Heads or Tails: Currencies and Capital

Heads or Tails: Currencies and Capital

Jeffrey Young
By Jeff Young

A section in our most recent PGIM Quant 2025 Q3 Multi-Asset Outlook, “Trade and The Global Monetary System: Two Sides of the Same Coin,” explored the intricate connections between global trade imbalances and monetary policy. Martin Wolf at the Financial Times has added to this critical conversation with his column, “Why Global Imbalances Do Matter.”  

Wolf argues that instead of taxing imports via tariffs, policymakers should target capital inflows, asserting that the trade balance and capital balance are two sides of the same coin (true), and that excessive capital inflows can do more damage to the US and global economy than trade deficits can (probably true – we’ll get to this). The mortgage market bubble that precipitated the Global Financial Crisis in 2008 serves as a striking example of what unchecked imbalances can trigger. Controversially, Wolf argues that if the US cuts its fiscal deficit without simultaneously addressing capital inflows, the result could be another asset bubble with similarly catastrophic impacts.  

So the best approach, according to Wolf, is to tax capital inflows while also cutting the fiscal deficit. 

We agree that persistent trade deficits are a problem, and that they cannot be addressed without altering the dollar’s role in the global monetary system. But we remain unconvinced of the tight linkage between capital inflows and financial instability (in large developed markets). And we certainly don’t believe the link is so direct that it justifies taxation.  

First, it’s not net capital inflows driving financial crises; it’s excessively loose monetary policy. Take Japan as an example. Despite being a current account surplus and capital-exporting country, it experienced one of the largest financial bubbles in history. This was arguably caused by international cooperation to reduce global imbalances – specifically, loose monetary policy to counteract the Plaza Accord’s strong yen effect. After Japan, China became the world’s largest current account surplus and capital-exporting country, only to face its own slow-moving financial crisis.  

Second, the composition of capital inflows to the US is changing in a beneficial way. The share of inflows into foreign direct investment (FDI) and equity has risen to about one-third of the total, while the share going into debt has fallen to around 45%, down from an average of 70% just a few years ago. And with accelerating investment by foreign governments and companies, the volume of higher-risk assets held by foreign investors is set to rise. This marks a transition from inflows predominantly funding US government debt (which finances the fiscal deficit) to inflows directed toward substantial FDI in US companies or the expansion of businesses (which finances private sector activity).  

This is one of the more intriguing features of US capital inflows. The US functions as a provider of both safe assets (Treasuries) and risky assets (FDI). And the two are interdependent; risky assets carry less risk because they are anchored in the stability of the safe-asset country, while the creditworthiness of the safe asset is bolstered by the economic growth and revenue-generating power of the risky assets. No other country offers this. 

It’s hard to make a case for taxing these capital flows, especially when they’re so tightly intertwined. Identifying which flows to target would be a challenge in itself. But Wolf’s piece highlights a growing impatience with global imbalances and the struggle to find new ways to address them. What’s more likely is a return to older approaches, particularly dollar depreciation. The first half of this year threw consensus currency forecasts for a loop. For instance, the forecast for the EUR/USD was predicted to be around 1.06 at the end of June. Instead, it closed at 1.17, far exceeding even the most bullish projections. 

Over history, when US administrations have focused on trade deficits, the dollar has consistently depreciated: from March 1985 to July 1992, it fell 36% in real trade-weighted terms; between January 2002 and March 2008, it dropped by 25%. This year, the dollar is already down about 9% from its January peak. Compounding this structural trend, the US expansion is showing signs of fraying at the edges, prompting increased investor expectations of Fed rate cuts. Meanwhile, the ECB is nearing the end of its cycle of cuts, and the Bank of Japan is preparing for modest rate hikes.  

From a portfolio perspective, global imbalances are impossible to ignore. And whether or not they capture your attention, they undoubtedly influence your portfolio. 

References

Jeff Young