the U.S. benefits from lending at very low rates while it earns substantially higher rates on the capital it sends abroad

TO BE NOTED: From Antonio Fatas and Ilian Mihov on the Global Economy:

"Changes in the funding of the U.S. current account deficit

Since the mid 80's (and with the exception of a small pause in the early 90's) the U.S. has run a current account deficit, which means that domestic spending has been larger than domestic income/production. This deficit was growing in the period leading to the current crisis and it led to concerns about global imbalances and how countries would adjust to them. Here are a couple of charts that show some of this evolution as well as some recent changes that point to adjustments in the way the current account deficit is being financed.

The first chart shows the evolution of the U.S. current account balance. We clearly see the downward trend during the 1995-2007 period and then a reversal during the last year, 2008. This reversal is very much driven by a large drop in imports. Exports have also decreased (as world trade has collapsed), but imports have fallen by a much larger amount. Some of this fall is related to the decrease in the price of oil during 2008 relative to 2007.

U.S. Current Account Balance (Billion USD)

A second interesting fact in the chart above is the behavior of net investment income. Net investment income remains positive during all the years. This means that the US receives more investment income from investments abroad than what it pays to foreigners for the capital that it has borrowed from them. If you take into account the fact that the US has become a large debtor to the world (i.e. that the foreign liabilities are substantially higher than the foreign assets) this is a surprise. One would expect a debtor to be paying interest on the debt. What we see below is that in net terms the U.S. is receiving interest payments on a negative net asset position. In other words, the U.S. benefits from lending at very low rates while it earns substantially higher rates on the capital it sends abroad. Financing a current account deficit under this conditions is much easier!

This investment income has more than compensated the income sent abroad in the form of "Net Transfers". This income include worker's remittances to their countries of origin. The fact that these two variables have been very close to each other means that the current accounts is very close to net exports (the balance on goods and services) [A reminder on balance of payments accounting: Current Account = Net exports on goods and Services + Net Investment Income + Net Transfers].

How was the current account financed during these years? The U.S. was borrowing from other countries (those with current account surpluses looking for investment opportunities). Of course, we observe capital flows in both directions and what matters is the difference between the two. Interestingly, during these years, capital flows in both directions grew. The chart below shows these flows. The current account deficit needs to be financed by foreign lending to the US (labelled below as "changes in foreign assets in U.S." which by convention are positive if there is a flow) in excess of US lending to other countries (labelled below as "changes in US assets abroad" which by convention are negative if there is a flow).

Funding of U.S. Current Account (Billion USD)

Up to 2007 we see both flows increasing but the size of foreign lending to the US is always larger than the flow in the opposite direction, and this difference funds the current account deficit.

In 2008 we see a collapse of both flows. The flow of lending to the U.S. goes from around 2 trillion to 600 billion. This collapse is matched by a decrease of capital flows from the U.S. to foreign countries from 1.3 trillion to almost zero. What is even more interesting is that if we split this flow into private and official (government and central bank related) flows, we see that private flows from the U.S. to other countries changed from an outflow of about 1.3 billion in 2007 to an inflow of 480 billion - this represents a change of close to 1.8 trillion. In other words, a large part of the current account deficit in 2008 was financed by U.S. nationals selling their assets abroad and repatriating the funds to the U.S. The change in these private flows more than compensate the drop in capital flows from other countries. [At the same time, official flows from the U.S. to other countries increased to reach almost 500 billion. Most of this lending is likely to be associated to the lending facilities that the Federal Reserve has made available to European central banks]

A final comment on the chart: the "statistical discrepancy" also helped funding the U.S. current account deficit in 2008. The swing from negative to positive from 2007 to 2008 indicates that while in 2007 there were some "missing" capital outflows, in 2008 we are missing some of the capital that flew into the U.S. by an amount that is large (about 130 billion).

It will be very interesting to see how these numbers change during 2009 and 2010. The selling of U.S. assets is not a sustainable source of funding. It is likely that the current account deficit will become smaller but not by much (given the limited growth that we are seeing in other countries) so there will be a need for capital inflows to the U.S. to be larger than what we have seen during 2008.

By the way, if you are interested in this topic, I recommend the excellent blog of Brad Setser.

