Monday, April 27, 2009

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
on April 27, 2009 |   Edit