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LinkedInFederal Reserve Board Chairman Alan Greenspan was careful to frame the risk created by rising US external debt for foreigners investing in the US (and in the process financing the US current account deficit) as one of “concentration” risk. Too much of their international portfolio would be invested in the US, they would not be sufficiently diversified, and the lack of diversification itself would lead them to limit their future financing of the US (or demand higher rates).
To quote the maestro:
“Given the size of the U.S. current account deficit, a diminished appetite for adding to dollar balances must occur at some point … International investors will eventually adjust their accumulation of dollar assets or, alternatively, seek higher dollar returns to offset concentration risk, elevating the cost of financing the U.S. current account deficit and rendering it increasingly less tenable.”
Greenspan almost has to frame his (and one assumes, the Fed’s) concerns in terms of excessive concentration. He cannot very well come out and say that the US is not an attractive place to invest. But is Greenspan right? Is the risk one of too heavy a concentration in US assets, or is the risk that US assets themselves could simply be unattractive to foreign investors at current prices/ interest rates?
I suspect it is a bit of both. If the US current account deficit is absorbing 75-80% of global surplus savings (i.e. savings not invested at home, or the the rest of the world’s current account surplus), the share of US assets in foreign portfolios (notably foreign central bank portfolios) is rising. So yes, they are over time taking more and more dollar risk, and having a more and more unbalanced portfolio. Greenspan is onto something. A rapidly rising US external debt — barring a surge in the amount of global savings that is invested in foreign assets/ a fall in so-called home bias — implies an ever increasing share of foreign savings will be invested in the US.
That said, you don’t need a theory of optimal global portfolio allocation to highlight the risks of investing in the dollar. Nouriel and I argue that over time, the US trade deficit needs to fall from a bit over 5% of GDP today to no more than 1% of GDP to stabilize the United States external debt to GDP ratio. That could happen today and happen fast, stabilizing the US external debt to GDP ratio at around 30%. But that kind of adjustment would be jarring, as Steve Roach emphasized today. The adjustment could happen gradually and over time, stabilizing the US debt to GDP ratio at 50%. That just might work out OK, a slow fall in the real dollar would lead to a gradual increase in real interest rates and a tendency for US income to grow faster than US consumption. Or the US could continue running large deficits for some time, which almost assures that the subsequent adjustment will happen fast and that the US debt to GDP ratio will stabilize at a high level. But it is hard to see how even the modest adjustment scenario happens without some additional dollar depreciation — even from today’s levels.
So continued investment in the US to fund deficits on the current scale means foreigners are taking on the risk of having an ever increasing share of their assets in one country, and moreover, the risks intrinsic in having even a small share of your assets in a country with a large external trade deficit. The combination of the two is scary. Does that mean investing in dollar assets is a bad idea? I guess that depends. If your home currency has already fallen substantially against the dollar (i.e. the euro), and you think you have identified the next google, investing in the US is probably a good idea. If Stephen Jen is right, the euro has already overshot and should appreciate against the dollar over time, and you might even want to buy a plain old treasury bond (I would personally not recommend it, I have trouble calling the dollar undervalued when the US trade deficit is so large in relation to US exports, and so much higher than what is consistent with a stable external debt to GDP ratio – call me old fashioned. Plus, the euro started life at 1.17-1.18, so even 1.3 is only a 10% appreciation from pre dollar bubble days). If your home currency has not adjusted against the dollar and you are buying low yielding treasury, agency or corporate bonds, it is hard for me to see how current US interest rates compensate for the risk of future dollar depreciation, given the gap between the current US trade deficit and the trade deficit consistent with a stable debt to GDP ratio.
There was no risk of excessive portfolio concentration for those investing in the Argentine peso back in 2000. It was still a bad bet because the peso was overvalued back then. The last thing you want to do is to concentrate your currency risk over time in the currency of a country with a large and likely growing trade deficit. Yet that is exactly what Asian (and other) central banks must do to sustain the current system of large US trade deficits, rising US external debt AND low dollar interest rates.
Hey brad-
Do you have any insight into who is managing these enormous foreign reserve portfolios that foreign central banks are accumulating? Is it done in house, or are their consultants? Because if there are consultants- this is my rambling idea – and they are all advising their central bank clients to make the some sort of portfolio decisions (ie diversify the hell out of dollars), that could lead to a huge destabilizing run on US treasuries and dollars. Anyways thats my doomsday scenario for the weekend.
