The great currency differentials

31 August 2020

Much has been written about comparisons between the Global Financial Crisis (GFC) in 2009 and that of today. Having worked in the currency markets since the late 1990s, I can see four stark differences between 2009 and 2020 and the factors influencing currencies.  
Although the size of the fiscal stimulus is likely to be more than double the stimulus implemented in 2009, its composition is going to be very different.
In 2009, public investment made up 31% of fiscal spending versus 7% now. If we exclude China, the allocation to public investment in emerging markets and developed markets falls to 1% and 0%, respectively. Even in China, the definition of ‘public investment’ has changed from projects such as transport, urban pubic facilities, water and environmental projects to ‘new infrastructure’ projects including 5G, industrial internet and data centres. Instead, the key area of focus in 2020 is supporting household revenue and businesses. 
This suggests that sectors and countries linked to the ‘old infrastructure’ spending, such as commodity exporters, are unlikely to experience the same bounce in 2020 or beyond that they did in the years that followed 2009. 
Another key difference between 2009 and today is that the non-financial world has seen a notable increase in public and private debt. According to the Bank of International Settlements (BIS), in the last three years, the average leverage in the world has increased to 234% of gross domestic product (GDP) vs a figure of 205% in the three years running up to the GFC. 
As can be seen in Chart 1, emerging market debt has witnessed the sharpest rise from 116% to 186%, i.e. a 60% increase in leverage. This increase in leverage is in sharp contrast to early 2000 when emerging market leverage was on a declining trend. 
It is very likely that over the next few years we will witness a resumption of steady net downgrades as rating agencies absorb the notable further deterioration in debt dynamics that is likely to take place.
Beyond the level of leverage, there has been another slow but steady change in the structure of the global economy that is likely to make the comparisons with 2009 more difficult. In 2001, the inclusion of China in the World Trade Organisation (WTO) gave momentum to a further shift towards globalisation, causing a boom in global trade (see Chart 2).
Over this period, China’s share in global export markets rose from 2.5% in 2000 to roughly 11% in 2015, supporting a significant expansion in China’s production capacity and fuelling strong growth in commodities prices. This trend, coupled with a significant allocation to ‘old infrastructure’ spending as part of the fiscal package in 2009, supported growth in many commodity exporting countries as well as in countries that are part of the Chinese production chain, many of which are in the emerging market space. In 2020, it is unlikely that the same dynamic will play out again. 
Possibly the most important difference between 2009 and 2020 is that trend growth at the global level – which we define as the five-year moving average of total factor productivity (TFP) and population growth – is much lower than it was prior to the GFC (see Chart 3). 
At a global level, trend growth has fallen from 2.1% to 1%, due to meaningful drops in both population and TFP growth. The decline has been most aggressive in emerging markets where TFP is estimated to have fallen by 65% versus only 35% in developed markets. Although measures of TFP need to be taken with some caution, some of the declines are remarkable. TFP in Latin America appears to be negative at -1.4%. With population growth moderating from 1.2% in 2009 to 0.9% in 2019 it suggests that trend growth in Latin America is actually negative. 
Our sense is that in the absence of structural reform, these trends are unlikely to reverse, as they are likely linked to the changing role of China in the global economy and peak globalisation. Quite the contrary, the notable increase in government debt we are likely to experience in the next few years as a result of the COVID-19 crisis is likely to put further downward pressure on trend growth.
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Currencies tend to be driven by both cyclical and structural factors. While structural factors refer to the underlying economic factors that can be expected to lead to better growth prospects in the future, such as sound macroeconomic policies, level of government debt etc, cyclical factors tend to be linked to interest rate differentials and global growth. 
With interest rate differentials compressed to zero in developed markets and close to all-time lows in Australia and many emerging markets, global growth is likely to play a more dominant role. As such, an improvement in growth prospects is likely to put pressure on the US dollar. That said, our sense is that this decline is going to be more muted and with greater dispersion amongst currencies as the structural factors have notably deteriorated for a number of different currencies.
More specifically, our sense is that there are a number of characteristics that will support countries’ endeavours to keep interest rates low and help to differentiate them from others that are likely to be less successful, which could also translate into currency weakness:
  • Being a net creditor to the world. One of the reasons Japan has managed to successfully keep interest rates low in spite of high levels of government debt is that it is a net creditor to the rest of the world – not only does it run an 3.6% current account surplus, but it is a net creditor to the world to the tune of 68% GDP – thereby limiting the impact of the international perception of the sustainability of its policies. Countries that rely on external financing and are net debtors, are likely to be more vulnerable to changes in sentiment and perceptions of their own sustainability;
  • Maintaining institutional credibility. Venturing into quantitative easing may not have led to a structural decline in the quality of policymaking in developed markets, but the risks of a slip into unorthodox policies such as pure monetary financing and capital controls for countries with less institutional strength are not negligible – see Argentina’s return to monetary financing of the fiscal deficit. For less developed countries, venturing into the world of quantitative easing and aggressive liquidity injections, it will be critical for authorities to credibly commit to an exit plan;
  • An independent central bank able and willing to sustain the local bond market. Central bank demand is a crucial tool in maintaining low interest rates at a time of great fiscal issuance. The response by central banks, particularly in developed markets, has been very aggressive. Three potential issues could limit the use of this tool:
  1. Not all countries have independent central banks able to purchase unlimited amounts of domestic government bonds. The recent question marks around the European Central Bank's ability to purchase sufficient amounts of eurozone peripheral debt is a very good example of this issue.
  2. The ability for central banks to absorb any losses on the assets bought. This limitation is likely to be a function of both the seigniorage a central bank earns as well as the ability for the sovereign to recapitalise it.
  3. Central banks need to be comfortable that inflation remains consistent with the medium-term objective. While some degree of inflation overshoot may be desirable from both the debt sustainability and the monetary policy perspectives, an excessive rise in inflation would be problematic and limit both the ability and desire to implement financial repression – especially for central banks with inflation targets; and
  • The extent of foreign currency liabilities. US dollar-denominated debt of non-banks outside the US has doubled since 2009 and currently stands at $12 trillion of which $3.8 trillion are owed by emerging markets. Although the level of external debt for the median emerging market economy is still distinctly lower than in the late 1990s and stands at just over 200% of FX reserves – roughly half of the peak in the late 1990s – there has been a deterioration in this trend as the outstanding value is now more than double the level in 2010 and currently stands at roughly 18% of emerging market GDP. Even in the case of countries that have historically been able to match USD debt with a stream of USD income, a sharp drop in revenues can leave them meaningfully exposed.
A combination of factors suggests to us that even in a period of successful financial repression at the global level there is likely to be notable differentiation from country to country and that these differences are likely to be more pronounced than in the past.
With greater relative performance between currencies as markets differentiate more, this could provide opportunities for alpha strategies. The low volatility of recent years and subdued trading ranges have made it more difficult to add value. But careful judgement will be needed, to determine which currencies will benefit and which are vulnerable in the current environment. 
Francesca Fornasari is head of currency solutions at Insight Investment.

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