from Follow the Money

Is the world ready to finance a $1 trillion US current account deficit?

December 16, 2005

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Judging from the capital inflow into the US in October, I guess the answer is yes.  And I suspect the US may well give the world a chance to add $ 1 trillion to its dollar portfolio next year. 

That may be a strange thing to argue after the US current account deficit (somewhat unexpectedly) fell in the third quarter.  But the fall reflected a couple of one offs (Katrina related transfer payments, and some more dark matter) that I don't suspect will be sustained. 

The third quarter current account deficit was only $195.8 billion, or $782.4 billion annualized.   But the $196 b deficit reflects a $9 billion improvement in the US "transfers" deficit as European reinsurers made big payments to US insurers after Katrina and Rita.  That alone cut the overall deficit by $9 billion.  Add the $9 billion back in, and the overall deficit in the third quarter was about $205 billion, or $820 billion annualized.

The US also conjured up a bit of dark matter in the income balance. 

Payments on US government debt held abroad rose by $2 billion, and other "private payments" rose by $7 billion.  That is what one would expect.  US policy rates are rising.  US external debt is rising.   That generally is a bad combination.  But the US earned an extra $2.15 billion on its foreign direct investment abroad, and foreigners earned $4.1 billion less on their direct investment in the US.  (Yep, the US continues to offer a raw deal to foreign companies operating in the US, at least judging from their reported income).   Combine the two, and you get a $6.25 b fall in (net) income payments.  Other US private receipts also increased by $5.6b, for reasons that elude me (interest rates outside the US were pretty low).  This increase in US earnings abroad, along with the fall in payments on US FDI, allowed the income balance to improve in the third quarter. (Note -- this section has been edited since first posted, I initially misread one number)

I don't think that will last.  If you take away the surge in FDI-related dark matter, the underling income balance deteriorated significantly.  

What of the fourth quarter?  The $69 billion October trade deficit suggests the q4 current account deficit will be much, much larger.  $70 billion a month * 3 works out to $210  billion, and that would just be the trade deficit.   Add in a $20 billion transfers deficit and a $10 billion income deficit - remember, I don't think the big improvement in net FDI payments will be sustained, and payments on US debt will continue to rise -- and the fourth quarter current account deficit could reach $240 billion.    

That probably is a bit high.  But even if the trade deficit falls back to around $65 billion a month in November and December, the quarterly trade deficit would reach $200 billion, and the q4 current account deficit might reach $230 billion, or something like 7.1 or 7.2% of US GDP.

A 7.1-7.2% of GDP current account deficit for all of 2006 works out to around $950 billion.

But I would not be surprised if the US current account deficit rises a bit during the course of the year, both absolutely and as a share of GDP.

Suppose that in the fourth quarter of 2006, the quarterly trade deficit rises to $220 billion, the transfers deficit is around $25 billion, an the income balance is around $20 billion -  these are not unreasonable assumptions.   The US will have a lot more external debt by the end of 2006, and the interest rate on that debt will slowly rise in line with US policy rates, pushing up the income deficit.  Moving from a $200 billion to a $220 billion trade deficit  requires say 6% growth in imports and 5% growth in exports, or 10% growth in imports and 11% growth in exports (all numbers q4/q4).  And if the q4 2005 trade deficit comes in closer to $210 than to $200 billion, it obviously doesn't take much to generate a $220 billion quarterly trade deficit a year from now.

A $265 billion deficit in q4 2006, and say a q1 06 deficit of $240 billion, a q2 deficit of $245 billion, and q3 deficit of $255 billion.  Add them up - I get $1005 billion, or about 7.5% of GDP.   That assumes an income deficit during the course of 2006 of around $70 billion - a big shift, in other words.  But not an unexpected one.

A trillion dollar US current account deficit in 2006, and a trillion dollar's in Chinese reserves in 2006.  There would be a certain symmetry.

Obviously, a big fall in oil prices - or a big fall in non-oil imports - would keep the US from approaching that kind of deficit. But so far this year, neither the markets nor the world's central banks have demanded that the US adjust. 

The dollar appreciated during the course of 2005.  That's why I have trouble seeing how a surge in exports will save the US.   The stronger dollar in 2005 should work to slow 2006 export growth.

Long-term interest rates more or less have remained unchanged.   That supports consumption and investment. And if oil prices stop rising in 2006, that too opens up more room for consumption of other goods and services.

Of course, the US can only spend more than it earns so long as the rest of the world is willing to finance the US.  

And the People's Bank of China is certainly aware of that it will take large losses on its dollar portfolio if it continues to finance the US.  Last I checked, Yu Yongding sits on the PBoC's monetary policy committee, and he was pretty clear about this in a recent speech.  (quote from Market News International, via Steve Hsu)

In the first stage we must reduce accumulation, then later we should reduce our reserves....[China and Asian countries] don't need that large an amount- more than $2 trillion- of foreign exchange reserves.... This is a very big problem and I think the Chinese government should take some action to reduce the growth rate of the accumulation of foreign exchange reserves as we're still facing the possibility of a big devaluation of the US dollar, so the capital losses will be huge. If that happens, it will be tremendous hit to the Chinese economy. ..  The trouble is, with such a huge amount of foreign exchange reserves, that there is no way to spend it very quickly and there's no plan to sell it of course-- otherwise that inflicts damage on ourselves. You don't want to dump shares when the stock market has not collapsed yet and you are the biggest shareholder ... all east Asian countries have tremendous foreign exchange reserves and they all want to get rid of them, but if you do this then you cause competitive devaluation, not of their own currencies, but of the US dollar. So we should do this in an orderly fashion. If Asian countries moved too fast, everyone would lose... It would be utterly unfortunate if Japan sells a proportion [of their reserves, for] that causes problems. Then China panics and China sells a proportion -- it would be very damaging.

Yu tells the truth. 

So far, though, Yu has not convinced the Chinese government to cut back on its reserve accumulation: Chinese reserve accumulation has grown every year since 2000.  And so long as China, Russia and Saudi Arabia's central banks are as willing as the markets to finance the US - if not more willing - the US seems set to keep on spending.

One last note: according the q3 data release, central banks only provide $39 billion in financing to the US in the third quarter.  I don't believe that.  China's reserves increased by around $60 billion in the third quarter, so if it put two-thirds of its reserves in dollar assets, it alone could have provided $40 billion in financing.  Over the first three quarters, central banks have provided $146 billion in financing for the US.  That works out to a bit under $200 billion for the year.   But global reserve accumulation this year is likely to be close to $500 billion (once adjustments are made for valuation effects, and including all the foreign assets of the Saudi central bank).  Does anyone really think only 40% of those reserves are being invested in the US, and 60% are going to low-yielding yen and euros?   I certainly don't.

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