In focus

The fate of the US dollar through the prism of balance of payments


The US dollar stands at a crossroads, as the structural and cyclical trends that have propelled it are being disrupted by Covid-19. We see potential for the dollar to weaken, as some of its structural fragilities are being exposed by the pandemic. Nonetheless, the magnitude of any downward move is dependent on a confluence of factors.

After rising sharply at the beginning of the Covid-19 crisis, the US dollar has weakened in the second half of 2020. While the downward move has been relatively pronounced, it has not been universal. The greenback has depreciated more against developed market currencies, especially the euro, but less so against emerging market ones. Nonetheless, investors are wondering if this could be the beginning of a major trend that could see the dollar weaken substantially, after a long period of strength.

Drivers such as economic growth, fiscal policy, interest rate differentials and the relative demand for assets can explain movements in the dollar. But importantly, all these drivers can be viewed through the lens of the balance of payments – the record of all international trade and financial transactions made by a country’s residents with the rest of the world – allowing a better understanding of their effect on currency. This paper looks at the components of the US balance of payments.

The first half of the paper focuses on the developments in the US current account and the macro-economic signals provided by the fluctuations in the trade flows. The second half explores the US financial account and possible changes in the demand for US dollar assets. Together, the two sides of the balance of payments can help to shed light on the direction of the dollar.

The relationship between the current account and the dollar

Analysis of the US current account – expressed variously as the difference between domestic savings and investment, the balance of trade in goods and services with the rest of the world, and the mirror image of the financial account (see the next section) – can help build up a picture of drivers of the dollar.

At a very high level, the relationship between the current account and the dollar has not been clear cut. The US has run a persistent current account deficit, on average around 2.5% of GDP, since 1980 (Figure 1), but this has not been an obstacle to the dollar going through periods of very strong growth in this period. The last time the US had a current account surplus was in 1991.

However, what is clear is that periods of significant dollar weakening have been associated with a widening current account deficit. For example, in the mid-1980s and again in the early 2000s.

In more recent times, between 2014-2020, the current account deficit was very stable at around 2%, providing a more favourable backdrop for the dollar.

The recent sharp widening in the current account deficit (explained in the sections which follow) could therefore be an ominous signal for the dollar.

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