By James Lord, Global Head of Foreign Exchange and Emerging Market Strategy at Morgan Stanley
My career in sell-side research started in the mid-2000s, when I focused on Emerging Markets. The 2003-07 period felt like the glory days of the asset class, and times were good for markets in general. However, instability was brewing behind a veneer of attractive returns and low volatility. One warning sign was the widening imbalances between the economies running current account deficits and those with surpluses. These imbalances peaked at around 3% of GDP in 2007, thanks to loose financial conditions and strong growth.
The 2008 global financial crisis proved to be the catalyst for the unravelling of those imbalances. Tighter financial conditions exposed the economies with wide current account deficits and external financing needs to currency weakness and a sharp recession. Current account positions rebalanced rapidly.
Over the last few years, current account imbalances have widened again, to levels that bear watching. Based on the IMF’s current account forecasts for global economies in 2022, imbalances are substantially wider in USD terms than in 2007. As a percentage of global GDP, a more accurate measure, the expected imbalance is around 2.2% of GDP – up substantially from around 1.6% in 2019 and the highest since 2010, but at least not back to 2007 levels. Yet two key differences in this cycle make the picture more concerning.
The first difference versus 2003-07 is the composition of the world's surplus and deficit economies. In 2022, commodities, and oil prices in particular, appear to be playing a bigger role in driving the imbalances. Oil-producing nations now represent a larger (and growing) share of the total current account surpluses than in the mid-2000s, when the world's largest manufacturing export powerhouses accounted for the lion's share of the surpluses. On the deficit side, excess demand in the US remains a driver, but less so than in 2007. The US current account deficit at around 3.5% of GDP today is a far cry from the 6% levels seen in 2006-07 and even smaller as a share of global GDP. Instead, oil-importing deficit economies will contribute more to the deficit side of the equation. On our oil forecasts, these imbalances could grow starker than the IMF numbers suggest. The IMF’s current account forecasts for 2022 are based on the expectation (in the April World Economic Outlook) that oil prices average US$106/bbl this year (based on Brent, WTI, and Dubai crude benchmarks). Morgan Stanley sees an average for Brent and WTI of US$113/bbl.
The second difference is that today’s imbalances, driven in large part by higher oil prices, are growing at a time of slowing global economic activity and rapid monetary tightening. In contrast, times were good in 2003-07 with rapid growth and easy financial conditions. For economies suffering the misfortune of larger deficits today, weaker growth is hampering the ability to attract capital, while any capital available today is less abundant and also more costly. This combination will generally put downward pressure on their currencies. In a more 'normal' cycle, slowing growth and tighter policy would cause oil prices to subside and help to bring about a rebalancing of external positions. In this cycle, supply-side constraints are forcing oil prices higher even as growth slows, pushing imbalances even wider.
Currency traders and investors are well aware that terms of trade have been an important factor in exchange rate movements this year. Less appreciated is the fact that the rise in oil prices is making the external positions of the world's national economies increasingly less balanced. With the major central banks hiking rates and withdrawing liquidity, oil prices merit close attention given the potential exchange rate and capital flow implications.
What does this all mean for currencies? Wider global imbalances don't necessarily change our view on the US dollar, which we expect will start to head lower once global growth bottoms and the Fed can dial down its hawkishness. But they do pose greater risks for currencies with widening deficits, more unorthodox macroeconomic management and weak fundamentals. We'd expect these currencies to underperform as long as the Fed is tightening, growth is weak and oil prices are rising – all macro themes Morgan Stanley economists and strategists expect to remain in place in the near term.