Why closing the trade gap won't save the US economy
Well the dollar’s revival at the beginning of the week barely lasted an instant. Investors generally de-risked their portfolios by taking profits in equity and commodity markets after a parabolic run. Given the truly tectonic nature of the cracks in the global economy we continue to expect a sea-change in the dollar’s fortunes. The reason for our long-held view lies in the absence of any near-term improvement in the US current account deficit. This is a big issue in itself but what sometimes goes unnoticed is the other side of the trade deficit coin, the huge capital account surplus.
US Trade Deficit: Blaming China
At the last count the US trade deficit grew to $225bn over Q4 2005, an increase of 21% over Q3. The current account deficit (the combined balance on trade in goods and services plus income transfers between the US and the rest of the world) ballooned to $805bn over Q4 2005, 7% of GDP.
Much has been made of the extent to which China’s emergence as a major economic powerhouse has made a bad situation that much worse. In a US mid-term election year the air is filled with the sound made by US congressmen baying for the Chinese authorities to shelve their countries’ long-standing dollar-peg. The past few days witnessed another nano-shift by the Chinese.
However, it is the economic pressure rather than the political browbeating that should ultimately win the day. In essence, the worse the US trade position gets, the greater the pressure on the Chinese authorities to allow the renminbi to appreciate (because the amount of dollar purchases the country needs to make will have to increase, which will be expensive and add further to China’s internal economic imbalances).
Although much is made of a synchronised global economic upswing, as things stand (and they may look very different in twelve months time!), the US has opened up a pretty substantial growth gap relative to its developed economic trading partners which will naturally cause larger trade deficits. At the same time, the dollar’s weakness is having no effect on trade. China’s currency is weakening in close step with the dollar and it is Chinese exporters who are gobbling up market share.
Politicians are quick to warn about the dire consequences of running a prolonged trade deficit. Some economists make less of the issue, pointing to the size of the deficits in the context of the giant US economic behemoth.
Much less, however, is made of the effect of the flip side of the trade deficit, the huge capital account surplus (i.e. overseas investors lending the US money). This surplus has helped to keep US interest rates lower than otherwise they would at this late, late, late stage in the economic cycle and allowed the household sector to embark upon its unprecedented borrowing and spending binge.
US trade deficit: Who's funding the borrowing binge?
As many readers already know, the only way a country (in this case the US) can run a prolonged current account deficit (consuming more from foreigners than foreigners consume from it) is to run an equal and opposite capital account surplus (borrow more from foreigners than is borrowed by them). The record surge in overseas investment has provided the fuel to feed the spending splurge. The consequence has been that the US government and its households spend at rates which radically outpace their income.
When the US trade position is eventually eased probably by the necessary, and very likely, revaluation of Asian exchange rates, the impact on the US economy could be more negative than positive!
The reason for this is that the surge in those currencies will simultaneously cut the US off from the source of cheap capital that it has become accustomed too. This transition has to happen eventually, but it would be wrong (as many US congressmen seem not to understand!) to think that the transition would be a good thing for the US economy.
For every borrower there is a lender and in every developed economy net financial borrowing, or lending, takes place in four major sectors (households, corporations, government and foreigners) as they interact with one another. For one of these sectors to be a net borrower, the money has to come from one of the other sectors.
In the US, households have, over the past twenty years, gone from being by far and away the largest accumulator of financial assets (in excess of 10% of GDP in the 1980s) to a position of being net borrowers.
This decline in household savings has, of course, spurred household spending and, in the short-term, raised living standards. As households stopped saving, foreign lending stepped in and now overseas investors are financing both the household and the government financial deficits. If this funding dries up so, necessarily, will the borrowing of US entities, which means that spending will almost certainly be curtailed.
The colossal US borrowing binge has driven net assets held by overseas investors (foreign holdings of US assets, less US holdings of foreign assets) up to an unprecedented 38% of GDP (readers might note that up to 1989 the US was creditor to the rest of the world to the tune of 13% of GDP). If present trends are extrapolated into the future the figure is forecast to hit 50% by 2010. As we noted previously, the figure could be even higher if the Chinese decide to switch away from devaluing bonds into physical assets such as infrastructure and commercial property.
All this foreign investment works wonders for living standards while it is occurring, but eventually a reversal is inevitable. This is because overseas investors lend money to the US for the same reason that all lenders lend (future consumption). Eventually these lenders will expect repayment and all the apparent benefits that have accrued to the US from higher borrowing will reverse.
US trade deficit: A cheap dollar can't save the US economy
The willingness of overseas investors to part with hundreds of billions of dollars to the US has, and continues, to fuel a spending spree of epic proportions. Now overseas investors hold a high percentage of all US assets and these assets are not attractive relative to those of the rest of the world.
The only institutions still prepared to purchase US assets despite incipient dollar weakness, are Asian central banks which are less motivated by price and more interested in trying to ensure currency stability with the dollar. As these imbalances correct, as inevitably they must, the substantially negative impact on the US economy from the decline in available cheap capital will outweigh the transient benefits of a cheap dollar on the country’s trade position.
By Jeremy Batstone, Director of Private Client Research at Charles Stanley
