A gift that keeps on giving

A current account deficit

As discussed in our Global Trade note, a current account deficit (or a surplus) is a mix of merchandise and services flowing in- and out of any country

It is a good thing if the economy is booming and cannot provide all the domestic consumer demands or the total volume of investments local business requires – imports provide for the short fall. In fact, a country’s trade deficit often falls when the economy falters because consumer demand and investments drop as well

It is a bad thing if domestic business is systematically undercut by unfair competition by foreign trade such as dumping practices

And because a mix could often be both a good thing and a bad thing, international trade agreements provide for procedures to evaluate and seek redress in cases of unfair competition

Unilateral decisions to curb a deficit, usually made ‘across the board’ by a government, will unsurprisingly mix imports of products the consumer demands and the business investment requires (the good) and imports of those products competing unfairly on the market (the bad)

As of mid-2018, with the US economy running strongly, the shortfall in consumer products and equipment for industry is not a probability – it is a certainty because the domestic manufacturing and service industries cannot run above capacity for very long

Intuitively, we know that – when the economy heats up and additional products or services are not available at the usual prices – scarcity will lead to higher prices under the combined effect of tariffs on the imports and competing demand for the domestic products

Prices will go up and some of the domestic demand will be squeezed out – at consumer level because higher prices may not be affordable for some and at investment level because the business project may turn out to be unattractive at the higher cost

These simple observations are not really questioned by anyone and we challenge the most fervent protectionist to prove us wrong

However, all countries - bar one - have to pay attention to the current accounts because, over time, even though the timeframe may be flexible, the balance between imports and exports has to be secured

Capital flows balance current account deficits

Unsurprisingly, because a trade deficit automatically implies that the country is exporting less goods and services than it is importing for consumption and investment, the yearly deficit has to be financed somehow to balance year-by-year the sum of all current account payments in and out of the country

There are 3 sources of finance to be tapped to do so

And only 3 because no alternative sources of finance are available

• Private (non-governmental) savings – what is held privately after consumption expenditures and investment
• Government ‘overshot’ – the budget ‘surplus’
• Capital inflows originated outside the country – such as dividends or profits from foreign subsidiaries of domestic companies or capital transfers by foreigners

Private savings are the savings of the private sector (consumers and businesses) after taking consumption, investment and taxes into account

Government ‘overshot’ is – well – rare… and in fact the financing of government deficits will compete with businesses by borrowing a share of private savings, 'crowding out' business investment in the process

Capital inflows are a mixed bag as defined above, but a substantial part of this inflow, transferred by foreigners is an ‘I owe you’, a promise the capital inflow will be made good in the future, helping avoid a balance of payment crisis

Part of these IOYs will actually be spend on investments in the country, contributing to increase its production capacity and not redeemed (at least not immediately, as the investments run their course!)

All countries bar one …

That country is the US and the country is in a unique situation

The country is running current account deficits persistently over time, without facing balance of payment crises,  because the positive capital account is induced by foreign US dollar holders

Recording dollar capital flows in and out of the US financial system, surpluses should be understood as investments made by foreign holders of dollars in the American economy (in the form of actual investments or of deposits in the American banking system)

In essence, this amounts to American individuals, businesses, and the government borrowing on balance from their foreign counterparts

source: tradingeconomics.com

As this happens, international trade, mostly led in US dollars, generates a dollar surplus in each of the global exporters

These dollar-denominated funds, deposited in non-US based banks, feed into the eurodollar market, which contributes decisively to financing international trade

• a fraction will be deposited in the US banking system as 'excess free reserves'
• the balance is loaned out across the international banking system

As the deposit/loan process repeats multiple times across the market (always staying in dollar currency), ever larger dollar liabilities are being created by this multiplier effect

To quote the Wall Street Journal (paywall), 

....the dollar remains so dominant. In the $5.1-trillion-a-day foreign-exchange market, the U.S. currency is on one side of 88% of all trades, according to the Bank for International Settlements’ 2016 survey. While its weight in foreign-exchange reserves has declined a little, it still accounts for 62.5% of the $10.4 trillion in allocated reserves identified by the International Monetary Fund

Regarding the capital account, the point is that inflows (into the US financial system) should not be viewed as funds 'borrowed' on the international market, as is the case for any other country required to balance a trade deficit, to cover a government deficit or to finance private investments by 'importing' capital

The US is different because the surplus countries deposit their dollar funds in the American system as a way of clearing their excess holdings (and fullfiling reserve obligations) - all the while these funds are not actually 'needed' in the US economy

The surplus capital account is an important (and maybe the main) driver in the complicated interaction with the current trade account, private savings and the Government budget

Because these accounts have to balance overall, the capital surplus deposited in the US economy will necessarily generate a deficit in either one of the other accounts (or in all of them...), stimulating imports in excess over exports in current accounts 

Consequently, it is reasonable to assume the trade imbalance of the US with foreign exporters of goods and services will stay as long as the US dollar is recognized as reserve currency, used in international trade the world over (not only for US trades)

If a country, such as China, decides to reduce its holdings in Treasury bills or in US dollars, China’s central bank will sell some Treasuries and convert some dollars in other currencies, mainly in euros or Japanese yen – to name two leading currencies

In other words, whichever way you put it, someone will accept the dollars (or the Treasuries) because of their value as reserve currency – in anticipation of a balance of payment crisis, an insurance of sorts

And if China can indeed sell some dollars and Treasuries, the monetary authorities of the country will keep in mind that, in a US dollar wholesale, they would probably push the dollar down and their own currency up by sheer effect of the volume – most certainly the reverse of China’s best interest, on top of the currency trading loss the Central Bank of China would have to endure

In summary, the US may indeed live ‘beyond their means’ on the basis of a traditional household account, but the US is not a ‘traditional household’ and is free of these constraints – more like a swaggering buyer, taking delivery of merchandise by writing IOY’s that will never be redeemed

Running current account deficits without concern for a balance of payments crisis, the US knows full well that the money paid out to settle its export shortfall balances its capital account surplus  

Viewed through this lens, the country ‘taking advantage’ is the US – distributing dollar IOY’s to willing foreign providers of goods and services – and the countries ‘being taken for a ride’ are all its trading partners

The primary objective of the US monetary authorities - and of the Administration - will be to maintain the unique privilege of minting the world's reserve currency

But the privilege is linked in no uncertain terms to the responsabilty of keeping the international markets liquid, a mission both indispensable and ambiguous ...as we discuss in a forthcoming note