Brad Setser

Brad Setser: Follow the Money

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The currency strategist at Morgan Stanley might want to talk to the chief economist at Morgan Stanley

by Brad Setser
September 23, 2004

Steve Johnson’s market insight column in Thursday’s Financial Times keys off Morgan Stanley’s currency strategist Stephen Jen’s argument that “As long as Asia insists on staying inside this dollar area, then the current account deficit is not what people think it is.” Rather, the US current account deficit excluding the Asia dollar zone is only 2.2% …

What? Jen’s numbers are right, much of the US currrent account deficit is with Asia and it is offset by financing from Asia. But why does it make sense to net all this out and hide the real size of the US external deficit? Dollar claims on the US held in Asia are still external debts of the United States, and claims on future US exports. Stephen Roach, Morgan Stanley’s chief economist is more worried, both about the underlying 5.7% of GDP current account deficit in q2 and the assumption that the rest of the world will finance it in the face of rising disenchantment with US hegemony.In a sense, Stephen Jen’s core argument is right: to quote Johnson paraphrasing Jen: “the current account deficit run being run against Asian nations is not unduely worrying as long as Asia continue to park its capital surpluses in US assets.” Current account deficits are never a problem so long as they are financed! The real question is whether a growing deficit can continue to be financed by Asia, and when will the strains start to show.

Jen’s call may suit the relatively near-term time frame of currency strategists — though I would be reluctant to bet that the dollar will rise in the face of large expected q3/ q4 current account deficits (oil above $45 a barrel does not help the current acccount). But more importantly, the basic analytics are off. The fact that Asia is part of a de facto dollar zone does not mean that it makes sense to net out the US current account deficit with Asia, or that the US current account deficit with Asia won’t cause problems.

Argentina was a part of the dollar zone until the end of 2001, but that did not mean that its current account deficit and rising external debt did not matter … or that what really mattered was the current account deficit Argentina ran with the non-dollar zone. What mattered was the stock of external debt relative to its export capacity, and Argentina’s ability to borrow to pay interest on its existing extenral debt, and in the process to run up its debt stock. Once it could no longer borrow, it had to adjust, and since the currency board blocked rapid adjustment, it ended up defaulting.

The US is in a better position because it is borrowing its own currency, both from Asia and the rest of the world, and so its creditors are taking the risk the dollar’s real value will fall. But presumably Asia’s willingness to keep financing the US in dollars is a function of the size of the total set of external claims on the US economy relative to the United States ability to service those debts, not just the external claims on the US from outside the Asian dollar zone. If the United States’ current account deficit with Asia doubled, to 6% of GDP (pushing the overall deficit up to 8.5%), would Jen really argue that the relevant US external deficit is only 2.5% of GDP? All external debt, including debt owed to the Asian dollar zone, is claim on US exports.

Stephen Jen leaves out two points that I suspect will cause tensions within the US/ Asian dollar zone in the near future — though my definition of the near future (next two-three years) may be a bit different than his (next two-three months?).

1: The imbalances created inside the U.S. economy by a large and growing current account deficit with Asia, financed by Asian inflows into the US fixed income market. That favors interest sensitive sectors, and hurts manufactures and other producers of tradables. It encourages a housing bubble, and the shift of resources out of goods production. That risks protectionist pressure, but in this case, the pressure reflects not just the tensions created when one sector is falling and another rising, but rather the broader macroeconomic imbalances created when a country imports close to 16% of GDP and exports a bit less than 11% and makes up the difference by borrowing from abroad. The US is taking on external debt, but not building up it s future export capacity. China’s export growth to date has come in part by taking market share from other Asian exporters (total US imports from the Pacific Rim were roughly constant between 2000 and 2003), but China can only sustain its current pace of export growth by moving into markets now served by US producers. That is happening in 2004 — overall US Pacific Rim exports are rising, suggesting China is no longer just taking market share from other Asian producers, and that trend is only going to continue looking forward. If it is not offset enormous growth in US goods exports to china/ asia (enough to shrink the overall deficit), not just the export of US treasuries to China’s central bank, there is almost sure to be friction. Think about Republican congressmen running for election in ohio in 2006 …

2: The growing financial risks that Asian central banks are taking by lending in dollars to a country with a growing external debt stock and a widening current account deficit. It is one thing to lend to a country with a 15% of GDP external debt and a 4% of GDP current account deficit (US in 2000). It is another thing to lend to a country with an external debt of almost 30% of GDP and a current account deficit of close to 6% of GDP (US in 2005) — particularly if its export sector is smaller as a share of GDP then it was when its external debt was smaller. As the debt level rises (and US interest rates creep up), Asia will have to lend the US money not just to finance the trade deficit, but also a growing deficit in investment income created by payments on the existing stock of debt. By 2008, US debt could be close to 50% of GDP, and the current account deficit above 7% of GDP if nothing changes ($ stays constant, US keeps on growing, etc). That means that Asian central banks will have lots more dollar assets and the required real depreciation to keep the US deficit from rising will be larger. Consequently, Asia’s prospective financial losses will be a lot bigger than they are now …

At some point, I suspect some Asian country will defect, and conclude its does not want to take the financial risk associated with adding to its dollar reserves. I don’t know when precisely that is going to happen, and whether the Asian central banks’ tolerance for risk ends before the US political system loses its ability to cope with the internal tensions created by growing Asian imports (in the absence of an offsetting rise in exports sufficient to lower the trade deficit), but it will happen! Asia currently wants to be part of a dollar zone (at relatively weak exchange rates) is willing to intervene massively to prevent their currencies from appreciating against the dollar, but there is no guarantee that Asia’s desire to remain part of a dollar zone will last. The real question is when do the tensions created by Asian financing of US external deficits become so large that Asia concludes that it has to opt out of the dollar zone, or the US political system concludes it has to opt out of more or less open trade in goods across the Pacific?

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