Mysterious happenings in America's international financial accounts
AT THE start of this year, when the American dollar stood at $1.36 to the euro, most economists expected it to stay weak or to become still more feeble. Instead it has since risen by 14% against Europe's single currency, hitting a 14-month high of $1.19 this week. Another puzzle: contrary to dire predictions that America's vast current-account deficit would plunge the country ever deeper into debt to foreigners, recent figures show that foreign debt has actually fallen, relative to GDP, in the past few years. Does this mean that the current-account deficit isn't a problem after all, and that the dollar will keep on climbing? No, it doesn't.
Last year, America had a current-account deficit of $668 billion. In effect, it had to borrow this amount from the rest of the world. However, the new numbers, published last week by the government's Bureau of Economic Analysis, show that America's net external liabilities rose by only $170 billion in 2004, to $2.5 trillion. The mystery goes deeper. Since the end of 2001, America's cumulative current-account deficit has amounted to $1.7 trillion, yet America's net external liabilities have increased by only $200 billion, and have fallen as a percentage of GDP (see chart). What's going on?
The explanation is that the value of foreign assets and liabilities changes with exchange rates and share prices. The rally in global stockmarkets in 2004 boosted the value of America's external assets by more than the value of its liabilities because Americans own more shares abroad than foreigners own in the United States. In addition, foreign stockmarkets outperformed Wall Street last year.
Even more important over the past three years has been the impact of a cheaper dollar. About 70% of America's assets abroad are denominated in foreign currencies, so when the greenback falls, their dollar value rises. Meanwhile, as the home of the world's main reserve currency, America has the advantage that virtually all of its foreign liabilities are in dollars, so that the currency's depreciation does not increase their value. Thus a fall in the dollar boosts America's net wealth.
It may be tempting to conclude that America can comfortably continue to run huge deficits and let a falling dollar erode the real value of its external debt. But foreign investors are not stupid: if they expected a persistent decline in the dollar, they would demand a higher yield on American assets to compensate them for their expected loss. This would increase the current-account deficit.
If the dollar hangs on to its gains, then the end-2005 figures for America's net foreign indebtedness could prove truly shocking. Brad Setser, of Roubini Global Economics, a research firm, estimates that at current exchange rates the capital loss on America's foreign assets could amount to $350 billion this year. Add that to his forecast for the current-account deficit of $820 billion, and it seems that America's net foreign liabilities could leap by $1.2 trillion, to $3.7 trillion by the end of 2005. Of course, a further drop in the dollar and a fall in American share prices could trim those liabilities again in 2006. But that is hardly a reason to buy dollars.