The q2 US current account data
The q2 US current account data poses two puzzles.
The first is the sharp drop off in official inflows in q2. They fell from $150b in q1 to $70b in q2. That fall was, incidentally, offset – mechanically – by a change in (net) FDI outflows. The large net outflow of q1 disappeared. Net private portfolio flows were more or less constant.
The second is the continued absence of any evidence of deterioration in the income balance. Or, if you prefer, the continued growth of dark matter. I am fairly sure Ricardo Hausmann and Federico Sturzenegger would argue that this the real puzzle is the unwillingness of some others to accept the evidence that the US has a lot of dark matter on its balance sheet. After all, the US seems to be able to continually conjure up additional dark matter whenever it is needed to keep the income balance positive.
The first isn’t really a puzzle. Not in my view. The US data is wrong.
Not wrong in the sense that the BEA made an error in their calculations. But wrong in a deeper sense. The BEA’s quarterly data is based on the TIC data, and the TIC data simply doesn’t capture all official inflows.
Why I am I so confident –
First, the last survey data revised total official inflows up by $130b between q3 05 and q2 2006. I expect a similar revision. The pattern here is very consistent.
Look at the gap between the unrevised data and the revised data in the following graph.
When the data for the last four quarters is revised, I expect that net official purchases will be revised up, and foreign private purchases will be revised down. Indeed, I would be surprised if net private bond inflows (foreign private purchases of US bonds net of US purchases of foreign bonds) are currently about flat. No doubt there has been some true private inflows form abroad, but I would bet the scale of those inflows is about equal to the scale of US purchases of foreign bonds.
Second, different US data sources don’t tell a consistent story. The BEA – using the TIC data – reports a $43.3b increase in foreign official holdings of Treasuries and Agencies in the second quarter. The New York Fed’s custodial holdings of Treasuries and Agencies increased by $90.8b over the same time period – that is a rather significant difference, and the FRBNY data in theory captures a narrower set of holdings (only those at the Fed) than the BEA’s data.
Third, $70b is just too small given the scale of official reserve growth in the second quarter, which I estimate to be close to $300b (The COFER data will offer a more definitive answer at the end of September). You don’t need to take my word for it though. Brazil, Russia, India and China combined to add $250b to their reserves. That total hasn’t been adjusted for valuation changes, but it is indicative.
I don’t think anyone really thinks the world’s central banks put less than a quarter of their reserve growth into dollar assets.
To be honest, China alone almost certainly bought more than $70b of US debt in q2, given it $125b or so in reserve growth.
Sum it all up and I expect that, once the revised data comes in, the overall increase in central bank’s dollar assets over the past four quarters will be close to $700b – only a bit less than the US current account deficit. Last year the revised survey data actually brought the total up to above the total implied by my estimate of dollar reserve growth (which comes from the COFER data, not the BEA data).
The absence of any deterioration in the income balance is, by contrast, a real puzzle. Simple math would suggest that $800b a year more in net debt would tend to – at a 5% average interest rate – lead to a $40b deterioration in the income balance. That though hasn’t happened.
And I don’t really feel like I understand why – in part because I don’t yet have a good feel for the revised data on income payments. It does seem to suggest that the US has bigger gains from financial intermediation, that is borrowing cheaply to buy higher yielding assets abroad, than the previous data set. That supports the “dark matter” hypothesis.
Mechanically, the improvement in the US income balance in the second quarter came from a roughly $2b ($1.9b) improvement in the balance on FDI. The US received $49.6b more on its investment abroad than it paid on direct investment in the US.
Two points are important here –
First, the gain doesn’t come from spectacular reported returns abroad so much as from low returns on direct investment in the US – the reported return on FDI in the US is only 4%. That is less than the return on Treasuries.
Second, almost all of the difference comes from a $37b gap in “reinvested earnings” – that is income that US firms earn abroad and then keep abroad. The US tax code provides US firms with a strong incentive to do this; they don’t have to pay taxes on their overseas earnings until the earnings are repatriated. Foreign firms also have a strong incentive to show profits in a low tax jurisdiction abroad – whether Ireland, Switzerland, the Netherlands or another locale.
