The Current Account Deficit Matters
Is the dollar at risk because of America's enormous current account deficit? Many "experts" are spreading information that is confusing, outdated or simply not applicable. Yes, the current account deficit puts the dollar at risk; at the same time, however, a lower dollar will provide no long-term solution to the current account deficit.
The current account deficit is the trade deficit plus certain financial flows. It is precisely the amount foreigners must acquire in US denominated assets to keep the dollar from falling. In 2005, foreigners picked up the tap of over $800 billion - or more than $2 billion a day. If we buy sneakers from China, but have nothing to sell to the Chinese, it makes the current account balance worse; if our government issues debt that is not acquired by domestic taxpayers, foreigners are lending a helping hand to finance our spending. The current account deficit is now about 7% of gross domestic product (GDP) - historically, currencies have caved in when the current account deficit has been above 5% for an extended period.
Some say in the grand scheme of things, even a $1 trillion deficit a year does not matter because America has tens of trillions in assets. That analysis compares apples with oranges. If you earn $100,000 a year, but spend $120,000 a year with $1 million in the bank, of course you are not going to be broke tomorrow. Indeed, if you spend the $120,000 to invest in a new business, you may justify carrying negative cash flow until you reap the rewards of your investment. But if you use the $120,000 to consume, you should seriously think about how sustainable your lifestyle is. America's savings rate turned negative last year.
The more relevant aspect, however, is that one cannot mix cash flow items with balance sheet items. It may well be that we have untapped reserves - there may be lots of family silver we can still sell. But the current account deficit must be financed every single day at a rate of over $2 billion a day; otherwise, the dollar will fall.
Some argue that the reasons foreigners finance the current account deficit because they like investing in the US. Almost: foreigners invest in dollar denominated assets because they perceive it in their interest. Asia over the past years has been highly dependent on export to the United States. By buying dollar denominated assets, they can keep their currencies weak: when the Chinese sell sneakers to American consumers, you receive dollars in return; the Chinese in return have to decide what to do with the dollar they receive. If they were to sell dollars and buy Chinese yuan, there would be upward pressure on the yuan. If, however, they re-invest their dollars in denominated assets, they can keep their own currencies weak to have more competitive exports.
Those who say foreigners like to invest in the US forget an important aspect: the daily financing requirement. We don't need foreigners to sell dollars for the dollar to fall, we just need them to buy less. Because of the current account deficit, the US has become extremely vulnerable. If we alienate foreign investors, they might just allocate some of their new investments elsewhere.
And that's where the crux of the issue lies: do we do enough to make the US an attractive place to invest in? US companies seem to prefer deploying their large cash holdings by expanding overseas. Assume that the US economy will slow down - will foreigners be as inclined to invest in the US as they have over the past couple of years? Assume protectionist sentiment continues to increase, won't foreigners be tempted to establish new trading channels?
We have focused many of our writings in recent months on the threat of a US slowdown and rising protectionism because we see these as instrumental warnings flags for a possible further fall of the dollar. It doesn't matter that other countries may be less open than the United States - these countries have their own set of issues, but they do not have a $800 billion current account deficit that needs to be financed daily.
The general perception is that foreigners, in particular central banks, mostly purchase US Treasuries. In my view, any analysis that is published now and focuses on this point should include that there has been a qualitative shift in the interest of foreigners. Over the past year and a half, it has become increasingly clear that Asian governments are looking for ways to secure their future resource needs. Since then, red flags have been raised by American politicians when foreign companies want to acquire resources that may be considered of strategic importance to the US. The attempt by the state-controlled Chinese oil conglomerate CNOOC to acquire the (non-US) assets of US based Unocal caused a firestorm that caused the transaction to be abandoned. The CNOOC/Unocal transaction was the first in a series that has highlighted that the rest of the world is not interested in buying US made sneakers, but technology and resources that we are reluctant to export. As the world tries to keep the global boom going, we see increased friction with a serious potential to have protectionism escalate. And there has been an alarming up-tick globally that may spur a tit for tat game: most recently, Bolivia announced it will nationalize its oil & gas industries; in Peru, there are threats made against the mining industry; in China, Citigroup was told it cannot take control of a Chinese bank. Protectionism does not rise out of thin air - it is a human reaction to a threat that is perceived to come from the outside; we say "perceived" as the roots are far more complex and domestic policies tend to be as much to blame as foreigners. Textbooks warn about the threat of protectionism because of the experience during the Great Depression; yet when times are tough, it is all too easy to blame foreigners.
But it is just as human to fight the symptoms rather than the disease. Strikingly, if you look at Federal Reserve (Fed) Chairman Ben Bernanke's book analyzing the Great Depression, you will find discussions on how too strong a dollar due to the gold standard made the Depression more severe; you will find a discussion on monetary contraction during the Depression. But what about a discussion of the dangers of the credit expansion that set the stage for the Depression in the first place? Similarly, we have had extremely accommodating monetary and fiscal policies (low interest rates and taxes) for years; the focus in an upcoming economic slowdown will likely be on how to put growth as the number one priority on the agenda.
