Opinion and Editorial - August 09, 2006
Who pays for America's current account deficit?
Paul Donovan, London
Whenever economists gather together, sooner or later the conversation
will inevitably turn to what is politely referred to as the problem of
"global imbalances". This is the fact that the United States is running
an extraordinarily large current account deficit, and the rest of the
world is (by definition) running an extraordinarily large current
account surplus.
It is a fact of economics (one of the very few incontrovertible facts)
that a balance of payments position must balance out -- so the U.S.
current account deficit requires an equivalent capital inflow to finance
it. Today that flow amounts to something in excess of US$1.5 million
dollars every minute, every day (including weekends).
The scale of the imbalance, and the stresses that it places on the
global economy, are well known. America is spending more than it can
afford to spend in the long run, and the rest of the world is denying
itself the better standard of living it could otherwise enjoy.
Eventually, the imbalance will resolve (and economists hope that it will
be resolved in a relatively smooth manner). In the meantime, the weight
of the current account deficit means -- whatever the new U.S. Treasury
Secretary may protest to the contrary -- that the U.S. dollar is a
structurally weak currency.
For the last few years, the principle creditor in the balance sheet of
global imbalances has been Asia. Thus the task of funding the U.S.
current account deficit has fallen to Asian investors.
Asia has obliged by funding the U.S. current account deficit through
foreign exchange market intervention (including that intervention
conducted by Indonesia) -- and, indeed, around 40 percent of the U.S.
current account deficit (or approximately $553,000 per minute) has been
financed through Asian central bank action in the foreign exchange
markets.
This year, Asia is unlikely to stay the largest creditor bloc. Asia's
replacement as the principle creditor is, inevitably, the oil exporters
of the world. With oil prices pushed up by a combination of political
risk, supply constraints and strong demand, oil revenue (petrodollars)
have been accumulated by oil exporters at a far faster pace than they
can spend them. Their current account surpluses have grown, and (partly
because of oil imports) the current account surpluses of Asia have moved
off their recent peaks.
Why does this geographic shift matter? The geography itself is not that
important, but this is about more than location; it is also about the
institutions that move money around the world economy. While Asian
current account surpluses have effectively been managed by the actions
of central banks, this is not the case with the oil exporters.
OPEC countries' central banks intervention in the foreign exchange
markets has accounted for less than 10 percent of the U.S. current
account surplus in the immediate past. Oil exporters' current account
surpluses are far more likely to be recycled by the private sector than
has been the case with the current accounts of Asia.
Thus, the change in the current account creditor countries that we have
seen emerge this year means that we are also witnessing a shift in the
institutional management of money around the world -- away from (Asian)
central banks and towards (oil exporters') private investors.
Generally speaking, central banks are more constrained in their
investment choices than are private individuals. The (very strong) bias
of central banks is to invest foreign exchange reserves into government
fixed income assets -- and in the current environment that means U.S.
Treasuries.
Private investors, of course, can invest wherever they chose. Thus, as
Asian central bank's surrender their role to private sector investors,
we are likely to see an asset allocation shift away from fixed income
and towards other asset classes like equities and real estate.
The damage for U.S. fixed income markets may be mitigated --
particularly if the Federal Reserve cuts rates more aggressively in 2007
than investors currently expect. The problem for investors is trying to
balance the different forces that are at work.
Certainly if current international investment trends continue, it
suggests that the drop in U.S. Treasury bond yields will be less
aggressive than the Federal Reserve's easing cycle might otherwise
suggest. In a risk case scenario, if oil prices rise significantly the
shift away from central banks and towards private investors would
accelerate, and U.S. bond yields could even rise.
Large global shifts like the move from Asian to oil exporter funding of
the U.S. current account position are difficult to interpret at a local
economic level. Certainly, the move suggests further dollar weakness
lies ahead.
This general dollar weakness is likely to offset the effects on the
Rupiah of rising Indonesian import demand and a shifting interest rate
differential (if, as I expect, Indonesian interest rates fall earlier
and faster than those of the United States).
For fixed income markets the position is more unclear. U.S. Treasury
yields should still fall as investors anticipate Federal Reserve easing
-- but they are unlikely to decline to the low levels that we saw a few
years ago, as shifts in international investment flows limit the
decline. Indonesia's bond yields remain sensitive to oil prices,
(because of concerns about local inflation pressures and government
subsidies).
Thus a significant increase in the oil price could produce a double
pressure for Indonesian bonds -- rising rates on domestic concerns,
against an international backdrop where asset allocation shifts are
exaggerated and Treasury yields fall less than is currently anticipated.
The writer is Deputy Head of Global Economics, UBS Investment Bank. He
can be reached at [EMAIL PROTECTED]
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