The USA's External Imbalance in a Financial Perspective

Per Flink Iversen, Economics

INTRODUCTION AND SUMMARY

There has been considerable focus on global imbalances, above all the USA's external imbalance, in recent years. This article looks into two remarkable circumstances in relation to the financial aspects of the USA's current-account deficit and international investment position.

Firstly, it is interesting that the world's largest economy, the USA, has been able to finance a very large current-account deficit without this leading to significant instability in the international financial markets. The article therefore examines the financing of the USA's external deficit. Particularly Asian and OPEC economies have had substantial financial assets to invest, while a large proportion of the USA's borrowing has been via sale of Treasury securities. So the USA's external debt primarily comprises liabilities that are sensitive to fluctuations in interest rates, and higher global interest rates will therefore reduce the USA's net capital income significantly.

Secondly, it is remarkable that the USA's net capital income is still positive, despite its large external debt. One reason is that returns on foreign direct investments (FDIs) from the USA are significantly higher than returns on FDIs in the USA. It is difficult to state one specific reason for this difference, however, since it seems unrealistic that US enterprises operating abroad can systematically generate higher returns than foreign enterprises operating in the USA. The obvious conclusion is therefore that one or more of the statistics used are problematic. This article reviews some of the explanations offered by various commentators, including the discussion of " dark matter" .

In any case, the USA's current-account deficit is substantial, and its external debt considerable. In a future perspective, a sustained current-account deficit will increase the external debt further, and net capital income will decline. As a consequence of the internationally integrated financial markets and large gross capital flows it is not given, however, that the USA will have difficulties financing its external deficit in the future.

FINANCING THE US CURRENT-ACCOUNT DEFICIT

Current-account deficits and global imbalances
With 1991 as the exception, the USA has had a current-account deficit every single year in the period 1982-2005, cf. Chart 1. Moreover, the deficit has grown year by year, reaching 792 billion dollars, or 6.4 per cent of GDP, in 2005. The growing current-account deficit is primarily attributable to the development in the trade balance.

In view of the current-account deficits, the USA has accumulated considerable external debt, whereas before it was a net creditor, cf. Chart 2. Particularly since the mid-1990s there has been a substantial increase in foreign net investments in – or net lending to – the USA. In 2005, the USA owed more than 2,500 billion dollars, equivalent to just over 20 per cent of GDP.

The US current-account deficit is the most visible characteristic of the global imbalances and is mainly related to high domestic demand in the USA. A low interest rate and higher asset prices have increased demand and been key factors behind the deterioration of the balance of payments in recent years. At the same time, large parts of the global economy outside the USA have seen growing savings ratios and have thus been willing to finance US consumption by acquiring ever larger portfolios of US bonds. This has been referred to as a global " saving glut" .^[1] Moreover, high oil prices have led to growing current-account surpluses in the oil-exporting countries.

Who finances the USA's external deficit?
The USA's current-account deficit is set off every year by an equivalent capital inflow from abroad. However, capital imports from a given country, e.g. Japan, need not correspond to the country's current-account surplus vis-à-vis the USA. The financing of the USA's external deficit may take a completely different course from the bilateral current-account surpluses and deficits, and the nature of the capital flows may thus have a separate impact on the USA's external imbalance. Owing to data availability, the following description of the development in the capital inflow to the USA is based on the development in net investments in long-term securities^[2]. Long-term securities make up a large share of the total foreign portfolio of US financial assets and of the total net capital inflow, which otherwise primarily comprises direct investments and financial investments with shorter maturities than one year.

The development in the USA's financial net investments by the largest regions shows that most of the US capital imports in the late 1990s came from Europe, cf. Chart 3. Asia's share grew significantly around the millennium rollover, and in recent years the capital inflow from Asia has been on a par with the inflow from Europe, except in 2005, cf. below.^[3] Net investments from other economies, not least Latin America, have also increased in recent years and now account for approximately 20 per cent of total net investments in the USA.

