The IMF released its 2020 External Sector Report on 4 August (see here), which aims to produce "multilaterally consistent estimates for current account and real exchange rate norms" for the 30 largest global economies, which cover c90% of global GDP.
The report has a wealth of interesting data, but we focus here on the salient analysis for currency valuation of the 13 included EMs and their key external vulnerability factors.
The report estimates current account and REER gaps by comparing actual current accounts (adjusted for cyclical components) and REERs with their staff-assessed norms (or benchmarks).
The idea of current account "norms" stems from the concept that running a non-zero current account balance is often desirable for individual countries and is essential for absorbing country-specific shocks and efficiently allocating capital across borders, but with each country having an "equilibrium" balance that is consistent with fundamentals and desirable policies.
As the report says, "Some countries may need to save through current account surpluses (for example, because of an ageing population); others may need to borrow via current account deficits (for example, to import capital and foster growth). Similarly, countries facing temporary positive (negative) terms-of-trade changes may benefit from saving (borrowing) to smooth out those income shocks."
In general, Advanced Economies (AE) tend to have a higher surplus or lower deficit to account for their ageing populations and lower growth prospects (ie more need to save), and EMs tend to have a lower surplus or higher deficit to import the capital needed to exploit higher growth potential (ie more need to invest).
Other factors are also taken into account to balance the opportunity cost of holding reserves with the need to build external buffers, including the size and composition of financing flows, considerations of intergenerational equity for countries dependent on exhaustible natural resources, and the contribution of domestic and foreign policy distortions.
Based on this concept, the IMF staff calculates the "current account gap" as the difference between the current CA (adjusted for cyclical factors and policy distortions) to the CA norm. These gaps are then translated into REER overvaluation (undervaluation) by calculating the extent of REER depreciation (appreciation) required to move the balance to its benchmark, based on country-specific elasticity of the current account to REER changes.
The IMF also runs several complementary models under its EBA framework (see here for methodology). Results can differ based on technique and the most appropriate method varies by country (though the framework is especially difficult to apply for commodity exporters). For the summary analysis, we report the staffs' preferred CA and REER gap estimates for each country (with qualitative adjustments), but will present the full range of estimates later on.
As of 2019, the IMF deemed c40% of current account balances as “excessive” relative to their norms in 2019, broadly unchanged from 2018.
Countries with the largest negative current account gaps (ie 2019 current account balance below the norm) across the 30-country sample include Great Britain, Belgium, Saudi Arabia, Canada, Argentina and South Africa. Countries with the largest positive gaps (ie 2019 current account balance above the norm) include Thailand, Singapore, the Netherlands, Germany, Sweden and Malaysia.
Based on these results, countries with the largest positive REER gaps (ie overvalued currency) include Saudi Arabia, the UK, US, Canada, Belgium and South Africa. Countries with the largest negative REER gaps (ie undervalued currency) include Turkey, Germany, Sweden, Singapore, Mexico and Thailand.
The report also highlights several key risks to external stability. External assets and liabilities have more than tripled as a percent of GDP from the early 1990s to 2018, reflecting the persistence of current account deficits/surpluses across countries and heightened external vulnerabilities.
That said, the composition of the NIIP is also important. Debt liabilities in foreign currency increase the likelihood of an external stress episode, while equity liabilities do not exhibit that strong a relationship. This is concerning, as FX exposure across EMs has increased in recent years.
Heightened global risk aversion, as we are experiencing now in the wake of Covid-19, amplifies these risks. A second wave of Covid could tighten global financial conditions, deepen the decline in global trade, further reduce current account balances of commodity exporters, and narrow the scope for EMs to run current account deficits, potentially pushing vulnerable EMs to the brink of external crisis.
On the other hand, robust FX reserves, deep local financial markets, and limited foreign debt exposure (both by currency and holder) play a mitigating role. Interestingly, the IMF highlights a shift in the key driver of external vulnerability from low levels of FX reserves leading up to the Asian Financial Crisis, to elevated current account deficits leading up to the Global Financial Crisis, to elevated FX-denominated debt liabilities today (mitigated by relatively small CA deficits and relatively high levels of FX reserves).
