The U.S. current account deficit continued to widen in the
second quarter. Not only did the deficit in the trade balance, which records
exports and imports of goods and services, grow larger, but the deficit in the
income balance also widened a bit and unilateral transfers abroad increased.
However, the incipient stabilization in the real trade balance, which measures
volumes of exports and imports, is a hopeful sign. If history is any guide, the
current account deficit could begin to narrow later this year or early in 2007.
Although the current account deficit could begin to narrow,
we continue to project generalized dollar depreciation over the next year or
so. Foreign purchases of U.S. assets have weakened somewhat over the past two
quarters, and we look for further declines going forward. U.S. assets should
lose some of their relative attractiveness as interest rate differentials
between the United States and the rest of the world narrow further. We believe
that the Fed's tightening cycle has come to an end, and the FOMC will cut rates
early next year. In contrast, many foreign central banks have more tightening
to do simply to return monetary policy to more "neutral" settings.
Some analysts warn that a dollar "meltdown" is in
store, but we think the probability of that eventuality is rather low. A
disorderly drop in the dollar's value could occur if the ability of U.S.
borrowers to honor their foreign obligations were suddenly called into
question. In our view, however, it would take a massive disruption to the U.S.
economy, such as a crippling terrorist attack that shook the U.S. economy to
its very foundation or a catastrophic natural disaster, to lead to a stampede
of foreign capital. The most likely scenario, at least in our view, is one of
modest dollar depreciation over the next year or so.
Current Account Deficit Widened a Bit, but Is Stabilization
Just around the Corner?
The U.S. current account deficit in the second quarter was
the second largest on record.
As shown in Exhibit 1, the U.S. current account deficit
widened from $213.2 billion in the first quarter of 2006 to $218.4 billion in
the second quarter, the second largest deficit on record. Previously released
monthly trade data had already showed that the deficit in trade in goods and
services, which comprises the vast majority of the overall current account
deficit, had widened by about $2.7 billion in the second quarter.
Exhibit 1
The United States will likely post another record deficit
this year, but it may soon begin to narrow.
The bad news is that the United States will likely register
yet another record deficit this year. Last year, the red ink in the current
account totaled $792 billion. This year, the current account deficit is on pace
to hit $860 billion, about 6.5% of GDP. The good news is that the deficit may
top out this year. Exhibit 2 shows monthly trade deficits in both nominal and
real (i.e., volume) terms. The nominal trade deficit continues to widen, which
is consistent with the increase in the overall current account deficit. Not
only have higher oil prices pushed up the value of petroleum imports this year,
but the dollar's depreciation since the end of 2005 may also be inflating the
nominal trade deficit. This socalled "J-curve effect" occurs because
trade volumes change slowly. In the meantime, dollar depreciation means that it
takes more dollars to buy a given volume of imports.
However, the real trade deficit appears to be stabilizing.
Indeed, the volume of goods and services exports in the second quarter was up
8% relative to the same period in 2005, but import volumes grew only 6.2%. In
the mid- to late 1980s, the last time that the U.S. current account deficit
narrowed significantly, the turnaround in the real trade deficit preceded the
diminution in the nominal trade deficit by about six quarters. Looking forward,
we expect that the current account deficit will top out this year before
narrowing somewhat next year. If our forecast of slower growth in U.S. domestic
demand is correct, then import volumes should decelerate further.
Exhibit 2
Are Foreign Investors Becoming Less Enamored with the U.S.
Economy?
A current account deficit, which means that a country spends
more than it produces, needs to be financed by capital inflows from the rest of
the world. In the case of the United States that means net capital inflows must
total roughly $860 billion this year, or nearly $3.5 billion every business
day. Although the red ink in the current account may decline somewhat over the
next year or so, will foreign capital continue to pour into the United States
in sufficient quantities to finance the deficit?
Foreign purchases of U.S. assets are beginning to weaken.
There already are signs to suggest that capital inflows are
beginning to weaken somewhat. Although foreign direct investment in the United
States remains rather solid at around $50 billion per quarter, Exhibit 3 shows
that foreign purchases of U.S. securities have weakened for two consecutive
quarters. Interest rate differentials between the United States and many
foreign countries narrowed over the past few months as investors began to
anticipate the end of the Fed's tightening cycle. In contrast, most market
participants look for further tightening from many foreign central banks.
Narrowing interest rate differentials have reduced the relative attractiveness
of U.S. securities.
That said, foreign investors are hardly boycotting U.S.
securities at present. Exhibit 4 shows that foreign investors purchased a
whopping $908 billion in the 12 months through July. According to popular
perception, the U.S. current account deficit is financed largely by foreign
central banks, especially those in Asia. Like many popular perceptions, this
one is not supported by the facts. Purchases of U.S. securities by the foreign
official sector, essentially foreign central banks, totaled $126 billion over
the past 12 months. Although this amount is not insignificant, it pales in
comparison to purchases of U.S. securities by the foreign private sector.
Exhibit 3
The tax-law induced repatriation flows that helped to
support the dollar last year have disappeared this year.