Capital imports from Europe relate to a large extent to the UK, whose net investments in 2005 rose substantially to 316 billion dollars, cf. Chart 4. The increase was evenly distributed on all types of securities. The high investment volume does not reflect the US current-account deficit vis-à-vis the UK, which was only 21 billion dollars in 2005, but rather the considerable capital flows from other countries into the USA via the UK. Particularly the OPEC countries in the Middle East have had large current-account surpluses in recent years as a result of the high oil prices. However, these countries have by and large not increased their net investments in the USA. Presumably, political considerations prevent the governments of these countries from purchasing US government securities directly, so instead they operate via e.g. UK investment banks. In addition, retained profits in European enterprises have increased, cf. IMF (2006).

Especially Japan and China have contributed to Asia's positive net investments in recent years. Japan's current-account surplus has been a major factor behind the acquisition of US assets. The Bank of Japan has intervened in the foreign-exchange markets to stabilise the exchange rate, cf. Chart 5 (left), which has led to ultra-high net investments in the USA. However, Japan's net investments in the USA declined considerably in 2005, to 46 billion dollars, despite a current-account surplus of 99 billion dollars, compared to 94 billion dollars in 2004. In fact Japan's portfolio of US Treasury securities decreased because the Bank of Japan stopped intervening in the foreign-exchange market in 2004.

Even though Japan's net investments in US Treasury securities were negative in 2005, Japan still holds a large portfolio of Treasury securities, cf. Chart 6. In terms of the overall securities portfolio, Japan is also the largest creditor, followed successively by the UK, Luxembourg, the
Cayman Islands and China.^[4]

China's current-account surplus has been growing in recent years. Moreover, direct investments in China have been considerable. Since China has imposed restrictions on private capital exports, the People's Bank of China has bought up the capital flowing in. This has boosted the foreign-exchange reserve considerably, and the renminbi has been kept almost unchanged against the dollar. The central bank has thus to a large extent determined how the capital has subsequently been invested. Consequently, a large proportion of China's net investments in the USA have been purchases of Treasury securities by official institutions. The mid-2005 foreign-exchange reserve was estimated at 711 billion dollars, while China's portfolio of US assets was 527 billion dollars, of which US Treasury securities accounted for almost 300 billion dollars.

The percentage of the USA's total external liabilities held by foreign official institutions has been growing since 2000, cf. Chart 5 (right).^[5] This is, inter alia, attributable to investments from Japan and China. In 2005, this share was 16 per cent, which is lower than in the early 1980s, however.

The large capital inflow from the Caribbean is partly attributable to the tax legislation of the Cayman Islands, which has attracted a large number of banks and management companies.

The impact of interest rates on capital income
Net capital income is included in the current account and is an expression of income from a country's assets less payments on its liabilities.

The USA's net capital income is vulnerable to changes in interest rates. A breakdown of the US international investment position, which equals the external debt (with sign negative), into net portfolios of interest-bearing assets, equities, FDIs and other items shows that the USA is a net debtor in terms of interest-sensitive assets, cf. Chart 7. Interest-sensitive assets include e.g. bonds and deposits in banks.^[6] On the other hand, the USA is a net creditor in terms of equities and FDIs.

This structure means that a higher international level of interest rates will increase the USA's net interest payments to abroad, whereby net capital income is reduced. Ceteris paribus, a global increase in interest rates by 1 percentage point in 2005 would have reduced the US capital income by around 40 billion dollars. Over the last year, the rate of interest has risen in both Europe and the USA, and the USA's external debt has also grown in 2006. Against this background, the USA's interest payments to abroad are expected to increase considerably this year. Since the net capital income is included in the current account, a sustained increase in interest rates will augment the necessary improvement of the trade balance for the external balance to be restored.

CAPITAL INCOME AND EXTERNAL DEBT

Positive net capital income
The USA's net external debt has been mounting in recent years, reaching just over 2,500 billion dollars at end-2005. Nevertheless, the USA's net capital income vis-à-vis abroad has remained positive and was 18 billion dollars in 2005, cf. Chart 8. It is difficult to point to one specific reason for this remarkable circumstance.

