Brad Setser

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The deterioration in the US income balance has just begun ….

by Brad Setser
September 26, 2006

Mark Whitehouse highlighted the deterioration in the US income balance in yesterday’s Wall Street Journal.   The US paid more in interest and dividends on its external borrowing (and foreign equity investment in the US) than it received on its external lending (and its equity investment abroad). 

It many ways, though, the deterioration in the US income balance has just begun.   In this post, I’ll argue that that US lending abroad has a shorter-term structure than US external borrowing.   Most US lending and US borrowing is denominated in dollars.  Consequently, an increase in US short-term (policy) interest rates tends to increase the return on US lending abroad faster than it increases the interest rate the US pays on its borrowing.  

In the first half of 2006, this effect turned out to be quite significant – slowing the pace of deterioration in the US income balance.  US lending abroad is around $3.9 trillion (end 2005 data), so a gap on US borrowing and lending rates can have a significant impact on the overall income balance. 

But as US policy rates stabilize and the interest rate on US borrowing catches up with the interest rate on US lending, this effect will disappear.   The result: higher net income payments, even if the gap between the returns on US equity investment abroad (decent) and the returns on foreign equity investment in the US (embarassingly low) continues …

The gory details (and graphs) follow.

In absolute terms, interest payments on US external debt have grown faster than the interest the US receives on its external lending.   It should: The US external borrowing exceeds US external lending by about $2.5 trillion (mid 2006 estimate).   Rising net interest payments (and a stable surplus on direct investment) explain why the US income balance is now negative, as following chart shows.


However, the pace of deterioration in the interest balance seems to have slowed in the first part of 2006.    Why?  Largely because the interest income on the United States $4.7 trillion in external lending has been rising almost as fast as interest payments on the United States $7.25 trillion in external borrowing (mid 2006 estimates).


Why is it growing fast?   The most likely explanation is that US lending abroad is very short-term, so it reprices more quickly.    The implied interest rate on US external lending fell faster when US interest rates were falling.    And it is now rising faster when US interest rates are rising.


Alas, with the Fed on hold, the interest rate the US gets on its external lending won’t continue to grow.   And barring a miracle, the average cost of US external borrowing will continue to climb.    The net result: a further $60b deterioration in the income balance. 

This phenomenon can be discussed in slightly different terms.   The debate over dark matter has died down, but I wouldn’t have noticed the swing in the implied interest rate the US gets on US external debt if Hausmann and Sturzenegger had not raised the topic (an updated version of their argument can be found here).

Hausmann and Sturzenegger postulated that the US borrowed cheaply from the rest of the world to lend money out at higher rates.   Think of it as borrowing cheaply from the People’s Bank of China to buy high yielding Brazilian debt.    The argued that the United States ability to provide a safe store of value allowed the US to earn an  “insurance” premium.  The US offered the world’s investors safety, and then put the funds that came in to work. 

It was an interesting idea, but it didn’t turn out to be true.  The amount of US lending to high-yielding emerging economies is very small relative to total US lending to the world.

Most US external lending seems to be short-term, dollar-denominated floating rate loans to borrowers located in offshore financial centers, whether London or the Caribbean.   

Consequently, when US short-term interest rates were low, the interest rate the US earned on its external lending was below the interest rate the US paid on its external borrowing.

That is the opposite of what Hausmann and Sturzenegger postulated.  The US was paying an insurance premium, not getting it.   

But that changed, big time, this year.   The implied interest rate on US lending has increased from around 2.5% in 2004 to around 5% in the first half of 2006.   The implied interest rate on US borrowing has increased by far less, rising from around 3% to a bit over 4%.   As a result, the US is now earning a bit of an insurance premium.

But it isn’t really an insurance premium, at least not in the sense of Hausmann and Sturzenegger thought of it.   It really looks more like a fixed to floating swap, with the US paying something closer to a fixed rate on its longer-term borrowing, and the US getting a floating rate on its short-term lending.    That swap was out of the money when US rates were low in 2002, 2003 and 2004.   And it is now “in the money.” 

