Quarterly Foreign Exchange Focus - March 2007

Executive Summary

Recently released data show that the U.S. current account deficit totaled nearly $860 billion in 2006, an all-time record. However, there are tentative signs that the deficit may be starting to stabilize. Not only did the current account deficit decline by more than $30 billion in the fourth quarter relative to the previous quarter, but the underlying dynamics in the real trade deficit are also pointing in the direction of stability. That said, the current account deficit is not likely to get significantly smaller anytime soon.

The balance of payments data also show that capital inflows from foreigners are beginning to weaken a bit. It appears that narrowing interest rate differentials between the United States and the rest of the world are beginning to reduce the relative attractiveness of U.S. assets. And U.S. investors are looking abroad as well as interest rate differentials narrow. Indeed, portfolio investment in foreign countries by U.S. investors shot up to an all-time high in the fourth quarter.

Although we believe that the probability of an outright dollar collapse is rather low, we project that the greenback will depreciate modestly versus most major currencies in the quarters ahead. In our view, the combination of a large current account deficit in conjunction with narrowing interest rate differentials, which will further erode the relative attractiveness of dollar assets leading to smaller net capital inflows, equals dollar depreciation.

Will the Deficit in the Current Account Narrow Following Last Year's Record?

As shown in Exhibit 1, the U.S. current account deficit narrowed from $229 billion in the third quarter of 2006 to "only" $196 billion in the fourth quarter, the first time in more than a year that the red ink in the current account has fallen short of the $200 billion mark. The decline in the current account deficit in the fourth quarter did not come as a huge surprise. Previously released monthly data had shown that the deficit in international trade in goods and services, which comprises the vast majority of the overall current account balance, had narrowed by nearly $23 billion in the fourth quarter.1 The new information was the swing in the income balance from a $5.5 billion shortfall in the third quarter to a $3 billion surplus in the fourth quarter and the $2.3 billion improvement in net unilateral transfers. Despite the narrowing that occurred in the fourth quarter, the $857 billion current account deficit that the United States racked up last year was the largest in history.

Exhibit 1

Has the high water mark been reached? Will the deficit narrow further, or was the fourth quarter just a one-off event? There is reason to believe that the current account deficit is stabilizing, and that it may even narrow further going forward. The 5% decline in the volume of petroleum imports, which may not be sustainable, surely contributed to the decline in the value of the current account deficit last quarter. However, Exhibit 2 also shows that the real (i.e., price-adjusted) trade deficit has essentially stabilized over the past year or so. Economic theory suggests, and history shows, that adjustments in the real trade balance precede adjustment in the nominal trade balance.2 The good news is the stabilization in the real trade balance suggests that the current account deficit should also stabilize in the quarters ahead.

The bad news, however, is the current account deficit is not likely to get significantly smaller anytime soon. The value of U.S. imports is more than 50% larger than the value of exports, so the latter needs to grow significantly faster than the former simply to stabilize the deficit. A significant decline in the current account deficit would require a sharp slowdown in the rate of U.S. economic growth. Although we

believe that overall GDP growth will remain sub-par over the next few quarters, an outright U.S. recession, which would lead to a significant narrowing in the current account deficit via a decline in imports, is not our base case view.3 Therefore, the U.S. current account deficit likely will remain "large" for the foreseeable future.

Exhibit 2

Net Capital Inflows are Weakening

The counterpart to the current account deficit is the net capital inflows that finance it. Not only do foreign investors purchase U.S. assets, which are recorded in the balance of payments as capital inflows, but capital also flows out of the country when U.S. residents buy foreign assets.

