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The Pulse of Capitalism

Issue Number 04-4, January 2005

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International Comparisons
Business Activity Indicators
Financial Indicators - United States
Selected International Transactions - United States

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.

Net change in foreign owned U.S. securities ($millions)
2000 2001 2002 2003 FH 2004
U.S. Treasury securities
    Official -5,199 33,700 60,466 169,685 164,719
    Private -69,983 -14,378 100,432 113,432 100,998
        Total -75,182 -19,322 160,898 283,117 265,717
Other U.S. securities
    Official 44,036 26,646 32,166 30,032 19,229
    Private 459,889 393,885 285,500 250,981 150,681
        Total 503,925 420,531 317,666 281,013 169,910
Source: Survey of Current Business, July 2004

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:

"Central bank holdings of foreign currency assets, particularly foreign government securities, have risen sharply in recent years. Known as foreign exchange reserves, these holdings reached $3.0 trillion at the end of 2003, up roughly $600 billion from 2002 and more than double the level in 1995.
"----The scale of central bank's recent reserve purchases has made those institutions key players in setting the pattern of capital flows across national barriers. Indeed, for a number of countries, central bank reserve purchases have at times become the main vehicle for investment abroad."
The authors then go on to discuss three aspects of these capital flows.

      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.

"Properly managing the monetary base is important for controlling inflation. As we shall see, inflation concerns sometimes prompt central banks to neutralize the impact of reserve purchases on the monetary base through a matching reduction in net domestic assets - an operation known as sterilization.

"Reserve Purchases across Currencies and Countries
Almost all foreign exchange reserves are held in five currencies: the U.S. dollar, the euro, the Japanese yen, the British pound, and the Swiss franc. Dollar reserve holdings are by far the largest, accounting for roughly 70 percent of the total at end-2003. Euro reserve holdings are next in line, representing about 20 percent of the total.
- - -
"Significantly, the predominance of dollar reserve holdings has made foreign central banks important players in U.S. financial markets. Indeed, at end-2003, central bank holdings of dollar assets, at roughly $2.1 trillion were equivalent to more than half of marketable Treasury debt outstanding.
"Central banks in Asia have accounted for the bulk of recent global reserve growth.----Of the roughly $1.2 trillion increase in global reserves from the end of 1999 to the end of 2003, $582 billion reflects purchases by developing countries in Asia and another $375 billion reflects purchases by Japan.
- - -
"Reserves and the Allocation of Global Capital Flows Central bank reserve purchases have been large enough in recent years to be a key factor in determining the allocation of global capital flows.---A country that saves more than it needs for domestic investment sends its surplus saving abroad to purchase foreign assets. In contrast, a country with a saving shortfall, such as the United States, can maintain a higher level of investment spending by borrowing from abroad.
"---In 2003, Asia was the source of substantial capital outflows, amounting to roughly $309 billion.---Western Europe and Canada were also net suppliers of saving to the rest of the world in 2003, providing a total of $96 billion. Other sizeable outflowsCon the order of $71 billionCcame from the oil-exporting countries."
The authors then supply a chart showing the world's combined savings (current account surpluses) totaling $531 billion in 2003 flowing to the United States to offset its current account deficit.

      b. Motives for Reserve Purchases

"---In contrast [to private investors], national central banks buy and sell foreign assets for policy reasons that go beyond trying to maxi- mize risk-adjusted returns. The banks' two main policy objectives are tied to coping with often volatile private capital flows.
Self insurance. A central bank might acquire foreign currency assets to have resources to weather potential currency market turbulence.
"---Mexico, Korea, and Russia, for example, all suffered destabilizing runs on their currencies during financial crises in the middle or late years of the [1990s] decade. For Asia, however, self-insurance has likely been a less important motive for reserve accumulation during the past two to three years.---all major Asian central banks now have reserve coverage that exceeds 1.5 [1.0 or above is a common measure of adequacy] and often goes far higher.
"Countering private flows. Central banks also buy reserves to 'lean against the wind' when private capital inflows or outflows threaten to bring unwelcome changes in the value of the domestic currency. In particular, when private investors are putting upward pressure on the currency by buying domestic currency assets [presumably securities], the central bank can attempt to contain that pressure by selling domestic assets and buying foreign currency reserves. Similarly, when private capital outflows threaten to weaken the currency, the central bank can sell reserves and buy domestic assets.
"Impact on Local Financial Markets
While the motives for central banks' purchases of foreign assets may vary, the effect on domestic financial markets is the same. As noted earlier, reserve purchases directly increase the monetary base, injecting liquidity into the economy. This liquidity injection in turn puts downward pressure on domestic interest rates."

