Quarterly Foreign Exchange Focus - December 2006

Executive Summary

The United States incurred a $226 billion current account deficit in the third quarter, which set yet another all-time record. The good news, however, is that the deficit may soon stabilize if not begin to narrow somewhat. The recent decline in petroleum prices should help to reduce the deficit a bit in the quarters ahead, and export volumes are currently growing faster than import volumes, which should also contribute to smaller deficits in the future. That said, unless the U.S. economy were to slide into recession, which we do not expect in the foreseeable future, the current account deficit will not likely get significantly smaller anytime soon.

Contrary to popular perception, Asian central banks are not the principal financiers of the current account deficit. That distinction goes to foreign investors, who remain avid buyers of U.S. securities. However, capital inflows have weakened somewhat this year, which has exerted modest downward pressure on the greenback. Looking forward, we project that the Fed will ease modestly next year. Narrowing interest rate differentials with the rest of the world would reduce the relative attractiveness of U.S. assets. Further declines in net capital inflows should cause the greenback to depreciate modestly versus most major currencies.

The major risk to our forecast of modest dollar depreciation would be stronger-than-expected economic growth in the United States, which would reduce prospects of Fed easing and could lead to dollar strength. Although dollar appreciation is not our base-case forecast, it is not inconceivable either, especially if U.S. economic growth turns out to be stronger than expected.

Current Account Deficit Sets (Yet) Another Record in the Third Quarter.

As shown in Exhibit 1, the trade-weighted value of the dollar has declined nearly 5% this year, bringing its total drop since early 2002 to about 18%.1 As we have discussed in previous editions of our “Quarterly Foreign Exchange Focus,” the dollar’s value reflects developments in the U.S. balance of payments.

Exhibit 1

Exhibit 2

In that regard, one of the reasons the greenback has weakened versus many currencies this year is because the U.S. current account deficit has continued to widen (see Exhibit 2). Indeed, the deficit swelled to an all-time record of $226 billion in the third quarter of 2006. Over the past four quarters the deficit has totaled nearly $880 billion, which is equivalent to 6.6% of U.S. GDP that is also a record for the United States, at least in the “modern” era.

The vast majority of the red ink in the U.S. current account reflects the deficit in trade in goods and services, which also set a new record in the third quarter. There are two other relatively minor components that, together with the balance on goods and services, make up the overall current account. The income balance records payments of investment income between the United States and the rest of the world. In the third quarter, the United States incurred a small (i.e., $3.8 billion) deficit because income payments that it made to foreign investors slightly exceeded income payments received from the rest of the world. The other component, unilateral transfers, totaled $21.5 billion in the third quarter. The bulk of these transfers were accounted for by private remittances (e.g., income sent home by foreign workers living in the United States).

Exhibit 3

The bad news is that the current account deficit set another record in the third quarter. The good news is that the deficit may stabilize and begin to reverse somewhat over the next few quarters. The run-up in oil prices earlier this year helped to inflate the current account deficit, but petroleum prices have subsequently declined. Moreover, export volumes are growing faster than import volumes at present, which reflects relatively strong economic growth in the rest of the world (see Exhibit 3). Assuming that energy prices do not spike again, the current account deficit should begin to narrow. That said, unless the U.S. economy slides into recession, which we do not expect in the foreseeable future, the current account deficit is not likely to decline significantly anytime soon.

Foreign Investors Remain Willing Financiers of the U.S. Current Account Deficit.

Contrary to popular opinion, the massive current account deficit of the United States does not reflect undervalued foreign currencies or unfair foreign trade practices. Although those factors may contribute at the margin to the U.S. current account deficit, the red ink in the country’s external accounts generally reflects a macroeconomic phenomenon, namely, the United States spends more than it produces.2 When an individual spends more than he or she produces, that individual must either sell assets or borrow. Likewise, the United States must either sell assets or borrow from the rest of the world, and the financial account of the balance of payments show how the country finances its current account deficit.