Let's start with the former. As shown in Exhibit 3, purchases of U.S. securities by the foreign private sector surged in 2004 and 2005. Although these purchases remain at high levels, they have weakened somewhat over the past few quarters. This slowdown in purchases of U.S. securities by the foreign private sector may reflect the effects of narrowing interest rate differentials between the United States and the rest of the world. For example, the differential between the yield 10-year government bond in the United States and the comparable security in Germany narrowed from 110 basis points at the end of 2005 to 75 basis points at the end of last year. The differential between the United States and the United Kingdom narrowed by a similar amount. Everything else equal, narrowing interest rate differentials reduce the relative attractiveness of U.S. fixed income securities. However, inflows of direct investment, which are not as sensitive to interest rate differentials as are inflows of portfolio capital, have picked up a bit over the past year or so.

Exhibit 3

The recent behavior of U.S. investors also suggests that narrowing interest rate differentials may be at work. As shown in Exhibit 4, U.S. purchases of foreign securities jumped from $54 billion in the third quarter to $116 billion in the fourth quarter, the largest amount on record. Although much of the jump in the fourth quarter reflects increased buying of foreign stocks by U.S. investors, fixed income purchases have been strengthening as well. Indeed, U.S. purchases of foreign bonds totaled about $110 billion more in 2006 than in the previous year.

Large Current Account Deficit + Weaker Capital Inflows = Dollar Depreciation

As shown in Exhibit 5, the Federal Reserve's "Major Currency" index, which plots the weighted-average value of dollar vis-à-vis seven major currencies, has declined more than 25% on balance since the beginning of 2002. We fear that more depreciation lies ahead. To recap our discussion above, the gaping current account deficit of the United States may stabilize but it is unlikely to get significantly smaller anytime soon. Everything else equal, the current account deficit will put downward pressure on the dollar because the excess of imports over exports creates a net demand for foreign currencies.

Exhibit 4

Exhibit 5

In order to keep the dollar stable in the face of large current account deficits, net capital inflows will need to remain very strong. However, the analysis above shows that foreign purchases of U.S. securities are starting to weaken a bit while purchases of foreign securities by U.S. investors are strengthening. It appears that narrowing interest rate differentials between the United States and the rest of the world are reducing the relative attractiveness of dollar assets. Looking forward, we expect that interest rate differentials will narrow further as the Fed remains on hold while other major central banks continue to hike rates.5 In our view, the combination of a large current account deficit and further narrowing in interest rate differentials equals more dollar depreciation. Indeed, we project that the greenback will weaken on a trend basis versus most major currencies (see Exhibit 6).

Exhibit 6: Forecast of Dollar Exchange Rates

Where are the risks to our forecast? On the one hand, stronger-than-expected economic growth and/or higher-than-expected inflation in the United States would keep the Fed on hold longer than most investors expect.6 If growth turns out to be robust, the Fed could actually start raising rates again by the end of the year. In that event, the greenback could strengthen against many major currencies.

On the other hand, the major downside risk to our forecast would be a significant weakening of U.S. economic growth caused by, say, cascading problems in the mortgage market. In that event, the Federal Reserve could enter a major easing cycle that could lead to significant (i.e., more than we project) downward pressure on the greenback. Would the dollar collapse under such a scenario? Probably not. Recall that in late 2003 and early 2004 when the dollar was sliding rapidly many central banks in Asia, especially in Japan and China, bought massive amounts of dollars in the foreign exchange market to help stem the downward pressure against the greenback. Another bout of extreme dollar weakness probably would induce these central banks to intervene again. Although many Asian governments can live with a modest rate of appreciation, the last thing they want to see is runaway appreciation of their currencies. In sum, we do not believe that the bear market for the greenback has completely run its course, and we look for a modest pace of dollar depreciation in the quarters ahead.

Wachovia Corporation
http://www.wachovia.com

Disclaimer: The information and opinions herein are for general information use only. Wachovia Corporation and its affiliates, including Wachovia Bank, N.A., do not guarantee their accuracy or completeness, nor does Wachovia Corporation or any of its affiliates, including Wachovia Bank, N.A., assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sales of any security or any foreign exchange transaction, or as personalized investment advice. Securities and foreign exchange transactions are not FDIC-insured, are not bank-guaranteed, and may lose value.