from Follow the Money

Dark matter watch

January 3, 2006

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Ok, not real dark matter.   Hausmann and Sturzenegger defined "dark matter" as the difference between the assets (or liabilities) implied by US "income" payments, and the United States net international investment position.   So anything that reduces the size of the US net international investment position (i.e. cuts into net US external debt) technically reduces the stock of dark matter.

But I suspect that over time dark matter will be used a bit more broadly - it will come to serve as shorthand for all the factors that have kept the US international investment position, not just the US income balance, from deteriorating by as much as would be implied by the sum of recent US current account deficits.  

In 2002, 2003 and 2004, the US ran a cumulative current account deficit of $1663 billion; the US net international investment position only fell by $203 billion (with direct investment at market value).   That is largely because the value of US assets abroad rose by $1,564 billion, that that rise stemmed largely from $1,058 billion in currency related gains (data here).  And net US income payments basically did not change by much over that time period.

As we have discussed previously, the increase in US external liabilities associated with ongoing current account deficits was largely offset by a big surge in the value of US assets abroad.  And that surge in the value of US assets abroad reflected the dollar's fall v. the euro, and other European currencies.  One euro was worth a lot more at the end of 2004 than at the end of 2002.   For more, see Helene Rey and Pierre-Olivier Gourinchas

I had expected that the dollar's 2005 rally would take those valuation gains away.   After all, the dollar was higher at the end of 2006 than it was at the end of 2003, let alone the end of 2004.    So I had anticipated a very large deterioration - something like $1.2 trillion - in the US international investment position.  The US would not only give up its $272 billion in 2004 valuation gains, but also some of the $415 billion from 2003.

Alas, I was wrong on that too.  While the dollar value of American holdings of euro and yen denominated bonds is down, the dollar value of American holdings of euro and yen denominated stocks is not.  Yes, the dollar rose, and that cut into the dollar return on holding European and Japanese equities.   But European and Japanese equities also did far better than US equities.   In dollar terms, European equities did about as well as US equities (though German equities did better) while Japanese equities did far better.  

The US cannot count on big valuation gains on its external assets to offset the 2005 US current account deficit.   That is a change.  But since the US holds a lot more foreign equity than debt denominated in euros or yen, it also won't experience big valuation losses.   The capital gain on US holdings of European and Japanese equities from the superior performance of these markets relative to US markets will offset the valuation losses from the dollar's rise.

If, in dollar terms, the dollar value of US holdings of foreign equity and foreign holdings of US equity end the year about where they began, the US net international investment position will deteriorate by the 2005 US current account deficit.  Since I expect the final deficit to come in at a bit over $800 billion, the US net international investment position will go from negative $2.5 trillion to $3.3 trillion (26.5% of 2005 GDP).  Not great, but not as bad as it could have been.

And if the US runs a roughly $1 trillion current account deficit in 2006 - something that is not implausible if recent bad trade numbers continue - the US NIIP will hit -$4.3 trillion, nearly 33% of US GDP, at the end of 2006.   Again, not great, but not as bad as it could have been ... 

Two puzzles: If investment abroad has been such a good deal for Americans recently, why don't Americans put more of their savings abroad?  And if investing in local equities yields better returns than investing in the US without the currency risk, why are foreigners so willing to buy US bonds?   

Sure, Japanese buyers of US bonds did very well in 2005.  But neither  European buyers of US equities in 2000 did not nor did European buyers of US bonds in 2002-03 did as well.  And judging from the data that led Hausmann and Sturzenegger to deduce the existence of dark matter, European foreign direct investment in the US has been a total disaster.  Not only have European firms taken a bath on currency moves from 2002-2004, but they earn less on their US factories than they would have if they had just bought US treasury bonds ...  American firms in Europe, by contrast, have earned more on their European operations than they would have holding euro-denominated government bonds. 

I'll have a bit more on dark matter - real dark matter, as defined by Hausmann and Sturzenegger - soon.   I'll give out one hint though: read PGL's and Kash's posts on Ireland, transfer pricing and corporate tax avoidance (or minimization, if you prefer).   It seems like Ireland generated about $9 billion of Microsoft's $33 billion total profit in the last fiscal year .. hmm..

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