Beyond The Horizon A Long View Of The Dollar

Sanjeev

Sanjeev

In the short run, the view forward is based on what we can see. In the medium term, our view is based on what we can anticipate; for this, we have to look around corners and anticipate the complex interplay of market forces based on the rules of Behavioural Economics. And in the long run, we have to sit on the moon and take a philosophical view of ‘the way we are’. This moralistic view is general in nature but has (usually) been found to be far more accurate than the ‘mathematical models’ of econometricians, which are subject to allegations of linearity.

Declaimer: This article written was originally in August 2013, and some of the data points may be outdated.

The Empact of Currency price movement

To explain further, in the short run, currency price movements would be impacted by ‘carry trading’ flows, interest rate differentials, equity market valuations & macro- fundamentals. In the medium term, other factors like the Current Account Deficit/ Surplus + Budget/ Fiscal balance, besides investment flows and BOP balance, will additionally impact Fx fundamentals. In addition, the composition of the financing of past deficits, and their very nature (short-term or long-term financing) would impact currency valuations.

However, for anything beyond a Business Cycle (say, 8 years), we have to turn to understand ‘moral philosophy’, the ‘way we are’. No econometric model could have forecasted that the JPY would actually APPRECIATE over the 20 years, as Japan’s Public Debt Ratios reached the stratosphere, and its Govt progressively bankrupted itself with deficit financing of useless pump priming, Yet, the amazing proclivity of the Japanese to work hard, generate a surplus (25% savings rate in a developed economy + current account surpluses of ~7% of GDP) and salt it away in near-zero-coupon Govt bonds, has resulted in a situation that has foxed economists, currency forecasters, traders and the world at large. Even now, long after the event, it is impossible to explain how the world’s most heavily indebted Govt has the world’s highest appreciating currency.

Currency
Current A/c Bal. % of GDP
Budget Bal. % of GDP
Twin Bal.% of GDP (A)
Appreciation since 2008
Savings % of GDP (B)
(A)+ (B)
Remarks
CHF/ $
+12% -0.2% +11.8% 15-20% 16% +27.8% Fear-driven (safe haven) flows
JPY/ $ + 2.3% -8.4% -6.1% 35-40% 5% (1.1%) Internal Savings
          Now let us look at the same chart for some other major currencies:
Currency
Current A/c Bal. % of GDP Budget Bal. % of GDP Twin Bal.% of GDP (A) Appreciation since 2008 Savings % of GDP (B)
(A)+ (B)
Remarks
CNY/ $ +3.7% -1.7% +2% 15% 40-50% +42-52% Managed currency
Re/ $ – 3.5% -5.4% -9% (8%) 32% +23% Flow-dependent
$ -3.3% -9% -12.3% 6% (6.3%)  

*’(A)’ Represents the Savings Surplus/ Deficit, while (B) represents the Savings flow. The balance between the two is the Savings Deficit, to be funded by ‘outsiders’. The higher this ratio, the more the currency is prone to ‘confidence failures’.

The picture above is inaccurate, in the sense that the Twin Balances (Current Account + Fiscal) are a snapshot at a single point in time, while the currency trends are over a longish period, which has been the most turbulent and paradigm-shifting period in the last century. During this period, the respectability given to developed countries has eroded, while ‘fundamentals’ have started to drive long-term currency trends. This ‘trend’ will accelerate, in that there are no ‘holy cows’ left in the currency markets. The sharp erosion in the credibility of Europe in 2011 has increased the probability that the US will suffer a similar fate in 2014-16, when its Public Debt Ratio crosses 100% of GDP.

From the medium-term picture, let us shift our gaze to the long-term picture, which is about looking at the character of the various nationalities.

  • Swiss: they look very good, the best picture of wealth creation out of the above lot. At 16%, their savings rate is also the highest in Europe, although it is lower than everybody else (except the US). But the inward flow of external savings, whether as safe haven (or tax haven) flows, keeps their Interest Rates (0.01% for short-term and 0.99% for 10-year bonds) at the same levels as Japan.
  • Japan: they may have a profligate Govt, but that is more than made up by the proclivity of the Japanese to salt away Govt bonds under their mattresses. They remain net incremental creditors, despite their Twin Balance ratio bracketing them closer to India and the US than to China/ Switzerland.
  • China: after allowing for the fact that their data cannot be trusted (especially their Budget Balance and savings rate numbers), and we do not know how much savings have been destroyed by their Bank NPAs, it still makes for a pretty picture. Certainly, if they get their Bank NPAs under control, they are doing way better than India.
  • India: is in competition with the US on who gets to bankruptcy first. The only saving grace is that domestic deficits will be easily funded by a 32% domestic savings rate, leaving the Re dependent on (foreign) capital flows to decide its course.
  • US: seems to be determined to get to the bottom of the pile. With a sclerotic savings rate of 6%, it will remain a net guzzler of overseas savings. If we take the balance between the Twin Balance (as % of GDP) and the Savings Rate, we will get some idea of the potential increase in money printing, which is the main supplier of Inflation and thence, currency depreciation.

To summarise, the CHF looks all set to keep going strong, while among the rest, it is likely China (provided they don’t suffer a Bank NPA crisis) will do well. Japan is probably going into long-term decline as its savings rate drops into negative territory, while India will do better than the US, mainly because of a better savings rate. Another likely joker in the Indian pack could be a sharp drop in the Current Account Deficit, because of falling energy prices (driven by a sharp U-turn in energy prices as Solar energy gets to grid parity by 2017).

Many of the above fundamental factors could change during a long-horizon view of 11 years. The US Current Account Deficit could reverse if their energy industry goes into overdrive (either because of shale gas conversion or Solar). Their Budget Deficit will mostly depend on politics; with 18% of their GDP in Medicare, of which 6% of GDP lies in Medicaid, this is likely to see some major change, either after the Presidential elections or in 2014 (when their debt ceiling is hit). Or the Bond Markets do an ‘Italy’ on them…

China will likely see its Current Account Surplus drop, as they shift to domestic consumption. Their Budget Deficit could go up, as they clean up SOE and Local govt Balance Sheets. Japan could see a deterioration in their savings rate, with an improvement in Govt deficits. Nothing much can be assumed about India unless we see some guts in Govt, which drops the Fiscal Deficit. And of course, India is the most sensitive to energy prices; a tectonic shift to renewables will create both a wave of FDI and a sharp drop in the Current Account balance. This is worth paying for, but keep an alert watch on these factors, to figure out where to go, as things change…

For now, I would recommend staying open on the Dollar. If I MUST do something, I would trade volatility. All hedges should be short-term in nature, and flexible enough to be changed as the fundamentals change.

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