We now hear every day how US policy makers want a weaker dollar - how the Chinese are "unfairly" subsidizing their currency. Under Greenspan's reign, Fed officials would never discuss the dollar. Bernanke has done so already on a couple occasions, not succeeding at doing so only indirectly when discussing the current account deficit. In our view, the new Fed has no credibility when it comes to the dollar, and policy makers should be very careful what they wish for. Most recently reported import prices were up over 2% month over month; the most recent unemployment report showed slowing job growth with increasing pressure on wages.
To top all these fears off, the US now pays more in interest to overseas investors on their investments in the US, than the US receives in interest from its investment overseas. A relationship more typically associated with a third world country means that higher interest rates in the US do not automatically make the dollar more attractive as we owe foreigners even more in interest payments.
There are those who argue that Americans mostly invest in infrastructure overseas, whereas foreigners tend to buy interest bearing securities. As a result, we will reap the benefits in years to come. Maybe, but again, we are mixing apples and oranges - as far as the dollar is concerned, we need to worry about the current account deficit to be financed today.
Those worried that the budget deficit puts additional pressures on the dollar may be correct in the long-term, but these deficits do not carry the same urgency as the current account deficit.
The current account deficit could be reduced by an increase in foreign consumption and a decrease in foreign savings; by a decrease in domestic consumption or an increase in domestic savings; or by an increase in domestic real purchasing power. Let us examine these:
Bernanke talks about a global savings 'glut' - what he means is that e.g. the Chinese that save up to 40% of their income are not consuming enough. The focus on an increase in consumption in the rest of the world is understandable. It would allow the current account deficit to shrink without many of the feared negative side effects, such as a severe recession or a much weaker dollar. Part of the reason the Chinese are such excellent savers is because their capital markets are still in their infancy; the Chinese trust their savings accounts. While a middle class in China is growing, we doubt that the pickup in worldwide consumption will be fast and sufficient enough to rescue the current account deficit. It also remains to be seen what these consumers will consume - what consumers goods do we produce in the US that are attractive to Chinese consumers? Let us also not forget that the growth policies pursued worldwide have created bubbles not just in, say, the US housing market, but also in Asia. Asian economies are rather vulnerable right now; much of the reason why Asia is supporting the dollar is precisely because of their own bubble economies - policy makers are concerned about severe local recessions should their currencies strengthen. We have stayed away from Asian currencies in the Merk Hard Currency Fund because we do not trust that Asian central banks will stand by and see their economies falter if and when the US economy slows just as upward pressure on their own currencies increases. Asian central banks will be tempted to engage in competitive devaluation of their own currencies.
What about saving the current account deficit with decreased domestic consumption? That sounds nice on paper, but translates to 'recession' in plain English. It is a likely scenario, not one favored by policy makers. Indeed, part of the reason why gold has performed so well is that many expect that a weakening economy will be fought with further fiscal and monetary stimuli; the fear here is that inflation, which has been progressing through the production pipeline, will not be contained. The reason why inflation has not shown up in the 'core' government statistics is because globalization has held back inflation on anything we can import from Asia.
What about an increase in domestic savings? It would help, but unless we have it accompanied by real wage growth, we will have to reduce consumption to increase savings. Indeed, we expect that the savings rate has to go up as investors can no longer extract equity from their homes as the real estate market abates. We do not need the real estate bubble to burst for home owners to take stop taking money out of their homes; all we need is for the market to be stagnant - especially in a rising interest rate environment. And while globalization has so far held back inflation, it has also kept back real wage growth. We like to cite the example of an American based producer that is squeezed by both high commodity prices (courtesy of global overproduction) and low pricing power (courtesy of cheap imports and high consumer debt): the prudent manager will put an increased emphasis on outsourcing to remain competitive. This is the reason why job and wage growth have lagged in this economic expansion.
The beauty of the US economy is its flexibility. Workers in debt with only limited unemployment benefits must find a new job quickly. As a result, new businesses that are able to cope and thrive in this new environment are created. However, we are concerned that the policies in place over the past couple of years will at some point cause a political backlash. Many workers - and not just blue collar workers - feel that they have to work harder than ever while not earning more money. We are concerned that such an environment will be a breeding ground for populist politicians and increased protectionism. And as we impose barriers on trade, we will be penalizing foremost those firms who have learned to adapt to the current environment. This is not the place to argue what a fair trade policy should be, but we want to put out the warning that one has to be very careful when we politicians impose solutions on the market.
A lower dollar will not resolve the structural challenge the US is facing. A lower dollar will not re-create the US manufacturing industry. A lower dollar will not turn America into a nation of savers. We believe the pressures on the dollar will persist as long as there are not fundamental changes that will truly promote savings and investments. And to make it perfectly clear, we do not have an "ownership society" as long as the banks are the ones owning our homes.
We manage the Merk Hard Currency Fund, a fund that seeks to profit from a potential decline in the dollar. To learn more about the Fund, or to subscribe to our free newsletter, please visit www.merkfund.com.