Asia Won't Finance U.S. Trade Deficit Forever

**Ray** · 13 Apr 07,, 19:50

Not too sure if this fits in here, but sure would be interested in knowing the views of those who understand economics.

Asia Won't Finance U.S. Trade Deficit Forever: Michael R. Sesit

By Michael R. Sesit

April 13 (Bloomberg) -- For the better part of 20 years, economists have been warning that the widening U.S. current- account deficit is unsustainable.

A significant reduction of imbalances -- the U.S. deficit and correspondingly large Japanese, Chinese and German surpluses -- would require a precipitous fall in the dollar and slower domestic-demand growth in the U.S. relative to the rest of the world, economists contend.

If the adjustment were triggered by a sudden loss of confidence in the dollar, the result could be higher U.S. interest rates, a global recession and a financial crisis as rising loan defaults cause massive losses for banks, says Jonathan Wilmot, London-based chief global strategist at Credit Suisse Group.

Contrary to many predictions, the U.S. current-account deficit has proved to be quite sustainable, while financial markets have been remarkably buoyant and prophecies of impending doom premature. For investors, adhering to the bearish view of things has been, at the least, a distraction and, at worst, decidedly unrewarding.

The stock market crashed in 1987. Still, Wilmot explains, the world economy didn't unravel; the dollar didn't fall much further on a trade-weighted basis; and U.S. bond yields declined. The current-account deficit, which in 1987 stood at $160.7 billion, shrank to $50.1 billion in 1992. Bolstered by payments from other countries in support of the first Gulf War, the U.S. even posted a $2.9 billion surplus in 1991.

Swelling Deficit

More recently, the U.S. current-account shortfall ballooned to $856.7 billion in 2006 from $519.7 billion in 2003. The misalignment between exports and imports accounts for about 90 percent of the deficit. During that period, the Standard and Poor's 500 Index rallied 61 percent, while the trade-weighted dollar fell 14 percent, a comparatively small amount given the size of the U.S. deficit.

``Policy makers still worry about the deficit; I'm not sure people in the market are that worried,'' says Martin Barnes, an economist at BCA Research Ltd. in Vancouver. ``But if the dollar were to get very weak, then people might start to focus on the current account.''

By then, it may be too late. The trade gap is beginning to resemble a stretched rubber band. The tension can be relaxed through the combination of a weaker dollar, which should help boost U.S. exports and reduce imports; Americans saving more and surplus countries less; cheaper oil; and improving domestic- demand-induced growth abroad.

`Very Long Time'

Otherwise the rubber band must snap eventually, though it is anyone's guess when that will happen. ``Things that appear to be unsustainable can go on for a very, very long time,'' Wilmot says.

Economic gurus have offered theories on how the U.S. deficit can keep widening. They include the dollar's role as the world's reserve currency and what some economists at Deutsche Bank AG describe as a new variant of the international trade and gold- standard system agreed on at the 1944 United Nations Monetary and Financial Conference in Bretton Woods, New Hampshire.

Known as Bretton Woods II, it involves Asian countries tying their currencies to the dollar at highly competitive levels and using their reserves to lend money to the U.S. by purchasing its financial assets, especially Treasuries.

That allows these nations to pursue an export-oriented economic-development strategy, which maintains growth and keeps their large populations employed. In return, an overvalued dollar permits Americans to keep consuming cheap imports, spend more than they save and borrow from Asia at low interest rates.

Building Pressures

``Some have called it the world's biggest vendor-financing scheme,'' Barnes says. ``The U.S. gets to satisfy its insatiable demand for cheap imports, and Asia keeps its factories running.''

Even so, there are limits. While reserve-currency status bestows on the U.S. advantages not enjoyed by other countries, it doesn't render the U.S. immune from financial turmoil. And even Deutsche Bank, in a report last December, said Bretton Woods II ``cannot persist in its current form forever.''

Meanwhile, investors should be aware of the pressures building, especially since funding the U.S. deficit is dependent on other nations.

