From Goldman sachs insights
1. Markets are worrying over the “true” intentions of the new administration.
Concern that President Trump is mercantilist and may talk down the Dollar has seen the Dollar fall notably below the 2-year rate differential, as markets have priced a protectionist risk premium. Our last FX Views argued that this decoupling is unlikely to last, given that the correlation of the Dollar with front-end differentials is one of the more stable relationships out there (“This is NOT the End of the Dollar Bull Run“,
FX Views, February 2, 2017). That said, today we examine the persistent and large US current account deficit, given that it is often cited as evidence that the Dollar is overvalued and needs to fall. We argue that the current account deficit, which stands at 2.6 percent of GDP, is a flawed metric on which to make a valuation judgment for the broad Dollar. This is because the deficit is heavily skewed towards one country – China – which alone accounts for 1.8 percentage points, while Mexico, Japan and the Euro zone each play only supporting roles. The US current account deficit is therefore to a large degree a bilateral phenomenon vis-à-vis China, which also means that it bears implications not for the broad, trade-weighted Dollar but for $/CNY. We examine the implications that the bilateral current account has for the $/CNY exchange rate, concluding that – if the new administration wants to have a material impact on external trade – this is where its focus will ultimately have to be. We remain firmly convicted RMB bears and, in the broader context, Dollar bulls.
2. The persistent and large US current account deficit is often used as “Exhibit A” by those arguing that the Dollar is overvalued. The typical thought process goes that the current account deficit exceeds some equilibrium level, so that the broad, tradeweighted
Dollar needs to fall to shrink the deficit. Implicitly, this assumes that the deficit is broadly dispersed across countries, so that an adjustment in the tradeweighted Dollar helps brings things into alignment. This is, however, not what things
look like. As Exhibit 1 shows, the current account deficit is heavily skewed towards one country – China (blue bars) – while the remaining current account position is comparatively balanced. Exhibit 2 shows this is also the case for the US trade deficit. This means the overall current account position is relatively meaningless as an indicator for the broad Dollar. In fact, because it is so skewed towards China, it is arguably more of an indicator about the $/CNY exchange rate. Indeed, if the new administration wants to meaningfully improve the current account position of the US, this is a conversation that needs to be had with China, not the Euro zone, Japan or Mexico.
3. Standard FX valuation models often compare the current account to some notion of equilibrium and then back out the required change in the trade-weighted exchange rate needed to bring the two into alignment. We have used this approach many
times, including to show that – even as long ago as mid-2015 – the RMB was not overvalued, since its appreciation in previous years had merely erased a large undervaluation (“Is the RMB overvalued“, FX Views, August 28, 2015). This approach works well when a current account imbalance is well dispersed across countries, in which case a broad appreciation or depreciation can rebalance things. But this is not the case for the US, where the current account – seen from the US perspective (Exhibit 3) – is largely a bilateral story vis-à-vis China, with the Dollar actually appreciating against the RMB in recent years (Exhibit 4), in effect compounding the
problem. We estimate a bilateral version of this model, meaning that we estimate the required bilateral move in the real exchange rate of the Dollar versus the RMB that is needed to bring the bilateral current account of the US vis-à-vis China to some lower level. The first step in this calculation is to estimate an underlying bilateral current account, closing output gaps in the US and China and feeding through past real exchange rate moves. The second step then calculates the required real exchange rate adjustment.
4. The real appreciation of the Dollar vis-à-vis the RMB means that the underlying current account deficit is worse than meets the eye. Exhibit 5 shows our estimate for our base case assumptions (black line), along with the contributions from closing output gaps and feeding through past exchange rate moves. While the headline current account deficit vis-à-vis China is 1.8 percent of GDP, the underlying imbalance is closer to 2.1 percent, due to the real appreciation of the Dollar versus the RMB. If we assume standard elasticities for trade flows versus the exchange rate, along with the export and import shares in GDP for the bilateral relationship, this implies a real devaluation of the Dollar versus the RMB in a range of 10 – 20 percent, if the objective is to bring the bilateral current account to something closer to a -1.2 to -1.5 percent of GDP range. Exhibit 6 provides a sensitivity analysis for the required real depreciation along two dimensions: (i) the horizontal axis shows different values for the target bilateral current account, where the closer to zero this value is, the more the Dollar needs to fall; and (ii) the depth axis shows our assumptions for the trade
openness of the US versus China (the weight of bilateral exports and imports in GDP), where more openness means that the exchange rate needs to do relatively less work. We allow for various degrees of openness, since it may be the overall degree of trade openness of the US, not just the bilateral one, that dictates the needed exchange rate adjustment. In the event, we think any meaningful RMB appreciation versus the Dollar is unlikely, given that the underlying dynamics of China’s balance of payments are deteriorating rapidly, as we have been flagging and as yesterday’s balance of payments data for Q4 showed (“China’s Balance of Payments Outlook Deteriorates“, Global Markets Daily, January 3, 2017). Instead, we think it is more likely that China could import more from the US, introducing liberalization steps on that side, but – again – this would be negative for the alreadyweakening balance of payments. We remain firmly convicted RMB bears and, in the broader context, Dollar bulls.
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