The financing of the US current account deficit

2004 Current account deficit: $666 billion

2004 Net FDI outflow: $133 billion

2004 Net portfolio equity outflow: $63 billion (TIC data); $37 billion (BEA) data. The difference seems to stem from different treatment of equity purchases related to mergers and acquisitions.

Is the US an attractive destination for foreign investment? Well, not for equity investors. American citizens invested more outside the US than foreigners invested in the US, and American citizens bought more foreign stocks than foreigners bought American stocks. Equity outflows added to the amount of debt that the US needed to issue to finance its current account deficit.

In broad terms, roughly $890 billion in net external debt issuance by the US financed the $666 billion current account deficit, $170 billion in equity outflows, and $57 billion in net outflows from banks and non-bank financial firms.

The outflow from "banks and non-bank financial firms" probably is linked to hedge fund activity in Caribbean: US banks and broker-dealers extend credit to a Caribbean based hedge fund to buy US securities. That does not generate any net financing for the US.

The sums add up a bit too well, in part because I cheated. The net debt issuance data comes from the TIC, other data from the BEA. If I just used the BEA data, there would have been a decent error term. Errors and omissions are a fact of life in the balance of payments.

But the basic point is pretty clear: Equity investors, on net, prefer to invest elsewhere, so the US relies on debt, big time, to finance its current account deficit.

Warning: the remainder of this post is long and wonky.

Who is buying most of this debt: foreign central banks, of course.

The US reports $358 billion in inflows from foreign central banks -- an amazing sum, and more than enough to finance a decent chunk of the US current account deficit.

But that no doubt the $358 billion in reported central bank financing understates the United States real dependence on foreign central banks.

Global reserves went up by around $700 billion in 2004. Let’s assume $80 billion of that is just the higher valuation of existing euro and yen reserves. That leaves $620 billion in new reserve purchases. If only $358 billion (57%) went to the US, $262 billion (43%) went into euros and yen. Since Japan added $177 billion to its reserves, mostly in dollars, that kind of ratio would imply that other central banks were diversifying their reserve portfolio in a big way ...

I don’t think that happened. Europe got some money from foreign central banks, but not anything like $260 billion.

Nouriel and I estimated overall dollar reserves increased by $460-470 billion in 2004, implying $150 billion in new purchases of euro and yen reserves. Stephen Roach thinks the right number is closer to $500 billion, leaving about $120 billion for new euro and yen reserve purchases.

Either way, foreign central banks played a big role in the financing of the 2004 US current account deficit. True, foreign private investors bought something like $400 billion of US debt and $25 billion of US equities, but US private investors also took a fair amount of money out of the country. If the world’s central banks added between $470 billion and $500 billion to their dollar reserves, on net, the private sector only financed around $195-165 billion of the total current account deficit.

This is not all that hard to figure out if you start by noting that the world’s central banks added $700 billion to their reserves, and work backwards, rather than by starting with the US data.

That is why I was slightly disappointed with this speech by Ragu Rajan, the IMF’s chief economist. If any institution is well placed to track global reserve accumulation, it is the IMF. Yet rather than emphasizing central bank financing, Rajan goes to great lengths to minimize it.

Rajan argues that the US deficit is financed primarily by private investors:

"Overall, the bulk of US assets sold to foreigners are still [sold] to the private sector. That may come as a surprise to some of you who believe that the US current account deficit is being financed by foreign central banks ... the [foreign official sector] still only amount to about one-third of the total gross inflows into the US. ... It is therefore entirely correct to say the US current account deficit is more than fully financed by foreign private investors while US private investment abroad is partially financed by foreign central bank investment in the US."

Rajan is right in a sense: it is impossible to say whether a dollar from a foreign central bank is financing a dollar of the US current account deficit or a dollar of US investment abroad. And, according to the BEA, US direct investment abroad and US purchases of foreign equities totaled $341 billion in 2004. That is about the same as the reported reserve financing ($358 billion).

Still, I think this argument is somewhat misleading.

Here is why.

