Morning Brief – Twin Deficits

Twin Deficits

Until recently the “Twin Deficits” theory was seen as a rather bland and mundane economic theory that had good basis but limited physical evidence. However, the post-millennial explosion of national debt brought with it an appreciation of the importance of the theory to the value of a currency. In particular, the theory teaches us about the resilience of currencies in times of trouble and their propensity to get themselves back on track as conditions worsen. It should therefore be no surprise that it’s front and centre of the FX market’s mind as we look towards policy normalisation post-Coronavirus.

The phenomenon of twin deficits isn’t new: it refers to a scenario in which one nation has a simultaneous deficit in its current account and its fiscal account. In plain English, that means it imports more than it exports and at the public level, it spends more than it receives. The conclusion of both of these domestic deficits is a reliance upon external financing – the country must borrow from abroad. Globalisation has meant that credit networks traverse borders and continents with ease, however, as we are being reminded once again, the picture turns somewhat more gloomy in the presence of an external threat and a global turndown.

In reality therefore the dependency upon external financing created by a nation’s twin deficits impacts their ability to pave their way through a crisis and their capacity to normalise the economy once the worst of it has passed. To make our analysis even more challenging, there will be new joiners to the twin deficit club. Germany for example, having provided exemplary support to its economy during coronavirus through fiscal spending but having operated with a surplus in both its current and fiscal accounts for some time will likely see large increases in its debt burden. Whilst it may maintain its status as a net exporter the composition of its fiscal account will change. There is also the critical consideration of just how much the debt accumulated in the response to the coronavirus enabled a faster normalisation in the economy – something that only time will tell.

Taking into account policy responses and forecast GDP normalisations produced by the IMF we can model which countries are most likely to revitalise their economies without burdening the budget balance. These countries are best exemplified by Japan, Singapore, Hong Kong, South Korea and Malaysia. There are some Eastern European nations that make the cut too including Czechia (Czech Republic) and Hungary. Each of these nations have an independent currency and all but the Japanese Yen find their value predominantly determined by cash flows and economic performance. During times of distress and while the Dollar is still King in foreign exchange markets, these currencies afford good value.

Discussion and Analysis by Charles Porter

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