Issue Number 04-4, January 2005
The External Debt: Global Reserve Growth
One of the areas we watch closely in the Pulse is the U.S. international investment position, which we will refer to as the external debt. This debt grew from -$323.4 billion in 1994 to -$2,430.7 billion in 2003, an average annual increase of -$234.1 billion. As a percentage of GDP, the debt grew from 4.6 percent in 1994 to 22.1 percent in 2003. (Direct investment in this data is valued at current cost.)
Since 1999, a period of economic weakness, the debt has grown exceptionally fast, from -$775.5 billion to -$2,430.7 billion, an increase of 213.4 percent. This growth continued in the first half of 2004 with an increase of -$285.4 billion. Historically, economies such as Mexico, Brazil, South Korea, or Indonesia prospered during periods of capital inflow but faced crises when those flows slowed or stopped. One of our great unanswered questions is what would happen if the U.S. experienced such a slowing or reversal. Consequently, it is very important that we follow developments that have an impact on the U.S. position.
The U.S. net international investment position consists of a variety of financial and other assets (see Pulse #04-1), but in this discussion we will focus on foreign investments in U.S. Treasury and other securities as they are especially sensitive to economic and financial developments.
As the table shows, there has been a persistent decline in foreign investment in U.S. securities other than Treasuries, particularly in the private sector. Foreign investment in U.S. stocks and private and agency bonds comes mostly from Western Europe, particularly Britain, so we must conclude that investors there are finding investment opportunities less attractive in the U.S. This trend, however, has been dwarfed in the last two and one half years by an enormous increase in purchases of U.S. Treasury securities by both official and private sectors. The combined purchases of these sectors in 2003 totaled $283.1 billion, which equaled 77.7 percent of the Federal government fiscal deficit.
Foreign official reserve assets
The accumulation of official foreign assets was discussed in
Current Issues, Federal Reserve Bank of New York, Matthew
Higgins and Thomas Klitgaard, September/October, 2004 issue. They
described the development as follows:
a. Accumulation of foreign currency reserve assets and implications
The discussion first notes that a purchase of reserve assets
will increase the monetary base (supply) since the central bank
normally just credits the account of the domestic private bank.
However, this monetary expansion can be neutralized by simultaneously
selling government securities, which results in a charge to the
private bank's account.
b. Motives for Reserve Purchases
The authors then go on to discuss the option and results of central banks using sterilized reserve purchases, concluding:
"Sterilized reserve purchases will still have an effect on domestic financial markets because they alter the mix of financial instruments held by the private sector. In particular, they result in higher private holdings of domestic public sector securities (whether issued by a country's treasury or central bank) and reduced private holdings of reserve currency securities.
c. Effect on U.S. Financial Markets
The gravity of the external debt problem is apparent if we consider the secondary effects of the developments posited in the preceding sentence. "Higher U.S. interest rates" would slow or end the housing boom along with consumer borrowing generally; in addition they would push more borrowers now on the edge into bankruptcy. "Encouraging saving (equivalently, discouraging consumption)" would cut the legs out from under the recovery in production and profits. "Reducing investment spending" would curtail economic expansion which has become crucial to continued job growth as well as constantly growing government revenues to support expenditures. In addition, "lower U.S. asset prices" would again devastate the securities markets and the wealth effect on individuals. Above all, these developments would discourage job growth and income growth, both of which are essential if the economy is to flourish.
The phenomenon of global reserve growth is very strange. Why does the whole world send its savings surplus to the U.S.? The size and liquidity of U.S. markets is one reason. There are no other markets with the same combination of public information, safety, and ease of transaction. The reserve status of the dollar is also a factor, especially in view of the fact that many basic commodities (such as oil) are priced in dollars. But as we have seen, many countries are now using dollar purchases to, in effect, devalue their currencies. The U.S. on the other hand, is declining to correct its fiscal and monetary policies that lead to depreciation of the dollar in currency markets. The net result is a de facto competitive attempt at currency devaluation carried out by different means. This raises echoes of the competitive currency devaluations (in terms of gold) that characterized the 1930s.
The goal of Asian nations seems to be to maintain their export surpluses, which increase domestic employment as well as income and reserves. The U.S., on the other hand, stimulates employment by using capital inflows to increase consumption. Can both concepts be correct and can they be sustained indefinitely?
The graph at the beginning of this article shows how the U.S. dollar has declined against the euro since 2001. A similar decline has occurred in the dollar index for major trading partners. Alan Greenspan spoke out publicly on the need to address this problem during Thanksgiving week, and the European Monetary Commissioner, Joaquin Almunia, said the euro may continue to rise unless the U.S. government follows up its rhetoric with action. Clearly, the international monetary system will be a prominent topic in 2005.
The GDP data is mixed, with Canada, Germany, and Britain showing moderate advances while Japan and the U.S. show moderate declines. Industrial production picked up in all five economies, but the advance was negligible in Britain where it has been almost unchanged for three years.
Again we note the correlation between retail sales and trade balances. The two countries with the largest trade deficits are the two with the strongest retail sales growth while the two with the largest trade surpluses (Japan and Germany) have negative retail sales growth. Excessive domestic stimulus appears to be the difference. The correlation even seems to carry over to the consumer price data. Germany and Japan have experience considerably less price inflation than Britain and the U.S.