Consequently, there is a good reason to think that tax arbitrage is by far the biggest source of “dark matter.” The very low reported earnings of foreign firms operating in the US just don’t make economic sense; why run a business to earn less than you can make investing in US treasuries?
The details of income data also suggest a bit of tax arbitrage. Most reinvested earnings comes not from US manufacturing firms operating abroad but rather from financial firms, holding companies and the mysterious other …
But the real mystery, at least to me, is the fact that net US interest payments didn’t increase (one small caveat – the US quarterly data doesn’t separate out dividends, so technically I should say the balance of interest and dividends on portfolio equities. However, dividends historically have been small relative to interest payments).
The amount of interest the US paid on its external debt is going up – it rose from $134.7b in q1 to $143.1b in q2.
But the interest the US received on its lending rose just as fast – going from $96b to $104.5b. Net interest payments actually fell by a tiny bit ($0.1b).
Since the US has a borrowed a lot more – about $ 5 trillion more — than it has lent out, mathematically, a constant deficit on the interest balance implies that either that the interest rate on US lending has to be rising faster than the interest rate on US borrowing or that the interest rate on US borrowing has to be falling faster than the interest rate on US lending.
If I did all the calculations correctly, it turns out that the implied interest rate on US lending has been constant (at around 4.7%) while the implied interest rate on US borrowing is actually falling, from a bit under 4.4% in 2006 to 4.25% in the first half 2007.
These numbers all reflect the revised US data on income payments, and thus differ from some numbers I have calculated in the past. They also are calculated by dividing payments by the estimated stock.
I thought I understand the mechanics of this before: the US lends short and borrows long, so a rise in short-term rates feeds into US interest income before it feeds into US payments. But I am no longer quite as confident this is the entire story. I certainly wouldn’t have expected a fall in the average interest rate on US external debt in the first half of 2007. That to me is a real puzzle.
On one point, though, there shouldn’t be much debate. Exchange rate adjustment works. The non-oil US trade balance is heading down.
That reflects the fact that the US economy has slowed relative to other economies.
But it also reflects changes in the exchange rate. Growth in both Europe and China (and thus Asia, given China’s size) have accelerated relative to the US. The US bilateral deficit with Europe is now shrinking rapidly – as the bilateral deficit with Canada. The bilateral deficit with Asia (including China) isn’t.
It does not take a lot of sophisticated economics, at least in my view, to figure out why. Europe has let its exchange rate adjust. Emerging Asia, by contrast, has let the size of its central bank balance sheet adjust. It has, generally speaking, opted to add to its reserves and in the process finance the US deficit rather than allow exchange rate appreciation.
Brad, I wonder whether the illegal economy is not large enough that you should include estimates of it in your calculations.
According to Wikipedia, the wholesale drug market alone is roughly $100B. Surely a large fraction of that is US, say $50B. There’s the tax gap, of which a significant portion ($50B?) is money smuggled out of the US to evade taxes (and not for drugs). Cars and guns are smuggled out of the US.
There’s a lot of dark matter, and most of it seems to increase the current account deficit.
From Peter Schiff from Euro Pacific Capital,
http://www.europac.net/newspop.asp?id=10010&from=home
Inflation Adjusted GDP Statistics for 2010 extrapolating from current Global Economic trends
China 11,484.08
United States 11,142.77
Japan 9,198.72
Germany 6,073.71
United Kingdom 5,105.31
France 4,741.69
Italy 3,899.76
Canada 2,714.15
China supplants the United States as the world’s largest economy, not in 30 or 40 years as is commonly believed, but perhaps as soon as before the end of this decade. The U.S. retains its lead over Japan for second place, yet the margin declines from over 300% to just 10%. (My prediction is that the yen will rise more significantly than most other currencies meaning that Japan’s GDP will likely surpass U.S. GDP as well.) Further, the GDP of the thirteen nations sharing the euro is currently about 12.8 trillion dollars. After the dollar’s decline it will rise to a staggering 25.6 trillion, more then twice that of the U.S. As a result, considering the EU as a single nation, the U.S. economy would then rank forth among the world’s largest, with its GDP declining from 43% of world GDP to only 21%.
