I spent a bit of time trying to estimate how market moves in 2006 will impact the US net international investment position (the NIIP is the gap between all US external assets and all US external liabilities).
My calculations are rough, but the bottom line is crystal clear – 2006 was another good year for the US. Its $900b or so in borrowing from the rest of the world will largely be offset by the increase in value of existing US investment abroad. Scratch that. Insert “$600-700b in net borrowing from the rest of the world – including least $300b and probably far more from central banks and oil funds -- and $200-300b (on current trends) in mysterious financing from errors and omissions will be more than offset by the increase in value of existing US investment abroad.
25% or so returns on foreign stocks are very good for the US – even if foreigners got 15% on their US stocks. The US has more equity investment abroad than foreigners have equity investment in the US (largely because foreign markets have outperformed US markets consistently in dollar terms since 2002 -- not because of large US investments in the rest of the world). My very rough calculations suggest that the value of US equity investment abroad increased by about a trillion dollars more than the value of foreign equity investment in the US rose.
That is enough to wipe out the additional debt taken on to finance the US current account deficit.
The net debt position will rise to around $5.25 trillion, up from $4.45 trillion. That is easy enough to understand. The US is financing its current account deficit overwhelmingly with debt.
Throw another $0.35 trillion non-interest bearing debt – US currency – that circulates abroad into the mix. That total didn't change much.
Sum it up, and the NIIP – the gap between the value of US investment abroad (counting US loans to foreigners as an asset) and foreign investment in the US (counting foreign lending to the US as a US liability) could have fallen not just as a percent of US GDP, but absolutely.
My very rough calculations show the gap between the value of US assets and US liabilities falling from negative 2.55 trillion in 2005 to negative 2.35 in 2006. Not bad.
Using the balance of payments data from the first three quarters, I estimate that the US took on an additional $1.7 trillion in liabilities to finance its current account deficit and the purchase of $1 trillion in assets. Yes – the net financial flows are smaller than the US current account deficit – that reflects the large errors term in the US balance of payments.
But the value of existing US investment abroad rose by $1.6 trillion, trumping the $0.7 trillion rise in the value of foreign investment in the US.
So in some sense, the US ran a current account deficit of more than 6.5% of GDP without paying a price – its aggregate balance sheet didn’t deteriorate. The US in effect borrowed against the rising (dollar) value of its existing investments abroad to finance consumption in excess of US income in much the same way as US homeowners have borrowed against the rising (dollar) value of their homes to finance consumption in excess of their income.
The flip side of the fact that US investment abroad has done well is, of course, that those foreigners who financed the US didn’t do so hot. They would have been better off investing in say Europe than lending to the US. Since the dollar’s decline started in 2002, the US simply hasn’t been the best place in the world to invest. Far from it.
The other story that the aggregate data masks is the huge rise in the gross external debt of the US. It will approach $9.9 trillion by the end of 2006 (my calculation), offset by $4.6 trillion of lending. That is up from $8.35 trillion in 2005 – and something more like $4.35 trillion back in 2000.
I am still putting the final touches on a few calculations, but I think the average interest rate on that debt in 2006 will be a bit over 4%. If that were to rise to 5% (likely) or 6%, the amount of net interest the US has to pay on its external debt would soar.
There is another story that the aggregate numbers mask.
The distribution of gains from US investment abroad are no doubt highly concentrated.
The appreciation in the value of existing US investment abroad helps the have-mores have even more.
It doesn’t do much for auto parts workers in the Midwest, or others who suspect that globalization is putting downward pressure on their income. And while the US as a whole may be borrowing against the rising value of its external assets, many of those actually borrowing from the rest of the world are not.
Those borrowing from China are not necessarily those sitting on large capital gains from their existing equity investment in the Europe. Think of the US treasury. Or a US homeowner with a big mortgage and few assets other than their house.
My calculations are admittedly rough. I didn’t try to look at the true geographic distribution of US investment abroad – I used the overall increase in foreign stocks reported by the Wall Street Journal as a proxy for the United States actual portfolio. That may or may not be right. I don’t think it will be far off though. The overwhelming majority of US investment abroad is in Europe and Canada – not in the BRICs. And equity investment in Europe did very well in 2006 in dollar terms.
I did try to adjust for the increase in the value of US investment abroad that reflects reinvested earnings (something I didn’t do last year …. ) and for the increase in the value of foreign investment in the US that reflects reinvested earnings. Concretely, that meant I subtracted $200b from the raw increase in valuation on US equity investment abroad, and $100b from the increase in foreign direct investment in the US. For complex reasons, this is needed to avoid double counting.
I also assumed that 23% of US corporate and agency debt held abroad is denominated in foreign currencies, and I assumed that it was all in euros. The 23% number comes from Warnock; it is a bit old, as it is based on 2004 data. I just projected the same percentage forward on to a larger stock. The euros rise in 2006 consequently added about $75 to the US debt stock.
I wouldn’t bet much money on my calculations. But I also suspect more refined calculations won’t change the basic story. The US took on a ton of new external debt in 2006. And it didn’t really hurt the United Sates aggregate balance sheet. The value of existing US assets abroad increased in value faster than the US took on new debt. Exorbitant privilege indeed.
So long as the US can finance a huge deficit even as foreigners investing money outside the US do far better than those investing in the US, well, the US external accounts won’t look so bad.
For more details on the historical evolution of the US net international investment position, I also recommend Higgins, Klitgaard and Tille.