US reaches milestone dependence on foreign funds with Moody's warning
Author: Trevor Lloyd-Jones
Source: BI-ME
Published: 29 January 2008
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INTERNATIONAL. As the Bush administration and US Congress try to craft an economic-stimulus plan, a cloud hangs over them: the federal deficit.
Iraq and Afghan war costs of US$9.6 billion a month and a gaping federal deficit funded by borrowing from foreign governments limit how aggressively the US government can cut taxes or boost spending to fend off a recession. And just over the horizon, a fiscal crisis that some call a day of reckoning looms larger.
Statistics released on Wednesday by the nonpartisan Congressional Budget Office (CBO) show that the federal deficit - the gap between what the government spends and the revenue it collects - is projected to leap to US$250 billion in the current budget year. That's up 53% from the US$163 billion deficit in fiscal year 2007.
If Congress approves the roughly US$150 billion economic-stimulus plan being discussed, the deficit for the current fiscal year, which began on 1 October, could swell to almost US$400 billion. The CBO presented those estimates to Congress as part of its budget and economic outlook for 2008 to 2018.
"Ongoing increases in healthcare costs, along with the aging of the population, are expected to put substantial pressure on the budget in coming decades," Director Peter Orszag told the House Budget Committee.
Lawmakers can sharply cut government spending, sharply raise taxes or pass some combination of the two, Orszag said.
The Bush administration frequently notes that although the deficit is high, it is still low in historical terms as a percentage of the total economy, amounting to 1.5% this budget year, according to CBO estimates. That's true. But in the context of what lies ahead, the deficit puts the economy on a weaker footing to address the fiscal challenges that successive Congresses have ducked.
Public debt per capita at US$170,000
Comptroller General David Walker, chief auditor of the government's balance sheet, has all but shouted from the rooftop that the government had more than US$50 trillion in unfunded liabilities at the close of 2006, compared with US$20 trillion in 2000.
That number is the sum of what the government has promised to pay in the future, from pensions and government healthcare to interest on debt.
The liabilities amount to about US$170,000 per person or US$440,000 per household, Walker said. The largest drivers of this trend are entitlement programmes such as Social Security and Medicare.
These programmes will be more strained when the first baby boomers reach official retirement age in two years time.
Some economists think that to avoid passing the fiscal burden to future generations, lawmakers and President Bush should propose ways to pay for the stimulus - a combination of tax rebates for consumers and tax relief for businesses - over a longer time frame.
"If we do something right now like a tax rebate and a couple of other things, it would be sensible to pay for it over a five-year period or something like that," said Alice Rivlin, a former Vice Chairman of the Federal Reserve and now a senior researcher at the Brookings Institution, a centre-left policy-research organisation.
While supportive of a short-term stimulus, Rivlin said long-term challenges must be considered.
"In the long run, we are in serious deficit trouble, and the long run is not so long anymore," said Rivlin, Director of the Congressional Budget Office from 1975 to 1983. "We have just made too many promises under our entitlement programmes, and we're going to have to change course."
Moody's neither upgrading or downgrading
This month, the rating agency Moody's Investors Service warned that if Congress didn't address the expected budget strains associated with Social Security and Medicare, US government bonds could lose their AAA rating. Investors then would demand higher interest rates to reflect a greater risk of a US government default on its debt obligations, further eroding the nation's fiscal outlook.
The firm was clearly neither downgrading nor about to downgrade in the foreseeable future. It was a warning about pension costs, healthcare costs and the track the US government is on. But as a warning to investors, there are three worrying aspects to the Moody's statement.
First, this is a serious warning about the long-term health and standing of the US in the community of global economies. Second, Moody's has provided us all with another symbolically powerful milestone. Third, this warning foreshadows looming political battles. The US has overspent and it now faces retrenchments. This means struggles over what to cut and whom to stick with the bills.
The terrible retail numbers of the Christmas season, fire sales of leading US firms, a sliding dollar and falling asset values - homes and securities - are all urging in the same direction. Economic downdraft and increased struggles over how to spend remaining funds will be the order of the day in households, legislatures and boardrooms.
New threats to confidence
What does a downgrade warning statement mean? Moody's is one of the three dominant research and ratings firms that monitor public and private issuers of bonds and stock. Thus, Moody's rates the quality of the bonds sold by governments around the world. At the present time they rate the credit quality of government bonds sold by 100 nations. Moody's has rated US government bonds since 1917.
Since 1917 it has been awarded the highest rating there is, AAA. Many developing countries have fought and struggled with ratings downgrades over past decades. So this is no minor matter.
Debt ratings affect the ability to obtain credit, the size of the interest rate and the amount of credit available. Credit ratings signal the safety level and success of a nation's economy. Downgrades - even warnings of possible downgrades - tend to rattle investors and reduce business confidence. Trouble usually comes close on the heels of a warning and downgrade. A US downgrade would be disastrous. An official downgrade is very, very unlikely. However, there is much worth pondering.
The first reason all of us in the world should care about the statement is purely economic. America borrows billions of dollars a day from the rest of the world to keep her economy going. It imports between US$53 billion and US$63 billion more than it exports each month. This gap is filled by borrowing and selling assets. This is occurring at a fever pitch lately. Foreign entities inject tens of billions per month into government bonds, home mortgages, stocks, bonds and loans.
Middle East funds pouring in
Lately, Middle Eastern oil exporter sovereign wealth funds and East Asian export surpluses are being channeled - by the tens of billions - into leading US financial institutions. Anyone who exports oil, or goods and services to the US, ends up with dollars. The more they sell and the higher the price they get, the more dollars they end up with. America runs huge, persistent and rising trade deficits with oil exporters and Asian goods producers.
Oil prices have been rising fast. Huge pools of dollars have built up in state administered accounts and been channeled into international investment funds, sovereign wealth funds.
