Term Project on IBEE

Are the US current account deficit and external debt sustainable?

Submitted by

Rahul PareekIMI, New Delhi

Make a chart of the U.S. current account deficit, both in absolute $ value and as a share of GDP from 1990 to 2008. Find also the most recent estimate of the U.S. current account deficit for 2008 and 2009 (Q1 and Q2).

US Balance on Current Account

This graph shows the U.S. trade deficit / surplus as a percent of GDP since 1960

through Q4 2008. The trade deficit as a percent of GDP started declining in 2006,

even with the rapid increase in oil prices. With oil prices declining sharply, the

trade deficit has plunged to 3.7% of GDP in year 2008, Q4.

The oil deficit will fall further in January, and if all else stays the same, the trade

deficit might fall close to $30 billion per month in Q1 2009. At that pace, the

deficit as a percent of GDP would be in the 2.5% to 3.0% range

Current Trends

The U.S. current-account deficit--the combined balances on trade in goods and

services, income, and net unilateral current transfers--decreased to $132.8 billion

(preliminary) in the fourth quarter of 2008, the smallest deficit since the fourth

quarter of 2003, from $181.3 billion (revised) in the third quarter of 2008.

The current-account deficit decreased to $673.3 billion (preliminary) in 2008 from

$731.2 billion in 2007.

The US trade deficit — which is a good proxy for the current account balance

(the income surplus offsets a transfers deficit) — is now around $40b a month. At

its peak it was more like around $60b a month. That implies, if nothing changes,

the 2009 current account deficit would be around $500b, down from a peak of

$700b. The actual figures for the first quarter of 2009 will be released by the

bureau of Economic Analysis on June 17, 2009

(a) For the same sampe period (1990-2008), chart the evolution of the net foreign assets of the U.S. (NIIP) and decompose the total NIPP in the part that is the net stock of foreign direct investment from the part that is the rest (portfolio, banks, other forms of debt).

Up to 2007 we see both flows increasing but the size of foreign lending to the US

is always larger than the flow in the opposite direction, and this difference funds

the current account deficit. 

In 2008 we see a collapse of both flows. The flow of lending to the U.S. goes

from around 2 trillion to 600 billion. This collapse is matched by a decrease of

capital flows from the U.S. to foreign countries from 1.3 trillion to almost zero.

What is even more interesting is that if we split this flow into private and official

(government and central bank related) flows, we see that private flows from the

U.S. to other countries changed from an outflow of about 1.3 billion in 2007 to an

inflow of 480 billion - this represents a change of close to 1.8 trillion. In other

words, a large part of the current account deficit in 2008 was financed by U.S.

nationals selling their assets abroad and repatriating the funds to the U.S. The

change in these private flows more than compensate the drop in capital flows

from other countries. [At the same time, official flows from the U.S. to other

countries increased to reach almost 500 billion. Most of this lending is likely to be

associated to the lending facilities that the Federal Reserve has made available

to European central banks]

(b) Discuss the evolution of the U.S current account deficit and net foreign assets: how much of the evolution of the deficit (as a share of GDP) is due to changes in private savings, public savings (fiscal deficits) and investment rate (all as a share of GDP).

Evolution of Current Account Deficit

The current account deficit has been on a steep upward trajectory in recent

years, rising from a relatively modest $120 billion (1.5 percent of GDP) in 1996 to

$414 billion (4.2 percent of GDP) in 2000 on its way to its current level. The US

current account deficit reached $850–875 billion in 2006. It now accounts for

about 7 percent of GDP, more than double the previous modern record of 3.4

percent in the middle 1980s (as a result of which the dollar dropped by 50

percent against the other major currencies over the three-year period 1985–87).

