The U.S. Current Account Deficit: Is Our Economic Health in Foreign Hands?
March 2005
By: ChartingTheEconomy.Com
We got a glimpse the other day of just how vulnerable the markets may be to the massive current account imbalance
that the U.S. is running with the rest of the world. It was reported that South Korea was seeking to diversify its official
reserves out of the U.S. dollar (dollar). On the same day the Dow was down over 174, the dollar fell sharply, bonds
dropped, the options market’s short-term risk forecast had its biggest one-day rise since July, and gold was up
sharply. Not all of this can be directly attributed to the news about South Korea. Oil was also up sharply (to over $51
per barrel) on the same day which helped spook the markets. However, it was no coincidence that the markets
behaved the way they did on the same day that news about South Korea’s plan to diversify their dollar holdings was
reported. The next day it was reported that South Korea was not going to start selling dollars after all. Time will tell.
This incident, however, gave us a view of what may be to come if the U.S. cannot reduce its current account deficit.
The U.S. current account deficit is the broad measure of the U.S.’s global trade imbalance. In addition to trade in
goods and services it includes certain financial transfers. There are multiple factors that have helped cause the
imbalance that we face today. However, the two most commonly identified causes are that the U.S. would rather
consume, than save, while that the rest of the world would rather do the opposite. In fact, personal savings as a
percent of personal disposable income has been on a steady decline in the U.S. for the past 20 years from a level of
near 11% in 1984. The national savings rate for 2004 was just over one percent of disposable income which is the
lowest it has been since the great depression. As the savings rate in the U.S. has declined, Americans have steadily
increased their level of consumption. As a result, consumer expenditures now make up roughly 70% of gross domestic
product.
We all know that much of what we purchase is foreign made – look around your home. Just about all of our current
account imbalance is made up of the trade deficit between the U.S. and the world. In turn, the U.S. trade deficit is
caused entirely by our massive negative imbalance in the export/import of goods. The U.S. actually has a positive
balance in the trade of services. Accordingly, it is our ever increasing purchase of foreign goods, and the fact that
foreign nations are not reciprocating in their purchase of U.S. goods, that fuels our current account deficit.
Chart #1 shows how the annual U.S. current account deficit has grown. In 2004 the trade deficit was negative $617.7B
which represents most of the current account deficit.
The Current Account Deficit – Low Interest Rates
As we just discussed, the fact that Americans are consumers and many foreigners are savers has a material affect on
the U.S. current account deficit. To a large degree this is a cultural difference that may be slow to change, if ever.
There are other reasons from cheap foreign labor to unfair trade practices that also add to the deficit. For now let’s
focus on two things. First, the low interest rates in the U.S., and second, the artificially high dollar versus major Asian
currencies.
The low interest rates of the past several years may have helped stave off a recession, but they may also have added
to the current account deficit. Knowing that consumer spending makes up over two-thirds of the U.S. GDP, the Federal
Reserve cut interest rates to historically low levels in the past several years. The upside was a quick return to growth
for the U.S. economy by spurring spending. However, the downside was a reduced incentive for Americans to save.
The last couple of years we have had negative real interest rates (interest rates minus inflation), a very rare
occurrence. In this environment, it can be argued that spending is the best thing to do with your money. Why, because
many short-term guaranteed investments would actually lose money after inflation when there are negative real interest
rates. Also, with the cost of borrowing so low, buying on credit is much more appealing. So, the low interest rates have
kept the economy growing but have also helped increase the U.S. current account deficit.
Low interest rates did help weaken the dollar. Even so, the current account imbalance has continued to grow. Now,
with interest rates on the rise, in theory the dollar should begin to strengthen. The problem is the dollar is still artificially
strong against major Asian currencies, and even with increasing interest rates the dollar may be slow to strengthen and
even continue to decline.
The Current Account Deficit – Artificially High Dollar
You would think that with the sharp fall in the dollar in recent years the current account deficit would begin to reverse.