The following chart (an updated version of the charts in my earlier post) tries to illustrate the various sources of  what Hausmann and Sturzenegger label “dark matter” – namely the imaginary assets that keep the US income balance from being as negative as it should be, given that the US is a substantial net debtor.     Some dark matter comes from the fact that US FDI abroad pays higher dividends than foreign direct investment in the US.  Some comes from higher reinvested earnings on US direct investment abroad than on foreign direct investment in the US (though this appears to be of declining importance).   Some comes from the fact that US equity investment abroad exceeds foreign equity investment in the US, and the US ends  up making money issuing debt to buy equity. Some comes from the fact that some US external liabilities don’t pay any interest – lots of dollars circulate abroad.  Some comes from the fact that Hausmann and Sturzenegger assume that all US debt should pay a 5% interest rate, and when US rates are lower than 5%, their methodology allows the US to book the difference between its borrowing rate of 4% and the 5% it should be paying as an external asset.     And some comes from the difference between what the US pays on its external borrowing and what it gets on its external lending – the “insurance” or “swap” component.

Assuming I did the math correctly, the total stock of dark matter in my graph should match the stock calculated by Hausmann and Sturzenegger.

What stands out in this graph, apart from the fact that the stock of dark matter seems to be shrinking?  

Let me highlight four things.

First, the US doesn’t really borrow all that much to invest in foreign equities, despite what Jim O’Neill of Goldman –who I greatly respect and generally agree with — and many others argue.   The gap between total US equity investment abroad and total foreign equity investment abroad at the end of 2005 was around $2.25 trillion.   That gap was basically zero in 2001-02, but the strong relative performance of foreign stock markets led to a surge in the market value of US equity investment abroad.    

However, most US equity investment abroad, however, is balanced by foreign equity investment in the US, not by US borrowing from the rest of the world.  What might be called the equity for equity swap on the US balance sheet ($5.9 trillion at the end of 2005) is far larger than the debt for equity swap ($2.25 trillion).  

The equity for equity swap also generates the majority of US dark matter, largely because of very low reported returns on foreign equity investment in the US.  The dark matter from the equity for equity swap is the sum of the light blue (FDI dividends) and purple (reinvested earnings) bars; the dark matter from the debt for equity swap is represented by the tan line (borrowing to invest).

Second, from 2000 to 2004, the difference between the (large) reinvested earnings on US firms abroad and the (small) reinvested earnings of foreign firms operating in the US accounted for the majority of US dark matter.  Look at the purple bar.   That changed in 2005.    US firms stopped “reinvesting” their earnings and instead made huge dividend payments to take advantage of the homeland investment act.   And so far in 2006, the net gains on reinvested earnings are far smaller than they were from 2000-2004 – largely because foreign firms in the US are now reporting somewhat larger reinvested earnings.   The difference in reinvested earnings generated $500b in dark matter in the first half of 2006 v $2000b in dark matter during the 00-04 period. 

Incidentally, the surge in the market value of US FDI abroad in 2005 has had the effect of converting dark assets to “real’ assets, as it reduced the difference between implied rates of return on US investment abroad and foreign investment in the US.

Third, the pink bar shows the “dark matter” from the US net debt position.  This reflects the fact that Hausmann and Sturzenegger assumed that the US should be paying 5% on its external debt, and – as explained earlier – if the actual interest rate was lower than 5%, there methodology effectively counted the difference between what the US should be paying and what it really was paying on its net debt (net debt is the difference between total US lending and US borrowing) as a “dark asset.”      

Not surprisingly, the value of this dark asset (the pink bar) soared as US interest rates fell, reaching almost a $1 trillion in 2003 and 2004.   It is now shrinking, though, as one would expect.

Fourth the bright red bar represents the gains (and losses) on the portion of the US external balance sheet that comes from borrowing from the world to lend to the world (Insurance services in Hausmann/ Sturzenegger land, or a fixed for floating swap in Setser land).   That red bar was negative from 2001 through 2004.   

Why – the rapid fall in interest rate on US external lending fell pushed the interest rate on US external ending below the interest rate on US external borrowing.    

