Wednesday, July 21, 2004

Rebecca McCaughrin at Morgan Stanley's office in London has a very interesting little discussion concerning the imminent demise of a strange macro phenomenon.

The General has noted before that even though the US net investment position is massively negative and has been increasingly so since the late 1980s, US net investment income magically remains positive. For example, in 2003 the US net investment position was a whopping -$2.43 trillion (that's -22% of GDP; -24% at market value). US net investment income, however, was surprisingly positive -- $33.3bn -- as it has been throughout recent history, flying directly in the face of the country's ever-growing status as the "world's largest debtor". While this disconnect has persisted since 1986, McCaughrin thinks it is about to end.
In our view, the confluence of rising US rates relative to the rest of the world, a stronger dollar, and converging rates of return on portfolio investment will likely exacerbate US imbalances . . .

. . . According to our FX team, the dollar correction has run its course, and by next year should begin to appreciate against the EUR, JPY, and GBP. With UK, Euroland, and Japanese assets representing roughly two-thirds of gross assets (US-owned foreign assets) and liabilities (foreign-owned US assets), even a small adjustment in exchange rates can have a significant impact on servicing costs. A stronger dollar will exacerbate the debt service burden since it decreases gross assets and receipts on US foreign-currency holdings, but will have little impact on gross liabilities, which are mostly dollar-denominated. . . .

. . . higher US interest rates mean interest payments rise more than receipts, exacerbating the debt service burden. . . . US investors hold a lower share of debt in their foreign portfolios -- just 7% of gross assets -- whereas foreigners have a much larger concentration, with government and private holdings of debt accounting for nearly 40% of gross liabilities. Liabilities should thus be more sensitive to interest rate movements than are assets. As US rates rise relative to the rest of the world, interest payments will increase by more than receipts. . . .

. . . converging rates of return on other private investment should enlarge the deficit in net income on portfolio and other private investment, as net external liabilities continue to grow. . . . The rate of return earned by US investors on their overseas portfolio investment used to exceed returns earned by foreigners. However, the gap has eroded over the last several years, and US investors now generate a return that is only 0.3% larger. As this trend plays out, and foreigners demand a return at least equal to the return US investors receive from their overseas investments, interest payments will rise further relative to receipts.
I'm a bit skeptical about the strengthening dollar over the near-term, but the interest rate and profit rate stories are spot on. If the stronger dollar turns out to be correct, this combination will send the current accout deficit into the nether regions in no time.

Consider this. If US net investment income had simply been zero for 2003, the current accout deficit as a percentage of GDP would have been 5.1% rather than the actual 4.8%. If the +$33bn had instead been -$33bn -- much more in line with the -$2.43 trillion net investment position -- the current account deficit for 2003 would have been 5.5% of GDP. The soft-landing story Republicans are so fond of is going to start pulling out to sea.

Can anybody say "debt trap"?

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