Not yet. One of the biggest reasons is that China and Japan have kept their currencies artificially weak compared to
the dollar. The reason for this is simple, to support their exports to the U.S. China has not allowing its currency, the
renminbi, to float versus the dollar. As the dollar has declined in value against most other foreign currencies, it has not
declined against the renminbi which many believe is now very under valued. In the case of Japan, it has been buying
massive amounts of U.S. treasuries with the dollars they receive from their trade surplus with the U.S. The result is a
stronger Japanese yen versus the dollar because they are not selling the dollars they receive on the foreign exchange
market. The bottom line is both China and Japan have been supporting their exports by keeping their currencies weak
against the dollar. These are leading causes of the increasing current account deficit.
What are Foreign Countries Doing with Their U.S. Dollars?
Americans get foreign goods, and foreigners get our dollars in return. What they do with these dollars is up to them.
They can either sell them on the foreign exchange – converting them into other currencies, or they can invest them in
the U.S. Up until now foreign countries have mainly been doing the later. One of the favorite U.S. investment
instruments of foreigners has been U.S. Treasuries (U.S. Federal Government debt). Chart # 2 shows how foreign
ownership of U.S. treasuries has increased in recent years.
Chart #3 shows the picture another way. Foreign ownership of the U.S. Government debt as a percent of the total
outstanding debt held by the public has grown sharply in the past several years. Foreign ownership as of December
2004 was nearing 45% of the total.
As seen in Chart #2, in just the past four years the amount of U.S. treasury securities held by foreigners has almost
doubled from just over $1 Trillion to just under $2 Trillion. It is hard to even visualize just how large these numbers
are. To put this into perspective, let’s convert these numbers to a level that is more meaningful, a per household
number. Chart #4 shows the household share of U.S. Federal Government debt held by foreigners. If the U.S.
Government paid off the debt held by foreigners today, every household in America would need to come up with almost
$17,000.
Of course this is not going to happen, but it helps give perspective. The good news is that foreigners see the U.S. as a
good investment, so they are willing to hold large sums of U.S. debt. If they did not, they would be selling the dollars we
send them on the foreign exchange markets. If that were to happen, what we saw in the markets the other day after the
news from South Korea would be small by comparison.
What Countries Own Our Debt?
It is in no country’s best interest to see a collapse in the dollar. If this happened, there could easily be a global
economic slump. However, at some point foreign countries, like any reasonable investors, start to see diversification as
prudent. The question is when and to what level? In some respects it is already happening. Russia in November 2004
said it might start increasing the amount of euros it holds. Japan’s holding of U.S. treasuries actually peaked in August
2004 and has declined slightly through December 2004. The recent news out of South Korea also shows just how
nervous some countries are becoming.
It should also be noted that Alan Greenspan recently has begun to caution that foreign countries may seek to diversify
their dollar denominated assets. At the European Banking Congress in Frankfurt Germany in November 2004
Greenspan stated: “It seems persuasive that, given the size of the U.S. current account deficit, a diminished appetite
for adding to dollar balances must occur at some point. But when, through what channels, and from what level of the
dollar? Regrettably, no answer to those questions is convincing. This is a reason that forecasting the exchange rate for
the dollar and other major currencies is problematic.” So, even Greenspan points out that it is extremely difficult to
know what will finally cause foreigners to begin selling U.S. dollars and to what degree they will act. However, he is
growing cautious.
Chart #5 shows the major foreign holders of U.S. treasury securities as of December 2004 and the amount each
country holds.
An Example of How Demand for Securities Can Change
Chart #6 shows annual net foreign purchases of U.S. Treasury Bonds & Notes since 1990. The massive accumulation
of these assets by foreigners in the past several years is obvious. What is of equal interest is that after the last peak in
foreign purchases in 1996 how quickly the demand slowed in the following years. This is a good example of how
quickly foreign demand for U.S. assets can change.
Why Should We Be Concerned About the Current Account Deficit?
