Current Accounts Matter

October 20, 2011

Currency movement and indeed all traded financial instruments are being dominated by event risk out of Europe, where headlines are being dictated by political decisions more than underlying economic trends.  Markets driven by politics are especially hard to play.  Even if one’s assumptions prove ultimately correct, it still remains a daunting task to get the trajectory of headlines precisely right.  German Finance Minister Schaeuble’s warning seems reasonable that uncertainty surrounding the euro debt crisis will persist well beyond the imposed early November deadline for a deal and that it will in fact be not fully resolved until well into 2012.  That doesn’t mean that Europe will be alone hold the spotlight each and every day for the foreseeable future, but it is fair to say that the unpredictable twists and turns of the crisis will be the dominant factor through the rest of this October.  It’s what former Defense Secretary Rumsfeld called a known unknown.  That being said, this seems to be a convenient and appropriate time to look at an important and generally under-appreciated determinant of currency values.  I refer to national current account balances.

The current account, known among professionals as X minus M, is a direct component of nominal GDP.  The current account’s sign tells if a country is a net saver or net spender.  Many of the transactions summarized in the current account involve exchanges of one currency for another.  While capital flows exceed those associated with the current account by a huge margin, the current account tends to be more stable and predictable than other parts of the balance of payments.  The perceived health of the current account can also influence capital flows.  Shifts in exchange rate values affect relative competitiveness and thus future changes in the current account, but the lag between cause and effect can be lengthy and non-linear. 

A more predictable pattern at least for the long run is the correlation of current accounts with currency strength.  Over the eight years from 2003 to and including 2010, the annual current account to GDP ratio of the United States ranged from negative 6.0% to negative 2.7%.  The United States is a heavy chronic current account deficit nation.  The shortfall is now running around 3.2% of GDP, still close to its best year since 2003 and roughly half the size of its worst point.  Examined through a longer historical lens, 3% still represents a substantial imbalance that many consider unsustainable.  Even if economically manageable, it’s not viable from a political standpoint.  The biggest U.S. deficit in the late 1980s associated with the Plaza Accord of September 1985, a G-5 agreement to promote a weaker dollar, was 3.8% of GDP. Dollar depreciation didn’t eradicate the U.S. current account deficit, but the existence of a chronic gap is a prime reason for why the dollar has been a depreciating asset in the long term.  More about that later, but what about other economic blocs?

  • Japan’s current account is chronically in surplus.  The annual surpluses ranged from 2.8% to 4.8% of GDP from 2003 to 2010.  It will be about 2.5% of GDP this year and next.
  • Switzerland is the king of surplus nations.  The surplus is presently running somewhat above 10% of GDP and ranged from 2.3% of GDP to 15.8% of GDP in the sample period of years examined.
  • China is a nouveau riche member of the surplus nation elite, with a surplus range of 2.8% of GDP to 10.1% of GDP during the sampled years.
  • Britain runs chronic deficits, which ranged from 1.6% of GDP to 3.4% of GDP in 2003-2010.
  • The euro area is a hybrid of surplus and deficit nations that trade heavily with one another but extensively with the outside world as well.  As a whole entity, Euroland’s current account runs much closer to equilibrium than any of the above economies.  In the first half of 2011, an unusually large deficit of 1.1% of GDP was experienced.  That’s outside of the minus 0.7% to +1.1% range of annual outcomes from 2003 to 2010, and next year’s imbalance will probably settle back into that range.
  • Wide discrepancies are probable among euro area members this year and next.  Germany is in substantial surplus, roughly equal to 5% of GDP and considerably bigger than Japan’s and even slightly larger than China’s relative size.  A review of the region’s vulnerable economies produces a very different picture.  The Greek gap lies between 6.5% and 8.5%.  Portugal’s deficit is very similar to Greece’s.  Spain’s deficit is hovering around 4%, and Italy’s is only fractionally smaller than Spain’s.  The only euro member with a surplus but also on the short debt watch list is Ireland.

The table below presents the changes in the dollar’s value against selected other currencies from ten years ago, twenty years ago, and somewhat more than 40 years ago (that is, in 1970 before the first dollar devaluation in 2H71). 

Dollar since Oct 2001 Oct 1991 1970
Vs D-mark +52.6% +19.2% +155%
French franc +52.6% +21.1% +16%
Italian lira +52.6% -10.0% -56%
Swiss franc +83.5% +65.4% +389%
Japanese yen +57.5% +69.2% +368%
U.K. pound -8.6% -7.9% -34%

 

The mark, French franc, and lira were joined at the hip on the final trading day of 1998, so of course they share identical movement over the past ten years even though German is a surplus nation, while France and Italy run deficits.  The direction over these most recent years has been upward for the euro, whose current account is near equilibrium, and downward for the deficit-ridden dollar.  The right-most column encompasses some 29 years when these currencies traded separately versus 12 when they’ve moved precisely in tandem.  The mark over this stretch of time rose 155% against the dollar versus just a 16% advance in the franc.  The economic fundamentals of Italy, including current account comparisons, have been consistently worse than those of France, so there remains a large gap in the 41-year performance of the franc and lira.  Italy’s currency, in fact, is 56% weaker than the dollar than it was in 1970.

The euro hasn’t distinguished itself as well as nations that continue to be underwritten by sizable current account surpluses.  Over the past ten years, the euro’s 52.6% appreciation against the dollar was slightly less than the yen’s 56.5% gain and much less than the Swissie’s rise of 83.5%.  Swiss officials only recently took forceful action against the franc’s excessive strength.  Japan was intervening heavily in the early noughties.  More importantly, Switzerland’s current account has a considerably larger relative size than Japan’s. 

A third broad observation concerns the relative strengths of the euro and mark vis-a-vis the dollar.  In the beginning of floating dollar exchange rates, there were three hard currencies, the Swissie, the yen and the mark.  The independently floating yen and Swiss franc are each more than 350% greater in dollar value now than back in 1970, but the synthetic mark has risen just 155%.  For the last dozen years, the mark was weighted down by its association with other European currencies that didn’t have some of Germany’s economic credentials.  Inflation hasn’t been the problem.  The ECB was created in the German Bundesbank’s image and in fact has delivered a better grade of price stability than under Bundesbank management.  However, Germany’s strong current account surplus has been exchanged for a euro area current account that has hovered near balance.

Finally, look at sterlingAgainst the dollar, it is weaker than its value ten years ago, twenty years ago, and 41 years ago, and is the only currency in the table with that distinction.  Sterling has no association with the surplus members of Euroland.  It’s deficit is smaller than America’s but is of significant size in absolute terms.  The U.K. no longer enjoys the perks that come to an economy whose currency dominates reserve asset portfolios.  Britain gave birth to the United States and remains a generation or so ahead.  Both economies are on the downhill slope, and that is reflected in the depreciating long-term trend of their currencies.  The U.K. was first in this evolutionary life cycle, and so sterling is somewhat ahead of the dollar on the down escalator.

Copyright 2011, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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