On 15 January 2008 there was the the announcement of US$22 billion more being invested in Citigroup and Merrill Lynch by these sources .
According to the most recent available data from the US Treasury Department's TICS System, across September and October 2007 foreign entities were net purchasers of US$76 billion in US government debt. This means that foreign entities purchased US$76 billion in claims on future tax collections or asset sales by the US Federal Government.
Across the same two months, foreign entities were net purchasers of US$26.4billion in Agency bonds, largely US government-supported home mortgages. This largely means that billions of dollars in mortgage payments will be collected and sent to the foreign owners of these mortgages. In September and October 2007, the US was a net seller of US$39.2 billion in corporate bonds .
This can be seen as a series of promises to repay loans with interest from the future earnings of American corporations. Last but not least, America net sold US$32.8 billion in stock to foreign holders across September and October. Stocks represent ownership in US corporations and claims on possible future dividends. All of the above is sold to keep the international financial markets functioning and the US economy moving forward.
The US needs more money to continue purchasing oil and other goods and the lenders are left with more dollars than needed or wanted. The US borrows and sells to get access to spending power and the international funds loan or buy to preserve their position.
Thus, the rating and perception of American assets are no minor matter. The holes opening up in US books are requiring greater and greater foreign capital to fill up. There are no free repair jobs. All this money comes with strings attached and returns required. Downgrades make money harder and more expensive to bring into the system.
Trade and politics in the mix
Over the last several years, US assets have been inflated. Over the last few months this has run into reverse. In many cases other regions were inflating faster before July and they are deflating more slowly now. America's assets are almost universally priced in dollars and dollars have been declining against most other currencies. This acts to further reduce the international relative performance of US assets. Declining dollars and lagging asset price inflation downgrade the US market returns.
This brings us to point number number two. The US has reached a milestone in its dependence on foreign wealth. East Asian goods exporters and Middle Eastern energy exporters have been pumping vast sums into the US economy and into leading financial firms. Citigroup, Merrill Lynch, Morgan Stanley, Bear Stearns and others have received tens of billions from sovereign funds directly and are actively seeking more.
Governments of the potent net exporters sit atop US$3 trillion to US$5 trillion in assets. This is being deployed to increase their returns and assure their positions in the global economy.
Lately, this means the money is used to rescue and purchase influence in leading US financial firms. By extension, these purchases extend - at very least the possibility - of broader influence in the US. Part of being in a downgraded position is the increasingly intense hunt for foreign money and favour.
Thirdly, these developments and the weakening state of economic affairs, beg a series of political questions that are likely to shape debate and decision for the next few years. Many Americans are asking what is being given in return for all this investment, purchase and borrowing?
As belt tightening looms, government tax and spending decisions are made, foreign policy actions are debated, free trade is contested, the new investment partners and sovereign funds will be in the mix.
As spending is paired by American state agencies, households and firms, political pressures will surely intensify. This creates political disagreements and raises the stakes of debate. Free trade and foreign policy issues are hugely important around the world and they loom large in the 2008 election cycle. The US has muddled through the closing months of 2007 by selling its assets at a rate of US$87 billion per month in September and October. That rate has risen over the last three months.
All this begs a question. Why do the funds buy? What exactly is the US selling? Suspicion of foreign buyers and their motives is clearly rising in the US, judging by any scanning of the American newspapers related to the recent deals of Dubai World, Kingdom Holding, Dubai International Capital, Abu Dhabi Investment Authority or the Kuwait Investment Authority.
Goose and the golden egg
Policymakers and the shrewdest minds in the Middle East region agreed unanimuosly at the World Economic Forum last week that the United States is the best place to be at a time of a global slowdown. This is because the rest of the world is likely to suffer a sharper downturn than the world's largest economy. The economies of the Arabian Gulf have an action agenda to transform themselves with unprecedented inrastructure spending, and now is not time to kill the goose that lays the golden egg.
"This is a pure investment opportunity," said Bader Al Sa'ad in Davos. He is the man who runs Kuwait's US$200 billion-plus sovereign wealth fund.
The Kuwait Investment Authority, which spent US$5 billion in buying stakes in Merrill Lynch and Citigroup this month, is looking at the US financial and real estate sectors, which have been the epicentre of the crisis. "This opportunity doesn't come along every day," Al Sa'ad told reporters.
Bert Heemskerk, CEO of the Netherlands' Rabobank, said more brave investors will put money into banks after some stocks halved in value in the recent sell-off.
"You might need a strong stomach for it but I'm pretty sure that the prices are hovering near the bottom of what they should be," Heemskerk said.
The crisis has also attracted Sultan Ahmed bin Sulayem, Chairman of Dubai World which has a US$20 billion portfolio of real estate outside Dubai, staked in the world's biggest economy. "We are buying in the US....Somebody's problem is somebody's profit. Something you want to buy, you can buy cheaper now. The US is a very strong market," Sulayem said in Davos.
People are starting to say that there is a wall of money coming at the US, but this should be a reasurance rather than a warning sign. For now there is still enormous liquidity in the banks and corporations of the Middle East.
Yet even as the region likes to believe it is immune to the capital adequacy concerns at the banks, and the global effects, the recession is likely to spread to the Middle East by the end of 2008.
Oil price futures are sharply down in recent days, with some contracts pointing to an oil price as low as US$50. This seems a shocking statement with oil trading today at only just under US$100, but it still places crude above where it was just 15 months ago. Some Middle East projects are likely to be slowed down or cancelled. Most of course will not and growth in the Gulf will continue at well above the global average.
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There is a definite slowdown in Europe and North America. The US is in a recession with a capital 'R' and it has only just realised it. Credit crunches always start more subtlely and last longer than people expect.
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