How fiscal policy influences currencies

In the US, it is claimed that extending 2017 personal tax cuts could push debt to more than twice the level of GDP by 2054. In the UK, the government risks falling foul of its self-imposed fiscal rules and, in Germany, decades of parsimonious fiscal policy have given way to new-found budgetary largesse. All three have the potential to impact currencies, but how?

What’s the theory behind how fiscal policy influences currencies, if at all? One way to consider this is to think about how policy influences the attractiveness of a countries financial assets to foreign buyers. Expansionary fiscal policy, for instance, is likely to lead to higher real yields, all else equal, and particularly so if budget leniency is counterbalanced by monetary tightening should the central bank fear an overheating economy.

So, at least in the short-term, a loose fiscal and tight monetary policy stance would seem the best way to engineer currency strength. But it is clearly not as simple as this. One constraint is the level of debt, for if fiscal largesse comes at a time when debt levels are already deemed to be excessively high, any short-term currency strength could soon disappear. Much also depends on access to savings pools to fund larger deficits; especially external savings pools. For instance, the US, by dint of the safe-asset position of the treasury market clearly seems to enjoy better and cheaper access to foreign savings than other countries, particularly those in emerging markets.

Another issue is the reason for fiscal largesse. Budget expansion that seems likely to generate significant economic returns in the future, via higher levels of public and private investment for instance, may prove more beneficial to a currency than fiscal expansion that appears somewhat wasteful. We could go on but perhaps the best way to try to answer the question is to look at the potential currency implications of the fiscal outlook in the US, UK and Germany. While the US seemingly has the advantage of access to a large pool of global savings to fund higher deficits, projections do suggest that debt levels could reach dangerous proportions at over twice the level of GDP.

In addition, many analysts’ concern is that US policy in many areas such as financial sanctions and tariffs is undermining this available pool of savings. An increased need to borrow that butts up against diminished willingness of foreign savers to lend threatens higher yields – but also a weaker US dollar. Again, there’s a lot more that we could say on this issue but, for now, see us as viewing US budget and debt dynamics as bearish for the US dollar, not bullish.

What about the UK? Unlike the US, the UK has fiscal rules. The UK government plans to only borrow for investment (not current spending) and to project a lower debt/GDP ratio by the end of the five-year planning period. It might seem that fiscal targets means fiscal discipline and that means currency strength, not weakness.

However, as we will find out in today’s Spring update from the Chancellor, the problem with setting rules is that you can fail to meet them and if, as these rules are not actually needed in the first place, the government can create currency weakness when it needn’t have. Does it seem that the government has created a recipe for disaster now? After all, the previous Conservative government conspired to collapse the pound down to almost one dollar in the September 2022 mini-budget.

In the Standard Bank’s view, the answer is ‘no’. Rightly or wrongly the market seems likely to accept the government’s attempts to keep fiscal policy on track. In Germany, the fiscal train has left the tracks as the new government has set about expanding the budget considerably. This is action that stands the best chance of generating currency strength, not least because the expansion is starting from a small base and the country is not beholden to overseas savings pools. This being said, Germany does not have its own currency and hence the impact of fiscal expansion will be somewhat diluted because it shares its currency – the euro – with 19 others.