What makes a currency powerful?

The BIS Triennial Central Bank Survey of foreign exchange turnover was released last week. There were, perhaps, two main headline for the press to report. Firstly, the Age of the Dollar persists, and secondly, London still dominates.

The dollar is one of the two currencies traded in 88.3% of transactions, far ahead of the second-placed currency, the euro (which is one-half of 32.3%). The top four currencies are the same as they were in the 2004 survey (the Swiss franc has been replaced in the top five by the Australian dollar) and the dollar's share has marginally increased in that period (from 88.0%).  The UK's share of the OTC foreign exchange market has risen from 32% in 2004 to 43.1% now, while the US' share has fallen from 19.1% to 16.5%.

The fact that the FX market is still, as Brexit approaches, centered on London may at least mean that I don't have to move country again quite yet. There's a lot that should be written about changing nature of the industry and the challenges it - and the City - faces, but that's not today's story, which has two parts. Firstly, that the dollar's dominance is intact and what that means, and secondly that which currencies are used to transact foreign exchange doesn't really correlate very closely with which economies dominate global trade now. In both cases, China looms large.

On the surface, China is a 'loser' in this survey, at least to the extent that ambitions of challenging the dollar (in any make, shape or form) as the dominant global currency, are not being realised very fast. 0.1% of global FX trading took place in China in the last survey, much the same as was the case in 2004. The yuan meanwhile was involved in 0.1% of FX trades in 2004, and has risen to 4.3% now, taking it from 29th to 8th place in the overall rankings. That's progress, but it's still not to a dominant place.

There's no doubt that controlling the world's reserve currency has benefits for the US. For example,  long-term capital flows into the US regularly lag the size of the current account deficit, because there are plenty of central bank flows to make up the difference was others try to prevent their currency from appreciating. Of course, the downside to that is evident now, as the dollar is overvalued when the President, at least, wishes it wasn't.  More strategically important, is the ability of the US to leverage the dollar's status, for example by imposing fines on any firm which flouts US sanctions and allows dollars to flow in and out of prescribed countries. That allows the US to impose its geopolitical policy on there to a degree that isn't necessarily repaired the other way round. In turn, it irks any in Europe and Asia. Having more clout in Asia in particular, was one reason for the Chinese authorities to promote the use of the yuan in the first place.

What has happened with the euro however, demonstrates clearly how difficult it is to challenge the dollar's status. Back in 1992, the dollar was one-half of 82% of all transaction, while the second-placed Deutsche mark was involved in 39.6%. So the mark, back in 1992, had a bigger share than the euro does now -  in second place with 32.3%. Is being in second place, meanwhile, much use? It's hard to see how it really helps the ECB or the Eurozone in general. On that basis, any ambitions that China might have to establish the yuan as a really big part of the FX market, regionally or globally, is a tall order - and might not really be worth the effort.

But the size of the FX market, where, in what instruments and which currencies it takes, isn't the only measure of size that matters. 

In another part of the BIS website, you can also find the calculations for real and nominal efective exchange rates, and  the trade weights the BIS uses to calculate them. Back in 2004, China's share of global trade was a little below Japan's, and a little above the UK's. The US and the Eurozone were miles ahead of everyone else. Now, China is between the eurozone and the US, in second place in a market dominated by three really big players and a lot of smaller followers-on.

This means that China now has a big weighting in other countries' real effective exchange rates. And so, what happens to the Chinese yuan matters a lot. The table below shows how much of a weight each of the top 5 global currencies has in the effective exchange rates of the others. So, to take a politically-charged example, the pound is an important currency in Europe, with a weighting of 10.5% in the euro's trade-weighted value, but that's nowhere near the importance of the euro to the UK, with its 45% weighting. A major disruption to UK-Eurozone trade can hurt Europe, but would hurt the UK more.

If I just add up how much these 5 currencies matter for each other in total, I find that the euro is ore important than the others in driving effective exchange rates, but the yuan is more important than the dollar.

Why does this matter? Because China's currency policy may be becoming less passive (or more passive-aggressive). Between 2004 and 2016 the Chinese allowed the currency to appreciate in real terms by 60%, importing disinflation and exporting inflation to the rest of us. Re-orienting the economy away from exports and towards domestic source software growth played a part. Since mid-2016 however, the yuan has lost about 10% of its real value. That doesn't mean that the value of the currencyhas been manipulated, just that as the economy has slowed and the dollar has appreciated, the Chinese haven't always seen fit to intervene to keep the yuan strong to the same extent as they used to intervene to slow the pace of its appreciation.

The result has been that the other major currencies have all done better, in real effective terms, than a glance at bilateral exchange rates might suggest. The euro isn't as weak as a look at EUR/USD suggests, for example. But for the Chinese authorities, what this brings is clout. What the yuan's value does matters much more at a global level now, than it did before. Which begs another question - which would you rather focus on, the seemingly unattainable goal of grabbing some of the dollar's exorbitant privilege, or how to run your own currency policy to better effect, now that it affects even the biggest economies in the world?

“The dollar tends to fluctuate between been too high and being about right, but it has never been too low” Joe Gagnon

“Forget Tariffs. Here’s a better way to close the trade gap.” That’s the title of an article in Barron’s by Matthew Klein in which he argues in favour of a proposal by Senators Tammy Baldwin and Josh Hawley to require the Federal Reserve to keep the current account balanced around zero over 5-year periods. For the record, the US current account has been in deficit on average, by just over 2% GDP since the end the Bretton Woods era. 