Wouldn’t buybacks explain in part why US dividends are low? For example, this report from S&P lists S&P500 q306 dividends as $54.8bn and buybacks as $109.8bn. $100bn here, $100bn there, and before you know it you’re talking real money and some of that would presumably otherwise be paid out to foreign investors as dividends.
Also, would the use of convertibles distort the picture?
Just a thought.
for tax reasons, us companies tend to pay out smaller dividends/ do more buybacks (better to have capital gains than income) relative to foreign companies, but i don’t think that is the main driver — dividend payments on portfolio equity are generally small. and on FDI, US companies don’t pay themselves dividends from their earnings abroad (except in years like 2005) b/c the dividends = repatriation and thus are taxable and foreign firms with direct investment in the US also report small dividend payments. the big gap between (low) foreign earnings and (high) US earnings comes entirely from “reinvested” earnings, which are just an accounting entry. profits earned abroad are used to finance FDI abroad …
“The world’s financial system is overflowing with stocks, bonds and other financial assets - $140 trillion worth, to be precise… At the epicenter of these financial flows is the U.S., which takes in about 85% of the flows from countries that are net exporters of capital - places like Japan, China and the Middle East…”Of all the savings that citizens world-wide are willing to put outside their countries, the U.S. gets 85% of it…” see chart: http://bigpicture.typepad.com/comments/2007/01/worlds_assets_h.html
that’s the nub — the US gets 85% of the net flows (extra-european flows) without offering anything like the best returns (indeed, recently it has offered very “subprime” returns to non-dollar investors). the question is why.
bsetzer:
I stumbled upon this while wandering through swamps of dark matter:
United Nations Conference
FDI Data Compilation in Brazil
December 2005
Page 5:
” The compilation of reinvested earnings is likely the major shortcoming of the Brazilian balance of payments. This item has not been compiled in Brazil for almost 10 years.”
http://www.unctad.org/sections/wcmu/docs/C2em18p02_en.pdf
Enjoy!
- apologies I spelled your name wrong
DC,
The Schiff “article” you posted is just nonsense, and to me displays a profound lack of understanding of how trade works. The basic premise supposes that an exporter simply puts a different label on a box of widgets and sends it to a different destination.
Lets look at Canadian/US trade, for example. Canada was only recently surpassed by China as the #1 import source country, and AFAIK is still the #1 destination country for US exports. Putting real names to the widgets, you’ll see that cars and energy are significant trade items. Even at current exchange rates, a new car plant in Canada is probably not competitive with an equivalent in the US. Looking at energy, a lot of the export is natgas, which goes by pipeline to the US. In theory, it could be liquified and sent elsewhere, but even ignoring the huge costs it would take a decade or more to develop meaningful capacity. Likewise electricity, which pretty much has to go to the US or nowhere at all. In other words, it’s preposterous to assert that exports can simply be redirected.
A similar dynamic will exist in varying degrees and for various reasons in the vast majority of trade. The bottom line is that if the US suffers a large decline in GDP and/or a large decline in the USD, it’s gonna leave a mark everywhere. Even Schiff likely knows it’s BS, and just throws outrageous stuff like that out there to troll for talking head gigs.
BTW, what does it have to do with the calculation of US income payments?
“But the interest the US received on its lending rose just as fast - going from $96b to $104.5b. Net interest payments actually fell by a tiny bit ($0.1b). ”
A question: are these inflowing interest payments based on the dollar? Or are they based on fx and then converted to dollars?
The reason I ask: if the interest is being paid on foreign currency denominated assets and thus is originally calculated in say, euros, and then converted to dollars, exchange rate variance might help to explain the increase.
Just a guess.
But I don’t know if those holdings that are generating interest are foreign currency based or not.
