Why global imbalance persists

The U.S. can rely on capital inflows to sustain its ever-rising current account deficits chiefly because the rest of the world is dependent on the U.S. market and its buoyancy for growth.

IT is a problem that most governments recognise, but seem incapable of doing anything about. The deficit on the current account of the United States balance of payments or the excess of dollar outflows over inflows on account of the trade in goods and services, incomes earned by non-residents and unilateral transfers is unsustainable and rising. In the third quarter of 2005, its current account deficit touched $195.8 billion. Though marginally lower than the same deficit in the previous quarter, this figure signalled that the deficit would rise to a record level of around $790 billion over 2005 as a whole (or 6.4 per cent of U.S. GDP) as compared with $668 billion in 2004.

Edwin S. Truman, currently with the Institute of International Economics, reports that when he left the staff of the U.S. Federal Reserve in 1998, the current account deficit was just $201 billion or 2.4 per cent of GDP. But even then it was rising and had been declared as being on an unsustainable trajectory by the staff of the Division of International Finance of the U.S. Federal Reserve. Clearly the deficit is on a relentless climb, which governments seem unwilling or incapable of arresting.

The reason for the persistence of a tendency long identified as unsustainable is, of course, the seemingly insatiable appetite of the rest of the world for dollar-denominated assets. This results in capital flows into the U.S. for purchase of equities and long-term bonds, which exceed the current account deficit. Thus, the International Capital report of the U.S. Treasury indicates that the capital inflow into the U.S. during the third quarter of 2005 was $278 billion or $82 billion more than the current account deficit. The world's wealth holders seem to be more than matching the U.S. demand for funds to finance the current account deficit.

If this be the case, the intelligent layperson would ask, why the talk about global imbalances that pervades discussions on the world economy? What the evidence seems to point to is the operation of a mechanism or mechanisms ensuring global balance. There are four reasons why concerns about global balance still abound.

First, there is the matter of geography, reflected in the concentration of the world's current account deficits in one country and surpluses in a few. Consider for example 2003, during which the average monthly price of West Texas Intermediate crude oil was only $31 a barrel, as compared with $26 in 2002, $41 in 2004 and $51 during the first six months of 2005. In that year, 52 out of the 126 countries for which data is available recorded surpluses on their current account, while 74 recorded deficits, with the U.S. recording the largest deficit of $531 billion and Japan the largest surplus of $136 billion. From the data, it emerges that the surpluses of the top 17 surplus earning countries would have been necessary to cover the U.S. deficit. The surpluses of these 17 countries accounted for as much as 86 per cent of the surpluses earned by the countries that recorded a surplus. On the other hand, the U.S. alone accounted for 72 per cent of the total deficit recorded by the 74 deficit countries.

The second imbalance is that increasingly the U.S. current account deficit is being financed by surpluses accruing in developing countries, in violation of the conventional wisdom that capital should flow from the capital-rich North to the capital-scarce South. The collective current account of the industrial countries declined by $441 billion between 1996 and 2004, implying that, of the $548 billion increase in the U.S. current account deficit, only about $106 billion was offset by increased surpluses in other industrial countries. The bulk of the increase in the U.S. current account deficit was balanced by changes in the current account positions of developing countries, which moved from a collective deficit of $90 billion to a surplus of $326 billion - a net change of $416 billion - between 1996 and 2004.

The third imbalance is the fact that the U.S.'s deficit arises because it consumes too much whereas surpluses arise in the rest of the world because they save far more than they need in order to finance their investment (which in some countries like China is at remarkably high levels). According to The Economist, on an annualised basis in June 2005, U.S. households disposed of all but $1.9 billion (0.02 per cent) of the over $9 trillion in disposable income they earned. Households save less and consume more because the value of their wealth accumulated in the past has been rising, initially owing to the late 1990s boom in stock markets and subsequently on account of the housing boom. It is indeed true that while the sharp decline in the U.S. savings rate since the late 1990s was driven initially by a drop in household saving, the shift in the budget from surplus to substantial deficit (or an increase in government dissaving) since 2000 has aggravated the trend. But inasmuch as that shift was the result of tax cuts, its effects would have been felt through increased private incomes that contributed to the rise in private consumption.

This has a direct effect on the trade and current account deficits. According to a study by Catherine Mann of the Institute of International Economics, the biggest component of the non-oil/non-agriculture trade deficit of the U.S. is in consumer goods, which account for 21 per cent of U.S. imports and 8 per cent of exports. Together with the net deficit in autos, this accounted for nearly three quarters of the increase in the non-oil/non-agriculture trade deficit since 1997. In contrast, in many of the developing countries characterised by a current account surplus, household savings have been rising, and this tendency has been accompanied by a decline in government deficits or the emergence and increase of government budgetary surpluses.