Not only do foreigners buy U.S. assets, but U.S. investors
also buy foreign assets. Increased capital outflows, everything else equal,
would cause the dollar to weaken because U.S. investors generally need to
obtain foreign currencies to buy foreign assets. As shown in Exhibit 5, U.S.
purchases of foreign securities are running just north of $50 billion per
quarter at present, up a bit from the $45 billion per quarter that was averaged
in 2005. U.S. foreign direct investment abroad, which appears to have collapsed
in the second half of last year, has come roaring back. Actually, the apparent
collapse last year had more to do with tax law changes than anything
fundamental. A temporary change in the tax paid on foreign profits led to
massive repatriation that showed up in the balance of payments as negative
foreign direct investment. Indeed, repatriation flows may have helped to boost
the dollar last year, and their subsequent end this year may be one of the
reasons why the greenback has trended lower since the beginning of the year.
Exhibit 4
Exhibit 5
Conclusion
We project that the dollar will depreciate modestly over the
next year or so.
Although the U.S. current account deficit may narrow
somewhat in the quarters ahead, we believe that foreign purchases of U.S.
assets, which have started to weaken, will decline further in the months ahead.
We project that the Federal Reserve's tightening cycle has come to an end, and
we look for the FOMC to cut rates early next year.2 We also believe that many
major foreign central banks have a few more rates hikes up their sleeves, and
narrowing interest rate differentials should further reduce the relative
attractiveness of U.S. assets. Further declines in net capital inflows, in
conjunction with a current account deficit that narrows only slowly, should
exert modest downward pressure on the dollar (see Exhibit 6).
Exhibit 6: Forecast of Dollar Exchange Rates
Currency 06-Q4 07-Q1 07-Q2 07-Q3 07-Q4
Euro ($/€) 1.32 1.34 1.36 1.38 1.39
U.K. ($/£) 1.93 1.95 1.96 1.98 1.99
Switzerland (CHF/$) 1.20 1.18 1.17 1.16 1.15
Sweden (SEK/$) 6.95 6.80 6.65 6.50 6.45
Russia (RUB/$) 26.20 25.80 25.40 25.00 24.60
South Africa (ZAR/$) 7.50 7.60 7.70 7.80 7.90
Turkey (TRY/$) 1.50 1.52 1.54 1.56 1.58
Japan (¥/$) 112 108 104 100 98
Australia (US$/A$) 0.78 0.79 0.80 0.81 0.81
China (CNY/$) 7.85 7.80 7.70 7.60 7.50
India (INR/$) 45.60 45.20 44.80 44.50 44.30
Korea (KRW/$) 930 920 910 900 890
Singapore (S$/US$) 1.54 1.52 1.50 1.48 1.46
Taiwan (TWD/$) 32.25 31.75 31.25 31.00 30.80
Canada (C$/US$) 1.10 1.08 1.07 1.06 1.05
Mexico (MXN/$) 10.70 10.60 10.55 10.50 10.45
Brazil (BRL/$) 2.20 2.25 2.30 2.35 2.40
Some analysts contend that the dollar will depreciate much
more sharply and significantly than our forecast projects. Although it would be
foolish to cavalierly dismiss the risk of a dollar "meltdown", we
think one is rather unlikely. A dollar "meltdown" would occur if
foreign investors started to question the ability of U.S. borrowers (consumers,
businesses and the government) to honor their obligations. Wholesale selling of
U.S. securities, whose dollar proceeds would quickly be converted into foreign
currencies, would put significant downward pressure on the greenback.
In our view, the probability of a dollar
"meltdown" is rather low.
In our view, however, it would take a massive disruption to
the U.S. economy, such as a crippling terrorist attack that shook the U.S.
economy to its very foundation or a catastrophic natural disaster, to lead to a
stampede of foreign capital. The U.S. capital markets are the broadest, most
liquid and most transparent financial markets in the world and, short of an
unforeseen disaster, foreigners seem quite willing to put money to work in the
United States. There was no massive outflow of foreign capital after 9/11, and
the dollar remained generally stable in the weeks after that event. If the most
catastrophic terrorist attack in U.S. history does not trigger a dollar
"meltdown" we're not sure what would.
Couldn't foreign central banks cause a run on the dollar?
After all, the value of Japan's foreign exchange reserves total about $860
billion at present and China's reserves are closing in on $1 trillion. If a
U.S.-Sino political spat developed, couldn't China start dumping its dollar
reserves to pressure the United States? In theory, yes, but we do not place a
high probability on that eventuality. China has about as much interest in a
dollar crisis as the United States does (i.e., little interest). A dollar
crisis would trigger a recession in the United States, which would put a
serious dent in China's exports. Economic growth in China would slow, causing
unemployment to rise and, with it, the risk of social instability. Chinese
leaders simply do not want to go there. Japanese leaders also have little interest
in a dollar crisis.
China and Japan would likely help to prop up the dollar if
it came under significant selling pressure again.
If anything, the Chinese and Japanese governments would
probably buy even more Treasury and agency securities if the dollar started to
slide significantly again. Returning to Exhibit 4, purchases of U.S. assets by
the foreign official sector rose significantly in late 2003/early 2004 when the
dollar was encountering serious selling pressure. Indeed, the central banks in
China and Japan intervened massively in the foreign exchange market during that
period to help prop up the dollar, and they would likely do so again if the
greenback started to weaken significantly. In sum, we believe the greenback
will depreciate modestly over the next year or so, but we think the probability
of a dollar collapse is rather low.
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