It is natural first to compare returns on the USA's assets and liabilities, respectively. The return is calculated as income from the asset in relation to the value of the asset. The income on interest-sensitive assets comprises interest income, while the income on equities includes dividend, but not capital gains. The income from FDIs is calculated as the reported profits from corporate financial statements.

The USA is a net debtor for interest-sensitive assets and a net creditor for equities and FDIs, cf. above. Since FDIs involve greater risk for the investor than investments in interest-sensitive assets, it is not surprising that the return on FDIs has exceeded the return on interest-sensitive investments, thereby contributing to higher capital income.^[7] The USA's interest-sensitive net liabilities are, however, so much larger than the asset portfolio of equities and FDIs, also in net terms, cf. Chart 7, that a traditional surplus return on the latter can by no means explain the positive capital income.

Consequently, the composition of the USA's assets and liabilities is not the primary explanation for the positive net capital income. Instead, it is to a large extent attributable to the return on US foreign investments compared to the return on equivalent foreign investments in the USA. While the return on equities and interest-sensitive assets has been more or less the same in the USA and elsewhere, cf. Chart 9 (left), the return on FDIs from the USA has been significantly greater than the return on FDIs in the USA, cf. Chart 9 (right). On average, income from US FDIs has exceeded the return on FDIs in the USA by approximately 5.3 percentage points since 1982. This has brought considerable net income from FDIs, which thereby has exceeded net interest payments on the interest-sensitive portfolio, cf. Chart 10.

It should be noted that in the last few years other factors have also had a positive impact on US net capital income. Until recently, falling interest rates have reduced interest payments on US liabilities significantly, and depreciation of the dollar has increased the dollar value of returns on US investments abroad.

Explanations for the USA's higher FDI return
The economic literature offers various explanations of why returns on US FDIs have consistently exceeded the returns on FDIs in the USA.

Higgins et al. (2005) find it strange that foreign investors are still willing to invest so much in the USA since the return is relatively low. They analyse this in more detail by looking into FDI returns by countries and industries. This does not change the pattern, however. For example, the return on US FDIs in Europe and Japan has consistently exceeded the returns on European and Japanese FDIs in the USA. They then seek to explain the difference by suggesting that US enterprises abroad are more efficient than foreign enterprises operating in the USA. This is not supported by data. According to Higgins et al., another possibility is that the Americans have been better at investing in more profitable enterprises and that foreign enterprises in the USA are newer and therefore have higher up-front costs. Furthermore, it is pointed out that competition is keener in the USA than in other economies, leading to a lower profit ratio.

Finally, Higgins et al. also mention tax aspects as an explanatory factor behind the differences in FDI returns, cf. Laster and McCauley (1994). Buiter (2006) and Gros (2006) also attribute the difference in returns to taxation. Buiter argues that multinational corporations apply internal settlement methods to transfer profits from their US entities to companies in countries with lower corporate income tax, in order to reduce tax payments. This can e.g. be achieved by letting US subsidiaries pay an artificially high price for imported goods from foreign parent enterprises, i.e. " transfer pricing" . This reduces the booked profits of the US companies, while increasing the profits of the companies outside the USA.

The profits of US enterprises abroad and foreign enterprises in the USA comprise observable payment flows from dividend payments, as well as unobservable payment flows known as reinvested earnings. The latter are calculated residually as the reported profits of the enterprises less dividend payments. Gros believes that foreign enterprises in the USA underreport their reinvested earnings, since they wish to reduce tax payments in the USA.^[8] US enterprises abroad, on the other hand, have no incentive to underreport their reinvested earnings for the US
statistics since profits from such enterprises are not taxable in the USA until the profit is repatriated. Consequently, the net return from US FDI assets and liabilities, and thereby net capital income, is overrated in the statistics. Gros estimates that a more uniform compilation of returns from US and foreign enterprises in the USA would reduce net capital income by approximately 100 million dollars per year.

