In a speech in 2004, then Federal Reserve Chairman Alan Greenspan said: "It is difficult to imagine that we can continue indefinitely to borrow savings from abroad at a rate equivalent to 5% of U.S. gross domestic product." Well, by the third quarter of 2006, the U.S. was dependent on foreign lending to the tune of more than $860 billion, or about 6.5% of gdp, and the need for foreign money will most likely hang above 6% through 2007. The big question: Can the U.S. continue to count on this massive amount of foreign capital to fund its overseas obligations and finance its economic growth?
The question seemed especially urgent after the Treasury Dept.'s eye-opening report that net inflows of foreign capital into long-term U.S. securities fell to only $15.6 billion in December. It was the skimpiest monthly total in almost five years. Consider that during all of 2006 the U.S. needed, on average, more than $70 billion a month in foreign funds to finance its current account deficit, made up mainly of the trade deficit, along with net investment income that the U.S. owes to foreigners and certain government transfers.
The greatest potential vulnerability lies with the U.S. dollar and its role as the balancing agent between the financing needs of the U.S. and the willingness of foreigners to supply those funds. The fear is a sudden plunge in the greenback. The U.S. will always obtain the foreign financing it needs, but what level of the dollar will it take to attract those funds? U.S. indebtedness is a key reason why the dollar has already declined 27% against a basket of major currencies since early 2002.
THE SHARP FALLOFF in December capital inflows does not appear to presage any serious trouble, but a drop of that size bears watching in coming months. The monthly Treasury data are subject to big swings from month to month, and for all of 2006, foreign funds flowing into long-term U.S. securities totaled $896 billion, more than enough to cover the red ink in the current account deficit.
The December drop came as the U.S. continues to face a dearth of homegrown savings. That's pressure enough on the U.S. to draw in the capital it needs. But against this already shaky backdrop, two new trends are emerging that add even more weight on U.S. finance and the dollar.
First, there is increasing evidence that foreigners are diversifying their assets away from dollar-denominated securities toward other currencies. China, for example, recently announced it is forming a new agency to diversify $200 billion of its $1 trillion in foreign exchange reserves. Emerging-market economies are beginning to discover that U.S. investments, while relatively low risk, are also relatively low return compared with other investment opportunities around the globe.
FOR NOW, AT LEAST, the impact of these diversification efforts, while potentially harmful to the dollar, are less than clear. For example, even if China diverts $200 billion from U.S. assets, it will continue to amass about that much each year as a result of its trade surplus and incoming direct investment, notes Donald Straszheim at Roth Capital Partners. Nevertheless, countries from opec to Asia are taking a second look at their international portfolios, and the trend is certain to place further downward pressure on the dollar.
A second new threat is homegrown: Chances of outright protectionist measures, such as tariffs, appear to be rising. The new Democratic Congress shows signs it will be far more activist on issues affecting trade, especially with China and countries that manipulate their currencies to gain a competitive advantage.
After several months of good news on the U.S. trade deficit, the December gap widened sharply, to $61.2 billion, up from $58.1 billion in November. That rise brought the annual deficit to $764 billion, with bilateral gaps with China, the European Union, and Japan, respectively, making up 30%, 15%, and 11% of the total.
Given the competitive pressures on U.S. producers, especially automakers, from the weakness in the Chinese yuan and the Japanese yen, companies are sure to be more aggressive in pressing lawmakers for relief. The House of Representatives leadership has already given the White House 90 days to present Congress with a plan to address several trade issues involving China, Japan, and the European Union. The implication is that after 90 days, it will come up with its own plan.
Any U.S. action that reduces Chinese imports, however, also will result in less foreign exchange for the Chinese to invest. That could make the Chinese less interested in the auctions of U.S. Treasury securities. China is second only to Japan as the largest holder of U.S. Treasury issues.
THE CORE OF AMERICA'S NEED for foreign capital lies in its lack of domestic savings. That savings pattern seems likely to continue for a long time, given the long-term pressure on the federal budget and the current downtrend in personal savings.
For example, in the third quarter of last year, net private saving by U.S. consumers, businesses, and governments totaled $224.9 billion. The retained earnings of U.S. businesses accounted for all of that and more. The household and the government sectors were both net drains on U.S. savings. Households actually spent $111.7 billion more than they earned in the third quarter, and the personal savings rate for all of 2006 was negative for the second year in a row, something that hasn't happened since the Depression years of the 1930s. Plus, the federal government's outlays in the third quarter exceeded its receipts by $165.6 billion.
In fact, U.S. savings financed only about one-quarter of last year's U.S. net investment, which excludes the outlays needed to replace depreciated equipment, buildings, and such. Foreigners supplied the remaining three-quarters. The savings issue is critical, in part, because investment is the lifeblood of future economic growth, and that growth requires savings, whether they are homegrown or borrowed from abroad.
The U.S. will continue to receive a large share of the world's excess savings, especially from those developing economies that don't have financial institutions and market systems to allocate their huge foreign exchange reserves to domestic uses.
However, the dollar will remain vulnerable, especially as the U.S. faces the enormous financing requirements created by the retirement and health-care needs of the baby boomers. In the near future, the U.S. will require either ever more foreign capital or an increased rate of domestic savings.
Absent the latter, the U.S. is sure to eventually bump up against its foreign borrowing limit. The day of reckoning will be at the point when foreigners demand more for their money, either through a weaker dollar, higher interest rates, or both. On the way there, any more reports of waning interest in U.S. securities are likely to attract much more attention in the currency markets, to the detriment of the greenback.
By James C. Cooper