Worsening economic conditions in the United States point to a weaker dollar in the future. The combination of low GDP growth, high debt levels, unsustainable fiscal and current account deficits and an overvalued USD makes devaluation the path of least resistance. However, most of America’s trading partners either face equally poor monetary and fiscal challenges or are determined to avoid allowing their currencies to appreciate. This creates a stalemate in the currency wars which facilitates more money printing and debt accumulation, with the consequence that asset prices rise to compensate for currency debasement. Until this predicament changes, the currency adjustments that a healthy and balanced global financial system would produce are not likely to occur.
At the heart of this dilemma lie on one side the mercantilist economies that repress consumption to promote exports (China, Japan, Korea, Taiwan, Germany) and on the other the Anglo-Saxon economies that promote consumption and accept persistent current account deficits (United States, United Kingdom, Canada, Australia). These conditions have persisted for decades because on each side powerful interests assert their influence to preserve them: in the case of the mercantilist, the manufacturing lobby; in the Anglo-Saxon economies, the banks which benefit from the financialization of the economy. Germany conveniently benefits from the euro which is structurally undervalued to support the weaker economies of the region.
The following table illustrates the current currency panorama and gives some insights on a few potential trading opportunities at the present time. The first column shows the deviation of the Real Effective Exchange Rate (REER) from the 30-year median level for the major EM countries and also the primary trading partners of the United States. The currencies above 100% are expensive relative to the median level of the past 30 years. This group is extremely heterogeneous. We would expect high-growth and productive exporters (China, Vietnam, Thailand, Korea, Taiwan and Poland) to have appreciating currencies over time, and that is what we see here. However, all these countries are bent on maintaining competitive currencies and current account surpluses. These economies all have strong fundamentals and moderate twin deficits (current account plus fiscal account). The remaining countries with currencies above the 30-year median face more problematic circumstances. India, the Philippines, Nigeria, and the United States all have low productivity growth, chronic current account deficits and high twin deficits. These countries have all allowed their currencies to appreciate to the detriment of their export competitiveness, and all of them tend to favor finance over the manufacturing sector. In this second group, the currencies of the United States and India are propped up by financial capital flows.
At the other end of the table, we have the countries which have currencies at weak levels relative to the 30-year median REER. Most of the cheap currency countries have a history of high currency volatility, driven by commodity cycles and flows of speculative capital (“hot money”). Argentina, Brazil, Russia, Colombia, Peru, Chile and South Africa are prematurely deindustrialized and dependent on exports of basic commodities that are increasingly capital intensive. The high levels of currency volatility are linked to boom-to-bust cycles, which disincentivize exports of manufacturing goods and increase dependence on commodities and debt accumulation. Typically, these countries will see significant currency appreciation during commodity upcycles, and, given how cheap the currencies are today, it is plausible this will happen again. The problem for these countries is that economic mismanagement and unproductive debt accumulation have left them with very high twin deficits and, consequently, very vulnerable to global financial volatility.
This leaves us with Malaysia, Mexico, Japan and Turkey. These four countries all have competitive currencies and are important participants in global manufacturing supply chains and stand to benefit from the current trend towards reshoring and restructuring of supply chains. Moreover, all of them except for Turkey, have sound economic fundamentals. These are probably the currencies with the most upside in a global synchronized economic recovery in 2022. In the case of Turkey any progress towards stabilizing the economy could lead to significant currency appreciation.