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It's All Just Talk: Economics, Not Political Pronouncements, Drive Currencies

It's All Just Talk: Economics, Not Political Pronouncements, Drive Currencies
(Dollar Photo Club)

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Thursday, 25 January 2018 07:48 AM Current | Bio | Archive

President Donald Trump said in an April 2017 interview with the Wall Street Journal: “I think our dollar is getting too strong, and partially that’s my fault because people have confidence in me. But that’s hurting—that will hurt ultimately,” he said.

“Look, there’s some very good things about a strong dollar, but usually speaking the best thing about it is that it sounds good. It’s very, very hard to compete when you have a strong dollar and other countries are devaluing their currency,” he said.

Trump must be gratified to know that this is no longer the case and that U.S. Treasury Secretary Steve Mnuchin is seemingly advocating a weaker dollar (perhaps in the context of the “risk” of a trade war, who knows?) at a press briefing in Davos, Switzerland, stating: “Obviously a weaker dollar is good for us as it relates to trade and opportunities”

Does this all really matter?

Really, it does not.

The utterances of politicians in favor of a strong or of a weak currency can create short-term noise as with the dollar’s decline yesterday, but it is economics and not political pronouncements that drive currencies.

The United states is a current account deficit nation.

By the way, forecasts for the U.S. current account deficit expect a -$118 billion deficit at the end of this quarter and a -$120 billion deficit in 2020.

In simple words that means that the United States has to attract capital from the rest of the world.

The recent tax cuts are likely to “increase” the U.S. current account deficit because of higher imports and because of that the U.S. will need to attract more capital form the rest of the world as a consequence.   

For the time being, it’s a fact that the traditional supporters of the dollar, the Asian central banks and the Middle East investors base are not buying.

The increasing demands for capital at a time when major suppliers of capital are largely absent is a weakening factor for the dollar. 

So, what are the economics of this?

When almost 50 years ago, in December 1971, the then G-10 currencies started to “float”, albeit in a limited way, after a new dollar standard was created whereby the major currencies of the most highly industrialized nations were pegged to the U.S. dollar at central rates, with the currencies being allowed to fluctuate by 2.25 percent under the “Smithsonian Agreement,” the idea that a weaker currency might boost GDP was common in those times.

When a currency would drop, exports would become cheaper while imports would become more expensive.

Investors could do well to take note that with the exception of commodities, this does not happen anymore.

Supply chains are longer and more complex than they were half a century ago. Today, the world is more globally integrated. Companies are not going to risk their market share for which they have spent years in building up just because of a currency move. Trade today tends not to react to currency changes in the way that it used to.

Currency moves change profit margins, they do not tend to change economic activity. U.S. firms will face the same competition from foreign imports unless President Trump broadens the scope of the Trump tariff tax.

U.S. exporters will boost profit margins, not market share in their overseas markets.

This is perhaps why no economy has devalued its way to greater prosperity in recent times.

The issue of currency will doubtless come up today at the ECB press conference that comes after the meeting of the Governing Council of the European Central Bank on its monetary policy. ECB President Draghi does still seem to be having problems overcoming an addiction to easing policy. As such, the euro may provide a convenient excuse, but Draghi is going to have a very hard time attempting to demonstrate that the euro is overvalued, mainly because it’s not overvalued. In fact, as of January 24th, the euro was about 5 percent undervalued against the dollar on its purchasing parity power (PPP) base as communicated by the OECD.

Please take care that the PPP does not determine exchange rates in the short term. Over the longer term (4-10 years) it does.

Etienne "Hans" Parisis is a bank economist who has advised investors on financial markets and international investments.

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The utterances of politicians in favor of a strong or of a weak currency can create short-term noise as with the dollar’s decline yesterday, but it is economics and not political pronouncements that drive currencies.
economics, political, pronouncements, currencies
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2018-48-25
Thursday, 25 January 2018 07:48 AM
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