Btw, another link on the story: http://www.marketwatch.com/news/story/us-current-account-deficit-falls/story.aspx?guid=%7BD7887EB0%2DB6D0%2D4DA0%2DA3DC%2DDEAFF376CC02%7D
“…the long-awaited and much-discussed “rebalancing” of the world economy is about to accelerate…” http://www.nakedcapitalism.com/2007/09/scary-words-from-martin-wolf-end-of.html
US Bankruptcy - Debt Limit Rise to $9.815 trillion
Wed Sep 12, 2007
Senate panel okays $850 billion debt increase
WASHINGTON (Reuters) - The Senate Finance Committee on Wednesday approved an $850 billion increase in U.S. borrowing authority to $9.815 trillion in order to avoid a default as the government nears its credit limit of $8.965 trillion.
http://forum.cromalternativemoney.org/viewtopic.php?t=33
“…So what to make of the Hong Kong government’s revelation that it has become the largest single shareholder in the operator of the city’s stock and derivatives exchanges?… China aside, governments in the region, including Japan, South Korea, Australia, India and even Indonesia, do not own stakes in their national exchanges…” http://www.ft.com/cms/s/1/7b6a8ff0-62ea-11dc-b3ad-0000779fd2ac.html
“…The setting of a dividend might be theoretically logical for a company with a high level of annuitized revenues that are highly predictable, but this simply doesn’t describe the cash flow characteristics of most companies. Economies go through cycles. Shocks occur. Products obsolesce and aren’t immediately replaced with superior models. The competitive landscape shifts. There are countless reasons why earnings don’t grow in a straight line, and sometimes even fall. And this in and of itself doesn’t mean a company stinks; it means that it’s not impervious to outside influences. Therefore, creating corporate finance policies that are flexible, adaptable and take into account uncertainty seem to fill the bill in an increasingly complex and volatile world…” http://www.informationarbitrage.com/2007/09/in-support-of-b.html#comments
“The [????] received $49.6b more on its investment abroad than it paid on direct investment in the US.”
“…Much like private companies, the government pays for some of its operations with borrowed funds, which then are repaid from future revenue. The government has never defaulted on its spending obligations…” http://www.philly.com/inquirer/business/20070913_Senate_panel_votes_to_raise_U_S__debt_limit.html
future revenue being from maintenance payments to the global economy’s engine. if parallels can be made with ‘investments’ in education, insurance, healthcare, professional services, management, information/data, marketing/PR, government…
“… Decoupling, the notion that the rest of the world can weather the effects of a slowing U.S. economy, had all the attributes of a successful advertising campaign. The message was simple, clear and succinct. One problem: It doesn’t fly…” http://www.bloomberg.com/apps/news?pid=20601039&sid=az2e6XMi4vFg&refer=home
Ooooweee the dollar is technically toilet paper but no one in the world wants that to be the case. Ha ha it’s only paper.
The government should write off the debt and start from scratch. Then they should write themselves off. The currency gets devalued every pot and pan in that country gets devalued.
To be sure billion here, trillion there, pockets lined with fudged numbers, funds parked elsewhere. What a party and what a potential nightmare.
News flash, Brad. Looks like the Fed has its own adgenda. If this isn’t a force job to get banks to borrow at the discount window, then what is? I said it once, and I’ll say it again; the Fed may lower the discount rate on Tues. Read this from Seeking Alpha:
“The Fed created a situation where the federal funds rate, at 6.5% on Monday, 6.0% on Tuesday, and 6.25% on Wednesday, was higher than the 5.75% discount rate. The reasoning behind the Fed’s actions is because until this week, it had little success encouraging banks to borrow from them to increase liquidity and ease the credit crunch. There is a stigma associated with borrowing from the discount window; historically, it is done only in extraordinary situations. By forcing banks to borrow, this might diffuse the stigma. The Fed also lowered the discount rate last month half a point with the same idea of getting banks to borrow from them (full story). “If the carrot won’t work, use the stick,” Crandall said. The Fed’s last tactic was more than effective.”
Will all this subprime mess etc. create inflation or deflation?
Pro deflation: less demand in the US, burst of assetbubble could spilover to other prices, credit contraction, development like in Japan after the burst of their assetbubble.
pro inflation: Asian demand continues, cost push inflation because of shortage of oil etc., low dollar means higher import prices, higher wages in Asia means higher prices, money supply increase all over the world
Follow up question: would deflation be contained in the US - just like deflation were/are contained in Japan?