Led by Japan, China and oil-exporting countries, non-U.S. investors owned 44 percent of outstanding U.S. Treasuries at the end of 2006, 18 percent of U.S. agency bonds, 34 percent of U.S. corporate-debt securities and 17 percent of U.S. equities, according to Joseph Quinlan, chief market strategist at Bank of America Capital Management in New York.

International Investors

Interest payments on U.S. Treasuries held by international investors climbed to a record $113.6 billion in 2005, the last year for which figures are available. If U.S. corporate debt is included, the figure surges to $300 billion, Quinlan said in a March 29 report.

For the first year since 1960, non-U.S. investors earned more dollars on their U.S. holdings in 2006 than U.S. residents earned on their overseas investments.

``The income account is a leading indicator for investors about sustainability of the current-account deficit,'' Wilmot says. ``Paradoxically, the time to begin to worry about the current-account deficit is when it begins to improve, because growth and investment opportunities outside the U.S. are beginning to look more attractive.''

In the fourth quarter, the U.S. current-account deficit amounted to 5.8 percent of gross domestic product, down from 6.9 percent in the third quarter and a record 7 percent of GDP in the last three months of 2005. Yet from 1990 through 1997, it was never worse than 2 percent.

Money-management firm Bridgewater Associates Inc. warned clients last December about the potential consequences of a bloated U.S. current-account deficit: ``Eventually, people who lend money stop lending it and expect to be repaid.''

That's when a trade gap becomes unsustainable.

(Michael R. Sesit is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Michael R. Sesit in Paris at at msesit@bloomberg.net
Last Updated: April 12, 2007 19:08 EDT
Bloomberg.com: Opinion

**Shek** · 13 Apr 07,, 22:16

Sir,

I created a new thread for your article.

This is a pretty standard article on the topic, discussing the export driven growth strategy from SE Asia, which requires a weak yuan (to make Chinese imports look cheap to the relatively strong US dollar), and the informal Bretton Woods II fixed exchange rate scheme where other SE Asia countries peg their currency against the yuan and hence to the dollar so that there aren't any exchange rate fluctuations that can change the relative competitiveness of their goods vis a vis China for export to the US.

Couple the export driven growth strategy and exchange rate policy, these governments have stocked up a war chest full of dollars so that they can defend their fixed currencies against any speculative attack, attacks which precipitated the Asian financial crises of the 1990s.

This can't last forever, but it has lasted for longer than many have predicted. The question becomes whether the adjustment will be sudden and painful, or gradually occur and have only a small impact as the world economy adjusts.

Here's another article that talks a little more about the global imbalances. Hopefully, it reads pretty straightforward.

http://www.nber.org/feldstein/returnofsaving.pdf

**Ray** · 14 Apr 07,, 09:19

Shek,

How does the above articles relate to China using the same towards her advantage and to US' disadvantage?.

We must also take into consideration Saudi Arabia newly found belligerent posture, which means she can manipulate the OPEC and also the effect of the Pakistan - China Energy Initiative.

Therefore, how does this finally work out.

That is what I would like to understand.

**Shek** · 14 Apr 07,, 12:22

Originally Posted by Ray

Shek,

How does the above articles relate to China using the same towards her advantage and to US' disadvantage?.

We must also take into consideration Saudi Arabia newly found belligerent posture, which means she can manipulate the OPEC and also the effect of the Pakistan - China Energy Initiative.

Therefore, how does this finally work out.

That is what I would like to understand.

Sir,

This arrangement is mutually beneficial for now. China (and SE Asia) sells relatively cheaper goods while growing their economy. Joe American can afford to buy goods on the "cheap," from cheaper electronics to cheaper clothes. Given that these countries hold in the vicinity of $2trillion in currency reserves and see major foreign direction investment (FDI) spending coming from the US, it is not in their interests to see a precipitous weakening in the US dollar. This would cascade through their own economies as exports would stall (stalling growth), FDI would shrink, and their reserves war chest would decrease in value.

Thus, the situation doesn't give an advantage to either side through an "economic" weapon.

**Ray** · 14 Apr 07,, 15:58

Good.

I was a bit apprehensive when I read the first article.

The 'economic weapon' does always worry!

Thanks for the simple way you put it across.