Reasons of Current Account deficit

1. Expansion of the fiscal deficit

The view that the current account deficit arises from the widening U.S. budget deficit has received considerable attention of late and recalls the discussion of

the mid-1980s, when the simultaneous emergence of fiscal and current account deficits in the United States gave rise to the "twin deficits" hypothesis. The simplest version of this hypothesis starts with the identity that the current account balance is equal to saving minus investment. Since the expansion of the fiscal deficit lowered public saving, the story runs, it must have lowered national saving and thus widened the current account balance to a similar extent. This version of the story is a bit too simple, however, as it assumes that private saving and investment remain constant, whereas in reality these quantities can and probably will change in response to a change in the fiscal balance. In the more sophisticated version of the story, a larger fiscal deficit boosts domestic demand, pushing up domestic interest rates relative to foreign rates; this, in turn, attracts investors and raises the value of the dollar, thereby leading to a larger current account deficit.

In theory, the fiscal explanation of the current account deficit is entirely plausible. In practice, however, the support for this proposition is weak. The United States has had episodes in which the fiscal and current account balances moved together, but it has also had episodes in which they diverged. Most notably, the fiscal factor cannot explain the widening of the trade deficit in the late 1990s, when the U.S. budget moved into surplus. At the international level, countries such as Japan and Germany are running large current account surpluses even as their budget balances are substantially in deficit. More generally, research into the determinants of current account balances has produced only mixed support for the linkage between fiscal and current account deficits.2

Why the reductions in public saving don’t associate with widening fiscal deficits lead more consistently to higher current account deficits? Most likely, larger budget deficits increase the government's draw on available credit and dampen private consumption and investment spending, thereby limiting the deterioration of the current account. It is suggested that, compared with a scenario in which no fiscal expansion had taken place, the loosening of fiscal policy since 2001 boosted the rate of private saving and lowered the rate of private investment. Accordingly, the effect on the trade deficit is estimated to have been fairly small.3 Rather than crowding out net exports, fiscal expansion appears to have primarily crowded out private investment and consumption.

In sum, the recent experience both of the United States and of other countries, as well as the results of model simulations, lead to conclude that the budget deficit has probably been only a small factor in the emergence of the large U.S. external imbalance. Of course, even if it does not narrow the current account deficit by much, reducing the budget deficit would be highly desirable for other reasons: It would free up resources for private investment, and it would reduce the burden on future taxpayers of repaying the federal debt.

2. Decline in the private saving rate

For observers who view the large current account deficit as an example of the profligacy of Americans, the sharp decline in private saving rates looms as large in their thinking as the sharp rise in the budget deficit. Since the mid-1990s, the personal saving rate has declined from roughly 5 percent of disposable income to less than 2 percent, and gross private saving (which includes corporate saving) has edged down from about 16 percent of GDP to less than 15 percent.

As noted earlier, it is important to distinguish between fundamental shocks affecting the current account and other developments which might merely represent economic responses to those shocks. On one hand, the decline in private saving could reflect a response to other developments in the economy--for example, a rise in the value of equity holdings and housing wealth, increases in expected future income, or declines in interest rates--and thus might not represent a fundamental cause of the U.S. current account deficit. On the other hand, the decline in saving rates could reflect a structural shift in household saving and spending behavior. Continued financial liberalization and innovation have made it easier for Americans to borrow, particularly against their real estate wealth, and this easing may have led to greater consumption.

If Americans have experienced a structural decline in private saving rates, how much of the widening of the external imbalance could this explain? The reason is virtually the same as in the case of a rise in fiscal deficits. High private consumption boosts GDP growth and--all else equal--forces up interest rates; although the rise in interest rates strengthens the dollar, it leads to much lower investment spending. Accordingly, and as in the case of a fall in public saving, a fall in private saving appears to crowd out investment more than it crowds out net exports, and thus leads to little change in the trade balance. However, that just as a decline in the budget deficit is desirable even if it would not substantially reduce the trade deficit, a rise in private saving rates also would be helpful because it would strengthen private balance sheets and provide additional resources for investment and growth.

