For the better part of 20 years, economists have been warning that the widening US current-account deficit is unsustainable.
A significant reduction of imbalances—the US deficit and correspondingly large Japanese, Chinese and German surpluses—would require a precipitous fall in the dollar and slower domestic-demand growth in the US relative to the rest of the world, economists contend. If the adjustment were triggered by a sudden loss of confidence in the dollar, the result could be higher US interest rates, a global recession and a financial crisis as rising loan defaults cause massive losses for banks, says Jonathan Wilmot, London-based chief global strategist at Credit Suisse Group.
Contrary to many predictions, the US current-account deficit has proved to be quite sustainable, while financial markets have been buoyant and prophecies of impending doom premature. For investors, adhering to the bearish view of things has been, at the least, a distraction and, at worst, decidedly unrewarding.
The stock market crashed in 1987. Still, Wilmot explains, the world economy didn’t unravel; the dollar didn’t fall much further on a trade-weighted basis; and US bond yields declined. The current-account deficit, which in 1987 stood at $160.7 billion, shrank to $50.1 billion in 1992. Bolstered by payments from other countries in support of the first Gulf War, the US even posted a $2.9 billion surplus in 1991.
More recently, the US current-account shortfall ballooned to $856.7 billion in 2006 from $519.7 billion in 2003. The misalignment between exports and imports accounts for about 90% of the deficit. During that period, the Standard and Poor’s 500 Index rallied 61%, while the trade-weighted dollar fell 14%, a comparatively small amount given the size of the US deficit. “Policymakers still worry about the deficit; I’m not sure people in the market are that worried,” says Martin Barnes, an economist at BCA Research Ltd in Vancouver. “But if the dollar were to get very weak, then people might start to focus on the current account.”
By then, it may be too late. The trade gap is beginning to resemble a stretched rubber band. The tension can be relaxed through the combination of a weaker dollar, which should help boost US exports and reduce imports; Americans saving more and surplus countries less; cheaper oil; and improving domestic demand-induced growth abroad.
‘Very long time’
Otherwise the rubber band must snap eventually. “Things that appear to be unsustainable can go on for a very, very long time,” Wilmot says. Economic gurus have offered theories on how the US deficit can keep widening. They include the dollar’s role as the world’s reserve currency and what some economists at Deutsche Bank AG describe as a new variant of the international trade- and gold-standard system agreed on at the 1944 United Nations Monetary and Financial Conference in Bretton Woods, New Hampshire.
Known as Bretton Woods II, it involves Asian countries tying their currencies to the dollar at competitive levels and using their reserves to lend money to the US by purchasing its financial assets, especially Treasuries. That allows these nations to pursue an export-oriented economic development strategy, which maintains growth and keeps their populations employed. In return, an overvalued dollar permits Americans to keep consuming cheap imports, spend more than they save and borrow from Asia at low interest rates.
“Some have called it the world’s biggest vendor-financing scheme,” Barnes says. “The US gets to satisfy its insatiable demand for cheap imports, and Asia keeps its factories running.” Even so, there are limits. While reserve-currency status bestows on the US advantages not enjoyed by other countries, it doesn’t render the US immune from financial turmoil.
Meanwhile, investors should be aware of the pressures building, especially since funding the US deficit is dependent on other nations. Led by Japan, China and oil-exporting countries, non-US investors owned 44% of outstanding US Treasuries at the end of 2006, 18% of US agency bonds, 34% of US corporate-debt securities and 17% of US equities, according to Joseph Quinlan, chief market strategist at Bank of America Capital Management in New York.
Interest payments on US Treasuries held by international investors climbed to a record $113.6 billion in 2005, the last year for which figures are available. If US corporate debt is included, the figure surges to $300 billion, Quinlan said in a 29 March report. For the first year since 1960, non-US investors earned more dollars on their US holdings in 2006 than US residents earned on their overseas investments.
“The income account is a leading indicator for investors about sustainability of the current-account deficit,” Wilmot says. “Paradoxically, the time to begin to worry about the current-account deficit is when it begins to improve, because growth and investment opportunities outside the US are beginning to look more attractive.”
In the fourth quarter, the US current-account deficit amounted to 5.8% of GDP, down from 6.9% in Q3 and a record 7% of GDP in the last three months of 2005. Yet, from 1990 through 1997, it was never worse than 2%. Money-management firm Bridgewater Associates Inc. warned clients last December about the potential consequences of a bloated US current-account deficit: “Eventually, people who lend money stop lending it and expect to be repaid.”
That’s when a trade gap becomes unsustainable.
Michael R. Sesit is a Bloomberg News columnist. The opinions expressed are his own.