Unemployment rates declined moderately except in Germany which experienced a small increase. Interest rates continued to fall in Canada and Germany but rose over a point in Britain and three quarters of a point in the U.S. The stock indices were mixed, with declines in Germany and the U.S. By the end of 2004, however, all five indices showed gains for the year.
There is a very clear divergence in the current account balances of the leading economies. Canada, Germany, and Japan have rising surpluses while Britain and the U.S. have rising deficits. The U. S. deficit for November was $-60 billion, which assures a record increase for the year. The Asian countries also have current account surpluses, so that most of the world's savings flow to the U.S. and Britain. This process clearly cannot continue much longer.
The trade and current account imbalances have impacted the dollar, which has fallen 9.4 percent against the currencies of major trading partners since 2002. But so far this decline has not benefited the U.S. trade balance as imports continue to rise faster than exports. Economic changes apparently come very slowly.
Real GDP increased 3.9 percent in the third quarter of 2004 after increasing 3.3 in the second and 4.5 in the first. The third quarter increase mainly reflected an acceleration in consumer spending and a slowdown in imports (which are subtracted in determining GDP). Inventory accumulation and investment in residential housing slowed
The industrial production index rose to 115.7, which put it ahead of the previous high of 115.4 set in 2000. Manufacturing and utilities rose, but mining was slightly lower. Capacity utilization was the highest since 2001. Manufacturers' new orders rose to a new high of $360.6 billion.
The construction boom continued unabated with increases in both residential and nonresidential sectors. Some signs of weakening emerged, however. Homes for sale rose from 370 thousand in December 2003 to 412 thousand in October 2004. And vacancy rates for rental housing, at over 10 percent, are the highest in over a decade.
Real gross investment surpassed its previous high set in 2000, led by business equipment and software. Residential and inventory investment made smaller contributions.
Business sales surpassed their 2000 peak in 2003 and have continued to climb since then. Retail sales did not fall during the downturn and also advanced through third quarter 2004. The business inventory-sales ratio remained low whereas the retail ratio has been stable over the past three years. Like retail sales, per capita consumption expenditures grew throughout the downturn, and the 2004 increase will exceed that of 2003.
Employment is the Achilles heel of the current economy. Total employment did not surpass the 2001 peak until October 2004. During that period the civilian labor force grew 4.1 million persons, an indication of the true loss of jobs in the downturn. Employment increased 1.6 million from January through September 2004, of which 1.3 million were in the services, spread over a variety of sectors.
National income growth continued to accelerate in the first three quarters of 2004. Compensation of employees and corporate profits led the upturn. The increase for 2004 should equal or exceed the best years of the 1990s. This result is mirrored in per capita real personal income, which rose $502 in the first three quarters. Curiously, average real weekly earnings (and average real hourly earnings) fell slightly in 2004. The divergence no doubt reflects adjustment for inflation; real personal income reflects inflation but does not reflect income disparity.
Gross saving rose more than capital consumption, resulting in higher net saving. Private saving increased while government deficit was little changed.
Although the commodity price index was little changed, metals were well above their 1995 base, and oil was about 50% higher than a year earlier. These increases were offset by lower agricultural prices. After declining in 2002, producer prices rose 4.4 points in 2003 and another 4.3 points through September of 2004. Consumer prices also rose 4.3 points during the 2004 period.
Corporate profits had a good year in 2003, rising $146.5 million and seem likely to record about the same amount of gain for 2004. The 10 year Treasury yield dipped below four percent briefly in March before rising to 4.73 percent in June, but has remained below that level since then, despite repeated increases in the federal funds rate by the Fed. The market seems to be saying that there is still an excess of funds available for investment despite the business upturn. M3 money supply growth was strong from April through August but then slowed.
The Federal Government deficit peaked in the third quarter of 2003 but still remains above the 2003 average. Due to tax cuts, personal current taxes remain over $200 billion below their peak in 2000. Total bank credit grew throughout the downturn, and this growth accelerated in the first three quarters of 2004. Real estate continued to be the fastest growing sector while commercial and industrial loans were little changed. Consumer credit growth slowed considerably after 2001 and continues at this slower pace.
Domestic non financial debt grew 7.8 percent in the first three quarters, and financial debt grew 6.6 percent. Federal debt grew 9.2 percent while household debt grew 9.7 percent.
Bankruptcy filings declined slightly from the 2003 pace.
The negative balance on goods and services has continued to widen during the first three quarters of 2004. The negative balance on goods has risen more than in 2003 while the positive balance on services has been below the 2003 level in each of the first three quarters. Both U.S.-owned assets abroad and foreign-owned assets in the U.S. surged in the first three quarters of 2004, but the gap between the two again widened. For each of the past three years, the U.S. will show an increase in liabilities exceeding one half trillion dollars. Foreign acquisition of U.S. Treasury securities in the first three quarters of 2004 surpassed last year's record pace. Two-thirds of the purchases were by official entities for currency support and for bolstering foreign reserves. The other third was from private sources for investment and has remained strong for the third consecutive year. Purchases of other U.S. securities continued to rise after a small decline in 2003, probably in response to stronger markets.
Copyright © Andrew Caughey, 2005
The Pulse of
Capitalism is published quarterly. Comments may be sent to Pulse
Publication, P.O. Box 140, Gibsonia, PA 15044. Telephone: (724)
Site designed, edited and maintained by IRN Internet Services