Confused, but on a higher level.

The whole world is voicing concern over the huge deficit that the US is building up. Yet nothing seems to stem the US spending and there are no signs of it slowing down. Despite 9/11, Iraq War, Enron, Sars, Katrina, the US consumer has continued to consume without respite. What exactly are the implications & how does it concern us?

Let’s start by understanding how this deficit occurs. The balance of payments (or BOP) is a measurement of all the transactions between any individual country and all other countries. The words “all transactions” can be misleading because some transactions may be estimated.

The total credits and debits for a country’s balance of payments must tally, however for any subset of the balance of payments statements there may be a deficit or surplus position. A balance of payments statement can be broken down into various components and the one’s which receive the most attention are current account, capital account & financial account.

Let’s look at the US 2005 figures

In 2005 current account had a deficit of approximately i.e. ( - 804BUSD)

Capital account transactions had a net of -6 BUSD

Financial account ( Net difference between US assets owned aboard & foreign owned assets in the United States ) + 801BUSD

Statistical discrepancy + 9 BUSD

Total + /- 0 ( Balanced )

In effect in 2005 the US imported USD 804 Billion of goods more than it exported and the net result is that foreigners own USD 804Billion of US assets. The basic principle behind this is that a country can only consume more than it produces if it borrows from abroad. Who then is financing the US? For one China. Current estimates of foreign reserves of China is about USD 875Billion. ( Overtaking Japan for the first time. )

China is gobbling up US treasury bonds. China needs these to boost trade, they use it as security and for various other reasons. Is this a problem?

Let’s look at this scenario. When a country has huge trade deficits, its currency weakens, In the case of US, if the dollar continues to weaken then what happens to the value of the US treasury bonds that China holds? Its value reduces. In fact the dollar has been steadily weakening. So who gains? I get confused.

Next, when the US currency weakens, its goods become cheaper in the international market and this boosts trade. The increasing trade creates a strong economy and it creates inflation. Inflation can be controlled. One way is to increase interest rates. The US FED acts and increases interest rates. ( The rational is that if interest rates are low & inflation is high, you should not save. )

When US interest rates increase, foreign investors find that investing in US is more beneficial than investing in other countries. There are huge investment inflows into the US. There is a huge demand for US Dollars and this pushes the value of the US currency upward, providing a counter balance. When interest rates increase, industries defer their investment and growth slows down, increasing unemployment.

While the US Dollar is freely floating, till last year, the Chinese currency Yuan was pegged to the US Dollar. The US has long been loudly complaining that the Yuan is undervalued. The Chinese understandably do not want the Yuan to rise against the US Dollar for fear of making Chinese goods more expensive. On the other hand if it is proved that China is a currency manipulator, then it would be in order for the US to impose tariff on Chinese imports. In fact two American Senators had wanted to propose a bill imposing tariffs of 27.5 % on Chinese goods. What has disappointed the US is the fact that in spite of China ending the decade old peg the Yuan has increased by only 2% against the US Dollar. The US gets confused.

There is another sect of financial gurus in the US who argue that it’s not the US which is overspending, but the savings glut in other countries. People in many Middle Eastern oil rich countries, Japan, China, Germany, Switzerland etc which are saving a lot. These countries also have big trade surplus, opposite to the US situation. They consume very little, mandatory retirement savings forces them to save and in Japan especially demographics forces the aging population to save no matter how little they get compensated. ( Interest rates I mean, even with 1 to 2% ) Naturally they have to invest their money somewhere and this wall of money is available to the US. Who wouldn’t lend to the US?

After we lend, we start getting worried, we get nightmares of crisis similar to the Asian /Thailand crisis. The Thai Baht at the time preceding the Asian crisis was pegged to the US dollar. The interest rate in Thailand was very high and foreigners especially US investors bought in a lot of money, changed it to Thai Baht and lent it locally (for real estate development projects for example ) at high interest rates. The plan was simple, convert it back into US dollars at the end of the term and you should be making a lot of money.

The basic rule is that the interest rate differentials between two countries should reflect the exchange rate movements between the currencies. If the US interest rate is 5.25 % and the Swiss interest rate is 2% the rule says that the US dollar should weaken with respect to the Swiss Franc over a period of time. At the time of the Asian crisis US investors ignored this basic rule that the Thai Baht should weaken with respect to the US Dollar as the currency was pegged. Over a period of time the Thai govt could not keep the peg and the Thai Baht started falling freely triggering the Asian Crisis.

If the US dollar should start weakening considerably then it will trigger a crisis of a much larger magnitude and this is what we are worried.

What is even more confusing is the current situation. The oil prices have sky rocketed, commodity prices are high and the world economy is going strong. Then naturally there should be inflation & the interest rates should go up. In the 1970`s when the price of oil went up, the price of all other commodities shot up & inflation grew rapidly. Not so this time.

The interest rates in the big currency blocks, USD, EUR & JPY remain low. No one has the answers, however theories abound. Here’s one. Oil is mostly traded in US dollars. So when the oil prices rise rapidly many countries become short on US dollars and need to borrow US dollars to pay for the oil. This borrowed US dollars or petrodollars fall into the hands of Middle East countries who do not have the means or the infrastructure to deal with such large amounts of money in a short time. ( The world consumes about 85 million barrels of oil a day and with an increase of 25USD per barrel over the past 12 months the USD needs of the world have increased by 85 m x 25 x 365 days ie US$ 775Billion )

These US Dollars that are now in excess with these countries are up for sale, either for rational diversification or irrational policies which gives the impression that the US Dollar can only fall. If you expect a currency to fall in value, wouldn’t you borrow in the same? And here we go on the merry go round again.

Then there are the super gurus who state that the world is forcing the US to run a deficit, for if it did not run a deficit where would the world find the about US$ 800Billion to finance its oil trade. ( No one else can print the US Dollar or? ) And that exactly is the US deficit USD 806Billion.

I am still confused but on a higher level.