The outsize current account deficit that the US economy has with the rest of the world had long been marked as an imbalance that needed to be fixed. The deficit fed itself on the seemingly insatiable appetite of foreign investors for US financial assets, the prices of which seemed to be powered by devices far more powerful than the anti-gravity devices of science fiction. In the normal course of events, theory suggests that when a country builds up ever-increasing trade deficits, the nations that provide the excess of goods and services should eventually tire of accepting IOUs.
In fact, this corrective mechanism would operate only when more or less equally placed markets are in competition and the financial markets in these markets move independently of each other. Such conditions have not obtained. For many years now, the US economy has grown quite amazingly while the advanced economies in Japan and Western Europe have fared between poor and modest growth. Thus, as has been facetiously, but accurately, said, the world economy was running on one engine, namely, the American consumer. To make matters more sticky, globalisation of financial markets and standardisation of valuation styles led the equity markets across the world to move synchronously, leaving investors with little choice for effective diversification. As a result, gross capital flows into the US greatly exceeded that which was required to finance its gargantuan current account deficit, the inevitable consequence of which was a strong and strengthening dollar, further perpetuating the process.
The buoyancy in world aggregate demand, so kindly provided by the US consumer, saw American imports of goods soar to $1,167 billion in 2002, as against exports of $683 billion. The current account deficit in 2002 was $503 billion, up from $393 billion in 2001. Gross capital inflows were $753 billion in 2001, which fell to $630 billion in 2002. The difference between these gross inflows and the current account deficit was the increase by US entities of their foreign assets, by $371 billion in 2001, which fell to $156 billion in 2002.
On the outflow side, it appears that US entities built up holdings of foreign securities and other claims through the banking system aggregating $238 billion in 2001, which in 2002 declined to an outflow of $29 billion. Thus, market players did indeed bet on the rebound of the depressed euro through 2001, anticipating and contributing to the currency realignment of 2002. Inflows from foreign central banks rose by $91 billion in 2002, while private inflows declined from $748 billion to $534 billion. Investment in corporate stock and bonds fell by $123 billion, while holdings with banks were down by $49 billion. But holdings of US treasuries were higher by $61 billion.
A notable feature is that between 2001 and 2002 there was not much change in the outflow of US foreign direct investment (FDI) at $124 billion, but such flows into the US sharply declined in 2002 by $101 billion to only $30 billion. Perhaps indicative of important differences in the character of these FDI flows.
What is quite remarkable is that these major changes in the capital account of the US, which have seen the euro go from 87 to 118 cents, an appreciation of 36 per cent, have yet to make much of an impact on trade volumes and balances. For the first quarter (Jan-Mar) of 2003, merchandise imports into the US rose by 14 per cent, while exports increased 4 per cent. In consequence, the goods trade deficit for the quarter was higher at $127 billion in 2003, compared to $97 billion for the same quarter last year. Curiously between February and March 2003, increase in imports from the Eurozone at 17 per cent was higher than for most other regions, such as Japan (9 per cent) and China (5 per cent).
The overhang of structural problems in the economies of Japan, Germany and several other European countries, a Chinese currency that is clearly undervalued, and declining crude oil prices make this process of re-balancing the external position of the US a particularly prolonged and peculiarly difficult task. More likely than not, this stage of the economic cycle may close with the imbalance largely uncorrected.
The author is economic advisor to ICRA (Investment Information and Credit Rating Agency)