What to see in IMF’s annual External Sector Report?

The IMF has just released its annual External Sector Report

The IMF said, USD and GBP are seen as being overvalued, the EUR slightly undervalued, while the JPY and CNY are close being to appropriately valued (or at least they were in 2020 when the report was concluded). The FX market won’t pay too much attention but it might be missing a trick.

For large developed-country currencies such as the USD, JPY and EUR, it seems that traders and investors pay little heed to issues of trade imbalances and currency overvaluation or undervaluation. The common reason is that the size of these imbalances is totally dwarfed by the amount of trading that goes on in these currencies and, in effect, the current account tail cannot wag the FX dog.

Things are arguably different when we get down to lesser developed countries, particularly if their current account imbalances are large and FX trading is small. For big, developed currencies like the USD and EUR we’ve usually regarded the alleged undervaluation or overvaluation of currencies to be of significance only if the imbalances are very large, and only then if they attract the attention of policymakers, said Mr. Steve Barrow, Head of Standard Bank G10 Strategy, adding, usually this has not been the case, at least not in recent years.

In fact, you arguably have to go back to Japan in the mid-1990s, or perhaps the euro zone in 2000 to find the last time that policymakers got really irate with currency valuations and decided to do something about it via FX intervention. However, this does not mean that FX valuation measures are without some use and the same can be said for the sort of rigorous current account assessment that the IMF makes in its annual External Sector Report.

This year’s report argued that USD is around 8% overvalued, which is similar to  GBP, while EUR is a modest 2% undervalued, and JPY and CNY are approximately in line with desired levels according to their current account dynamics. There is a degree of heterogeneity within the euro zone however, as Germany, for instance, is seen to benefit from the shared currency as ‘Germany’s euro’ is undervalued by around 9%. The valuation figures presented by the IMF this year are not very far from what we’ve seen previously. In some senses this seems strange as current account imbalances have widened considerably because of coronavirus with things like the lack of travel and tourism, and the surge in medical trade just two of the reasons.

The fact that the rise in the imbalances has not materially impacted currency valuations may owe something to the fact that actual currency movements have been an offset and that the IMF assumes these larger imbalances are temporary. If we take the US, we notice that the current account deficit has widened significantly during this crisis, as opposed to the global financial crisis in 2008 (the chart is on page 4). We think this might help explain the fact that, while USD strengthened in the wake of the GFC as the US current account narrowed significantly, the upside for USD during the coronavirus crisis was limit ed to the early months because the current account started to weaken significantly.

Looking ahead, the IMF’s logic might suggest a stronger USD as it sees the current account deficit shrinking next year. However, Mr. Steve Barrow is not so sure about this, in part because expectations for the budget deficit have stayed quite high and the amount that the government can borrow from the domestic private sector will likely be reduced as individuals spend down the involuntary savings they accumulated during the pandemic. If this forces the government to look overseas for savings to a greater extent it could mean a persistently large current account deficit. Add that to the overvaluation of the dollar, which could make some overseas savers reticent to fund the US at existing exchange rates, and we think it more likely that the greenback will give ground over the long haul.