Currency Misalignment Monitor, December 2023

The December Currency Misalignment Monitor – a monthly index that tracks currency misalignment among major economies – found dollar overvaluation edging up once again, to 17.4% against the basket of 33 other currencies included in our model. The overvalued dollar makes imports less expensive in the U.S. and our exports more expensive on world markets. Our overvalued currency is the biggest single contributor to our huge trade deficit, set to come in at more than $750 billion this year.

As in previous months, China’s and Japan’s currencies are severely undervalued against the dollar, by 23.5% for the Chinese yuan and 41.1% for the yen. That undervaluation supports their export-led growth strategies.

These estimates are based on new forecasts from the International Monetary Fund (IMF) contained in its October World Economic Outlook publication. Our estimates of over- and undervaluation are derived from applying our model to the IMF forecasts to calculate what exchange rates would be needed to set all major world economies to balance in the current account (equivalent to the trade balance plus investment income and foreign remittances) five years from today. The exchange rate model was developed at the Peterson Institute. However the original model only called for exchange rate adjustment if the 2028 current account balance exceeded 3% of the nation’s GDP in 2028. That’s a large number–$810 billion in the case of the U.S.

Our model targets zero current account balances in 2028 to demonstrate what sort of exchange rate adjustments would be necessary to eliminate the large imbalances between persistent deficit countries like the U.S. and surplus countries like China, Japan, and Germany. Standard economic theory says that exchange rates should be set at levels to balance a nation’s current account over the long term. Further, standard theory suggests that advanced economies like the U.S. should consistently run modest surpluses to provide for capital outflows to invest in emerging economies, which are traditionally capital poor and offer good investment opportunities.

But for decades, the opposite has been the case. Surplus nations like China and Japan manage their exchange rates to generate persistent surpluses on trade and current account bringing in foreign exchange which they then invest overseas. Advanced countries like the U.S. become the main destination for those capital flows, forcing them into persistent deficit. Deficits and surpluses in the major nations have become self-reinforcing phenomena.

Japan provides a good example of how an undervalued exchange rate can support exports to the U.S. The Japanese yen is currently around 150 to the dollar while our model says it should be at 106. Today Toyota might sell a Japanese-produced car in the U.S. at $40,000 based on the current 150 exchange rate. If the yen rate moved to its equilibrium rate of 106, then to achieve the same 6 million yen sales price would require raising the U.S. price to $57,000, which would either cut back dramatically on Toyota’s U.S. sales or reduce Toyota’s profits if it attempted to hold the U.S. price to $40,000.

The new IMF forecasts raise another interesting question over our valuation methodology. The October forecasts show Japan’s current account surplus declining from the 2021 level of 3.9% of Japan’s GDP to 3.2% in 2028. But it was back in 2021 when the yen began its steep fall from around 105 to the dollar to today’s 140-150 range. That depreciation should increase Japan’s exports and its current account surplus.

Similarly, China’s current account surplus is forecast to fall from 2.0% in 2021 and 1.5% this year to only 0.68% in 2028. The IMF has a history of being optimistic in its forecasts, perhaps because it does not want to provoke member nations by publishing alarming forecasts. However, if those forecasts are over-optimistic, and the current account surpluses in the out-years turn out larger, then the currencies are even more severely undervalued and a greater rise in their value against the dollar than that shown in our current Misalignment Monitor would be needed to bring their surpluses down to zero.

For the United States, the IMF forecast shows the current account balance improving from this year’s -3.0% to -2.4% in 2028. Since the IMF forecast shows U.S. GDP rising more rapidly than other large nations in the next couple of years, one could expect that a rising GDP will raise U.S. consumption and suck in more imports, leading to an even worse current account balance.

Of course, it’s hard to forecast figures like current account balances five years out, so the Currency Misalignment Monitor is not intended to contain precise recommendations of the correct exchange rates, but more ballpark figures and a demonstration of the severe misalignment that exists today.

On a more positive note, the current exchange rates in this month’s Monitor are based on Bank of International Settlements average exchange rates for the month of October, the latest published figures. The U.S. dollar has edged down slightly during November, as international investors begin to think that the Federal Reserve has finished raising interest rates and the U.S. is now close to the targeted 2%. However, a slide of a couple of points in U.S. dollar overvaluation will not alter the fundamental, longstanding problem of a trading disadvantage with countries with undervalued currencies.