FX misalignment and external vulnerabilities in key EMs
Below, we summarise the IMF’s external assessment for each of the 13 major EMs covered in the report. This includes: 1) the assessment of REER over/undervaluation (based on staffs’ preferred assessment and the EBA models); 2) the CA gap (also based on staff assessments and the model-based approach); 3) additional risk factors; and 4) potential mitigating factors.
Within the major EM universe, the TRY, THB, MYR, MXP, PLN and IDR were all identified as overvalued. On the other hand, the SAR, ZAR, INR and BRL were all seen to be overvalued.
However, it is worth noting that these assessments are based on end-2019 current account and REER levels. It is notable that the BRL has depreciated by 25% on a REER basis through the first 5 months of the year while the ZAR has depreciated by c17%, potentially reducing the extent of overvaluation.
Meanwhile, the TRY, THB, THB, MYR, and MXP have all come under pressure this year, potentially increasing the degree of undervaluation. However, in some cases (namely Turkey) this could simply reflect heightened domestic risk and an increasing perception of macroeconomic mismanagement.
Exposure to Covid-induced shocks
Current accounts will also clearly be impacted by Covid-19, with a resulting impact on estimated CA gaps. In general, we have seen a narrowing of current account deficits across EMs as the drop in exports is more than offset by collapsing demand for imports. Meanwhile, many AEs have seen current accounts widen as savings are drawn down and governments embark on ambitious spending programmes.
However, there are several key factors that will drive differences in the impact of Covid-19 across countries. In particular, countries with high exposure to tourism, remittances and oil are especially vulnerable, with the UN forecasting a 73% decline in tourism this year (resulting in a net impact of -6% to +2% of GDP on individual country current account balances) and the World Bank forecasting a 20% decline in global remittances.
Countries most vulnerable to the collapse of tourism include Costa Rica, Egypt, Greece, Morocco, New Zealand, Portugal, Spain, Sri Lanka, Thailand and Turkey.
Countries most vulnerable to the drop in remittances include Egypt, Guatemala, Pakistan, the Philippines, and Sri Lanka.
Countries most vulnerable to the drop in oil prices include Saudi Arabia, Norway, Russia, Malaysia and Colombia, while those likely to benefit most are Thailand, Turkey, Morocco, Sri Lanka and Pakistan.
Taking all these factors into account, countries most vulnerable to a combined shock to these three key factors include Saudi Arabia, Greece, Egypt, Portugal, Thailand, Tunisia and Morocco.
Conclusion: Some clarity to an inherently tricky exercise
Calculating "fair value" for exchange rates is an inherently difficult exercise, fraught with theoretical and practical obstacles. Any resulting estimates should therefore be taken with a heap of salt. That said, the IMF’s annual external sector report provides a clear, "multilaterally consistent" framework for FX valuation, and can thus provide some useful (if slightly backward looking) insights into the extent of external imbalances in key advanced and emerging economies.
The fact that the US$ appears to be materially overvalued is positive for EM assets, with any resulting US$ weakness reducing both credit and FX risk for investors in hard currency and local currency-denominated assets, respectively. That said, the estimated 11% overvaluation is not materially different from the 2019 assessment of 9%, and its reserve currency status means that Covid-related newsflow and global risk sentiment will continue to be the main near-term drivers (see here).
Meanwhile, the extent of potential under/overvaluation in key EM currencies (like the TRY and ZAR, respectively) can help inform investors’ risk management frameworks. Having said that, currencies can clearly deviate from their "equilibrium" values for long periods of time driven by higher frequency economic, political or technical factors, so fundamental over/undervaluation should not be taken as a definitive sign of where currencies will trade near-term.
While this report summarises, in our view, the most salient points for EM investors, for those interested in getting into the weeds on FX valuation and external sector assessments we recommend reading the full external sector report (here) and IMF white paper outlining the recently revised EBA framework (here).