Intro: Fiscal policy is perhaps the single most important driver of currency performance, particularly over the long term, due to its impact on inflation and growth, as well as its impact on monetary policymakers’ ability to maintain positive real interest rates.
As mentioned previously real interest rates are the major driver of forex moves over the short- and long term. For this reason, monetary policy considerations should front-and-center when forecasting currencies. That said, monetary policy is usually downwind of fiscal policy, which tends to be the ultimate driver of currency performance.
A country’s fiscal health is of utmost importance for long-term currency performance for several reasons. Firstly, fiscal deficits are highly inflationary. Secondly, they tend to undermine long-term growth. Thirdly, high government debt loads reduce a central bank’s ability/willingness to maintain positive real interest rates due to the upside pressure that this puts on government borrowing costs.
The Japanese yen has been one of the worst performing currencies over the past five years despite having a hugely positive net international investment surplus and related income account surplus, for the sole reason that its dire fiscal position has forced the Bank of Japan into keeping monetary policy extremely loose. Japan’s 250%+ government debt-to-GDP ratio and persistent fiscal deficits mean that in the absence of BoJ bond buying, interest rates would likely spike to levels which would overwhelm the government’s tax revenues. In contrast, New Zealand’s relatively prudent fiscal policies have allowed the Reserve Bank of New Zealand to maintain positive real interest rates for the most part, which largely explains why it has been the best performing developed market currency over this period.