By Frances Coppola
Even with this recent decline, the International Monetary Fund (IMF) says that the U.S. dollar’s real effective exchange rate is overvalued relative to economic fundamentals by 10-15 percent. In its External Sector Report for July 2017, it identifies the U.S.’s persistent trade deficit as evidence of dollar overvaluation. The IMF says that the U.K. pound, too, is overvalued and, again, this shows up as a persistent trade deficit.2
According to the IMF, both overvaluations arise not from FX markets, but from global trade imbalances. The U.S. and U.K. are increasingly acting as “consumers of last resort” for other advanced economies that have built up large and persistent trade surpluses, and the overvaluation of their currencies’ real effective exchange rates reflects these trade imbalances.3
A currency’s real effective exchange rate (REER) is its average exchange rate against the currencies of all the country’s trading partners, weighted by trade balance. It differs from the trade-weighted exchange rate in that it is adjusted for inflation. The REER thus measures the real value of imports – in other words, the value that an individual pays for an imported good at the consumer level, including any tariffs and transaction costs associated with importing the good.4
If the REER is too high, then imports are cheap relative to domestically produced goods, and the country is likely to run a trade deficit. If the REER is too low, then imports are expensive relative to domestically produced goods, and the country is likely to run a trade surplus. The REER is therefore a measure of international trade competitiveness.5
Persistent trade deficits and surpluses are usually associated with distortions in the REER. However, as the IMF notes, the REER does not necessarily cause the trade imbalance. Rather, economic policies both at home and abroad generate the trade imbalance and REER distortion.6
Both the U.S. and U.K. have run persistent trade deficits for many years, despite their currencies depreciating significantly after the financial crisis of 2007-8. The IMF says that until recently, these trade deficits were balanced by trade surpluses in developing countries, particularly China. But the surpluses have now diminished, as part of what it calls a “reconfiguration” of global trade imbalances due to the fall in oil and commodity prices in 2014-15.
According to the IMF: “Current account surpluses of oil-exporting economies, as a group, shifted from large surpluses to small deficits, while deficits in emerging and developing economies narrowed markedly. At the same time, surpluses and deficits in key advanced economies widened. These trends were generally supported by real exchange rate movements.”7
Now, it is advanced countries, particularly some EU countries, that are running persistent and growing trade surpluses. These are reflected in significant undervaluation of the euro’s REER relative to the fundamentals of those economies, though not for the bloc as a whole.8 The IMF notes that the growth of trade surpluses in advanced economies is mirrored by the rise in the U.S. and U.K. trade deficits.
The IMF says that in part, the rising trade deficits and stronger currencies of the U.S. and U.K. reflect better economic performance than in the euro area and Japan. In both countries, falling oil and commodity prices encouraged domestic consumers to spend, thus increasing imports. In contrast, in the euro area, which was still recovering from the 2012 euro crisis, domestic spending did not respond significantly to falling oil prices, so imports did not rise.
For the U.S., the IMF also notes the “exorbitant privilege” of being the world’s premier reserve currency issuer as a factor in its persistent external deficit. It says that global demand for dollar-denominated financial assets tends to strengthen the U.S. dollar’s exchange rate and thus enable the U.S. to run persistent external deficits at lower financing cost than a non-reserve currency issuer would incur.9
A country that runs a persistent external deficit (i.e. not denominated in its own currency) must borrow to finance that deficit: the Governor of the Bank of England, Mark Carney, recently described this as relying on “the kindness of strangers.”10 For both the U.S. and the U.K., there is therefore some risk that global markets will raise the cost of foreign currency borrowing, not only for the government but also for businesses. However, the IMF does not regard this as a significant risk in the short term. Its concern is more about the risk to global growth caused by what it calls “overreliance on demand from debtor countries,” and the possibility that those countries could introduce protectionist trade policy measures to defend against growing deficits.11
The IMF calls for action by both deficit and surplus countries to reduce trade imbalances. For surplus countries, it recommends structural reforms to encourage higher spending by domestic consumers, together with increased government spending in countries that don’t have high sovereign debt. For deficit countries, it recommends cutting government expenditure and/or raising taxes (“fiscal consolidation” to dampen domestic demand and thus bear down on imports, along with policies to improve export competitiveness and encourage domestic saving. It strongly advises against raising trade tariffs and non-tariff trade barriers to correct trade imbalances, or manipulation of currency exchange rates to benefit exporters.12
If the U.S. and U.K. take on board the IMF’s recommendations, exporting businesses in both countries could find that they benefit from extra government assistance, while importing businesses may experience a decline in sales. However, unless there is complementary action from countries running persistent trade surpluses, the real effective exchange rates of the U.S. dollar and the U.K. pound may continue to be overvalued, to the detriment of their export competitiveness.
With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “USD trade weighted index – major currencies,” FRED; https://fred.stlouisfed.org/series/DTWEXM
2. “2017 External Sector Report,” International Monetary Fund; https://www.imf.org/en/Publications/Policy-Papers/Issues/2017/07/27/2017-external-sector-report
4. “Real effective exchange rate,” Investopedia; http://www.investopedia.com/terms/r/reer.asp
5. “What is real effective exchange rate?,” International Monetary Fund; http://datahelp.imf.org/knowledgebase/articles/537472-what-is-real-effective-exchange-rate-reer
6. “2017 External Sector Report,” International Monetary Fund; https://www.imf.org/en/Publications/Policy-Papers/Issues/2017/07/27/2017-external-sector-report
10. “A fine balance,” Mark Carney, Bank of England; http://www.bankofengland.co.uk/publications/Documents/speeches/2017/speech983.pdf
11. “2017 External Sector Report,” International Monetary Fund; https://www.imf.org/en/Publications/Policy-Papers/Issues/2017/07/27/2017-external-sector-report
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