America: the world's biggest hedge fund
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Jun 30th 2004
From The Economist Global Agenda
Are markets about to start panicking about the dollar again—with good reason?
YOU, dear reader, along with everyone else from Tokyo to Tallahassee, will have been casting your gaze towards Washington this week, to see how large would be the puff of smoke emanating from the Federal Open Market Committee. Airwaves will be filled and forests felled with discussions, learned and otherwise, parsing the utterances of the members of that august committee of interest-rate setters, and particularly those of its chairman, Alan Greenspan, for clues as to how fast interest rates will rise in coming months. Precious few eyes, it is safe to aver, will have been on an annual survey of America’s net investment position released on Wednesday June 30th by the Department of Commerce’s Bureau of Economic Analysis (BEA). But since everyone knew what the Fed would decide on the same day, Buttonwood wonders whether the BEA’s was not the more important statistic coming out of Washington this week, since it provided reasons aplenty why the dollar has further—a lot further, perhaps—to fall.
Last year and earlier this year, if memory serves, financial markets were abuzz with talk of the dollar’s dismal prospects, perhaps even its imminent collapse. There was much discussion of America’s humungous twin deficits (its budget deficit and current-account deficit); fuming about Asian central banks trying to stop their currencies rising against the dollar (though less fuming about how their purchases kept down long-term interest rates); and raging about how none of this was sustainable. The dollar, most right-thinking people agreed, needed to drop, though in an orderly fashion so as not to scare off those nice Asian central banks who had bought squillions of dollars’ worth of Treasury bonds. Buttonwood himself even weighed in with a few less-than-cogent thoughts, and discussed the advantages of America as a holiday destination with his daughters. Naturally, the dollar went up, and talk about it doing otherwise has dwindled to vanishing point.
Perhaps that is why, in recent weeks, the greenback has begun to slide again, while gold has staged a comeback to $400 an ounce. Since mid-May, the dollar has fallen by 4% on a trade-weighted basis. On the face of it, this seems peculiar. The dollar has started to fall again even as the chatter about interest-rate rises has got louder. Naively, you might expect a currency whose interest rates are about to rise to go up, not down. One explanation why the reverse has been the case is that the Fed has been late in stamping on inflationary pressures, so real interest rates—ie, adjusted for inflation—are falling even as nominal rates are expected to rise. There might, however, be another explanation: that rising rates will make an already awful current-account deficit worse still, and that markets are again starting to realise that the only way in which this can be corrected in the long term is by a sharply lower dollar.
The current account essentially comprises two things: the trade balance and overseas investment income. America’s trade deficit is bad and getting worse, even though the dollar has fallen by 23% from its recent high in February 2002. A $46.6 billion trade deficit in March had risen to $48.3 billion in April. In the absence of a net surplus from foreign investment, notes Jim O’Neill, the chief international economist at Goldman Sachs, this would mean a current-account deficit for the year of more than $600 billion, or getting on for 6% of GDP. No problem, say the more sanguine: America has long been able to finance its large and growing deficit because it is such a wonderful place in which to invest.
There are, however, a couple of snags with this argument. The first is that Americans find foreign climes more attractive to invest in than foreigners regard America: net foreign direct investment (FDI) has amounted to minus $155 billion over the last 12 months. And who can blame them? Returns on FDI into America were 5.5% in the first quarter, compared with returns of 11.7% on American firms’ foreign investment. Nor is this an aberration: the returns in America have been consistently lower for many years.
This gap has been plugged by portfolio flows (investment in such things as stocks and bonds) but of late the overwhelming majority of these have been due to foreign central banks, particularly Asian ones, trying to stop their currencies rising against the dollar, and buying Treasuries as a by-product of this intervention. Foreign central banks now hold $1.2 trillion of Treasury bonds. As growth and inflation rise in Asia (or in Japan’s case, as deflation eases), the arguments for intervening look much shakier. Japan, indeed, seems almost to have stopped wading into the foreign-exchange markets. Foreign central banks are, moreover, starting to fret about the amount that they hold in dollars. None of this bodes well for the dollar’s future value.
Nor does the net income that America makes on foreign investment. In the first quarter, this surplus amounted to almost 0.5% of GDP. This seems extraordinary, for reasons that have everything to do with the BEA’s annual survey. This showed that America's net foreign liabilities have continued to rise, standing at over 24% of GDP at the end of last year, up from almost 23% in 2002. Despite that, the country still managed to make more money from investing abroad than it had to pay to foreigners, for the simple reason that American investors’ domestic financing costs were so much lower than their overseas returns. In other words, says Mr O’Neill, the United States is like a giant hedge fund, borrowing huge wodges of cheap money at home and then investing it in higher-yielding foreign assets.
Which is where we return to the subject of higher interest rates. When interest rates go up, this net surplus on America’s investment income will turn into a deficit. A yield on ten-year Treasury bonds of 6%, says Goldman Sachs, would in the space of a few years add 1% of GDP to the current-account deficit, solely through higher interest charges. Whether or not yields reach such giddy heights depends mainly on two things: how much inflation is actually picking up; and foreigners’ continued willingness to supply the giant hedge fund known as the United States of America with cheap finance. Still, Mr O’Neill, for one, thinks it “virtually impossible to be a structural bull on the dollar”. Buttonwood finds it virtually impossible to disagree. His pony-mad younger daughter is enthralled by the idea of a holiday on a dude ranch.
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