Antonio Fatás"

"It was a largely unregulated system. And it was largely offshore, at least legally. "

Brad Setser:

"The collapse of financial globalization …

Posted on Monday, December 29th, 2008

By bsetser

The last six months — if not the last year — logged what felt like a decade’s worth of financial news. So perhaps it isn’t surprising that swings that normally would attract an enormous amount of attention have gone almost unnoticed. Like the near-total collapse of private capital flows.

Both private capital inflows to the US and private capital outflows from the US have fallen sharply. They have gone from a peak of around 15% of US GDP to around zero in a remarkably short period of time …( FEAR AND AVERSION TO RISK )

The fall in private flows over the last four quarters has been much sharper than the fall in the US current account deficit. The current account deficit continues to hover around $700 billion (5% of US GDP). Financial globalization — the growth in private cross-border flows, and associated rise in private inflows and private outflows — doesn’t seem to have been as central to the ability of the United States to sustain large current account deficits as some thought back in 2004 and 2005.( INTERESTING )

The preceding graph is based on the BEA’s balance of payments data, scaled to US GDP (the quarterly data was transformed into an annual series by calculating a rolling 4q sum and the sign on private outflows was reversed). I did adjust the latest BEA data in one way. From q2 2007 on I subtracted “private” purchases of Treasuries from the “private’ total. The last survey of foreign portfolio holdings — which revised the data from mid-2006 to mid-2007 — basically re-attributed all private purchases of Treasuries from private investors in the UK to the world’s central banks. My adjustment thus anticipates the revisions that are likely to follow from the next survey.*

But even if “private” Treasury purchases since mid-2007 are counted there still would have been a stunning fall in private capital flows. Direct investment flows have continued. Other financial flows though have largely gone in reverse, with investors selling what they previously bought.( FLIGHT TO SAFETY ) In the third quarter foreign investors sold about $90b of US securities (excluding Treasuries) and Americans sold about $85 billion of foreign securities. And the reversal in bank flows on both sides (as past loans have been called) has been absolutely brutal. ( FROM THE CALLING RUN? )

This sharp fall has bearing on the bigger debate over the role global capital, global savings and foreign central banks played in helping to to create the conditions that allowed US households to sustain a large deficit for so long — and whether American and other policy makers should have paid more attention to the risks that came with the surge in foreign demand for US financial assets earlier this decade.

Back in 2004 and 2005 — when it was beginning to be apparent that the growth in central bank reserves had led to unprecedented demand for US assets from reserve managers — many argued that central banks weren’t as important to the financing of the US deficit as it seemed. While net central banks demand seemed large in relation to net private demand for US assets, central banks only accounted for a small share of gross inflows — and in some sense total foreign purchases of US assets matter more than anything else. Ergo, central bank demand wasn’t central to the ability to the United States’ ability to sustain large current deficits, whether from large fiscal deficits (03-04) or a rise in household borrowing (05-06).

Fair enough. But even then it seemed like the increase in private inflows was tied to an increase in private outflows, so there was a reason why the growth in private flows wasn’t generating much net financing. Note how closely gross inflows and gross outflows move together in the graph — setting aside the inflows attracted by high US interest rates in the 1980s and the period in the late 1990s when foreign investors really were clamoring to buy US equities. Most of the rise in total flows reflected a rise short-term flows and short-term cross-border bank flows often seem to offset each other. Or to put it a bit differently, the US deficit has not been financed by short-term borrowing from the world’s private banks. ( OK )

Think of the process this way. Suppose a US bank lends a billion dollars to a bank in London that lends that money to a hedge fund domiciled the Caribbean that buys a billion dollars of US securities. That chain results in an outflow and inflow, but the outflow just financed the inflow — it doesn’t help to finance the current account deficit. By contrast, China’s purchases of Treasuries and Agencies reflect in large part China’s current account surplus — not Chinese banks borrowing from US banks. They certainly help to finance the US current account deficit.

I think we now more or less know that the strong increase in gross capital inflows and outflows after 2004 (gross inflows and outflows basically doubled from late 2004 to mid 2007) was tied to the expansion of the shadow banking system.( OK )

It was a largely unregulated system. And it was largely offshore, at least legally( THIS IS WHAT I SAY WOULD HAVE HAPPENED WITH MORE US REGULATION ). SIVs and the like were set up in London. They borrowed short-term from US banks and money market funds to buyer longer-term assets, generating a lot of cross border flows but little net financing. European banks that had a large dollar book seem to have been doing much the same thing.** The growth of the shadow banking system consequently resulted in a big increase in gross private capital outflows and gross private capital inflows.

