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July 19, 2005

Capital Flows Barely Cover for Deficit
by Ashraf Laidi

The dollar is losing ground across the board despite a 26% increase in net foreign capital flows into the US at $60 billion in May from a revised a $47.8 billion in April. The report was positive for the US in 2 ways; 1) capital flows stood above the $55.3 billion deficit after having coming below it in the prior 2 months; 2) Flows increased over the prior month. But more concerns linger.

POSITIVES

• Net foreign purchases of US government and nongovernmental bonds rose across the board. Especially striking was the 240% increase in purchases of US government agencies at $22.7 billion. But the jump was mainly a payback of prior declines. Excluding the May figure, the monthly average from April 2004 stood at $18.4 billion.

• Net purchases of corporate bonds rose 13% to $20.4 billion.

• Non-official net purchases of US treasuries rose 108% to $20.8 billion, making up 75% of the $27.6 billion in total purchases of Treasuries for the month. Whether this concentration of private interest in US treasuries is a "positive" or a "negative" depends on the perspective. Since these private accounts largely make up hedge funds, their inherent volatility seems to be controlling the extent to which the US is financing its swelling trade deficit.

NEGATIVES

• Official purchases of US Treasuries (central banks) fell 51% to $6.8 billion in May, falling well below the Jan 03 - Apr 05 monthly average of $11.9 billion. Notably, the "official" share of total foreign purchases of US Treasuries fell to 25% from the monthly average of 44% between Jan 03 and Apr 05. Eroding interest in Treasuries from official accounts could suggest a waning urgency for foreign central banks to intervene in FX markets given the recent strength of the dollar.

• Foreign residents turned net sellers of US stocks at 720 million, the first net selling since September 2004. Foreign residents had remained net purchasers of US equities after the reelection of a Republican government in November. The reelection proved great news for equities as it meant the Bush Administration would not phase out the tax cuts of the past 2 years. But if the flows begin to show signs of waning, that could remove a vital force from the foreign inflows, which could erode the overall financability of the US trade deficit.

• US residents' purchases of foreign stocks rose 69% to $10.6 billion in May (see chart below), due to a 181% increase in net purchases of foreign stocks and a 27% increase in purchases of foreign bonds at $5.8 billion. Although total US purchases of foreign stocks and bonds are well below the 5-year high of $17 billion reached last October, the trend could well revert to renewed increase as US investors begin to see a top in the dollar. Such thinking could become prevalent among managers of international and global mutual funds which specialize in foreign stocks and profit from a weakening dollar.

• Gross holdings of US Treasuries by Caribbean centers (usually hedge funds registered offshore) edged up 1% in May to $125.9 billion after averaging a monthly increase of 7% between April 2004 and April 2005. We have long identified the danger of the increased concentration of foreign holdings of US assets by offshore hedge funds mainly due to the volatile nature of these funds. Using the current account data for Q1 for instance, we have seen how nonofficial foreign ownerships of US Treasuries soared 381% to $75.6 billion, reflecting the surging interest by offshore-registered hedge funds such as those located in the Caribbean centers. The problem with this phenomenon is the potential of having a nation's swelling trade deficit being reliant on the mercy of hedge fund strategies. The situation becomes especially risky considering that Caribbean centers' holdings have never shown monthly increases/declines for more than 3 months in a row since 2000.

Usefulness of the TICS data

There has been much criticism voiced with the timeliness and the volatility of the TICS data. Besides being 2 months old, it has shown much volatility as far as the break down of private and official purchases of US Treasuries. But these claims should also be criticized. The 2-month delay of the TICS data is not more delayed than the trade figures which are also 2-months old, or the GDP figures, which are also at least 2 months old depending on whether we're looking at the advanced or preliminary report.

More importantly, the claim of timeliness can be addressed with the fact that TICS data are effective in conveying emerging trends. Looking at the ratio of capital flows to trade deficit (first chart in the article); one easily notices the falling rate of capital flow coverage of the trade deficit, sliding twice below the 1.0 level and averaging 1.13 times in the first 5 months, compared to 1.35 and 1.43 in 2004 and 2005.

The TICS data also demonstrate the interest in foreign stocks and bonds by US residents, which is increasingly becoming an integral part of the report as US individual investors grow more global and a falling dollar increases the currency appeal of foreign stocks.

Dollar's Look Ahead

The dollar's inability to rally on today's TICS report can be partially explained by the fact that $60 billion was seen as an insufficiently large cushion for the $55.3 billion trade deficit for May--especially when the deficit is expected to pick up in subsequent months due to the rebound in oil prices. Thus, will foreign investors show an equal bounce in purchases of US assets in the months that follow?

The other reason to the dollar's retreat is the 2.1% inflation figure for the Euro zone, which supports the ECB's recent assertions that rising oil prices would exert upside price risks. Although the headline figure was mainly drive by energy prices, the report precludes any chances for an ECB interest rate cut, thereby providing a vital support for the euro.

With the US dollar falling to 3 ½ month lows against the Canadian dollar and the euro well propped of its 1.19 lows, the emerging dynamics suggest more than simply a cooling off in the dollar rally. Fed Chairman Greenspan's testimony to Congress this week is not expected to differ much from the speech he gave in early June. As long as the Chairman sticks to his usual upbeat assessment of the US economy, traders will take this as an affirmation of the status quo, which essentially implies means the need to await further data. Rather, we expect Treasury and currency markets to obtain more hints on the Fed's monetary policy course from the minutes of the June FOMC meeting due this Thursday, as they pertain to the conviction of the Fed's tightening bias.

Ashraf Laidi
Forexnews.com

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