The current account deficit, the US dollar, and global trade - building babel on credit

Now that the election is over we can focus on some other things going on in the world. I know everyone finds economics boring, but I actually think its pretty fascinating. And right now its a little scary.

Anyways, there is a unique set of events unfolding right now regarding the relationship of the US current account deficit, the US dollar, global trade and the relationship that has developed between the US and the rest of the world that has fostered global growth over the past few years. In particular, there is growing concern over sustainability of this relationship, as well as growing concern over the US dollar, whose value is tied to how well this relationship functions. Whether the dollar will fall further, and what such a fall will mean to the world, are both questions worth looking at. Though we can't be sure how, we'll undoubtably be impacted by such events.

A substantial devaluation of the world’s reserve currency, the dollar, could means some big changes to the way the world has worked over the last few years. This period has been termed the ‘US-centric global growth paradigm’ by Stephen Roach, Chief economist for Global Economic Analysis for Morgan Stanley in a recent paper. Some might welcome the end of this period, others might see it as destabilizing. I think I've stated my bias clearly enough in other posts, so in the following I will stick to just analysing the situation. I will get into some of the possible impacts of a falling dollar in a moment. For now I just want to go through the relationships by which the US dollar is valued, and state the case that says these relationships may not be sustainable, meaning the dollar may fall. The argument that the US dollar will fall is derived from the unsustainability of the current account deficit. Stephen Roach notes that the US current account deficit continues to widen. It has risen ‘from 4.5% in late 2003 to 5.7% in mid-2004’. To put this number in perspective, it means that ‘the US is now absorbing over 80% of the world’s surplus saving' to balance to outflow of dollars for trade.

So why does the US run such a large current account deficit? And what does this mean to the value of the US dollar?

Its pretty straightforward. The US runs a large current account deficit because it can import goods and services cheaper than it can produce them at home. This sends dollars abroad in order to purchase these goods.

Counter-balancing this outflow of dollars is an inflow of dollars due to the financial account surplus. Foreign investors, awash in dollars they’ve received for goods and services Americans are buying from them, invest those dollars back into the US in exchange for things like treasury bills and mortgage backed securities and corporate bonds and stocks.

These foreign investors are comprised of private investors, who want to invest in the US for a myriad of reasons (good returns, perceived safety, large and stable companies) as well as foreign central banks, particularly Asian central banks, that buy US debt in order to keep their own currencies from appreciating against the dollar.

The value of the dollar is essentially determined by this relationship. For example, if the current account was out of balance with the financial account, that would mean there were more dollars going abroad then were returning back home. Basically, there would be a greater supply of dollars then demand for dollars. Thus, the value of the dollar, as measured against other currencies, would fall. The reason the dollar hasn’t fallen dramatically this year as the current account deficit has risen (please be aware that the dollar has fallen over the last few years, just not as much as you might think given the size of the current account deficit) is because there has been such strong demand for US debt (in other words such a strong financial account surplus) and this has offset the outflow of dollars from the current account deficit.

And this is because of the Asian central banks.

The reason why Asian central banks are buying US debt is also pretty straightforward. Most Asian countries, most notably China, have economies that are driven by exporting goods to the US. Thus, they don’t want their currency to rise against the US dollar because that would mean their exports to the US would go up in price. So (through a bit of a complicated process that I won't go into here) China and other central banks buy US treasuries to hold down the value of their own currency. Japan also buys a lot of treasuries, but they are more concerned that the yen doesn’t rise against the Chinese yuan because Japan exports so many goods and services to China. To avoid this, as long as China pegs their currency to the US dollar, the Japanese are forced to do the same.

The bottom line of all of this is that China and Japan, and to a lessor extent the other Asian countries, are all involved in a vast ‘financing’ of the US by willingly buying US debt instruments to keep their currencies from appreciating against the dollar and against each other.

This of course begs the question: is it reasonable to expect the Asian central banks to continue to purchase American debt at such an enourmous rate?

There are a number of factors that make this unlikely.

For one, China is suffering from a big increase in commodity prices (oil, copper, steel, aluminum, on so on) and this is squeezing profits on Chinese businesses. As Donald Coxe, Chief Strategist of Harris Investment management notes, ‘global commodity prices have jumped 43% over the past 12 months, but prices of Chinese exports have gone up less then 2% over the same period.’ If these firms don’t have the money to pay back loans they owe to the Chinese banks, the results could be disasterous, creating a massive banking crisis. China’s banking system is tenuous at the best of times.

The trick here is that most commodities are denominated in US dollars. The removal of the US dollar peg to the Chinese yuan would ease the impact of high commodity prices on Chinese manufacturers.

Of course it would also initiate a devaluation of the dollar.

A second factor is that it appears that private foreign investors are beginning to become wary of investing further in the US. As Stephen Roach notes, the latest data for US treasury purchases show that ‘an average of $61 billion was purchased in July and August of this year versus a $76 billion average in the prior 10 months and that ‘over the 12 months ending August 2004, 33% of net foreign purchases of long-term US securities have come from the official sector, up from 15% the previous year.

In the environment of a rising current account deficit, the US needs more foreign investors to buy treasuries, not less. Yet the data seems to suggest the opposite, and that more of the burden is being put on central banks.

This brings up the question of whether its even possible for foreign central banks to extend their purchases of treasuries, even supposing they wanted to. As the current account deficit increases and private investors shy away from the increasingly risky US economy, are the Asian central banks going to even have the resources to take on more US debt? And for how long?

I don’t know the answer to this, but as Coxe notes, quoting Stein’s law, 'if something cannot go on forever, it will stop.' It seems likely that this to will end. And with the above mentioned factors, maybe sooner rather than later.

Of course, the next question is what this all means? What does it mean if the dollar devalues? The answer is that it could mean a lot of things, none of which are certain and many of which are frightening. But I’ll leave that for next time.

- posted by Sigurd11/07/2004 07:24:00 PM