by Joseph Joyce
Current Account Deficits and Safe Assets
The International Monetary Fund has issued its External Sector Report for 2017, and among its key findings: “Global current account imbalances were broadly unchanged in 2016…” The U,S. continues to record the largest deficit, $451.7 billion, which is equal in value to 2.4% of U.S. GDP. The continuing deficits contribute to the increase in the U.S. debtor status in its net international investment position (NIIP), currently valued at $8.1 trillion, which is equal to 42% of GDP. The Fund is concerned that these imbalances, as well as the persistent surpluses in Germany and other nations, “…raise the risk of disruptive corrections down the road, including due to diverging stock positions.” But as long as the dollar serves as the world’s reserve currency, a U.S. current account deficit will be an inherent feature of the international financial system.
The share of U.S.-dollar denominated liabilities in the foreign reserves of central bankscontinues to hold at over 60% of all reserves. Foreign central banks own about $4 trillion of U.S. Treasury debt, and foreign private residents another $2 trillion. Andreas Steiner of the University of Gronigen (see also here) has demonstrated that the reserve currency status of the dollars lowers the current account balance as foreigners exchange goods and services for U.S. securities. John Benedetto of the U.S. International Trade Commission has shown that the U.S. current account deficits of the last decade were largely financed by the purchases of foreign governments of U.S. government debt.
The increases in foreign official holdings of Treasury securities have been partially offset in the capital accounts of many emerging market economies by private capital inflows. Laura Alfaro of Harvard Business School, Sebnem Kalemli-Ozcan of the University of Maryland and Vadym Volosovych of Erasmus University Rotterdam (see also here) pointed that developing countries with high productivity growth have received equity inflows. The “uphill” capital flows in the opposite direction are due to the official purchases of Treasury debt by these countries’ central banks. These patterns are consistent with the “long debt, short equity” composition of many emerging markets (see here).
The foreign purchases of U.S. Treasury securities have had an impact on their return. Balazs Csonto and Camilo E. Tovar of the IMF have estimated that a percentage point rise in these holdings reduces the term premium on securities with maturities of 3 years or less by about 2.0-2.4 basis points. The fall in the cost of borrowing, while advantageous for U.S. borrowers, distorts domestic consumption and investment.
However, the supply of U.S. Treasury securities may not be sufficient it meet the demand. Ricardo J. Caballero of MIT, Emmanuel Farhi of Harvard and Pierre-Olivier Gourinchas of UC-Berkeley have examined the demand for “safe assets,” which they define as a “debt instrument that is expected to preserve its value during adverse systemic events.” Before the global financial crisis, these included the mortgage-backed obligations of U.S. government-sponsored enterprises, such as Freddie Mac and Fannie Mae, as well as privately-issued asset-backed securities that had been rated AAA. But their status as “safe assets” vanished once the crisis hit, and the resulting fall in the supply of “safe assets” has bolstered the appeal of U.S. Treasury debt.
The role of the U.S. in supplying financial assets to the world was examined in the 1960s by Emile Despres of Stanford University, Charles P. Kindleberger of MIT and Walter S. Salant of the Brookings Institution. They characterized the U.S. as a “world banker,” which performed a vital financial intermediary service in providing liquidity to foreign asset-holders in return for outflows of U.S. capital into foreign long- and intermediate-term investments. Pierre-Olivier Gourinchas and Hélène Rey updated this analysis in 2007 to highlight the U.S. role as a “world venture capitalist,” which holds foreign equity in exchange for safe, fixed-income liabilities. The U.S. equity holdings allowed their issuers to share the cost of the global financial crisis when they fell in value on the balance sheet of the U.S.
How long will foreign nations be willing to accept U.S. debt? Robert Triffin drew attention in 1960 to the inherent instability in the Bretton Woods monetary system due to the discrepancy between the amount of gold owned by the U.S. government and the growing quantity of dollars held outside the U.S., which could be exchanged for the U.S. gold. That linkage was discontinued in 1971 by President Richard Nixon.
U.S. government securities continued to be held outside its borders, in part because of the lack of any widely-accepted alternative. Ludiger Schuknecht of the German Ministry of Finance, however, believes that there may be a tipping point along a “safe assets Laffer curve” when an increase in the amount of government debt will result in increasing concerns about its safety and consequently a decline in the availability of safe assets. He points to the fall in the ratings of the government debt of many advanced economies in recent years as evidence of mounting concern about the creditworthiness of their obligations.
Barry Eichengreen of UC-Berkeley has examined the rise of the U.S. dollar, and pointed out that a multi-reserve currency system could be a viable alternative to the current arrangement. The use of China’s renminbi as a regional currency will grow, much as the euro serves countries that trade with members of the Eurozone. But the lack of broad and liquid financial markets for those currencies has left the demand for U.S. Treasury obligations intact for now. Consequently, there is a structural component of the U.S. current account deficit that does not respond to domestic policies. The U.S. NIIP deficit will continue to widen, and the IMF projects that with current policies the U.S. net debtor position will deteriorate, “…exceeding 50% of GDP by 2021.”
But this could change if there were a reappraisal of the “safety” of U.S. assets. What could bring about such an adjustment? The political chaos in Washington is contributing to a reevaluation of the role of the dollar. Assaults on our institutions lead to questions about the stability of our political process. Moreover, if Congress can not agree to raise the federal debt ceiling, foreign bondholders will reevaluate the ability of the government to fulfill its obligations. In that case, there may not be any “safe” assets, and the next financial crisis could be even more unsettling than the last one.