from Follow the Money

One more reason the dollar is under a bit of pressure …

May 18, 2006

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The dollar’s strength in 2005 was a bit of  a puzzle to those who worried about  the scale of the US current account deficit.  Afterall, a growing current account deficit – and the deficit grew by around $130b in 2005 – implies a growing need for external financing, and the world’s willingness to extend credit to the US (presumably) is not infinite.    Yet in 2005, a growing deficit was financed with few obvious signs of financial strain.

One way to finance a current account deficit is to sell off your existing assets.  We saw a bit of this on Monday -- when investors pulling out of emerging markets provided a source of support for the dollar.    Back in 2005, though, US investors were piling into emerging economies, not running away. 

But the US was able to finance a larger current account deficit in 2005 than in 2004 while placing less debt abroad?  Why -- as I will argue below, a fall in FDI outflows meant that the US received net equity inflows for the first time in several years.  Foreign FDI and foreign portfolio equity investments in the US (purchases of US stocks) exceeded US FDI and US portfolio equity outflow largely because US FDI fell to zero. Since the US invested less abroad in 2005 than in 2004, more of the funds flowing in to the US could be used to finance the current account deficit. 

I suspect the fall in US FDI stemmed from the Homeland Investment Act, a one-off tax break that encouraged US firms to bring funds home, not a sustained reduction in the desire of US firms to invest abroad.  

The implication: the US will need to place a lot more debt abroad in 2006 than in 2005.  See the charts below.

From 2002 on, US equity investment abroad exceeded foreign equity investment in the US – so the US financed both its equity investment and its current account deficit by selling debt abroad.   Put slightly differentl665-670 b current account deficit required placing $800b or so of debt abroad.  Actually, there was a large error term in the 2004 BoP data, so the actual debt flows were a bit over $700b, and  “errors” generated the remaining $100b or so.

feldstein2

If you are willing to use the TIC data to estimate portfolio equity flows to and from the US (portfolio equity = US purchases of foreign stocks and US purchases of foreing stocks), it possible to estimate the share of the US deficit that was financed “debt” and the portion that was financed by “equity.”  In turns out that equity flows turned around in 2005.  The blue bar shifted from a deficit to a surplus.  So to finance a $805b current account deficit, the US actually needed to place less debt abroad than in 2004.  

Did foreigners suddently fall back in love with US equities?    Hardly.  Rather, the US firms stopped investing abroad.   Outward FDI fell off a cliff.  Look at this chart.

feldstein3

Why?   Presumably because of the Homeland Investment Act.   Firms drew down their existing external assets, offsetting any new investments.

The scary bit for 2006: If US outward FDI resumes at a more normal pace, the US probably needs to place $1000-1100b of debt abroad to finance its (still growing) current account deficit.    The blue bar below represents the US need for debt financing, calculated by adding net equity flows to the current account deficit.  It doesn't perfectly match actual debt flows (the red bar) because of errors and ommissions, but they generally match up pretty closely.  

feldstein4

The 2006 debt financing need could be a lot bigger than the 2005 debt financing need.  

The interest rate differentials that favor the US may not yet be shrinking, but they aren’t growing quite the way they did in 2005 either. No wonder the US is relying more on central bank inflows once again.  Saudi foreign assets increased by $12.5b in March -- and no doubt grew by more in April, with oil higher.  Russia's reserves continue to grow by $5 billion a week -- a China-like pace. 

With this kind of reserve growth, I don't quite see how anyone can defend the growing US current account deficit as a natural outgrowth of market forces.

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