3. Productivity growth

In both the fiscal story and the private-saving story, the large U.S. current account deficit implicitly is the outcome of a rise in consumption relative to income. The third story I'd like to discuss highlights a more impressive achievement of the U.S. economy, the surge in labor productivity growth from about 1-1/2 percent annually in the two decades preceding 1995 to roughly 3 percent in the period since then. This surge is viewed as having several important consequences. First, higher productivity growth boosted perceived rates of return on U.S. investments, thereby generating capital inflows that boosted the dollar. Second, these higher rates of return also led to a rise in domestic investment. Finally, expectations of higher returns boosted equity prices, household wealth, and perceived long-run income, and so consumption rose and saving rates declined. Under this explanation, all of these factors

helped to widen the current account deficit. It links two key economic developments of the past decade: the rise in productivity growth and the widening of the current account deficit. It also helps to explain several other important developments, including the fall in U.S. saving rates and the 1990s boom in asset prices. The surge in productivity growth, while hardly explaining all of the deterioration in the trade balance since the mid-1990s, accounts for more of that deterioration than do the public and private saving shocks combined.

Moreover, the effect of higher productivity growth on the trade balance could have been even larger than the simulation indicates because it likely worked through several channels that the model does not incorporate. The simulation does not fully take into account the rise in stock prices and household wealth--and hence, consumption--that would have been spurred by expectations of higher productivity growth. Also, because the simulation does not fully account for the effect of enhanced perceptions of equity returns on exchange rates, it does not produce the rise in the dollar that, in all likelihood, resulted from the productivity surge.

4. Slump in foreign domestic demand

Developments at the global level have helped to widen the U.S. current account deficit. Domestic demand growth has slumped in many foreign economies because of varying combinations of an increase in saving rates and a decline in investment. This weakening of foreign spending has enhanced the supply of capital available to the United States, put downward pressure on U.S. interest rates, and put upward pressure on the dollar.

Some of the largest industrial economies in the world--Japan and the euro area--have been running current account surpluses while experiencing very subdued growth. In the developing world, the East Asian economies that went through financial crises in the late 1990s have seen a plunge in their investment rates even as their saving rates have remained extremely high; the weakness in domestic demand has likely motivated the authorities in these countries to keep their exchange rates competitive to promote export-led growth, a strategy that has also contributed to the U.S. external deficit.5 More generally, since 1999, the developing countries as a whole have been running current account surpluses--with the industrial countries, mainly the United States, necessarily running current account deficits--for the first time in many years.

What does our macroeconomic simulation model say about the likely effect of a slump in foreign consumption and investment spending? The slump lowers the path of foreign GDP, which in turn limits U.S. export sales. Additionally, by depressing perceived rates of return abroad, the weakness in foreign demand explains a considerable portion of the run-up in the dollar. Finally, weaker U.S. net exports reduce overall U.S. activity and depress interest rates a bit, thus raising domestic consumption and investment spending. Taken together, these

factors contribute importantly to the widening of the trade deficit since the mid-1990s.

5. Improvements in global financial intermediation

Another global factor that has been cited as contributing to the widening of the U.S. current account deficit has been an increase in global financial intermediation. Some suggest that home bias--the disinclination of investors to invest outside their own country--has been eroding and that this trend has permitted larger current account imbalances to be financed than would have been possible previously. This hypothesis is supported by the reduced correlation of national saving and investment rates in recent years, which implies that savings increasingly are being used to finance investment in other countries.6 Of course, an increased capacity of global financial markets to finance current account deficits does not, by itself, mean that it is the United States that would tap this enlarged capacity. However, observers suggest that the United States' unusually favorable investment climate, protections of investor rights, and prospects for rates of return made it likely that once international financing constraints were lifted, the U.S. economy would enjoy larger capital inflows.

So, how much of the enlargement of the U.S. current account deficit can we attribute to improved international intermediation? This is difficult to answer because it is hard enough to measure a concept as amorphous as international financial intermediation, let alone to gauge its effect on the current account. As a step in this direction, however, we reasoned that any reduction in home bias by foreign investors toward the United States would show up as a decline in the risk premium these investors demand for holding U.S. assets. This decline in the risk premium, in turn, would lead to a greater demand for U.S. assets and a rise in the dollar.

Based on an estimate of the decline in the risk premium that occurred since the mid-1990s, the decline contributed importantly to the rise in the dollar, and, therefore, to the widening of the trade deficit. Assuming that the lower risk premium can be attributed to growing international intermediation, this latter development apparently exerted an important influence on the U.S. current account.

