RESEARCH DIRECTOR, FOREX.COM
ECONOMICS textbooks would have you believe that a currency should adjust lower if it belongs to a country with a large current account deficit or an increasing budget deficit and for years US dollar bears have been citing the current account deficit as a reason why the greenback should depreciate. In 2008 the US ran a large current account deficit of 4.95 per cent of GDP, although an improvement has been registered since 2006.
But in reality the world throws up a much more complex set of drivers for FX markets – for example, the US dollar has had its ups and downs but it has failed to crumble under either the weight of this deficit or under the expectation that the budget deficit could surge to above 13 per cent of GDP this year.
A current account deficit, it seems, is only a negative currency factor when international savers decide they no longer want to finance it. The investment decisions made by international savers are based on a broad set of issues, not least of which are judgements over the relative stability, coherence and transparency of governments, central banks, legal systems and regulators. Liquidity is also an important consideration. It is clear that the prospects for the US dollar against a host of other currencies are less grim when all these factors are taken into account rather than just the current account and budget deficit.
But that is not to say that the deficits, and more specifically the financing of them, are not extremely important issues. A key element of this month’s trip by US Treasury secretary Timothy Geithner to Europe and the Middle East was to reassure investors that the US recovery was on track and that the Treasury was committed to its “strong US dollar policy”.
Without this policy, the value of the holdings of US assets held by foreign investors could be eroded and this could significantly weaken their resolve to underpin demand. In other words, Geithner was on a sales trip.
The results of recent Treasury auctions suggest that the US has not had too much difficulty in shifting its debt this year, which has supported the value of the dollar – overseas investors have underpinned demand at debt auctions in both the US and the UK. Interest in government debt in general has been supported by safe-haven demand resulting from the global economic crisis but this is no time for complacency from either government. Like the US, the UK’s fundamentals are far from pretty – it also carries a current account deficit and its budget deficit/GDP ratio could also rise to an eye-watering 13 per cent of GDP this year.
In this respect it is in a similar boat to the US, but the fiscal outlook in the UK has come under much heavier criticism. Both the S&P and the IMF have raised concerns over the rapid increase in the UK budget deficit: the S&P in May revised the UK’s debt rating outlook to negative from stable, putting it a step closer to a downgrade. Market behaviour suggests that it has shrugged off the risk of a downgrade, but if it were to to happen, there would many investors who would simply not be able to purchase UK government securities and such a significant fall in overseas demand would have a negative impact on sterling.
Looking ahead, the sensitivity of the US dollar and the pound to the financing needs of their respective governments could increase if confidence in the global economic outlook improves and brings with it a preference for more risky assets. The potential pressure on the currencies may be increased further by expectations of unwinding of quantitative easing by the Federal Reserve and the Bank of England next year since this would involve selling assets back to the market.
While a return to growth in 2010 will increase income into government coffers, the need to repair fiscal positions will ensure a particular focus on budget reform in both the US and the UK. The outlook for fiscal spending, or lack thereof, is likely to become an increasingly sensitive political topic in the run up to next year’s UK general election. If sterling is to see further appreciation over the medium to long run then the electorate will almost certainly have to give the next government a mandate for fiscal austerity.
There is, however, an obvious difficulty associated with tightening spending when unemployment is still rising. Both the US dollar and the pound are vulnerable to these issues but given the election and the S&P/IMF warnings, sterling is looking more exposed. Medium term, sterling-dollar may find itself heading lower.