It was quite positive in the first half of 2006 (all numbers have been annualized) – generating almost a trillion ($800b) in “dark matter.” 

Let me convert dark matter into plain English. 

The fact that US lending repriced faster than US borrowing saved the US about $20b on its interest bill in the first half of 2006.  If that gap persists for the full year, the total savings in 2006 will be around $40b .    

I suspect, however, that this advantage will disappear over the next year and half, as US external borrowing reprices.  

I also would assume that the average interest rate on US borrowing will climb toward 5%, eliminating another $400b in dark matter (i.e. pushing US annual borrowing costs up by about $20b … ) 

If I am right, even if the US went cold turkey, stopped borrowing and stopped running a current account deficit, the United States net interest bill will rise by another $60b as the interest rate on US external borrowing rises to 5% and the gap between what the US gets on its lending and what it pays on its borrowing shrinks.

Suppose the $60b gain that the US gets from a borrowing rate below 5% disappears by q2 of 2007.   And suppose the US current account deficit over the next four quarters is close $900b.  

The $900b in additional debt would imply another $45b in net interest payments (annualized).   The repricing of the United States existing debt would add another $60b.  

That would turn the $16b or so negative income deficit the US has now ($4b in q2, annualized) into a $120b deficit.    

Now, I don’t know the term structure of US external debt, so the repricing process may take a bit longer.   But – barring a Roubini-esque recession that leads to a big cut in US short-term rates and eventually a big fall in long-term rates – it is coming.     The only real question is how fast.     This is following graph shows what happens if it takes two years rather than one for the $60b loss from repricing to play itself out.    And in that context, the US income balance deteriorates from say $30b this year to $190b in 2008.

$60b from “repricing” and $100b or so from all the additional the US takes on to finance its external deficits.


For that matter, if a Roubini-eseque recession leads to a big fall in policy rates, income on US lending should fall faster than income on US borrowing ..  it wouldn’t help as much as you might think. 

One last note: I would like to try to publish my work on the disaggregated sources of dark matter somewhere.  Any ideas for a good target journal? 

Data notes. 

The disaggregated sources of dark matter are calculated by matching US external assets against comparable US external liabilities using the data in the US NIIP.   Gross debts exceed gross US lending.  Some of the difference is matched against US equity investment abroad.  The residual is the United States net debt.   Income payments are calculated from the BEA.

The implied interest rate on US borrowing and lending is calculated by subtracting estimated dividend payments on portfolio equity from the sum of government and other payments in the income balance.  Since data on 2006 dividend payments isn’t available, I have assumed that portfolio equity dividends remained at their 2005 levels.  The stock of debt is calculated by adding debt creating flows from the first half to the totals in the NIIP data.    I annualized both the income payments and the flows to estimate 2006 interest rates in a way comparable with previous years.


  • Posted by Gcs

    nice run thru on dueling capital accounts

    but surely u agree

    we regular folk
    need relief on the trade front first
    north wide deval deval deval

  • Posted by bsetser

    yes, EMs need to revalue against housing-bubble land.

    if i am right on the deterioration of the income balance, keeping the current account at $900b over the next year requires a $100b fall in the trade deficit. Oil could help, but that is a one off .. and the deterioration of the income balance is likely to be sustained, tho at a somewhat slower pace once the average US int. rate on US ext. debt converges with the marginal borrowing rate.

  • Posted by CalculatedRisk

    Brad, awesome work. If the differential in rates behaves like a “fixed to floating-swap” that can obviously have potentially serious consequences. I’ve been expecting the trade deficit to fall next year as the U.S. economy slows down, but that left me wondering about the current account deficit and long interest rates.

    Mark Thoma featured a Fed Economic note today by Tao Wu: Globalization’s Effect on Interest Rates and the Yield Curve. The note highlighted something we’ve discussed over the last year – that “the the effects of monetary policy tightening or loosening may be substantially weakened” because of globalization. If the Greenspan conundrum was that long rates stayed too low (fueling the speculation in the housing boom), the Bernanke conundrum may be that long rate rise when he is cutting rates (furthering the housing bust).