Evolution of Net Foreign Assets

Net investment income remains positive during all the years. This means that the

US receives more investment income from investments abroad than what it pays

to foreigners for the capital that it has borrowed from them. If one takes into

account the fact that the US has become a large debtor to the world (i.e. that the

foreign liabilities are substantially higher than the foreign assets) this is a

surprise. One would expect a debtor to be paying interest on the debt. What we

see below is that in net terms the U.S. is receiving interest payments on a

negative net asset position. In other words, the U.S. benefits from lending at very

low rates while it earns substantially higher rates on the capital it sends abroad.

Financing a current account deficit under this conditions is easier

Of all the remarkable things to happen in the U.S. economy over the past two

decades, the fall in the private savings rate must rank among the top ten. Net

private savings in the United States--the sum of household savings on the one

hand and business retained earnings on the other--used to fluctuate between

nine and twelve percent of gross domestic product [GDP]. Then in the mid-

1980s, during the Reagan years, private savings began to fall. This was a

mystery: after all, the government was running substantial deficits, and there

were theoretical reasons to believe that individuals might save more to offset the

risk--nay, the certainty--that higher levels of government debt would one way or

another increase their taxes in the future.

Some argued that the private savings rate was fallen because the 1980s stock

market boom had made people wealthier, and they wanted to spend some of that

wealth. But the crash in inflation-adjusted stock market values in the 1970s had

not led people to save more to offset their reduced stock-market wealth. It

remained a puzzle.

And the puzzle gathered strength in the 1990s. By the peak of the late-1990s

boom, the private savings rate was only three percent of GDP.

The Fall in Private Savings as a Share of GDP

According to the 2009 budget, the United States will have a $1.75 trillion deficit

this year. The figure represents 12.3 percent of estimated gross domestic

product, double the previous post-war record of 6 percent in 1983, and the

highest level since the deficit totaled 21.5 percent of GDP in 1945, at the end of

World War II. If we look at the chart below we will see that this is not the first time

something like this has happened. The earlier peak in US indebtedness occurred

between 1930 and 1933, when total debt peaked at 299% of GDP. In fact total

debt expanded quite rapidly between 1930 (211% GDP) and 1933, largely as a

result of GDP contraction and price deflation (which is why it would be preferable

not to see extensive price deflation this time round). As a result, while private

sector debt contracted between 1930 and 1933, public sector debt held steady,

and rose from 34% of GDP to 72% of GDP .

This is the phenomenon we are seeing now. If the stimulus programme is

successful then we might see US debt to GDP stabilising around 2013, since the

deficit is expected to remain around $1 trillion for the next two years before

starting to decline to $533 billion in 2013, according to budget projections.

The net investment rate shows some decline over the past 40 years because of a

progressive shift toward shorter-lived capital with its faster rate of obsolescence,

and hence higher capital consumption allowances (depreciation). However, this

is offset by a larger flow of capital services per dollar of capital.

The combination of good investment opportunities and very little domestic saving

with which to finance them has translated into an ever-growing reliance on the

net inflow of resources from abroad. Net foreign lending (current account

balance) reached -789 billion dollars in 2005, or a negative 7.2 percent of

national income. This degree of reliance on foreign financing is unprecedented,

but has been achieved with relatively few strains because foreigners perceive the

United States as offering safe and attractive investment opportunities. The

Federal Reserve has also supported the process in recent years with a steady

increase in U.S. interest rates. However, the strong demands for dollar-

denominated assets have kept the value of the dollar at a high level and greatly

weakened the ability of U.S. export firms to compete in global markets.

(d) Based on this analysis, are the U.S. current account and external debt sustainable? Does the U.S. differ or not from emerging market or not?

Current account sustainability:The U.S. current account deficit grew throughout most of the 1990s and into 2000. But, clearly, the U.S. current account deficit as a share of GDP cannot increase forever without disrupting the U.S. economy or the global economy. As Federal Reserve Chairman Alan Greenspan (2000b) said, “Widening current account deficit[s] require ever larger portfolio and direct foreign investments in the United States, an outcome that cannot continue without limit.” This section examines whether the United States can sustain a current account deficit of roughly the recent magnitude over the short term.

