US Current Account Deficit

There as been an interesting debate going on for the past decade about the burgeoning US current account deficit. Even as the world is accumulating savings at a frenetic pace, America is busy consuming it. In March 2005, Ben Bernanake, famously suggested that the world was suffering a "global saving glut". Asian Central Banks have been buying into dollar assets, especially US Treasury Bonds, with a voracious appetite. Ken Rogoff of the Harvard University called this massive influx of funds from the emerging economies as the "biggest foreign-aid programme in world history", with Asian Central Banks subsidizing American consumption and housing boom. How do we explain this twin phenomenon of "savings glut" across the world and the run down on savings in the USA? (the American household now saves less than 1% of their disposable income)

The US current account deficit stood at a very high 6.1% of the GDP or $856.7 bn for 2006-07. In fact, the trade deficit for 2006-07 stood at $827 bn. In contrast Japan had a current account surplus of $181.5 bn or 4% of GDP, China $249.9bn or 8.1%, Germany $165 bn or 4.9%, and Saudi Arabia $95.4 bn or 18.2%. The entire South East Asian bloc, excluding China and Japan, had current account surplus of over $150 bn for the period. The oil exporters have been running up surplus of over $500 bn annually. Execpt for Britain, France and Spain, every other major economy was running current account surpluses. The Euro area has also been continuosly running current account surplus. Trade surplus is the norm across the world.

Consequently, the Chinese foreign exchange reserves touched $1.2 trillion in April 2007, while Japan's reserves were $916 bn, Euro Zone had $451 bn, Russia $267 bn, South Korea had $247 bn, and India $204 bn. At the end of 2004, of the official foreign exchange reserves of all the countries, 66% were denominated in dollars, and 25% in euros.

Except for a couple of East Asian and Latin American economies, the consumer price inflation was at a historic low of 1-3% range. Unemployment figures have varied between 4-5% for the US over the past couple of years. Except for Japan, the 10 year Government Bond rates have been in the 4-5% range in all major developed economies, in the recent few years, the lowest since the 1960s. The global economy has been also growing in the 4-5% every year for the past few years.

We therefore have a high savings, high surplus, high growth Asia excluding Japan; high savings, high surplus, but low growth Japan and Germany; and a low saving, high deficit, and robustly growing America. The "savings glut" of Bernanke has coincided with a drop in investment across the world, except China, all the more surprising given the historically low interest rates and high economic growth rates.

China is in a league of its own. It has grown at around 10% annually since 1990. Its Gross Domestic Investment rate at 46% in 2006 is phenomenal and its Gross Domestic Savings rate at 50% is unprecedented, and continues its growth unabated. The Yuan, despite a slight relaxation in the band in July 2005, continues to be heavily supported with open market intervention by the Central Bank, and is undoubtedly under valued.

The other major story has been the oil exporters. Buoyed by the steep rise in oil prices and chastened by their reckless spending spree from previous oil booms, the oil exporters have been investing this windfall to form an oil stabilisation fund and the like. The growing savings in other emerging economies like India is understandable given the robust economic growth and productivity gains seen in the past decade.

Where have all these savings been going? The world has huge savings to invest, and America wants those savings. Ideally, I would like my investments to fetch good rates of returns and also be protected from any exchange rate risks. But these savings are going into the cheap US Treasury Bonds which are at historic lows, and faced with the spiralling current account deficit the dollar has been sliding, thereby further reducing the returns. But the massive flows from the rest of the world to the US continues, turning conventional economic wisdom on its head.

The Asian Central banks have been liberally deploying these huge savings to hold down their currencies by buying huge amounts of US Treasury Bonds.The windfall from the rise in petrol prices has also found its way into the US T-Bonds. Further, faced with the "savings glut", these economies have realised that their financial systems do not have the breadth nor the depth required to effectively manage these huge amounts. In the circumstances, emerging market Central Banks naturally find the US Government securities the safest bet, even with its low returns. Also dollar assets have another advantage in that they are much more liquid. As on March 2007, foreigners held US T-Bonds worth $2.2 trillion, of which China held $420 bn Japan $612bn, and oil exporters $113 bn.

There is a substantial body of opinion in the US that lays the blame for the deficit problem on China and its policy of deliberately holding down the yuan. They point to the huge Chinese trade surplus with the US and how it is causing a weakening of the dollar. The supply siders also blame the stagnant consumption, especially in Japan, Germany and parts of Euro zone. Bernanke himself subscribes to the view that the American deficit problem is not "made in the USA" and therefore has to have solution externally, in its originators. This supply side argument has its weaknesses. China and Japan account for less than 40% of the US current account deficit. Further, US takes only one-fifth of the Chinese exports. The US current account deficit has grown by more than five times the growth in the Chinese current account surplus. In fact, in pure numbers alone, the oil exporters have contributed a much larger share to the growth in the US deficit than the Chinese. Ultimately the fact remains that the massive inflow continues because there is an insatiable demand from the US consumers, and it will continue as long as that is not satiated. The "not made in the USA" logic is something akin to controlling prostitution by banning prostitutes without simultaneously addressing the demand.

The more interesting explanation for the rising deficit is the demand side one. The past couple of decades have seen historically low interest rates, unprecedented trade liberalisation, and active use of expansionary monetary and fiscal policy by the Government. All this has led to a massive spurt in imports from not only China but also from other East Asian economies. The historically low interest rates, coupled with low inflation and the huge variety of easy money generating financial instruments like flexible mortgage loans and its aggressive marketing by finacial institutions, sparked, in Greenspan's words an "irrational exuberance", spawning massive asset bubbles, first in shares and then in real estate. Unlike previous bubbles, which were confined to only certain sections of the society, these bubbles attracted a significant share of the population, and generated an "income effect" for them. Buoyed by this "wealth effect", the people started running down their savings and indulging in a huge spending spree, thereby generating the consumption boom. With interest rates at a historic low and housing equity liquid and easily accessible, Americans have completely given up saving on current incomes.

