from Follow the Money

No need to worry — the US isn’t going to run out of assets to sell to foreign investors any time soon …

May 1, 2007

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In a comment in the Financial Times about ten days ago, David Hale argues that there is little need to worry about either the dollar or the US current account deficit.   The US has no shortage of financial assets to sell the world, and the world has no shortage of savings to lend the US.

True enough.   

The question is whether the rest of world – or, more precisely, private investors in the rest of the world – want to lend that savings to the US and in the process buy US financial assets in the process.    

Right now, in my judgment, the data says that they don’t.     That is what currently worries me. 

Best that I can tell, there has been a very significant fall off in private demand for US assets over the past two quarters.   By private demand I mean net private demand – that is foreign demand for US assets relative to US demand for foreign assets.  

The US hasn’t noticed this fall off because foreign central banks have stepped up their purchases of US assets dramatically, offsetting the fall in private demand. 


The difficulties distinguishing private and official flows, along with lags in the data, make it hard to point to a single data point that illustrates the fall off in private demand.   It is easier, in fact, to demonstrate the surge in official demand, since the US TIC significantly overstates private flows and understates official flows (The growth in official holdings reported in the last survey suggests that official flows were about $140b larger than reported in the TIC data). 

We do know that central bank reserve growth rose to around $250b in q4 ($1 trillion annualized), stayed around there in q1 and look similar in q2.     Total dollar flows are harder to measure, but there is no doubt foreign central banks have increased their purchases of US financial assets over the past two quarters.   The Fed’s custodial holdings rose at an annualized pace of close to $400b in the fourth quarter of 2006, and then an annualized pace of over $500b in the first quarter of 2007 (April has been a bit slower).  I would bet that Fed’s holdings understate annualized inflows by somewhere between $100-200b ($25-50b a quarter).   

In all probability, central banks will continue to provide the financing the US needs that the private market no longer wants to supply.    The market certainly doesn’t seem all that worried by the shift in the composition of flows to the US.

But it seems to me that the risks that the official sector will balk at providing the US financing on the scale it now needs – while small -- are once again growing.   Most central banks have made it clear that they now have more reserves – and certainly more dollar reserves -- than they need.   More central banks seem to be finding it more difficult to reconcile fast reserve growth with their domestic goals at a time when changes in global markets have increased –not decreased – the scale of reserve growth needed to finance the US deficit.

David Hale argues that those who focus on asset markets are less worried by the US current account deficit than those who focus on the size of the US trade and current account deficit, because “the US has a vast capacity to attract capital.”  In some sense that is a truism – you cannot run a current account deficit without the ability to attract capital.      

But I would argue my rising concerns about the financing of the US deficit are very grounded in concerns that the relative attractiveness of US assets has slipped a bit,  making it hard for the US to attract the kind of private flows needed to sustain a large current account deficit.

On a backward looking basis, US assets haven’t performed all that well over the past five years or so.   Euro and pound denominated bonds have done much better that US bonds, in dollar terms, because of the currency gains.    Foreign equity markets have outperformed the US equity market. 

US equity markets have rallied recently – but the rally seems at least partially due to a fall in supply.  Private equity firms increase the supply of debt and reduce the supply of equity, helping to match the world’s supply of financial assets to central bank demand. I don’t think there is much evidence of a surge in foreign demand for US equities – and certainly not for a bigger surge in foreign demand for US equities than US demand for foreign equities.  

Sure, US firms have euro denominated revenues that are worth more in dollar terms.   But European firms have even more euro and pound denominated revenues that are worth more in dollar terms.   No wonder foreign equity markets have done better. 

Hale notes that foreign investors own a relatively small share of US equity markets -- both absolutely and in comparison to the share of foreign ownership in other markets. 

Very true. 

But Americans also have a relative small share of their wealth in foreign equities.  What matters is the relative attractiveness of foreign equities and US equities.  To generate the net inflows needed to finance an external deficit, foreigners need to find US equities more attractive than Americans find foreign equities.   That hasn’t happened for a while.

Most inflows to the US have come into the US bond market.   Those buying bonds are making one of three bets:  that the US dollar will rise, that long-term US interest rates will fall or that credit spreads (if you are buying corporate bonds) will fall. 

But US long-term rates are already fairly low (and lower than short-term rates), credit spreads are already low and the dollar is still kind of strong. 

The last point needs a bit of clarification.   The dollar, obviously, is not strong v. Europe, of course.    But folks are currently betting on the euro, not betting against it.   And Europe isn’t the region of the world financing the US.  Asia and the Middle East are.  The dollar remains strong v Asia.   The dollar isn’t so much strong v. the Middle East so much as oil has risen and their currencies haven’t.    

It isn’t obvious to me that the US bond is an attractive destination for private flows from these regions at current rates and at the current exchange rate. 

Mike Larson wrote recently that U.S. Treasury bonds are “quite possibly one of the least attractive investments on the planet.”    Bill Gross might quibble a bit.    He thinks the Fed may eventually need to cut rates to prop up the housing market and the US consumer, helping bonds.    But Larson’s general point stands.  US markets “have gotten trounced” recently by foreign markets recently.    

The cut in rates that Bill Gross expects would hurt the dollar, so any gains on the bonds would be offset by currency losses.   I certainly suspect that the dollar has further to fall v. many Asian currencies.

David Hale raised one point that was meant to reassure: total savings outside the US is about $7 trillion, far more than the roughly $1 trillion (a bit less) the US needs to borrow.   No need to worry, per Hale.   There is a lot of savings out there.

Alas, Hale’s statistic had the opposite impact on me.  The United States $1 trillion external borrowing need seems large relative to the world’s $7 trillion in total savings. There is lot of investment to be done in Asia, Latin America, Eastern Europe and the Middle East.  Most of that savings will stay at home.   

Moreover, Hale’s statistic highlighted another point:  The increase in the “external” savings of governments – the growth in their foreign exchange reserves and investment funds – is likely running at an annual pace of around $1.1 trillion.  That seems large relative to the rest of the world’s total savings, not just large relative to cross border flows.  

You can easily make the case that the state has once again occupied the commanding heights of the global financial system.  

Good thing too, at least for the US.   Right now the United States’ $1 trillion borrowing need is $1 trillion more than private investors (on net) want to lend to the US. 

The world unquestionably saves enough to finance the US deficit, but right now only other governments are willing to lend their savings to the US .  That kind of puts the world's leading champion of private markets in a rather awkward position.

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