from Follow the Money

Will Japan be able to stay on the sidelines for long?

November 6, 2004

Blog Post

Some facts:

1) In 2003, Japan increased its reserves by $200 billion, emerging Asia by $245 billion. The world as whole increased its reserves by $500 billion, so Asia accounted for most of the world’s reserve increase (BIS data).

2. $440 billion of the $500 billion reserve increase was lent to the US, financing 80% of the U.S. current account deficit (using BIS data rather than US data for reserve financing). However, because of 200 billion in net equity outflows, the United States overall financing need in 2003 was larger than its current account deficit -- $730 rather than $530 billion. To finance its deficit and net equity outflows, the US placed $440 billion of external debt with central banks, and roughly $290 billion with private investors.

3. The US current account deficit will be larger in 2004 than in 2003. $670 billion rather than $530 billion by my estimates. At least in the first half of the year, net equity outflows were on a similar pace as in 2003, close to $200 billion. The overall US need for external financing is rising.

4. In the first half of the year, China and the rest of emerging Asia added about $125 billion to their reserves, and on the back of its massive intervention in q1, Japan added $145 billion to its reserves. Annualized, that would generate almost $550 billion in reserves. Add in reserve accumulation by oil exporters, and rising reserves would have financed much of the rise in the US current account.

5. But Japan stopped intervening after q1, so its reserves won’t rise by $300 billion this year, only by $150 billion unless something changes. Emerging Asia’s reserves are still growing, though perhaps not quite as fast as earlier in the year.

6. Of course, some of the deterioration of the current account deficit is coming from oil. If the oil sheiks in the Gulf (not to mention the Russian maestros controlling Siberian oil) are building up their reserves and investing those reserves in dollars, they may be providing part of the needed financing.

7. Nonetheless, so long as Japan stays on the sideline, official financing of the US current account deficit will likely fall in 2004 -- $150 billion for the year from Japan and $250 billion from emerging Asia adds up to $400 billion. That is a lot of money, but still less financing than Asia provided in 2003, even as the US current account deficit is expanding.

8. One way to reduce the US need for external borrowing is for US investors to stop buying foreign securities, and US firms to stop investing abroad. John Taylor is right. I am not sure there is evidence that this is happening though -- Q1 outflows were unusually big, so the fall in Q2 may not mean much. Those closer to the markets would know more than I ... But even so, the rising US current account deficit likely implies a rising US financing need, even as the Bank of Japan has stopped providing the US with financing.

9. My tentative conclusion: the dollar may well continue to fall until an industrial country central bank steps in and starts providing the financing that the Bank of Japan provided earlier in the year. That central bank could well be the Bank of Japan. Alternatively, the dollar will have to fall far enough (or US interest rates will have to rise/ dollar asset prices fall) to make dollar denominated assets attractive to private foreign investors.

A couple of additional notes: First, as Higgins and Klitgaard highlight, emerging Asia’s reserve accumulation exceeds its current account surplus. Emerging Asia can only provide $250 billion or so of financing to the US because in addition to running a substantial current account surplus, it is also attracting substantial net capital inflows. Those capital inflows are captured by the central bank, and then lent on to the US.

So if capital flows to emerging Asia should slow, it is the US that might well face financing troubles! Emerging Asia’s reserve buildup would slow, and they would have less funds to lend to the US.

Conversely, Asian currencies pegged to the dollar are also falling against the Euro, and if European investors start dumping funds into emerging Asia is a bet that Asian currencies will eventually rise against the dollar (or European FDI in emerging Asia picks up), that indirectly could provide the United States with some of the financing it needs.

Second, there is some noise -- at least from Morgan Stanley analysts like Eric Chaney -- that the ECB may conclude that it should intervene to protect Europe from the dollar’s weaknesses during Bush’s second term. While I don’t agree with the Bretton Woods two argument that a new system of fixed exchange rates will make the US current accout deficit sustainable for twenty years, I should note that the proponents of Bretton Woods two long have been arguing that Europe would eventually have to join Asia in pegging to the dollar. The Bretton Woods two system of fixed exchange rates will expand before it collapses ...

European intervention would be a way of spreading the "burden" of supporting US consumption growth that exceeds US income growth and the US budget deficits beyond Asia. I am not sure Europe wants that role. Jacques Chirac hardly wants to bailout George W. Bush. Japan may feel like it has no choice. I suspect there is a bit of a game of chicken now going on in the foreign exchange market. If central banks don’t step in and provide some of the financing the US needs, then something will have to give -- since private investors don’t seem willing to step in and buy US dollar assets at current US interest rates and current US exchange rates.