The massive tax cuts of George Bush in the early years of the millennium, the largest post-war fiscal largesse, and the decade-long loose monetary policy of Alan Greenspan meant that the Government policies were actively feeding the binge boom. In fact the irresponsible tax cuts of the Bush administration has compounded the problem by turning the budget from a massive surplus to ever growing deficits. The end result is that except for the private sector, all other sectors of the American economy are running growing deficits.

There is another school which interestingly finds nothing wrong with the rapidly growing deficit. They see it a sign of America's strength that foreigners want to have a share in the world's greatest economic machine. They even consider that this deficit has been the engine that has kept the world economy afloat at a time when the Japanese and European economies were in recession. They contend that without the generosity of the American consumers, China could not have sustained its spectacular boom and the East Asian economies could not have so quickly emerged from the crisis of the late nineties. They also point out that the US annual borrowing of $850 bn is nothing compared to the American household wealth of over S35 trillion. But this household wealth itself is built on the dubious and illusory foundations of a stock and real estate bubble.

They also say that American borrowing is unlike those of others, given the unique status of dollar, as the world's reserve currency. In contrast to other countries who borrow externally, America can issue bonds on its own currency. All its external liabilities are dollar denominated, whereas the major share of its assets are foreign currency denominated. at a time when dollar is weakening with respect to other currencies, the Americans would enjoy double benefit from both falling real value of its debt and rising dollar value of its assets.

So where does this all this leave us? It is only a matter of time before the Asian and the oil exporting countries start looking for higher returns on their investments. (In fact, China recently entered into an agreement with Goldman Sachs, paying it $3 bn, for managing a part of its massive foreign exchange reserves) But given the deep legacy of the recent stock and real estate bubbles, driven by massive borrowings, America cannot hope to raise its interest rates to provide higher returns, without creating a serious run on its over-loaned financial system. It is also clear that the East Asian and oil exporting nations cannot easily pull out their huge investments from US T-Bonds without huge repercussions, which will primarily hurt them. Any frenzied withdrawal could send the dollar into a tailspin and lead to huge fall in the values of these investments. For the US economy itself, this would spark off interest rates hikes and a meltdown. We could then have a classic Ponzi scheme unravelling, with both the US and the global economy tanking into a recession or even worse. The best that the Federal Reserve can hope is to manage the financial system for a soft landing.

In fact, faced with depreciating dollar, the Central Bankers have already realised the need to slowly reduce their exposure to the US market, and consequently the pace of reserve accumulation has already started slowing down, except with the Bank of China. China will also have to slow down its purchases of dollar, as inflationary pressures mount. The strengthening Euro has become an attractive investment option for many Asian Central Banks. The rebounding Japanese economy has also attracted investments in Yen denominated assets. Further, with the rapid evolution of the financial sector in these emerging economies and the arrival of sophisticated and safe financial instruments, these countries will no longer need to look outside for parking their burgeoning savings.

The unfortunate thing about the massive influx of foreign money is that it has gone into financing America's consumption and housing boom and its reckless fiscal bonanazas for the rich, rather than into any productive investments. The private sector investment has not grown at the rate necessary to offset the profligacy at the other side. Chastened by the massive investment binge in the 1990s, the corporate spending as a share of GDP is at its lowest in a quarter century, thereby keeping the exports sector dull.

So what is the outlook? It looks bleak to say the least, and we will need a miracle to prevent a hard landing. With net external debt of nearly $4 trillion at the end of 2006-07, America will eventually have to generate more internal savings and/or run up external surpluses to pay off its huge outstandings. This will require Americans to sharply cut down their consumption (which in turn poses other risks) and also increase savings. The private sector will have to increase the historically low investment rate, so that exports can be boosted. Given the grim deficit scenario, it is a fait accompli that America will need its exports to grow steeply to start repairing the damage. And it will have to start immediately. The depreciating dollar will surely help.

What will America need to stave off a hard landing? Internally, American households will have to start saving more and its corporates will have to start investing more, especially for the export sector. Exports will have to start growing. Inflationary pressures will have to be kept under check, so as to contain interest rate rises and further fall in dollar. The Government will have to repsond with fiscal rectitude and turn around to a surplus and immediately at that. The irrepsonsible tax cuts will have to be rolled back and pork-barrel curtailed. The real estate bubble will have to be deflated so as to achieve a soft landing that would not adversely affect the financial sector. This in turn again requires the interest rates to not harden too much.

Externally, continuing cheaper imports of manufactured goods from China and the rest will be of great help in keeping prices under control. Japan and Germany will have to start consuming more and saving less, so as to provide market for US exports. Hopefully the dollar continues to remain weak, without however precipitating any drastic fall in confidence or run downs on the dollar. The Asian and Middle Eastern Central Banks will have to remain persuaded to not start withdrawing their investments in a frenzy at any time. The exit will have to be managed carefully. The financial sector in the emerging economies have to develop quickly in its breadth and depth.

Now in real life, common sense dictates that however credit worthy I am, there is a limit to how much I can borrow or will be lent by bankers. In other words, I cannot live beyond my means for long periods of time. With great luck, I may be able to fool all my creditors for some time, but only for some time. Then the chickens come home to roost! It will require a near miracle for both the US and the rest of the world to come out of this mess!