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.
"Costs and Risks of Accumulating Reserves
Sterilized reserve purchases face no clearly defined limit---However, sterilized reserve purchases generally come at a fiscal cost. In particular, they involve purchasing relatively low-yield foreign assets while issuing relatively high-yield domestic liabilities (or selling off relatively high-yield domestic assets).
- - -
"Reserve purchases also expose a central bank to foreign exchange risk. If the domestic currency eventually appreciates against the dollar or other reserve currencies, the central bank's foreign assets lose value in domestic currency terms. The capital loss is then passed on to the national treasury in the form of reduced domestic currency receipts of both interest and principal on its foreign exchange holdings." [It should be noted that this risk is low or non-existent for Japan because both short and long-term domestic interest rates are so low.]

      c. Effect on U.S. Financial Markets

"---In recent years, foreign central bank dollar reserve purchases have accounted for a large share of the capital flowing in for the acquisition of U.S. assets. According to estimates by the Bank for International Settlements (B.I.S.), dollar reserve purchases in 2003 came to $441 billion. These purchases financed 83 percent of the U.S. current account deficit, with private investors financing the remainder.----Over a longer periodCfrom 1995 through 2003Cdollar reserve purchases financed almost half of the cumulative U.S. current account deficit.
"The geographic sources of the dollar reserve purchases cannot be known with certainty, since comprehensive data are not available by region. Nevertheless, a rough estimate can be made by assuming that the share of global reserve purchases going to dollar assets - 88 percent in 2003 - applies to all regions. Under this assumption, central banks in Asia were by far the biggest buyers of U.S. assets, financing some 71 percent of the 2003 U.S. current account deficit. Central banks elsewhere would have financed another 12 percent of the deficit. Within Asia, the largest dollar reserve purchases likely came from Japan, China, and Taiwan, with India and Korea also making sizeable purchases.
"---Absent this inflow of official capital, U.S. asset prices would have to fall in order to attract additional private inflows. Lower U.S. asset prices would attract additional private inflows by raising the rate of return associated with any given income stream. (For fixed income assets, lower asset prices mean higher interest rates.) A weaker dollar would also be a likely part of the adjustment process, attracting additional private inflows by making U.S. assets cheaper in foreign currency terms. Finally, higher U.S. interest rates would help reduce the U.S. economy's need for foreign capital by encouraging saving (equivalently, discouraging consumption) and reducing invest- ment spending."


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.

International Comparisons
Canada Germany Japan United Kingdom United States
Real GDP (% chg. on year ago)
    2002 (Q4)
3.9 0.5 2.8 2.2 2.9
    2003 (Q4)
1.6 0.2 3.4 2.8 4.3
    2004 (Q3)
3.3 1.3 2.6 3.1 3.8
Industrial Production (1997=100)
117.3 109.9 91.7 100.0 110.9
117.5 110.3 94.5 99.9 111.1
    2004 3Qs
[email protected] [email protected] [email protected] [email protected] 115.7
@ Average fewer than nine months
Retail Sales (volume - % chg. on year ago)
    2002 (Dec)
1.4 -3.2 -3.0 6.4 4.9
    2003 (Dec)
0.8 -2.5 0.4 4.0 7.4
    2004 (Sept)
(Aug) 3.6 -1.4 -0.4 6.9 6.3
Consumer prices (1982-84=100)
172.9 146.7 119.0 207.0 179.9
177.7 148.3 118.7 213.0 184.0
    2004 3Qs
[email protected] [email protected] [email protected] [email protected] 188.3
@ Average fewer than nine months
Unemployment Rates
    2002 (Dec)
7.5 10.1 5.3 5.1 6.0
    2003 (Dec)
7.4 10.4 4.9 4.9 5.7
    2004 (Sept)
7.1 10.7 4.6 4.7 5.4
Interest Rates (3 months)
    2002 (Dec)
2.67 2.93 * --- 3.84 1.19
    2003 (Dec)
2.59 2.13 * * --- 3.86 0.90
    2004 (Sept)
2.41 2.10 * --- 4.93 1.65
Stock Indices (ending)
6,614.54 2,892.63 8,578.95 3,940.40 8,341.63
8,220.89 3,965.16 10,676.64 4,476.90 10,453.92
    2004 Sept
8,668.29 3,892.90 10,823.57 4,570.80 10,080.27
Current Acc't Bal's ($bn) latest 12 months
11.0 50.4 115.0 -13.1 -473.9
18.5 56.3 136.0 -30.8 -530.7
    2004 3Qs
26.7 90.2 169.0 -47.4 -603.2
Foreign Exchange Rates
1.57 0.95 * 125.22 1.50 126.75
1.40 1.13* * 115.94 1.63 119.28
    2004 3Qs
1.33 1.23 * 108.96 1.82 114.80
Currency units per U.S. $
UK pound in U.S. $s
U.S. dollar: index of dollar against major trading partners, January 1997=100
* Euro area euro in U.S. dollars
Sources: Economist, Economic Indicators,
F.R. Bulletin, Survey of Current Business

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.