The view behind the Baldwin-Hawley Bill is that the US current account deficit is a product of Americans consistently spending more than they earn, not because of profligacy on their part but because of foreigners consuming less than they produce (and saving as a result), dumping the excess into the US market and displacing US output (and jobs, and income). These over-saving foreigners enthusiastically reinvest the money they earn back into the US and the upshot is that the dollar has been consistently overvalued. Mr Klein cites Joe Gagnon, a former Fed economist who now works for the Peterson Institute, observing that “The dollar tends to fluctuate between being too high and being about right, but it has never been too low”. 

That’s an interesting statement, though it requires a caveat because what a currency being ‘too high’ means is up for interpretation. Broadly, there are two ways of looking at it, which come to different conclusions. The first is ‘PPP’-style valuation, which measures relative prices. That’s the valuation which matters if you’re tapping away on a keyboard by a swimming pool in a foreign country before heading out to dinner. The second is to look at where exchange rates are relative to a fundamental equilibrium that would be consistent with the current account being in balance (along with the rest of the economy) over the medium term.  

On a PPP basis, the dollar has been a bit more than 10% overvalued on average over the last 20 years against the currencies of its top five trading counterparts.  Perhaps unsurprisingly, the currency which has been, on average, most undervalued on a PPP basis against the dollar is the Chinese yuan. Today, the dollar is not only overvalued against all that group (yen euro, yuan, Mexican peso and Canadian dollar), but the only major currencies which are overvalued relative to the dollar are the Swiss franc and Norwegian krone, which are pretty much always overvalued on PPP. 

Fair enough: on the basis of PPP, the dollar is unambiguously overvalued today. It’s a very expensive foreign holiday destination, especially if you’re British! On the other hand, back on 2011, when the Brazilian Finance Minister was complaining about currency wars and the dollar was anchored by QE, the dollar was undervalued against all the major currencies except for the Turkish Lira, Korean won and Mexican peso.

The most-accepted alternative measure of valuation is FEER, which looks at how much a country’s real effective exchange rate needs to adjust to be consistent with medium-term balance. In June the IMF conducted its 2018 External Balance Assessment and concluded that the dollar was 8% overvalued at the end of last year. It’s worth noting that the euro is also overvalued on this measure, by 6% (because the current account surplus is entirely due to the weakness of the economy, rather than the valuation of the currency). The most undervalued currencies, according to the IMF, were the Japanese yen, Malaysian ringgit, Turkish lira and Mexican peso. The Chinese yuan is about right and among the G10 currencies, Sterling and Swedish krona stand out as being undervalued. 

The IMF hadn’t stated doing its external balance assessment back in 2011, when the dollar reached its post 2000 low. However, the Peterson Institute, where Mr Gagnon works, didn’t just make one assessment that year, it made two - in April and November (the dollar’s low was in July). And indeed, they concluded that the dollar was overvalued by 8 ½% in April, and 9.3% in REER terms in November. On which basis, it was still nearly 8% overvalued at its low point. The PIIE position therefore, might reasonable reflect Mr Gagnon’s that the dollar is sometimes overvalued, sometimes fairly valued but never undervalued – at least on a FEER basis. The yuan was 16% undervalued in 2011 meanwhile, and al the Asian ‘Tiger’ economies had very undervalued currencies. The euro was fairly valued (when EUR/USD was around 1.40). 

The easy conclusion is that however we look at it, the dollar is overvalued now. And that is the view of the US administration, alongside anyone who thinks the US current account deficit is a product of foreigners ‘dumping’ their exports in the US at the expense of American workers.

I’m instinctively wary of that argument. Apart from anything, any argument that says the Swiss franc is undervalued fails to pass the common-sense test.  In particular though, pinning all the blame for the US current account deficit on foreign rather than US behaviour, seems nearly as unfair as blaming everyone else for the UK’s (even larger) current account deficit. The US’ position in the global financial system means that, to varying degrees, we all import US monetary policy and that suits the US just fine when the dollar is cheaper (or less overvalued, if you will) but after the rest of the world was bludgeoned into boosting demand as the US ran very accommodative fiscal policy under President Reagan, and even when the dollar lost half its value between the 1985 peak and the end of the decade, the US still barley got the current account back into balance. The patsies then were the Japanese who embarked on policies to boost domestic demand that ended up with housing and equity bubbles, the hangover from which we call ‘Japanification’. Maybe it was all worth it to ‘win’ the Cold War, but the strong dollar of the mid 1980s was a product of US fiscal and monetary policy far, far more than it was the result of anything that anyone else was doing.  

From a policy perspective, the US solution to its problem is the same as the one facing others when they find their exchange rates in the wrong place because of US policy. Global interest rates and bond yields are correlated and the US, because it has enjoyed stronger growth than other major economies, has higher rates and higher yields than others too. And so it has a strong currency. This is exacerbated by easy fiscal policy. If the US wants a weaker dollar (and a smaller current account deficits, for that matter) it needs tighter fiscal policy and easier Fed policy, dragging US yields down to everyone else’s levels. If it wants to run domestic policies with no regard for anyone else, as it has always done, it may find out that like everyone else, it can’t go on doing that for ever. And if we find out that the US economic out-performance is unsustainable in a joined-up global economy (one that is suffering from a trade downturn as well as self-inflicted harm in the UK and the Eurozone)  then we may indeed find that the next trough in US rates and yields is lower than the last one and not that dissimilar to what other major economies are already seeing.