Omer — interesting idea. last i checked tho, a relatively small fraction of US long-term external liabilities (@20% of corp long-term liabilities, i think) and almost no short-terme external liabilities were denominated in a foreign currency. and in any case, that should have pushed up interest payments (b/c of the euro’s rising value), not pulled them down …
long-term, both the $ value of fx denominated debt and the coupon should rise, so it shouldn’t alter the implied rate — tho given the way the us calculates its data, the upward adjustment to the debt stock would only happen after the US survey of portfolio liabilities.
Brad - thanks for explaining. I agree with your answer. I can see, as the dollar is devalued, how US external liability payments might increase if denominated in fx, in part or whole.
However, I’m a bit confused about one thing. I was referring to *Foreign* long-term external liabilities (i.e. funds owed to the US)rather than US liabilities in order to try to maybe explain why “…interest the US *received* on its lending rose just as fast….” (Which you suggested was puzzling.)
So, if money lent by the US and thus owed to the US is actually denominated in fx, might it not help to explain why receipts increased, since interest payments would be “pushed up” in dollar terms? Dollar receipts would increase as a result because the euro interest payments would, when exchanged into dollars, amount to more dollars. (Each euro would fetch more dollars.)
IOW, if US external payments to foreign lenders were denominated and thus paid mostly in dollars and, in contrast, if our external receipts and payments received from foreign borrowers were denominated in mostly fx (say, euros), then the net effect of the dollar devaluing (again, each euro would fetch more dollars)would be to narrow US net payments deficits. In a narrow sense and ceteris parabus, of course.
Perhaps I’ve misunderstood your point though…. I may have missed something. If so, sorry. Thanks again.
Brad–
in terms of “dark matter,” don’t forget the enormous amounts of 3rd world dictator money that find their way back into the United States. While pretty much all information you get on this stuff is below “gossip” on the credibility meter, it’s the only information there is … rumor is that Vladimir Putin is worth over $50 billion himself, and he has direct control over Russia’s entire accumulated national surplus ($250bn?). Chavez/Venezuela is a similar case; Venezuelan GDP has not risen nearly commensurately with what Venezuela should have realized from the oil spike of the last several years, so you have to figure that a lot of it has trickled back to the United States under different identities/banks/hedge funds (but still under Chavez’s control).
Omer — yes, funds lent in say Brazilian real should generate more interest (in $ terms now than before). But if i did my calculations right, the average interest rate on US lending was roughly constant while the average int. rate on us borrowing fell, so it doesn’t seem like a full explanation for the most recent period. I do suspect that the effect you described is one of the reasons why the BEA revised the overall income receipts series up (receipts = interest payments on uS lending). and it is quite possible i also just got my calculations wrong — i did them quickly.
I hadn’t heard the Putin = $50b rumor, but I guess the Russian oil czar wants to keep with the middle eastern oil sheiks … I am not sure tho that most of this would be stashed abroad.
Few people would have publicly predicted that the US$ index would be surpassed by the price oil. Interesting.
“More than $380bn has either been stolen or wasted by Nigerian governments since independence…” http://news.bbc.co.uk/2/hi/africa/6069230.stm
since when was putin a ‘3rd world dictator’? if ‘controlled’ may be more appropriate than ’stashed’ - and that the wealth controlled by chinese - and even ‘1st world’ leaders should be considered if this is a valid point. but i’d also imagine that putin may be the first to acknowledge that control is not absolute and there have to be some very signficant costs to maintaining it.
brad - as you have mentioned the black market, wondered why you ignored the first comment. whether you’re assuming the bulk of funds and flows in various parallel economies are somehow integrated into the numbers you track - which is what makes them truly parallel? - or if you care to elaborate as to if or how these concerns may affect the interpretations and outcomes that are the core topic of this post.
where i’m also getting confused/concerned is that lack of attention to the underlying ‘investments’ and expenditures on all the attendant professional services.
Brad–
I have a couple of thoughts.