Hausmann and Sturzenegger (2006) reverse the issue and argue that the positive net capital income should not be viewed as a singular return on external debt. Instead, the capital income reflects the USA's position as a net creditor vis-à-vis abroad. In support of this argument Hausmann and Sturzenegger explain that if income from one asset is higher than income from another asset, this means that the value of the first asset is higher than the value of the second asset, irrespective of the book value of the assets. The primary reason for the USA's positive net capital income is therefore that the value of US assets abroad is underrated in the official statistics since the assets contain a considerable element of immeasurable values. These hidden values are known as " dark matter" . In relation to FDIs, " dark matter" comprises e.g. know-how, branding and R& D.^[9] As an example, Hausmann and Sturzenegger calculate the USA's net assets in 2005 at approximately 352 billion dollars, whereas the official data says ‑ 2,500 billion dollars, on the basis of the positive net capital income of 18 billion dollars and an arbitrary 5-per-cent return on all assets.

Implications of the hypotheses for the balance of payments and the international investment position
How the positive net capital income is actually to be explained is of paramount importance to the further development in the US balance of payments and international investment position. Hausmann and Sturzenegger belong to the most optimistic school. According to their hypothesis, the USA's international investment position is positive, and moreover the trade balance is close to zero, cf. Table 1. The explanation is that the USA has been exporting " dark matter" for many years. Hausmann and Sturzenegger also believe that the high net capital income is sustainable since US enterprises will continue to export " dark matter" . Against that background, the issue of the USA's external deficit and thus the global imbalances is negligible.

Buiter's hypothesis also implies that the deficit on the trade balance is, in reality, smaller than the official data suggests since the value of the USA's imports has been artificially high. On the other hand, Buiter's explanation entails that the official data for net capital income is too positive, and consequently the current account is presumably more or less as the data shows^[10]. Buiter's hypothesis has no significant implications for the assessment of the USA's international investment position.

According to Gros' analysis, the current-account deficit is greater than the statistics show since net capital income has been overrated. External debt is also greater than shown in the statistics as the value of FDIs in the USA does not sufficiently reflect the accumulated profits of the companies.

Higgins et al. do not reflect on whether the difference in returns will also be seen in future, nor on whether the international investment position and current-account deficit are under- or overrated in the statistics. Presumably the reason is that they cannot give a definitive explanation for the differing returns on the USA's FDI assets and liabilities.

An assessment of the robustness of the analyses
Most of the above explanations of why the USA's FDI return has consistently been higher than the return on FDIs in the USA are difficult to verify. Buiter's hypothesis can, however, to some extent be disproved. If transfer pricing has been widely used the US terms of trade will gradually have deteriorated over the last decades since transactions between multinational corporations have expanded more rapidly than foreign trade.^[11] This has not been the case.

The Gros analysis suffers from a validation problem as it is based solely on assumptions that foreign enterprises do not report the correct data for reinvested profits. Gros does not assess the extent to which it is actually possible for enterprises to hide their profits from the tax authorities. The " dark matter" hypothesis suffers from an equivalent validation problem since it is not supported by an empirical analysis.

A more material weakness in Hausmann and Sturzenegger's theory is, however, that the hypothesis cannot convincingly explain away the global imbalances, including Japan's current-account surplus. In addition, Hausmann and Sturzenegger's calculations have been criticised for assuming the same return on different types of assets, which is unrealistic.^[12] This criticism is justified, but the calculations merely serve to illustrate a point and should not be taken at face value. Moreover, the assumptions regarding returns on assets are neither closely linked to the reasoning behind the theory nor to the overall conclusions.

As regards the difference between FDI returns in the USA and elsewhere, it seems implausible that foreign investments in the USA systematically yield lower returns than US FDIs, particularly since more than half of the USA's FDI assets and liabilities are held in Europe, where the structure of the economy does not differ materially from that of the USA, cf. Chart 11. It seems unlikely that foreign investors are willing to invest in the USA when they can apparently make higher profits at home, and that US investors should be better at generating profits, as stated by Hausmann and Sturzenegger and by Higgins et al. It is also strange that foreign investors can achieve a return on equities in the USA that is equivalent to US investors' returns on equity investments abroad, until the point where a foreign investment in a US enterprise exceeds 10 per cent of the share capital, which is the threshold between equity investments and FDIs. Consequently, the differences in FDI returns indicated by the statistics are deemed to be misrepresentative and should not be given too much weight.