    Excellent analysis! I look forward to reading the paper.

  • Posted by bsetser

    CR — thanks. So far tho it seems like long rates are falling even in advance of any Bernanke cut … i worry about a reverse conundrum (rising long rates as short-rates fall, which incidentally would be very bad for the US income balance … ) but, so far, there doesn’t seem to be any real sign it is likely.

  • Posted by Emmanuel

    This is deep stuff. I will go over it again when I have more time. Interest rate swaps–who would’ve thunk it?

    One last note: I would like to try to publish my work on the disaggregated sources of dark matter somewhere. Any ideas for a good target journal?

    With the obvious caveat that this is not my field (and that should probably disqualify me from commenting), the Journal of International Economics looks like a good ‘un. It has an impact factor of 1.667. I’d have said “American Economic Review,” but since you’re not a tenure track hamster, the JIE is probably a better match. I am a repository of useless information 😉

  • Posted by OldVet

    I’ve been rereading this piece with great interest today. Maybe in the US$ zone we are setting a “globally neutral” interest rate for the world, which suits central banks generally for economic growth reasons. Growth has been higher outside the US in recent years. And the US hasn’t got the only housing boom or bubble, by a long shot.

    EM central banks revalue or allow revaluation, then the dollar zone investors will face higher prices in EM’s. EM investors who’ve invested huge sums in the US$ zone recently will face falling dividends/interest to repatriate and invest in EM’s. (Think: Lakshmi Mittal, who invested in Arcelor, and will have uses for his earnings back in India in other ventures.) Maybe the EM’s have frothy housing markets too – in fact most do in fact – and they don’t want to kill off those real estate gains, even if they’re inflationary. Money is buying off the poor in EM’s, and putting land to higher value added activities; the poor move off with something in their pockets. Plus maintaining a very low exchange rate by EM’s protects employment.

    Maybe we’re looking at a global “trickle down” economy, warts and all.

  • Posted by Cassandra

    you’ve recently chiseled away at the energy component of the trade gap, but how about a post more precisely on the composition of the non-energy US trade gap – by country & segment, perhaps speculating upon what the first non-essentials to be jettisoned will be?? Unless of course the terms of trade for agric commod & software will turn so dramatically that we’ll make it up on the export side…

    Also, when we think of US mechandise trade deficits with Asia, should we think about including a percentage of our non-energy NAFTA deficits that reflect “back-to-back” deficits with Asian exporters?

  • Posted by bsetser

    Cassandra — “back to back” deficits? help me out there. I am not familiar with the term. I did do (I think) a post on the trade deficit by regions with data thru the end of q1. q2 didn’t change things much. i don’t have data on hand for the deficit by sectors — i leave those calculations to Catherine Mann.

  • Posted by Cassandra

    sorry … meaning Asian (primarily Japanese) assembly shops in Mexico exporting to US, that reflect Mexican surpluses v. US in national accounts, but where the comonents are imported from the co’s (Asian) affiliates. One might also consider some attribution of wages/profits left in Mexico as a result that subsequently contribute to their ex-energy deficits with Asia to get all the scraps properly attributed.

  • Posted by Gcs

    found this
    prolly aimed at emerging states

    i think applicable to the euro and
    at one time the dollar

    its by my former mentor bob mundell
    as usual
    he’s popularizing like a Hebrew prophet :

    “”Disinflation under inflation targeting works by monetary restriction, higher interest rates, returning confidence, capital inflows, current account deficits, and an appreciating currency. The appreciating currency then fosters more disinflation and helps the country to meet its new inflation targets. But after the new low-inflation equilibrium has been reached, the currency is overvalued and recognition of this brings on a speculative crisis.”

    or better yet if you got sinkless global credit
    a massive chronic trade imbalance

  • Posted by Steve Waldman

    Brad, this is a magisterial post, I’ve no idea where else you ought to publish this stuff, but I’m glad you publish it here. Thanks. This looks like a lot of work. There’s a lot to think about here. It almost looks like you are trying to come up with a portfolio of priceable instruments — swaps, net debt and equity positions — that would approximate the US NIIP. That’s pretty cool.

