from Follow the Money

Greenspan, part II

November 19, 2004

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Federal Reserve Board Chairman Alan Greenspan was careful to frame the risk created by rising US external debt for foreigners investing in the US (and in the process financing the US current account deficit) as one of "concentration" risk. Too much of their international portfolio would be invested in the US, they would not be sufficiently diversified, and the lack of diversification itself would lead them to limit their future financing of the US (or demand higher rates).

To quote the maestro:

``Given the size of the U.S. current account deficit, a diminished appetite for adding to dollar balances must occur at some point ... International investors will eventually adjust their accumulation of dollar assets or, alternatively, seek higher dollar returns to offset concentration risk, elevating the cost of financing the U.S. current account deficit and rendering it increasingly less tenable.’’

Greenspan almost has to frame his (and one assumes, the Fed’s) concerns in terms of excessive concentration. He cannot very well come out and say that the US is not an attractive place to invest. But is Greenspan right? Is the risk one of too heavy a concentration in US assets, or is the risk that US assets themselves could simply be unattractive to foreign investors at current prices/ interest rates?

I suspect it is a bit of both. If the US current account deficit is absorbing 75-80% of global surplus savings (i.e. savings not invested at home, or the the rest of the world’s current account surplus), the share of US assets in foreign portfolios (notably foreign central bank portfolios) is rising. So yes, they are over time taking more and more dollar risk, and having a more and more unbalanced portfolio. Greenspan is onto something. A rapidly rising US external debt -- barring a surge in the amount of global savings that is invested in foreign assets/ a fall in so-called home bias -- implies an ever increasing share of foreign savings will be invested in the US.

That said, you don’t need a theory of optimal global portfolio allocation to highlight the risks of investing in the dollar. Nouriel and I argue that over time, the US trade deficit needs to fall from a bit over 5% of GDP today to no more than 1% of GDP to stabilize the United States external debt to GDP ratio. That could happen today and happen fast, stabilizing the US external debt to GDP ratio at around 30%. But that kind of adjustment would be jarring, as Steve Roach emphasized today. The adjustment could happen gradually and over time, stabilizing the US debt to GDP ratio at 50%. That just might work out OK, a slow fall in the real dollar would lead to a gradual increase in real interest rates and a tendency for US income to grow faster than US consumption. Or the US could continue running large deficits for some time, which almost assures that the subsequent adjustment will happen fast and that the US debt to GDP ratio will stabilize at a high level. But it is hard to see how even the modest adjustment scenario happens without some additional dollar depreciation -- even from today’s levels.

So continued investment in the US to fund deficits on the current scale means foreigners are taking on the risk of having an ever increasing share of their assets in one country, and moreover, the risks intrinsic in having even a small share of your assets in a country with a large external trade deficit. The combination of the two is scary. Does that mean investing in dollar assets is a bad idea? I guess that depends. If your home currency has already fallen substantially against the dollar (i.e. the euro), and you think you have identified the next google, investing in the US is probably a good idea. If Stephen Jen is right, the euro has already overshot and should appreciate against the dollar over time, and you might even want to buy a plain old treasury bond (I would personally not recommend it, I have trouble calling the dollar undervalued when the US trade deficit is so large in relation to US exports, and so much higher than what is consistent with a stable external debt to GDP ratio - call me old fashioned. Plus, the euro started life at 1.17-1.18, so even 1.3 is only a 10% appreciation from pre dollar bubble days). If your home currency has not adjusted against the dollar and you are buying low yielding treasury, agency or corporate bonds, it is hard for me to see how current US interest rates compensate for the risk of future dollar depreciation, given the gap between the current US trade deficit and the trade deficit consistent with a stable debt to GDP ratio.

There was no risk of excessive portfolio concentration for those investing in the Argentine peso back in 2000. It was still a bad bet because the peso was overvalued back then. The last thing you want to do is to concentrate your currency risk over time in the currency of a country with a large and likely growing trade deficit. Yet that is exactly what Asian (and other) central banks must do to sustain the current system of large US trade deficits, rising US external debt AND low dollar interest rates.

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