Let’s take the broadest possible definition of foreign capital inflow into the US, i.e. look at gross inflows and net nothing out.

In 2003, foreigners invested $818 billion in the US, and Americans invested $283 billion abroad. Central bank dollar reserves increased by around $485 billion, including the money transferred to China’s state banks. Consequently, by my calculation, the increase in foreign central bank reserves explains more than 1/2 of the total inflows into the US in 2003.

In 2004, gross inflows into the US surged to $1433. Gross outflows also rose to $818 billion. So Rajan is right in a sense, even if you don’t use the US data. Total dollar reserve accumulation of around $500 billion would only explain about 1/3 of the total gross flows to the US.

But does it make sense to look at the gross flows without making any adjustments? I would say "no."

Why did gross flows (both inflows and outflows) surge in 2004? Largely because "claims by US banks and non-banks on foreigners" increased by $425 billion, and the "Claims by foreign banks and non-banks" on the US increased by $482 billion. However, the two lines almost offset each other. It is not a coincidence -- the world’s private banks typically don’t finance a country like the US.

Let me put it differently: If Europe’s private banks were extending a huge credit line in dollars (unhedged) to finance the US current account deficit, Europe’s bank regulators would be very, very worried. Extending a large line of credit in dollars to the US is far too risky for a private bank; they leave that business to the world’s central banks ...

In 2000 and 2001, net flows from banks and non-banks were close to zero. In 2002 and 2003, the US did get some financing from the world’s banks -- the flows did not offset. Why? One simple explanation, particularly for 2003: The Bank of Japan was adding to its reserve very rapidly then, and it used the surge in reserves to build up its bank accounts. The banks then lent out the dollars deposited by the bank of Japan, generating net new financing for the US.

What happens to the 2004 data if we net out the flows from banks and non-bank financial institutions?

Inflows to the US then total $1007, and outflows total $335 billion --that looks a bit more like the 2003 data. Not coincidentally, the difference, $672 billion, is close to the 2004 US current account deficit. Like I argued, the bank and non-bank flows offset each other. (If anyone wants to make an argument that the bank and non-bank flows just happen to offset, and they should be counted, please do -- I would be quite interested)

Afternetting out the bank and non-bank inflows, central banks accounted for nearly $500 billion of them of the $1007 billion in total inflows-- or about half. That is a lower portion than in 2003, but it is still not small.

Rajan’s argument is, I think, misleading in another sense.

Significant gross private inflows into the US are nothing new. They do not necessarily provide large amounts of net financing; private inflows into the US are often offset by outflows by private US investors. Offsetting flows are part of the ongoing cross-border diversifiction of savings and investment. Sometimes, of course, private inflows and outflows do not offset. In the late 1990s, a surge in private inflows from abroad was not offset by a surge in outflows by US investors, so that surge financed the expansion of the current account deficit. However, recent deficits, particularly the 2003 deficit, were financed above all by a surge in central bank reserve accumulation - not by a surge in private inflows.

Moreover, as Nouriel and I have argued, some private investment in the US is influenced by expectations about central bank action. So long as Japanese private investors believe the MOF and Bank of Japan will keep the yen from rising (the dollar from falling), they are willing to invest in the US to pick up higher yields than possible in Japan. Get rid of the exchange rate guarantee, and it might be another ball game.

Now private investors do still hold the bulk of the United States total external liabilities; total US external liabilities probably reached $12 trillion in 2004 (v. $8.7 trillion in assets), and only around $2.5 trillion of all US liabilities are owed to foreign central banks. And unless foreign central banks step up the pace of their reserve accumulation, private investors will play a bigger role financing the 2005 US current account deficit than they played in 2004. Of course, given the windfall the oil exporters are enjoying with oil above $50 a barrel, a lot of that "private investment" will be coming from the gulf’s oil sheiks ...

Rajan downplays the role of central banks a bit too much. Central banks are adding to their claims on the US more rapidly than the private sector. And their actions influence the actions of private investors. They are big, big players in the market. Their impact on the market, in my judgement, is very real.