Those private flows have now disappeared, or even reversed. They actually started to disappear back in August 2007. That didn’t keep the US from continuing to run a large (5% of GDP) current account deficit. The fall in private flows has been far sharper than the fall in the current account deficit.

Why didn’t the total collapse in private flows lead financing for the US current account deficit to dry up? That, after all, is what happened in places like Iceland — and Ukraine.

My explanation is pretty straightforward.

Central banks were the main source of financing for the US deficit all along.*** Setting Japan aside, the big current account surplus countries were all building up their official reserves and sovereign funds — and they were the key vector providing financing to the deficit countries.

And when (net) private demand for US assets fell, official flows picked up. As I noted earlier, private purchases of Treasuries after June 2007 are almost certainly really official flows. If those purchases are added to recorded official flows,**** total official flows over the last four quarters of data (q4 07 to q2 08) now almost match the current account deficit.

That is true even though I have calculated net official flows — and in the third quarter of 2008 for the first time in a long time the US central bank was a net lender to the world. Yep. The Fed provided $226 billion of credit through various swap lines in q3, and foreign central banks only bought $118 billion of US assets. This shows up cleanly if official inflows are plotted against official outflows (the graph is done on a rolling four quarter basis).

Central banks lent the proceeds of their swap lines with the Fed to private banks abroad, and private banks in turn repaid their maturing dollar debts — so the swap lines financed the unwinding of existing US loans to the rest of the world. Call it facilitating the unwinding of some of the legacy of the excesses of the past few year. Or call it a new wave of financial globalization, one led by the central banks …

At this point, I don’t really think that there can be much doubt that the enormous increase in central bank reserves over the last five years was central to the process that allowed the US to run large current account deficits during a period when private demand — that is private inflows net of private outflows — for US financial assets wasn’t there. At least not on the scale needed to finance the United States big deficits.

In my judgment, the US housing bubble — and the associated rise in private consumption as households borrowed against the rising value of their home — wouldn’t have been able to grow for as long as it did without this inflow from the rest of the world. But that is a story for a different post.( I NEED TO SEE THAT )

*Watch what happens when the data from the June 2008 survey is released. I would expect a large upward revision in official inflows from q3 07 to q2 08. The BEA data currently indicate $478 billion in official purchases over these four quarters and another $256 billion of private purchases of Treasuries.
** We know this in large part because of how much they have borrowed (indirectly, through their “home” central bank) from the Fed after financing from the interbank market and US money market funds dried up after Lehman’s collapse.
*** In theory, central banks could have bought a lot of euros and private European investors could have bought a lot of US assets, allowing the US to run a large deficit financed by European private investors even in the absence of a European current account surplus. This perhaps happened to an extent — but it seems to have been less important than central bank purchases of dollar assets.
**** This still likely under counts total official flows. Before they stopped buying Agencies this fall, central banks (especially China’s central bank) also bought Agency bonds from private intermediaries, so the survey tended to revise private Agency purchases down and official purchases up. And even the revised data doesn’t seem to pick up a large fraction of Gulf purchases — whether purchases of “risk” assets by sovereign funds or “safe” assets by SAMA (the Saudi Monetary Agency) and Gulf central banks."

I would expect the Central Banks of Saver Countries to be the buyers of our Treasuries and Agencies, and Japan to do so in order to keep exports high. This fits in with two of my predictions:

1) It is the Saver Countries ( China, Germany, Japan ) that want to really keep this current arrangement going.

2) Investors would simply have done more offshore investing had the US had tougher regulations.

I would add that two main problems:

1) The Flight To Safety ( Into Treasuries )

2) The Calling Run ( The need to raise capital )

Are bound up with this system. How? Very simple. As I've said before, foreign investors were also counting on strong and decisive government intervention in a financial crisis. They were directly tied into the same ideas and presuppositions as US investors. Our leaders didn't perceive that we were the LOLR for the whole world, and the Implicit And Explicit Guarantees extended to the whole world, by these Central Banks buying our debt.