that have unsustainably high fiscal deficits. This is a major theme for the foreign exchange markets since traditionally high debt levels have meant weak currencies for the countries involved.

Among those which will continue to be weak are the US dollar and the pound. The US and the UK are expected to clock up deficits – where government expenditure falls short of tax receipts – of 10.7 per cent and 13.3 per cent of GDP respectively this year, says the to the Organisation for Economic Co-operation and Development (OECD).

Sterling, which has fallen nearly 20 per cent against the UK’s main trading partners, has already taken a whipping from the market for a lack of fiscal discipline. And there could be more punishment to come. Phil McHugh, corporate dealer at Currencies Direct, says that sterling’s fate rests on the election: “We need to see some clear policies to reduce the deficit, and if we don’t then that should mean continued weakness for the pound.”

In comparison the US dollar has been fairly well supported and has risen by more than 5 per cent against its major trading partners since the start of the year. But can this continue? “The dollar is benefiting from its safe haven status and at the moment the markets aren’t focussing on the large deficits that are plaguing some of the individual states,” says McHugh.

But there are signs that some of the biggest states in the US, such as New York, California and New Jersey, have debt burdens that could rival Greece. California’s gross outstanding debt looks relatively stable at 8 per cent of its total economy. However, once you add on the liabilities of its massive pension fund then the debt burden is increased to nearly 40 per cent of its entire economic output. “The deficits in the US are tomorrow’s news,” says McHugh. “The markets will eventually look at these deficits and when they do then it will start to hurt US dollar strength.”

Foreign exchange traders should think about taking advantage of this weakness by shorting currencies with high fiscal deficits and take long positions in currencies that are underpinned by healthier government finances.

So what should be on the other side of this trade? As you can see on the chart below, back in 2005-6 India had one of the worst fiscal positions in the world. But the Indian government has since worked at bringing the deficit under control, and earlier this month was able to revise down its estimate for the shortfall to 5.5 per cent from 6 per cent for this fiscal year.

The Indian rupee has appreciated by 11 per cent against the dollar during the past 12 months and there could be more upside to come. Duncan Higgins, senior analyst at Caxton FX says: “Interest in emerging markets will remain strong throughout the economic recovery. I think that it’s been decided that emerging markets are a worthwhile bet for a long time to come.”

Likewise, other BRIC currencies should outperform their weak Western counterparts. Brazil’s fiscal position has also improved dramatically in the last decade. Although its budget deficit has widened during the economic downturn it’s still only expected to reach 0.9 per cent of GDP this year, a drop in the ocean compared to some deficits in the West.

Western currencies are exposed because of their fiscal imprudence. In comparison, the BRIC economies look like paragons of fiscal virtue and those that are freely traded should continue to reap the rewards.