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As Michael Mandel has noted, the US income balance improved in the first quarter – contrary to the expectations of “pessimists” like me. I would say “realists” – rising debt usually implies rising interest payments – who expected the US income balance to deteriorate.
The income balance is the difference between what the US earns on its overseas assets (US direct investment abroad, US lending to the world) and what it pays on its liabilities (foreign direct investment in the US, US borrowing from the world).
Certainly the improvement in this balance in the first quarter is consistent with one of the core predictions that Hausmann and Sturzenegger made – namely that the net income that the US earns from its investment abroad -- all those intangible assets -- would continue to rise, offsetting rising interest payments on growing debts. That is exactly what happened in the first quarter. Anualized, the first quarter data suggest that the US earned $172b more on its direct investment than it paid on foreign direct investment in the US. That is up about $30b from the 2005 total. A nice little gain. Something like $600b in new dark matter, to use Hausmann and Sturzenegger’s terminology. And US net interest payments hardly rose at all – they went from $161.6b in 2005 to $162.5b (annualized) in q1. The paid more on its debt, but it also earned more on its lending …
On the surface, it certainly fits the dark matter story. Michael Mandel noted (in a comment on my post) that Goldman must have earned a ton of money abroad in the first quarter … all sorts of intangible trading profits. But is it so? What does the more disaggregated data tell us? Lots of charts and graphs follow.
First, the balance on FDI -- which accounts for the majority of the income flows from US equity investment.
Let’s divide FDI income into two components – dividend payments and reinvested earnings. Dividend payments are real flows, cash that moves across borders. Reinvested earnings are virtual flows. Income from say US investment in Ireland is theoretically paid to the US foreign company and the parent company then uses those funds to invest in its Irish operations (something that it does, of course, for reasons utterly unrelated to Ireland’s low tax rate on corporate profits). No money actually crosses any border.
As Daniel Gros of CEPR has noted, there has been a consistent gap between the amount US firms reinvest in their operations abroad, and the amount foreign firms reinvest in their operations in the US. That gap remains – though in 2006, both foreign firms and US firms seem to be reinvesting a bit more than in the past. Q1 data has been annualized for the sake of comparison.
The absence of any US reinvestment in 2005 also stands out. There is an obvious reason. The Homeland Investment Act (HIA). The impact of that act shows up even more clearly if we look at dividend payments.
The HIA had a big impact – as I argued before, the very low rate of US investment abroad mean that net FDI flows helped finance the US current account deficit in 2005. US firms reduced their foreign assets, helping to finance the US current account deficit. 2006 is going to be a bit different.
What else stands out? The very low dividend payments from foreign firms operating the US. Their dividend payments in the first quarter were unusually low – as low as they were in the recession year of 2001. Lower actually.
Here is the same data expressed as a percent of the market value of US FDI abroad (and foreign direct investment in the US). 2005 and 2006 stocks were estimated based on flows and an estimated valuation changes – I will update them once the new NIIP data is out.
Certainly when it comes to dividend payments, the positive US income balance doesn’t come from exceptional returns on US investment abroad, but terrible returns on foreign investment in the US. And q1 was particularly terrible.
Adding back in reinvested earnings gives the overall estimated return on US FDI abroad and foreign direct investment in the US. Given how much ExxonMobil and similar companies must be earning on their foreign oil rights, given all the tax advantages of Ireland and given very robust global growth, the 8% return on US FDI doesn’t jump out at me. Rather, what jumps out at me is the low returns on FDI in the US. Foreign firms would have been better off holding short-term Treasuries that now pay 5% or so.
At least if the US data is really capturing their true earnings.
Second, debt. It is a bit more complicated that it seems. Remember, the US doesn’t just borrow from the world. It also lends to the world. Sure it borrows more than it lends. But its lending is important to this story.
Why – because, as I will argue – it seems like the US lending is very short-term. Thus US interest income from this lending changes quickly as short-term rates rise and fall. The US has shortened the term structure of its external debt (particularly in 2002 and 2003), but its borrowing still seems to have -- relative to its lending -- a longer term structure.
If you look at the disaggregated data on the composition of US borrowing and US lending, that story makes sense. The US doesn’t own many foreign bonds. And foreigners own a ton of US bonds. Bank lending to and from the US basically balances out. Ergo, the overall term structure of US lending is dominated by bank lending, and the term structure of US borrowing is driven more by the term structure of all the US bonds foreigners hold.
US interest payments certainly have been rising rapidly recently -- a point emphasized by Menzie Chinn. But so have US receipts on its lending abroad.
US receipts have actually been rising a bit faster than US payments, once you take account of the difference in stocks. This shows up more clearly if you look at the implied interest rates on US lending and US borrowing (doing this calculation required making some assumptions about dividend payments – since they need to be stripped out of the data. Trust me, those assumptions don’t drive the calculation)
I tried to explain this to Christopher Swann of the Financial Times – it is what underlies my quote:
“We did see an increase in the revenues Americans earned from foreign direct investment and overall, US investors benefited from rising interest rates because of the mix of their assets and liabilities. However, there is no reason to believe that the longer-term trend towards a weaker income balance has stabilised”.
But in all honesty, I didn’t find a good way of explaining it. There are too many moving parts. Assets from lending as well as liabilities from borrowing. Borrowing that is growing faster than lending. A general shortening of the term structure of US external debt given the shortening of the average maturity of US treasuries. But even taking this into account, US lending seems to have shorter-term structure than US borrowing and thus moves faster as short-term interest rates change.
It is the sort of thing that takes charts.
All in all, then, am I ready to throw in the towel and concede?
Certainly not. I wouldn’t be surprised if dividend payments on foreign FDI in the US are revised up. They seem too low to be true. And once short-term interest rates stabilize, the US won’t continue to get a (small) boost in its income balance from the fact that US lending “reprices” faster than US borrowing. Rather, the data will be dominated by the lagged impact of higher US rates on overall US borrowing costs. And the $1 trillion in new debt the US needs to take on even if the US current account deficit is only $900b.
Remember, the US borrowing need is actually a bit bigger in non-homeland investment act years than the US current account deficit, since the US needs to borrow to finance its new equity investments abroad.
And borrowing at 5% or 5.25% to earn 8% isn’t quite as good as borrowing at 2% to earn 7% …