Friday, December 17, 2004

The delicate dance between US capital inflows and capital outflows got a bit more delicate in October, and currency analysts are watching carefully to see if any toes are about to be crushed.
�The decline in the US dollar to record lows against the euro in October coincided with a rapid acceleration of US investment into foreign securities. US investors expect to reap a windfall in overseas equity positions from a falling dollar. Given the continued decline in the dollar during November and December, it is likely that this pickup in US investment in foreign equities has continued,� said Michael Woolfolk, senior currency strategist at Bank of New York

�Now we appear to have two things to worry about: the suspension of Asian central bank buying of US Treasuries and the acceleration in US buying of foreign equities. Were both to occur at the same time, the [inflows] would not only fail to cover the US current account deficit, but would risk dropping into negative territory.�
For the twelve months through October 2004, net foreign securities purchased by US residents increased to $61.4bn, $12.7bn more than in the 2003 calendar year. As I noted yesterday, US residents are buying foreign securities at the highest level since 1997. October in particular showed a big net move into foreign stocks and bonds. At $15.2bn, this was the biggest monthly outflow since July 2000 and the second biggest since July 1997, the cusp of the East Asian financial crisis. Thus we already do have "acceleration in US buying of foreign equities" and bonds.

The other "thing to worry about" is foreign purchases of US treasuries. For the 12 months ending October 2004, foreigners have net purchased $374.9bn in T-bills, up from $278.1bn in calendar year 2003. Sounds like no worries, right? Well, after averaging $39bn a month from November 2003 to June 2004, net buying has slackened off markedly to an average of just $15bn a month since July. Moreover, in these four months of weak foreign interest in US treasuries, Uncle Sam has had to rely on foreign central banks for 74% of the purchases.

The East Asians already appear to be losing interest in dollar-denominated assets. Perhaps the Bush administration's hope now is to tank the dollar so far that the weight of the sinking greenback forces the hand of the European Central Bank to begin intervening in currency markets itself.

In October, Brits, Germans and Swiss residents and central banks accumulated an additional $9.6bn in US assets, more than offsetting the declines from Japan and Korea. In this game of global hot potato, it may now be time for Old Europe to grab hold of the torrid tuber.

UPDATE: Brad Setser has good commentary on this issue as well today.

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