Finally, a fourth imbalance is that capital flows into the U.S. are increasingly in the nature of "official" investments in U.S. Treasury securities, whereas U.S. investments abroad are by private agents investing increasingly in real assets or privately issued paper. Data from the Federal Reserve relating to its holdings of assets for official institutions - which is a proxy for foreign central bank holdings - shows a rise of $85 billion in 2002, $167 billion in 2003 and $196 billion in 2004. Needless to say, not all of these investments are from developing countries, Japan is a major investor, but their contribution is important. This trend has only continued. According to the most recent Treasury data, foreigners invested a record net $54.6 billion into U.S. Treasuries in November even as U.S. investors pushed out a record net $16.4 billion into overseas equities. The flow into the Treasuries was more than twice its 12-month average of $26.7 billion, while net inflows into corporate bonds, at $35 billion, was only $3 billion above its average. Overall, a net sum of $89.1 billion flowed into U.S. assets, which though below the $104.2 billion of the previous month, contributed substantially to the average of $91.5 billion over the past six months. The jump in Treasury investments in November has been attributed to "petrodollar buying". With rising oil prices having contributed to larger Organisation of the Petroleum Exporting Countries (OPEC) surpluses, the speculation is that these petrodollars are being parked in the liquid U.S. Treasury market.

THERE is some controversy surrounding the sources of these funds. For example, the Treasury International Capital report quoted earlier indicates that $257 billion of the $278 billion of capital inflow into the U.S. in the third quarter came from private buyers. But as Martin Feldstein (among others) has pointed out: "The TIC measure of inflows from `private' sources overstates the actual private investment because it does not distinguish between a purchase by a private buyer for its own account and a purchase executed by a private institution on behalf of a foreign government. For example, if the Chinese government purchases U.S. bonds through J.P. Morgan or another private bank, these funds will be recorded in the TIC data as a private purchase. Similarly, purchases of dollar assets by governments of OPEC or their investment authorities that are done through British banks would look like private purchases with a British origin."

In actual fact, these flows, invested in relatively low-yielding government securities, come in large measure from developing countries and overwhelmingly from governments. To the extent that these inflows exceed the current account financing requirements of the U.S., they help sustain U.S. investments overseas. Those investments come from private sources and take the form of foreign direct or high-yielding portfolio investments. The international media reports that U.S. mutual fund investors put more money into non-U.S. funds last year than U.S. funds, an event that has happened only once since the figures were first compiled in 1984. Among the reasons quoted was "performance chasing". According to Emerging Portfolio Fund Research, a firm that monitors funds with $5,000 billion assets worldwide, emerging market bond funds have been outperforming developed world corporate bonds and yielding record returns.

U.S. investments overseas have, in fact, helped prevent its current account deficit from spiralling even further. Direct investments yield returns not just in the form of dividends but as payments for royalties for U.S. technology, for its professional and technical services and for its brands. `Other private services' such as education, finance, and business and professional services account for 6 per cent of total U.S. imports and 13 per cent of total exports. The U.S. balance on trade under this head is positive and has continued to rise. Direct and portfolio investments deliver cash returns from dividends and capital gains. Under normal circumstances a country that records persistent current account deficits and relies on capital inflows to finance them should sooner than later record deterioration in its balance of net investment income, as it pays out more to service foreign investment in domestic assets than it earns from its investment in foreign assets. This surprisingly has not happened in the case of the U.S. The reason is that the U.S. has been benefiting from the fact that it obtains large returns on so-called "intangible assets" invested through U.S. companies abroad and receives a higher yield on its financial investments in emerging markets than foreigners obtain from investing in U.S. Treasury securities.

Thus the U.S. derives two benefits from the current global imbalance. It can sustain the domestic debt-financed consumption splurge despite a spiralling current account deficit with financing from abroad. This ensures that U.S. income and employment growth remains reasonable despite its loss of manufacturing competitiveness. It can partly neutralise the effects of the worsening deficit on account of trade in merchandise with a surplus on the services and investment income accounts, by using capital inflows to sustain investments abroad.

Under normal circumstances, those countries that finance this "virtuous deficit" of the U.S. should have put a stop to this trend with adverse consequences for that country. But they too are dependent on the U.S. market and U.S. buoyancy to sustain their growth. Across countries and regions the evidence is one of large or overwhelming bilateral trade surpluses with the U.S. Most recently China reported that its trade surplus with the U.S. rose to $114.2 billion in 2005, up from $80.2 billion in 2004. Exports to the U.S. rose by over 30 per cent to $162.9 billion and imports totalled $48.7 billion. Dependence of that kind ensures that no one is willing to do anything to rock a boat, which threatens to, but never actually does, spring a leak.