Interesting the effect that Mr. Greenspan had on markets today. I guess he is showing that the Fed is now on the same side of the fence as the Treasury with regards to the dollar.
Brad: Greenspan’s setting up for a December or January surprise. Today was the first warning. There should be at least one or two more depending on the volatility of the Dollar downward move. I went back and looked at the last few interventions by the Treasury. Each time they intervened, it was not the absolute level but rather the volatility that was targeted.
However, I have hard time seeing how after a 50% downward move, short-sellers expect to make much more on the Dollar. This thing is near done. When short-term yields should be moving significantly higher, generating a substantial margin call in the US. That will move the Dollar higher while shifting the yield curve up as opposed to steepening it.
Greenspan’s got to be careful he does not lose control of this one. He’s flying right on the edge of the periphery here.
Ian, I think there are reports that Russia is devesting its dollar holdings, making everyone else a little nervous. Rumour?
Greespan’s blurb is for us (also referred to as “the residents”, not the bankers) commoners who understand the notion of “diversification”.
We are supposed to nod in savvy agreement.
Or pull out the barf bag.
Some $200B leaves this country every year to “diversify” seeking higher returns offshore. Foreigners prefer those same shores. They are the same kind of people exploiting the same situations of emerging economies.
The real players, as Sir Alan knows, are not the private foreign investors (who hardly need to hear the ‘diversify’ theme). Nope, it’s the central banks: BoJ and PBoC. And do they need to ‘diversify’?
I think they get a different message from Sir Alan.
Ian — no real idea, sorry. The overall sums managed are impressive — between them, the BOJ and PBoJ manage over $1 trillion in money, so perhaps more than the world’s hedge funds combined. Most of it is — no doubt from the treasury data — invested rather conservatively. But every now and then some of it is not — remember that the bank of italy had invested in LTCM. I think I read somewhere that the current governor of the PBoC managed the PBoC’s (smaller) reserves earlier on in his career …
Paul — you have more confidence on this than I do. This US administration has never intervened in the markets (treasury has the lead on market intervention), so it is hard to know what would lead them to pull the trigger. I went back and read Rubin’s account of the decision to intervene to keep the dollar from strengthening too much against the yen in 98, and while maybe the rethoric was about “volatility”, there clearly was also a sense the yen should not be at 148 or so and heading south — the level also mattered. suspect that was also true of the decision to intevene to support the dollar v. yen early on in the administration. the irony of course, is that while the bush administration talks about letting market forces set exchange rates, the value of the dollar has never been more managed that it is now. the intevention just is not coming from the US, but from the BoJ (until this summer)/PBoC/ others — all of whom are buying dollars and selling their own currency to keep their currency from appreciating/ and thus keeping the $ from depreciating.
one aside — the dollar has not depreciated by 50% in real terms. against a broad basket, (the jp morgan index) the dollar is still – i think — higher than it was in the mid 90s. We have not moved v. China, and China now accounts for much more of our trade. We almost import as much from china as from europe.
Calmo — you are absolutely right. No one has more concentrated exposure to the US than US residents with all their savings in dollar denominated assets. Of course, we also spend in dollars, so there is not an obvious mismatch — but were we ever to put as much of our national savings abroad as other countries are doing right now, the $ would be toast.
Additional thoughts while waiting the press releases from the G20 meeting.
AG’s remark reminds me of his marketing of the ARMs awhile ago which I thought was just bizarre. [ Was Raines embarassed that the head of the Fed was giving his advice on mortgage choices? I am not over it yet.]
Now he is addressing private investors in the fx market in the same manner. Does he really need to tell them that the US currency shouldn’t get all their bets?
I have De Long’s note in my head that this large, diverse, and savvy [ no matter what AG implies] group is a critical component and that if they were unified and acted as a single entity, it wouldn’t matter what BOJ or PBoC did. My read on them is that they aren’t all that unified, but they do sense a dollar decline and hence shorting opportunities if one can only avoid the 2 bullies. AG’s remarks only tend to encourage their sentiments, no? Is that the intent –to provoke BoJ and/or PBoC for a prompt entrance?
We’ll soon see.