A research report by Jens Nordvig and his colleagues at Nomura shows that external (current account) surpluses have been a poor indicator of currency performance over the past 20 years. External deficits are often the consequence of growth outperformance, decreasing country risk premiums and capital inflows, and hence may be associated with currency strength rather than currency weakness.
Do Current Accounts Matter? (Part I) Growth-sensitive flows more important for G10 FX than current account
Nomura FX Insights, 4 November 2013
Do Current Accounts Matter? (Part II) – Risk Aversion brings Emerging Market Current Accounts to the fore
Nomura FX Insights, 5 November 2013
The below are excerpts from the report, which is proprietary research of Nomura. Emphasis and cursive lines have been added. For access to the original report please see www.nomuranow.com/research and request access.
“Conventional wisdom states that a positive and sustained current account surplus should imply excess demand for the domestic currency and lead to currency outperformance…[However] we can empirically conclude, that current account surpluses, by themselves, have had limited currency impact for economies with globally integrated financial markets. This is especially true when the current account surplus occurs at the same time as (and potentially as a consequence of) slow economic growth.”
Evidence for developed market currencies
“We test [the relevance of current accounts for FX returns] empirically with data since 1984 for a sample of 17 G10 countries (including legacy Euro nations) and find that a trading basket using a simple current account rule – going long the currencies of countries with the top 3 current accounts and short the currencies of countries with the bottom 3 current accounts (“current account basket”) – has performed consistently poorly over the past 20 years.”
“The stronger performance of the current account basket in early years and the recent underperformance is consistent with the growing influence of cross-border capital flows as global financial markets became more integrated… Conditioning the current account basket on gross portfolio and direct investment flows as a percent of GDP (“gross investment flows”), we see that over time the strategy has worked best for countries where gross investment flows have been low.”
“Capital flows, as opposed to trade flows, are an increasingly significant factor in the currency markets. One of the most important drivers of persistent flow divergence across countries is relative economic growth and related asset market returns… Pre- 1992, countries with better current accounts [recorded] generally better growth trajectories than those countries with worse balances. Post-1992, Countries with better current accounts [recorded] consistently poorer growth… The regime shift for growth patterns in the mid-1990s occurs roughly at the same time as the peak performance point for the current account basket, and we believe there is a causal link there… We find that our strategy of picking currencies with better current account balance works best when we add the extra filter of only going long currencies of countries with stronger relative growth and short those with weaker relative growth.”
Evidence for emerging market currencies
“We test the basic hypothesis that a strong current account position is associated with foreign exchange outperformance empirically, with data from 18 EM countries since 1995, and find that currencies supported by a strong current account position have generally performed poorly over long periods of time.”
“[A] portfolio is created by simply going long the currencies of the three countries with the best current account balances (highest surpluses/lowest deficits) and going short the currencies of three countries with the worst current account balances (among countries with floating exchange rates)…The strategy has performed poorly since the beginning of our sample in 1995 with total negative returns of -38%.”
“The carry differential in the portfolio…strongly favors the countries with weak current accounts and thereby drives a lot of the negative performance of the current account basket.”
“We do find however that, in EM space as in DM, there does seem to be added benefit of conditioning a strategy based on current account strength on economic growth as well. EM currencies also appear to be different in that they are more sensitive to market volatility, and that there is marked outperformance in our strategy based on current account imbalances in periods of high volatility relative to low volatility.”