  • Posted by DOR

    “yes, EMs need to revalue against housing-bubble land.”

    Would anyone care to walk me through the logic — and morality — of American consumers enjoying a free housing bubble that jacks up baby boomer assets pre-retirement and allows living far beyond their means on the one hand, . . . and throwing a monkey wrench into emerging market economies that might set back literacy and healthcare for a couple of billion people by some 5-15 years, on the other?

    Just asking.

    * * *


    I’m not sure what point you’re trying to prove with the Mexican-made Japanese products sold in the US, but any such MNC ownership calculation would essentially erase China as a factor in the US trade deficit.


  • Posted by bsetser

    Mundell’s comments describe Argentina (94-01), Brazil before 99 (Plan Real) and Turkey from 99 or so to early 01 … but not entirely sure they apply now.

  • Posted by psh

    2¢: Harpers has been publishing closely-reasoned, graphics-heavy articles (e.g. housing & debt). Wider circulation than you were thinking, no doubt, but there’s a need to know. Could maybe scrounge an editorial contact if it seems feasible. Only you might need to [open rant] jettison the accursed “dark matter” trope once & for all, a metaphor in search of a concept that only obfuscates the problem [close rant].

  • Posted by MrBill

    Thanks Brad. Worth closely re-reading and then perhaps again.

    RE DOR
    “Would anyone care to walk me through the logic — and morality — of American consumers enjoying a free housing bubble that jacks up baby boomer assets pre-retirement and allows living far beyond their means on the one hand, . . . and throwing a monkey wrench into emerging market economies that might set back literacy and healthcare for a couple of billion people by some 5-15 years, on the other?”

    That is the question isn’t it? Not just the greatest intergenerational debt-equity theft ever perpetuated, but a north-south issues as well.

    However, as Brad has often argued, the source of those deficits is not just American prolifigy, but also Asian central bank currency manipulations, and a mainly OPEC producer preference to peg their local currencies against the USD, and buy foreign assets rather than investing in their own economies for the future needs of their people.

    There is no morality about it. Choices were made. There are consequences to be had.

  • Posted by Gcs

    brad”not entirely sure they apply now”

    just add good credit
    to the last step
    and instead of a “sudden” monetary cave in
    you get a long bleed of better paid jobs

  • Posted by OldVet

    Gcs, Mr. Mundell’s precis might just as well apply to the US (on the brink of a currency crisis) as EM’s, who’ve been through the process earlier already in Asia. Or not?

  • Posted by Gcs

    old vet….
    my deepest intuition
    imperial currencies
    don’t have EM moments
    so long as they remain a top dog

    ex imperial currencies do however
    vide uk pound pounding
    circa late 1940’s
    all the way to early 1990’s


    –in my estimation–

    a hyper share sized reserve currency
    will always be saved form its own folly
    by its fellow CBers
    for their own self interest of course

    preserving the system after all
    is on the table a that point

    reviewing the early 70’s
    and how the globe’s leading CBs
    stood for
    first the Nixon gangs
    gold toggling
    and then their window slamming
    confirms this i believe

    whats unclear to me:

    are we in a binary reserve system now ???

    the euro and the us dollar
    a fiat equivalent
    of the bimetalism
    of the late 19th century

    if so

    could the system shed one of it’s
    main reserves
    in a sudden cave in
    and still keep right on ticking away

    i very very much doubt it’s
    worth anyone’s risk to chance finding out

    and so the imperial hyper dollar
    may no longer reign alone
    but like the austrian empire
    forced to become
    austro hungarian

    if your a south slav
    or an every day austrian german
    it don’t look like much
    is changing

    till august 1914 that is

    then who cares anyway
    we’re all on a hand basket ride ….

  • Posted by OldVet

    Shame that China only gets 5% use of its reserves in order to keep the boat afloat, but at least Brazil’s struggling to intervene and keep the value of foreign investments down rather than up. Go Brazil! Of course I have stock in Brazil and believe that unlike China, it’s currency will rise to my advantage. Better bets are on the losers in the CB game.