Widely read:
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.
To explain further, in the short run, currency price movements would be impacted by ‘carry trading’ flows, interest rate differentials, equity market valuations and 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 understanding ‘moral philosophy’, the ‘way we are’. No econometric model could have forecast that the JPY would actually appreciate over the 20 years, as Japan’s Public Debt Ratios reached the stratosphere, and its government progressively bankrupted itself with deficit financing of useless pump priming, Yet, the amazing proclivity of the Japanese to work hard, generate a surplus (25 per cent savings rate in a developed economy + current account surpluses of 7 per cent of GDP) and salt it away in near-zero-coupon government 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 government has the world’s highest appreciating currency.
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 per cent 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 per cent, 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 per cent for short-term and 0.99 per cent for 10-year bonds) at the same levels as Japan.
Japan: They may have a profligate government but that is more than made up by the proclivity of the Japanese to salt away government 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: It 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 per cent domestic savings rate, leaving the Re dependent on (foreign) capital flows to decide its course.
US: It seems to be determined to get to the bottom of the pile. With a sclerotic savings rate of 6 per cent, 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 their 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 per cent of their GDP in medicare, of which 6 per cent 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 their current account surplus drop, as they shift to domestic consumption. Their budget deficit could go up, as they clean up SOE and local government balance sheets. Japan could see deterioration in their savings rate, with an improvement in government deficits. Nothing much can be assumed about India, unless we see some guts in government 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 playing 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, or buy deep-out-of-the-money calls on CHF: $, while selling deep-out-of-the money calls on $ : `. It is unlikely, however, that such long tenure instruments will get you any sensible pricing. All hedges should be short-term in nature, and flexible enough to be changed as the fundamentals change.
This article was originally published on April 28, 2012.
Disclaimer: This content is for information only and should not be considered investment advice or a recommendation.
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