Economists do not agree on a precise definition of a “sustainable” current account. In general, sustainability refers to a stable state in which a current

account deficit generates no economic forces of its own to change its trajectory. A country’s current account deficit is defined as unsustainable when (by its own forces) it triggers a sharp hike in domestic interest rates, a rapid depreciation of the domestic currency, or some other abrupt domestic or global economic disruption. Using this definition, a sustainable current account is one that changes in an orderly fashion through market forces without causing jarring movements in other economic variables, such as the exchange rate.

A simple and straightforward method of assessing the sustainability of a country’s current account deficit is to examine the ratio of its current account deficit to GDP. The current account deficit-GDP ratio may capture the sustainability of a country’s external position in that the ratio measures the excess of domestic expenditures over domestic production as a fraction of GDP.

It is generally believed that a current account deficit greater than 4.2 percent of GDP is unsustainable (Mann’s estimate). This estimate, based on the 1980s and early 1990s, represents the average threshold at which current account deficits in several industrialized economies started to narrow after trending up for a sustained period. Unfortunately, few other analysts have offered estimates of the sustainability threshold.

For a variety of reasons, the sustainability threshold for the United States is likely to lie above Mann’s estimate. First, in general, the average experience of industrial economies on which the estimate is based might not be applicable to the United States because the United States’ economic and financial importance in the world economy may make it “different.” Second, the economic situation in the United States in the 1980s and early 1990s is quite different from the economic situation today. For example, many observers believe trend productivity and GDP growth rose in the latter half of the 1990s. An increase in the U.S. economy’s long-run growth potential is likely to affect sustainabilityprospects. Third, the United States holds a special position in international financial markets. As the dollar is an international reserve currency, the demand for dollars and dollar-denominated assets is relatively strong. Finally, because the dollar is an international reserve currency, most of the assets sold to finance the U.S. current account deficit are denominated in dollars. As the dollar does not need to be exchanged for the currency in which the United States makes payments to borrowers, U.S. exposure to exchange rate fluctuations is quite limited. For all of these reasons, the United States is probably not subject to as stringent a measure of sustainability as other countries.Keeping in mind that the Mann benchmark may provide too low a threshold for the United States, the current account deficits observed in the recent past and projected for the near future are sustainable. The 3.6 percent deficit-GDP ratio in 1999 is below Mann’s threshold. The current account deficit-GDP ratio for 2000 is slightly above Mann’s sustainability benchmark.

Looking at the ratio of net international debt to GDP it provides an alternative method for assessing the sustainability of a country’s current account deficit. Net international debt is the collection over time of current account deficits. If an economy runs a current account deficit continuously, net international debt may become so high that foreign investors will lose confidence in the economy’s ability to service its debt or, worse yet, repay the principal. Once this happens, interest rates will rise or the borrowing country’s currency will depreciate to enable the country to continue financing its deficit. In this case, the current account deficit has generated economic forces of its own to change its trajectory, and the current account deficit and the associated debt have become unsustainable.

After remaining low and stable in 1990, the net international debt-GDP ratio for the United States rose throughout most of the decade. By 1998, net international debt reached a 20-year high of 12.6 percent of GDP. In 1999, net international debt fell slightly, to 11.6 percent of GDP.

United States net international debt of 12% reveals the unreliable situation of US. However, if we compare this situation with other countries then the U.S. situation is not particularly troubling. The ratio of United States is comparable to that of the United Kingdom. Moreover, the U.S. debt-GDP ratio stays in comparison to the Australian and Canadian ratios.

Analysis of External Debt (Is it sustainable ?)

The United States' net external financial obligations, in terms of both the total

stock outstanding (about $1.5 trillion) and net service payments ($25 billion) are

small in relation to its $9 trillion economy. The United States borrows almost

exclusively in domestic currency; more than 90 percent of its external debt to

banks is in dollars. In addition, most of the private capital flowing into the United

States consists of foreign direct investment and portfolio investment.

United States can afford to carry a larger external deficit than a country whose

obligations consist primarily of contractually fixed, short-term bank loans

denominated in foreign currencies. Thus the major advantages are

U.S. firms find it easier to sell goods in foreign markets.