By running the massive current account deficits of the past several years, we are putting an increasing amount of
control over our economic wellbeing in foreign hands. As we saw with the news about South Korea the other day, just
talk of a foreign country diversifying their dollar holdings can add high volatility to markets. If we do not begin reducing
our account imbalance, there will come a time when foreigners become less willing to hold dollar denominated assets.
When this happens, the U.S. will be forced to increase interest rates (maybe sharply) to continue to attract foreign
investment. If the account imbalance continues to grow, higher interest rates could be just a small part of the story.
What happens if foreign countries panic? That is the real problem.
If a few foreign countries begin to diversify their dollar holdings, it might start a rush to follow suit. In this worst case
scenario, as nations sell their dollar holdings the dollar begins to decline even further. Other nations begin seeing their
dollar denominated holdings being devalued and begin to sell. With few buyers, the dollar falls sharply and interest
rates rise rapidly. The falling dollar causes imports to become more expensive, inflation spikes, and gold prices soar.
This is not a pretty picture for most. While many would argue that this scenario is not likely, we should not write it off.
The reality is that this scenario becomes more likely as the current account deficit grows. The larger problem is that we
have less control over our own economic wellbeing.
Where Do We Go From Here?
Predicting the future direction of the current account imbalance is extremely difficult primarily because so much of it
depends on currency exchange rates, and the currency market is very difficult to forecast. What is clear is that the U.S.
needs to turn the tide on the rising current account deficit quickly. As stated earlier, increases in interest rates are
needed to get Americans saving again. While rising interest rates usually help strengthen the dollar, this time it may
not. This is not necessarily a bad thing. A further decline in the dollar, at a controlled pace, will help reduce the
current account deficit. In fact, the U.S. should continue to pressure China to let their currency float against the dollar.
This will lead to a rise in import prices. However, the positive side is more U.S. exports to China and more balanced
trade.
The U.S. also needs to reduce its massive federal budget deficit. Reducing the budget deficit should help increase
domestic savings. At the European Banking Congress in Frankfurt Germany in November 2004 Chairman Greenspan
stated “Reducing the federal deficit (or preferably moving it to surplus) appears to be the most effective action that
could be taken to augment domestic saving. Significantly increasing private saving in the United States–more
particularly, finding policies that would elevate the personal saving rate from its current extraordinarily low level–of
course would also be helpful.”
Conclusion
The U.S. needs to turn the tide on its rising current account deficit quickly. It is becoming clear that foreign
governments are beginning to see a need for diversification of their holdings in U.S. securities. Recent news that South
Korea was going to diversify their dollar reserves showed us how uncomfortable some nations are becoming with their
large holdings in dollars. It also showed us just how susceptible major markets have become to the U.S. current
account deficit as markets were very volatile after the news. It was also a reminder of just how much control foreign
governments that own our debt have over the markets and potentially over our economy.
While rising interest rates may cause Americans to begin saving more and consuming less, more is needed to reverse
the current account imbalance. A weakening dollar so far has done little to slow the increasing U.S. current account
imbalance, let alone reverse it. What this suggests is that a further weakening in the dollar is likely, especially against
major Asian currencies. Without this it is hard to see how the U.S. current account can be brought back into balance.
Sources
Chart #1: Data is from The Bureau of Economic Analysis (BEA). U.S. international transactions historical data and 3rd
quarter 2004 report. The 2004 number is an estimate using current account data for the first three quarters of 2004
and trade data for all of 2004.
Chart #2: Data is from The U.S. Treasury Department. Treasury International Capital System (TIC).
Chart #3: U.S. Treasury Department. Treasury International Capital System and Bureau of the Public Debt.
Chart #4: U.S. Treasury Department. Data on number of households is from the Census Bureau. For 2004 the
number of households is estimated.
Chart #5: U.S. Treasury Department. TIC. Caribbean Banking Centers include Bahamas, Bermuda, Cayman Islands,
Netherlands Antilles, and Panama.
Chart #6: U.S. Treasury Department. TIC