Business Activity Indicators - United States
2002 2003 3Q 2004
Industrial Production (1992=100) 110.9 111.1 115.7 *
    Capacity Utilization Rate (% total industry)
75.6 74.8 77.0
Manufacturers' New Orders (billions of $s) 316.7 329.2 360.6 #
New Construction Expenditures (billions of $s) 871.3 915.7 985.6 *
Real Gross Priv. Dom. Invest. (chained[1996]$s) 1,560.7 1,628.8 1,821.0 *
Business Sales - Mfg. & Trade (billions of $s) 822.0 857.0 933.0 #
Business Inventories (ending) (billions of $s) 1,163.7 1,185.5 1,225.2
Retail Sales (billions of $s) 269.2 283.3 301.1 #
Retail Inventories (ending) (billions of $s) 430.5 451.5 453.8
Per Cap. Personal Consump. Expend.'s (chained 2000 $s) 24,713 25,269 25,871
Nonagricultural Employment (millions) 130.3 129.9 # 131.0 #
    Goods Prod. (millions)
22.6 21.8 21.8 #
    Services Prod. (millions)
107.8 108.1 109.2 #
* Annual Rate
# Monthly average
Source: Economic Indicators

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.

Financial Indicators - United States
2002 2003 3Q 2004
National Income (billions of $s) 9,225.5 9,679.8 * 10,293.6 *
    Percent change
2.7 4.9 6.3
Per Cap. Disp. Personal Income (chained [2000]$s) 26,227 26,569 27,071 *
Avg. Real Gross Wkly Earnings (1982=100) 278.83 278.75 278.26
Gross Saving " 1,484.4 1,487.9 1,607.9 *
Consumption of Fixed Capital " 1,304.0 1,354.0 1,410.3 *
    Net Saving "
180.4 133.9 197.6 *
      Private "
459.8 501.6 567.1 *
    Government (all) "
-279.5 -367.7 -369.5 *
Commodity Price Index (1995=100) 74.7 89.0 88.3
Producer Price Index (1982=100) 138.9 143.3 147.6
Corp. Profits (with i.v.a.&c.c.a.) (billions of $s) 874.6 1,021.1 1,146.3 *
Interest Rates - 10 year Treas. 4.61 4.01 4.31
Money Supply - M3 (ending) " 8,552.4 8,845.7 9,311.0
    Percent change
6.6 3.4 5.3
Commercial Bank Credit (ending) " 5,885.8 6,249.8 6,695.0
Consumer Credit (ending) " 1,924.2 2,011.3 2,085.7
Credit Market Debt (ending) " 31,331.5 34,011.5 35,820.6
    Nonfinancial Sector "
21,220.2 22,910.8 24,182.6
    Financial Sector "
10,111.3 11,100.7 11,638.0
    Household Sector "
8,382.8 9,246.5 9,907.5
Total bankruptcy filings (thousands) 1,576 1,660 1,225
* Annual rate Sources: Economist, Economic Indicators, F.R. Bulletin, F.R. Flow of Funds, Administrative Office of the U.S. Courts

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.

Selected International Transactions - United States
2002 2003 3Q 2004
Trade Balance on Goods & Services ($bns) -421.7 -496.5 -445.0
    Goods "
-482.9 -547.6 -481.1
    Services "
61.2 51.0 36.1
U.S. Owned Assets Abroad, net [inc/capital outflow(-)] " -198.0 -283.4 -545.7
Foreign Owned Assets in US, net [inc/capital inflow(+)] " 768.2 829.2 1,002.2
    Net change in US Int'l Inv. Pos'n "
570.2 545.8 456.5
Net change in Foreign Owned U.S Securities
    Treasury Securities & Cy Flows "
182.4 299.8 329.1
    Other U.S. Securities "
317.7 281.0 269.3
Sources: Economic Indicators, Survey of Current Business

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) 443-2396
Material may be reprinted with acknowledgement of the source. Economic statistics are revised routinely and may, therefore, differ from one report to another.

Published February 2005

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