You must be a good instructor and you cadets are quite lucky I must say!

**~~Zhang Fei~~** · 17 Apr 07,, 02:32

A dollar collapse would simply mean that foreign goods will become less attractively-priced in the US. Since the US is the single largest market for most foreign exporters, this could really put a dent in their sales. The countries that let their currencies rise against the dollar will see exports to the US fall, while living standards rise, as domestic buying power increases. The US will see exports rise, while imports collapse, as the buying power of US consumers falls.

Since only 14% of US output consists of imports, American living standards aren't likely to decrease very much. Luxury goods importers are likely to be hit the hardest.

In the medium term, currency collapses and buying power declines are self-correcting, assuming the country's economy is reasonably open. For instance, Thailand is steadily losing ground to China in the race for foreign investment. Chinese wages are also gradually catching up to Thai wages, meaning that Thai buying power is increasing less rapidly that Chinese buying power. The post-coup leadership has come up with a lot of bone-headed economic policies, most involving the confiscation of foreign-owned assets, whether outright or via crippling taxes. And yet the Thai baht's buying power and exchange rate has slowly strengthened since the collapse of the Asian financial crisis. The fact is that a weak currency draws investors in for a very simple reason - the country's assets and wages become cheaper to foreigners without actually having lost their capacity to produce a given amount of profits denominated in foreign currency.

**Ray** · 17 Apr 07,, 04:04

Shek and Zheng,

I was reading on the Iraq War, one of the reasons given is that Saddam wanted or did convert the payment for oil to Euros. So is the case with Iran.

The article said it would lead to the crash of the dollar since it had to do something about securities that the world had invested in the US.

Could you explain this in simplistic terms.

How would that affect the US in its totality and the countries who have their money in the US?

What is the connection with the Asian Giants having collapsed earlier.

I know my queries are disjointed, but could you explain how the dollar affects the world economy or give some links which explains the same in simple terms shorn of high flaunting economical theories.

Zheng,

You state that only 14% is imported. US labour is expensive and so anything produced in the US will be expensive. Therefore, the US should buy cheaper goods from abroad. Therefore, why only 14% is imports?

**Jay** · 17 Apr 07,, 05:04

Zheng,
Can you explain more on that 14% part?? Are you comparing imports versus total US GNP? IMO that'll be a little flawed, as US imports are mostly basic necessities incld oil, electronics, textiles, home wares, fruits, juice, steel and timber. These are essential items and I think the US cannot start manufacturing these items overnight.

IMO, if the dollar collapses so will most of the emerging economies. US is number one trading partner for most of the countries. For eg, lets say US economy collpases, what would China do with the excess capacity? Their banking system, markets would totally tank and there will be a huge liquidity crunch. Remember, China alone has a trillion dollar worth of foreign exchange, and they would not really like a dollar melt down.

**Ray** · 17 Apr 07,, 05:12

Jay,

Then why did Saddam, Iran changed to Euro and I believe even China contemplating?

As whatever I little I have been able to understand, if the dollar slumps, many countries will collapse.

This is the connection I want a clarification on as also as to how converting to Euro affects the world and the US.

**Jay** · 17 Apr 07,, 06:00

Sir,
Answer for your 2nd question, as per my understanding,

The answer is to check the trade between Euro zone and the US. A slump in the dollar and a collpase in US economy would also affect Europe big time. Sinply put, the world produces and the US consumes. Currently, the US has the will and means.

China's move to Euro is understandable as Europe is currently China's number one trading partner. And it makes sense to bet on more than one horse.

Global trade is almost a whole cycle, If US is not buying from China and Europe, Europe cannot afford to spend more and China, India and other emerging countries cannot sell their goods.

Even if they convert half their forex to Euro, a US meltdown will take China along with it. Reason, there will be no US to consume what ever China makes and the non returns will affect China's banking system real hard and the ripple effect will take down most economies that supply China with raw materials.

**Jay** · 17 Apr 07,, 06:09

For your first question, the answer is, Iran was scared of US. If te majority of its assets were in dollars, the US can easily manipulate Iran's financial system. The US is increasingly using financial controls to strangulate rogue govts.