I think another story may be going on instead of the one that you, very compellingly, tell.
-Lower US Net official Capital Inflows: either your story is true, or Official lenders have started diversifying out of Dollars. I think this may not be excluded. All in all we have all been forecasting this in the past years. And it may not be wrong to assume that they have been doing this in q207, when news about possible US recession and monetary restriction had just started spreading about.
-US borrowing interest rate (plunging): well, if you credit Bernanke’s story, and if you assume that the interest rate applied on the blend of deposits that US sells to its lenders responds to market rules, it may be reasonable to conclude that nothing particularly strange has been going on.
However, only one of the above “alternative” stories may be true (because if foreign officials have been withdrawing money, interest rates should have gone upwards). Or maybe a thrid solution is possible: BEA data are wrong but not by as much as you assume and both stock inflow and net interest payments data should be revised (the former upwards, the latter downwards). And all in all, a certain amount of Dollar-abandoning may be occurring.
(But remember: US firms may find it profitable to not repatriate capitals, but foreign firms operating in the US may find it even more profitable to under report profits: the US tax regimes allows for this as well.
Bottom line: US income FDI payments outflows may be bigger than BEA tells. This also sheds light on another problem: we are too used to think at the interest rate applied on US borrowings as the rate applied on net income and payments. But if one of the data is wrong — as it may be the case for the FDI — the whole ratio, that is, the whole interest rate, changes. So should such a revision bring the net interest to, say, 4.4% or even 4.45%, the world’s Dollar wothrawing story may sound correct).
I agree with the Europe-China growth argument–in theory. But it sounds to me a very complicated argument if you account for the whole EU-25 countries (i.e.: the Dollar/EU value may be decreasing more than the Dollar/other European currencies is, while US vs Euro-area CA may be deteriorating less than the US vs rest of Europe; and viceversa).
Best
Bernardo
“…”Enron was only $1 billion; this fraud is much bigger,” one of the prosecutors, Justin Weddle, told a senior lawyer for KPMG… The handling of the case has significant implications for the prosecution of its former employees, as well as for a criminal case against Deutsche Bank, which is under federal investigation into its tax shelter work…” http://www.nytimes.com/2007/07/06/business/06kpmg.html?ref=business
Dr. Setser,
I still think there’s a hidden identity in the global economy. Simple extrapolation of trends continually seems to indicate that the US will tip into a negative income balance. Yet it hasn’t happened. Something always changes or responds to prevent it. In the 30 years since Nixon went off the gold standard and the dollar began to float, it hasn’t happened - it’s one of the few things that has stayed constant through all that!
The identity probably arises because the US has been insulated so well: dollar denominated energy and debt; monetary (and fiscal) power, economic importance, and market share sufficient to drive world markets (not just respond to them); reserve/emergency currency status; and foolishly pegged currencies in major trading partners. These factors evidently act like a complex series of negative feedbacks. As long as these conditions continue, the US will borrow for free - the US investment income balance will NOT shift negative.
It sounds odd - but it seems that it MUST be true. Now I just have to explain why….
EthanJ — let me know when you find the explanation.
revisions to the us external accounts that always seem to go in favorable way seem to be part of the reason in some very proximate sense.
Brad–
Third world oligarchs are naturally insecure in their positions. They want their money somewhere so that, if political turmoil threatens their domestic power base, they can go underground with the knowledge that their secondary power base - all the money they have saved up - is secure.
Therefore, they would want that money as far away from their home country, and as well-hidden as possible. There’s no point in piling up tons of money in your own country, just enough to maintain cash flow for the regime (which after all is pretty much a dictator’s “small business”). More than that requisite minimum simply increases the payoff of overthrowing you.
Brad, two papers mentioned elsewhere in connection with this:
Americans do IT better demonstrates the FDI by American companies abroad is MUCH more effective than FDI by foreign companies.
What explains the US net income balance? evaluates several competing explanations.
I can’t recall if you’d blogged either of these yet.
The August Trade Deficit figures came out today. Everyone in the financial media seems to like them.
What is there to like about a -57.6 Billion dollar mess?