Global: Global: Imbalances, Take 2
Rebecca McCaughrin (London)
In contrast to a country’s financial account, which is a flow concept representing the change in assets owned and liabilities owed, the international net debt position is a stock concept, representing the cumulative financial account balances, adjusted for movements in exchange rates and asset prices. For this reason, a country’s net international investment position (IIP) is a more accurate mark-to-market gauge of indebtedness. It is also one of the indicators used in our FX team’s fair value models, and so any changes in the underlying position can be important from an FX standpoint. In addition, this metric is used to determine a country’s debt-servicing burden. Since US gross liabilities are not only larger than gross assets, but are also more heavily concentrated in debt securities (37% instead of 7% for assets), this will be a key issue for the US as global interest rates continue to rise.
Further Deterioration in Net Foreign Debt Position
The US net debt position deteriorated to a new record high of $2.4trn or 22.1% of GDP in current cost terms (24.1% in market value terms). In other words, the US now owes an extra 22.1% of its GDP to the rest of the world after subtracting the amount owed by foreigners to the US. Although a weak dollar and strong overseas market performance helped to limit the deterioration, financial flows were still larger, adding an additional $198bn to the US’s net liabilities between yearend 2002 and 2003. A depreciation in the dollar increases the value of holdings denominated in foreign currency, but has no impact on USD-denominated assets. Since liabilities (foreign holdings of US assets) are almost fully denominated in dollars, while assets (US holdings of overseas assets) are mostly denominated in foreign currencies, the depreciation of the USD in the last two years has inflated gross assets and has had a positive impact on the net debt position — but only enough to slow, not reverse, the deterioration.
Global Context Matters
The US tends to attract the greatest attention as a large debtor nation. But there are a number of other countries that have accumulated far greater mountains of external debt as a share of GDP. Among the 37 countries that our group tracks for which position data are available, at least fifteen have at some point or another in the last two decades run a larger net debt position as a share of GDP than the US. Finland takes the prize for the largest liabilities on record; at -168% of GDP in 1999, it was off the charts for reasons explained below. Among industrialized economies, Austria, Finland, Greece, the Netherlands, Portugal, Spain, Sweden, Australia, and New Zealand are all currently running larger debt positions than the US. From this perspective — and one that we attribute greater importance to than flow concepts like the current account — the US is not nearly as ‘imbalanced’ as it is often portrayed.
Finland’s case is an extreme example of how valuation changes can create sharp swings in a country’s level of debt. Between 1998 and 1999, liabilities jumped by $139bn to $326bn even though FDI and portfolio inflows increased by just $2.3bn during that period. A small portion of the spike was due to the FX adjustment resulting from the introduction of the euro, but the bulk of the deterioration came from the 151% surge in Finish equity prices as the tech bubble inflated. This jump far exceeded the rise seen in other developed world markets. As the tech bubble burst, and Finland’s equity market plunged, the resulting revaluation yielded a halving of Finland’s net debt to -83% of GDP by the end of 2001. The net debt position halved again the following year, and by the end of 2003 was below -30%. Could the US see a similar price-driven swing in its own IIP? Probably not. Finland’s case is distinct in many ways from the US, the most obvious point being the small contribution of financial flows to its debt position. In the US, valuation and exchange rate changes have played an important role in inflating and deflating the overall level of indebtedness in the last five years, but the underlying mechanism of debt accumulation remains financial inflows.
Resistant to Reversing
Is there a threshold at which a country’s IIP becomes unsustainable? Oft-cited empirical work suggests that the US begins to test the limits of its sustainability as the current account nears 5% of GDP. (See Catherine Mann, Is the US Trade Deficit Sustainable?, Institute for International Economics, 1999. 5% is intended as a rough ballpark figure, not a precise target. Our US chief economist Dick Berner places the peak at a slightly higher 6%.) We looked at the same set of 10 industrialized countries used in the current account study (Australia, Canada, Finland, Italy, Norway, New Zealand, Spain, Sweden, UK, and the US) to determine whether there is also a ‘magic’ threshold at which the deterioration in a country’s net debt position tends to reverse. Excluding Finland, which is an outlier for reasons explained above, we found 6 episodes in which the net IIP narrowed. The average turning point for these instances was 24% of GDP.
Does that mean the US net debt position — which is just two percentage points shy of that threshold — will soon test its upper limit? That’s highly unlikely, in our view.
First, the range of turning points is fairly large for the countries we observed, extending from 9.1% to 43.4% of GDP. In addition, the ratio is much higher for later periods, and given the evolution in financial markets over the 1990s, these later observations are probably more representative of current thresholds.
This type of cross-country analysis overlooks the impetus for the expansion in liabilities. A temporary shock may make large liabilities more susceptible to a reversal, whereas a permanent shock, such as a boost in productivity, can have a permanent impact on the net IIP. Indeed, a recent Fed paper estimates that the increase in US productivity could easily account for 20% of the worsening in the US net debt to GDP ratio since 1994 (see Michael Kouparitsas, “How Worrisome is the U.S. Net Foreign Debt Position?,” Chicago Fed Letter, May 2004). This would imply that the US is capable of sustaining a higher net debt level than would have been the case prior to the mid-1990s.
Third, capital market deregulation and ongoing international portfolio diversification make historical comparisons moot. As the so-called home bias continues to decline, there will be more scope for investors to diversify their portfolios. Although there is no way to determine the composition of future diversification, the US is still an attractive option, given its asset market depth. Euroland capital markets have deepened since the introduction of the euro, but the US still accounts for 45% of the global equity market cap and 43% of the long-term debt market. Although capital market deregulation can contribute to an expansion in both liabilities and assets, there is greater potential at the margin for gross liabilities to expand by a larger amount, widening the net debt position. This is because US investors are closer to their ‘optimal’ overseas portfolio diversification (based on the traditional ICAPM) compared to their foreign counterparts.
Bottom Line
Based on the metric of the net IIP, the US is not as severely imbalanced as it’s often portrayed, with a host of other industrialized countries currently running larger net debt positions as a share of GDP. Moreover, ongoing capital market deregulation, international portfolio diversification, and the effects of permanent productivity gains have likely boosted the threshold for the US net debt position to a higher sustainable level, making both historical and cross-country comparisons moot. |