There is another thread which explains about North Korea and its frozen assets in Macau. There is also a detailed article in WSJ, I'll try to find it online if I can. When US accused a local Macau bank on its illegal transactions with NK govt, all the banks in the region incld Bank of China voluntarily froze all dollar denominated NK assets. The NK were very much infuriated by this move. Iran does not want to be in the receiving end.

**Jay** · 17 Apr 07,, 06:13

More on point,
Iran Seeks to Replace Dollar with Euro
By AFP

TEHRAN (AFP) - Iran has announced it would replace the dollar with the euro in foreign transactions and state-held foreign assets, in an apparent response to mounting US pressure on its banking system.

"The government has ordered the central bank to replace the dollar with the euro to limit the problems of the executive organs in commercial transactions," government spokesman Gholam Hossein Elham told reporters Monday.

"We will also employ this change for Iranian assets (in dollars) held abroad."

Amid US allegations that Tehran funds militant groups and is seeking a nuclear weapon, reports have suggested the US treasury has put major pressure on European banking giants to halt transactions involving Iranian clients.

Bankers in Iran have complained in recent weeks that it was becoming increasingly difficult to receive Iranian-held money denominated in dollars from European bank accounts.

They said that this was because of US pressure on European banking giants not to allow dollar-denominated funds to be sent into, or out of, the Islamic republic.

Elham implied the move would apply to oil revenues from the world's number four crude producer, although it would be difficult for Iran to force oil buyers to pay for all of its crude oil in euros.

"Foreign income sources and oil revenues will be calculated in euros and we will receive them in euros in order to put an end to our dependence on the dollar," Elham said.

In reality, Iran could still receive payment for oil in dollars and then convert it into euros for the state budget.

The move comes amid mounting pressure from the United States for the UN Security Council to agree sanctions against Iran over its controversial nuclear programme.

Elham added that Iran's budget would in future be calculated in euros.

"Until now the budget has been calculated according to revenues in dollars, but this calculation will now change," he said.

Economy Minister Davoud Danesh Jafari had already said in November that Iran would carry out transactions with currencies other than the dollar and its use of the greenback would drop to a minimum level.

Morteza Tamadon, a member of the government's budget and planning commission, said the government was looking to reduce its dependence on the dollar due to the greenback's recent slump as well as because of US pressure.

"Iran wants to reduce this vulnerability," he said, adding that the most reasonable option for the government would be to use a basket mixing both currencies.

"This is a political manoeuvre as a reaction to the US ban on dollar transactions with Iran," said leading economist Mohammad Reza Behzadian.

However he cast doubt on whether Iran would ever be able to demand that all foreign exchange payments for its oil be made in euros.

"Iran has said that 60 percent of oil sales are already being carried out in dollars. I suppose the government would keep the remaining amount in dollars because it has to.

"The exchange of petrodollars into euros would be very costly for Iran, inflicting high money loss during the procedure. The dollar is very much preferred by foreign sellers."

"It's mainly a political move," Investec analyst Bruce Evers told AFP in London.

"But also they may feel, possibly rightly so, that the euro is a stronger currency, and that with the dollar as weak as it is they're losing out and it could help them recoup some of the lost revenues."

At the Singapore G7 summit of the world's most industrialised nations in September, US Treasury Secretary Henry Paulson called for a tough stance from the world's financial leaders against Tehran.

He said the United States had evidence that major banks had become inadvertently implicated in terrorist financing, adding that US authorities were therefore engaged in an "educational" campaign.

The United States broke off relations with Iran after the 1979 storming of the US embassy in Tehran by student radicals, and ties have remained frozen ever since.

Iran to Replace Dollar with Euro?

**Jay** · 17 Apr 07,, 06:24

This a pretty good article that I read today when searching for Dollar and Euro.

http://www.imf.org/external/pubs/ft/wp/2006/wp06153.pdf

**Ray** · 17 Apr 07,, 07:18

Jay,

Thanks a lot.

It does remove some of the cobwebs that I had and, thanks for making it simple and without economic gobbledygooks and fancy theories.