Exhibit 4

When it comes to financing the current account deficit, the popular perception is that the United States is dependent on the buying of U.S. Treasury securities by foreign central banks, mostly those in Asia. Exhibit 4 sheds some light on this issue. In the third quarter of this year the foreign “official” sector (largely foreign central banks) purchased more than $80 billion worth of U.S. assets (mostly U.S. Treasury securities), which is not an insignificant amount. However, these official purchases pale in comparison to the $319 billion worth of U.S. assets that the foreign private sector bought. Contrary to popular opinion, the foreign private sector is the major financier of the U.S. current account deficit. Therefore, the view that foreign governments could blackmail the United States by refusing to buy U.S. Treasury securities, which could lead to a financial crisis, does not seem to hold as much water as some commentators claim.

Exhibit 5 disaggregates purchases of U.S. assets by the foreign private sector. Although foreign direct investment (FDI) is nowhere close at present to the inflows that poured into the country during the tech boom of the late 90’s, the current run rate of approximately $40 billion per quarter is quite solid.3 Purchases of U.S. securities by foreign investors, which totaled more than $131 billion in the third quarter, remain much stronger than FDI. Although foreign investors sold $7 billion worth of Treasury securities on net in the third quarter, they gobbled up more than $138 billion in non-Treasury securities.4 In sum, foreign investors, who are the principal financiers of the U.S. current account deficit, remain avid buyers of U.S. assets.

Exhibit 5

Furthermore, the United States is not financing its current account deficit entirely via debt. As the discussion above indicates, foreign direct investment and foreign purchases of U.S. equities also play important roles. At the end of 2005 (the latest available data), the value of foreign-owned U.S. assets stood at $12.7 trillion, of which $1.9 trillion was direct investment. In addition, foreigners owned $2.1 trillion worth of U.S. stocks. Although foreign investors may not buy as many U.S. assets going forward as they have over the past few years, a point to which we will return below, a complete evaporation of capital inflows, which some gloomy analysts predict will befall the U.S. economy, seems like a remote possibility.

Just as foreign investors can buy U.S. assets, U.S. investors can purchase foreign assets. Exhibit 6 shows that U.S. FDI abroad totaled $63 billion in the third quarter, the largest amount in nearly two years. In addition, U.S purchases of foreign securities held steady at $53 billion. Over the past few years, total U.S. investment abroad, both FDI and portfolio investment, has crept steadily upward.

Exhibit 6

Conclusion

The value of the dollar going forward will depend on the interplay of the current account deficit and net capital inflows. As discussed above, the U.S. current account deficit may begin to narrow somewhat in 2007, but it likely will remain “large” for quite some time. Consequently, the United States will remain beholden to foreign investors to finance its gaping current account deficit.

As shown in Exhibit 5, foreign purchases of U.S. securities have trended lower this year and, as noted at the beginning of this report, the dollar has depreciated on balance during 2006. Looking forward, we expect that net capital inflows will decline further. We expect that the Federal Reserve will ease monetary policy modestly in 2007, but we look for rates in most major foreign countries to either remain whe they are or to rise a bit.5 As interest rate differentials narrow between the United States and major foreign economies, U.S. assets will lose some of their relative attractiveness. In that scenario, foreign purchases of U.S. assets would weaken somewhat while U.S. purchases of foreign assets would strengthen. With the current account deficit remaining large, the decline in net capital inflows would exert downward pressure on the dollar versus most major currencies (see Exhibit 7).

Exhibit 7: Forecast of Dollar Exchange Rates

The major risk to our view of generalized dollar depreciation would be stronger-than-expected economic growth in the United States. As noted above, our forecast of dollar depreciation is predicated on our expectation of modest Fed easing in 2007. If, however, U.S. economic growth turns out to be stronger than expected, then the Fed likely will not cut rates. Most investors share our view that the Fed will ease modestly next year. In the event that the Fed remains on hold, let alone if it tightens further, long-term interest rates would rise, which would increase the relative attractiveness of U.S. assets. A rise in net capital inflows likely would cause the dollar to strengthen. We would place the odds of dollar appreciation over the course of 2007 as somewhere around 25%. As discussed above, however, our base case scenario calls for the greenback to trend lower next year versus most major currencies.

Wachovia Corporation
http://www.wachovia.com

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