One country’s external debt is another country’s asset. The U.S. capital account data leaves little doubt that foreign central banks have been a huge source of financing for the U.S. current account deficit. This really got started in 2002, when the U.S. first started to run large budget deficits, and the pace of reserve accumulation by foreign central banks picked up. It accelerated in 2003, and shows no real sign of slowing in 2004. This is the heart of the new Bretton Woods two system of managed exchange rates – though that is a bit of a misnomer: the original Bretton Woods did not finance enormous current account deficits.
The Bank of International Settlements (the BIS, the central banks’ bank) provides the key numbers in its annual reports. A couple of things stand out.
First, the increase in dollar reserves exceeds the inflows from foreign central banks reported by the BEA in the capital account data. In 2002, the BIS reported a $234 billion increase in dollar reserves. That compares with $139 billion in reported inflows from the Bureau of Economic Analysis (BEA). Not all dollar reserves are invested in the US, but most probably are (dollar denominated assets issued by non-US borrowers tend be riskier than US debt). So it is likely that the build up of dollar reserves provides a better measure of central bank financing than the BEA data. In 2003, the BIS reported a $341 billion increase in dollar reserves, v. $274 billion in the BEA data.
Second, Asia has a ton of reserves. Asia also has a ton of people. But it is hard to see why Taiwan needs more reserves than all of Latin America. Between the end of 2001 and the end of 2003, the combined reserves of Asia and Japan increased from $1158 billion to $1860 billion. That financed a large chunk of the US current account.
Third, China and Japan are not the only countries financing the United States, just the biggest. Between the end of 2001 and 2003, Japan’s reserves increased by $265 billion, and China’s by $191 billion (they just about doubled, rising from $212 to $403 billion). India’s reserves rose from $46 billion to $98 billion (a $52 billion increase). The combined reserves of the Asian NICs increased by $163 billion, whie Eastern Europe and Russia’s reserves increased by $87 billion.
Fourth, growing reserves are continuing to finance the US current account deficit. In 2003, Japan, China, India, Russia and the Asian NICs increased their reserves by $477 billion. In the first half of 2004, Japan increased its reserves by $145 billion, and China, Russia, India and the NICs increased their reserves by $125 billion (IMF data). Japan has stopped its massive intervention. But if we assume that the others are continuing to add to their reserves at a similar pace (China just reported a solid monthly trade surplus despite higher oil prices, and it is continuing to attract large FDI inflows) for the rest of the year, their total reserve accumulation would be about $395 billion – a bit below their 2003 pace, but still substantial. Of course, the U.S. financing need is even bigger ($800 billion, taking into account the US need to finance FDI outflows). But it is far easier to get $400 billion in private inflows (at current rates) than to get $800 billion in private inflows.
The fact that so many of the dollars that the world earns is going to buy US treasuries, not US goods, has a major impact on the structure of the US economy, as I argued in my earlier post. It favors interest-sensitive sectors like housing, and hurts manufacturing, for example. China is supporting the U.S. economy by buying US treasuries and keeping US interest rates low, not through booming demand for US exports! (Exports to china are up this year, but off such a low base that the overall impact is small — about 0.1% of GDP — and imports from China are on pace to increase by more like 0.4-0.5% of GDP)
The big question facing the global economy over the next couple of years is whether the US current account deficit and its need for financing will grow faster than the rest of the world’s (and specifically Asia’s) appetite for dollar reserves. Remember, the more dollar reserves Asian central banks hold, the bigger their prospective losses shoud the dollar depreciate against Asian currencies.