Buiter's, Gros' and Hausmann and Sturzenegger's explanations for the differences between FDI returns in the USA and elsewhere may all apply to some extent. Even though Hausmann and Sturzenegger's theory presumably paints a far too positive picture of the US debt situation, it cannot be ruled out that the hypothesis contains a small element of reality. It is probable that the USA is to some extent able to export know-how and branding, etc. and that the USA's foreign assets are therefore underrated. It also seems plausible that (foreign) enterprises do their utmost to reduce tax payments. On the other hand, neither explanation is satisfactory in itself.

In that case, net capital income is lower than the statistics show, and will continue to be so in the future, since Buiter's and Gros' explanations entail that net capital income is overrated, while Hausmann and Sturzenegger take net capital income at face value. Gros' theory has no direct implications for the trade balance, while Buiter's and Hausmann and Sturzenegger's explanations improve the balance of goods and services compared to the official data. Overall it cannot be precluded that the deficit on the balance of goods and services is smaller than indicated by the foreign-trade statistics, although it must currently still be considerable.

As regards the USA's net holdings of FDIs, and thus its international investment position, the hypotheses point in opposite directions. Consequently, it is impossible to say whether there is systematic distortion in the compilation of the international investment position.

CONCLUSION

Major uncertainties are attached to the data concerning the external balance of the USA. There are indications that the deficit on the trade balance is overrated, while net capital income is actually somewhat lower than the data shows. In other words, the current-account deficit may be either greater or smaller than indicated by the data. The actual international investment position may also deviate from the official data. However, it can hardly be ruled out that the current-account deficit is large and the external debt considerable.

The US current-account deficit is financed to a large extent by Asian and OPEC economies. A sustained current-account deficit will add to the external debt, and combined with the predominance of interest-bearing liabilities and rising interest rates this year, it will make even greater demands on the US trade balance if the global balances are to be restored.

It has been easy for the USA to finance its current-account deficit, owing to the internationally integrated financial markets and large gross capital flows. There is a risk that a sudden resolution of the global imbalances sets in, resulting in a major slowdown in the USA and increased instability in the international financial markets. However, the sustained US current-account deficit in recent years indicates that the depth of the financial markets is so great that major global imbalances may also be seen in future without necessarily resulting in dramatic adjustments.

LITERATURE

Bernanke, B. (2005), " The Global Saving Glut and the U.S. Current
Account Deficit" . Remarks by Governor Ben S. Bernanke at the Homer Jones Lecture, St. Louis, Missouri, April 14.

Buiter, W. (2006), " Dark Matter or Cold Fusion" . Global Economics Paper No. 136, Goldman Sachs Economic Research, January 16.

Department of the Treasury (2006), " Report on Foreign Portfolio Holdings of U.S. Securities as of June 30, 2005" . Federal Reserve Bank of New York, June 2006.

Gros, D. (2006), " Why the US Current Account Deficit is Not Sustainable" , International Finance, Vol. 9, No. 2, summer 2006.

Hausmann, R and F. Sturzenegger (2006), " Why the US Current Account Deficit is Sustainable" , International Finance, Vol. 9, No. 2, summer 2006.

Higgins, M., T. Klitgaard and C. Tille (2005), " The Income Implications of Rising U.S. International Liabilities" . Current Issues in Economics and Finance, Vol. 11, No. 12, Federal Reserve Bank of New York.

International Monetary Fund (2005), World Economic Outlook, September.

International Monetary Fund (2006), World Economic Outlook, April.

Kitchen, J. (2005), " Sharecroppers or Shrewd Capitalists? Projections of the U.S. Current Account, International Income Flows, and Net International Debt" . Unpublished manuscript, Office of Management and Budget.

Laster, D. and R. McCauley (1994), " Making Sense of the Profits of
Foreign Firms in the United States" . Federal Reserve Bank of New York, Quarterly Review 19, No. 2 (summer-fall).