U.S. firms find less competitive pressure to keep prices low.

More foreign tourists can afford to visit the U.S.

U.S. capital markets become more attractive to foreign investors.

e) How likely are the risks of a hard landing (a crash of the U.S. dollar triggered by foreign investors reduced willingness to lend to the U.S. and accumulate U.S. assets)?

Some disadvantages of the current account deficit leads to weakening of dollar. It

has got following implications:

Consumers face higher prices on foreign products/services.

Higher prices on foreign products contribute to higher cost-of-living.

U.S. consumers find traveling abroad more costly.

Harder for U.S. firms and investors to expand into foreign markets.

For the dollar to collapse, it would need to do so against the euro and the

Japanese yen, the world's two other major international reserve currencies.

However, the likelihood of a dollar collapse against the euro would appear to be

remote.

As the International Monetary Fund recently reported, the European banks are

more than likely in worse shape than those in the US, while any substantial

appreciation of the euro would only make it more difficult for Ireland and the Euro

zone’s Mediterranean member countries, which are all already experiencing

deep recessions, to cope with the discipline of the euro.

The likelihood of the dollar collapsing against the Japanese yen would appear to

be even more remote given Japan’s horrendously poor public finances and the

fact that a stronger yen would only add to the deflationary pressure already in

evidence on a rapidly contracting Japanese economy.

The second consideration is that it is hardly in China’s economic interest for the

dollar to collapse. This is not simply because of the resulting losses on China’s

enormous US dollar international reserve holdings. Rather, it is because any

substantial weakening in the US dollar would be associated with a corresponding

strengthening in the Chinese currency, which would seriously undermine China’s

export-led economic growth strategy.

(f) Will the U.S. dollar strengthen or weaken in the next 2 years and why?

The US dollar will strengthen in the next two years because of the following reasons

Redemption notices to U.S. Hedge funds caused a huge flow into dollars.

Hedge funds had sold dollars for years to buy foreign stocks. Making

these purchases required selling dollars and buying the local currencies

to buy stocks on these foreign stock exchanges. When these foreign

markets blew up, hedge fund customers seeing horrible results wanted

their money. Redemption requests followed. The funds had no choice

but to sell the foreign stocks and with the proceeds buy U.S. dollars to

redeem to their U.S. customers. This creats a dollar demand that was

significant but more importantly compressed into a short time frame.

Another reason overlooked is that foreign banks and financial institutions

were buying hundreds of billions of U.S. toxic mortgage and debt paper

in various forms and had to hedge their investment by shorting the dollar

for the last 2-3 years. A Swiss or British or French institution who owned

$100 million of real estate debt obligations packaged by Morgan or

Goldman in U.S. dollars and are getting a 6% per year return, needed to

make sure that if the dollar kept going down they would not lose 6% or

more because of the dollar depreciating. So they hedged the dollar risk

because, after all, they have to eventually give back to the local investors

Francs or Euros or Pounds. Since the debt obligations they owned

collapsed and their $100 million asset is now, let's say, worth only $50

million they do not really need to have a hedge on for $100 million U.S..

Hence they buy back $50 million in U.S. dollar hedges. In other words

they cover their hedge. They go from short the dollar to a cover - buy

back the dollar hedge. This creates demand for dollars.

The third reason is that many central banks from smaller countries had

many of their commercial banks hurting from the global fall out from the

U.S. mortgage crisis and they needed to acquire U.S. dollars and spread

them around to prop up their weak banking system. Their local currency

had little prestige especially in a global meltdown and even though U.S.

dollars were being created like monopoly money, they were still better

than the local funny money that was now even more suspect. These

central banks were borrowing or buying dollars.

Bibliography

http://www.bea.gov/newsreleases/international/transactions/

transnewsrelease.htm

R, N Cooper; Financial Times, 2004

H Bohn – “The Behavior of US Public Debt and Deficits” ;Quarterly Journal of Economics, 1998

PR Krugman – “Is the strong dollar sustainable”1985 - kansascityfed.org

RI McKinnon – “The international dollar standard and the sustainability of the US current account deficit”; Brookings papers on economic activity, 2001