Capital Flows

The euro currency unit was adopted by 11 European countries in January 1999 with an initial exchange rate against the U.S. dollar of $1.16. At the end of December 2000 it had declined to $1.07 or a swing of 7.8%. This decline had prompted the European and American monetary authorities to intervene in the currency markets in September by buying euros to boost its value. Such interventions do not change the fundamentals determining exchange rates but do tend to put a limit on further declines.

This fluctuation in the euro's value is not unusual, as the following chart shows:

Over the past ten years the Japanese yen has varied from 145 per dollar to 94, a 35.2% change. The deutsche mark varied from 1.76 per dollar to 1.43, an 18.8% change. The euro's decline is ascribed by the Economist (11/4/00 p. 79) as due to the following:

"....The principal force pushing the euro down against the dollar has been the belief of investors everywhere, including in the euro-area countries, that fast-growing America is a better place in which to stick their money rather than tired old Europe. Quarter after quarter the remorseless economic strength of the United States has reinforced their faith......The big question for the currency markets is whether anything is happening that will reverse the flood of capital out of euros and into dollars. This year European companies have been buying American rivals in droves. The flow in the other direction has been far smaller. Deutsch Bank calculates that a net $167 billion of M & A capital poured into the United States in the first nine months of this year, mostly from Europe. In sum, euro-area companies have spent a net $271 billion abroad."

The Economist then goes on to point out that portfolio security flows, the deposit of higher oil price money in U.S. dollars, and even the market collapse of high-tech stock shares have also had major impacts on the strength of the U.S. dollar.

Crises

[These comments are based largely on material contained in "Rethinking the International Monetary System", Federal Reserve Bank of Boston.]

These flows and fluctuations have had serious consequences in recent decades, the most recent of which were the collapse of economies in East Asia in 1997-98. Toyoo Gyohten, President, Institute for International Monetary Affairs, Tokyo, comments on these events as follows:

"When the crisis hit the East Asian countries, the first symptom was the acute shortage of foreign currency liquidity. Official reserves were depleted as the result of futile interventions. A sharp depreciation of the local currency swelled the debt service burden of banks and business firms enormously with unhedged foreign currency debt, thus seriously damaging their balance sheets. Currency crisis and banking crisis reinforced each other. Industries could not finance imports of vital materials, parts, and capital goods. Exporters could not obtain letter-of-credit facilities. Bankruptcies soared. In other words, the real sector of the economy crumbled."

By some measures, the Asian economies were quite sound - they experienced rapid real growth, low inflation and recorded fiscal surpluses. These favorable indicators along with relatively high interest rates led to an increase in priv- vate capital flows from $24 billion in 1990 to $62 billion in 1996. "---volatile bank loans played an unusually large role in capital flows to Asia. As a result, in late 1996 most troubled Asians had outstanding liabilities to foreign banks that were large in terms of GDP or foreign currency reserves. Much of this debt was due within one year and denominated in unhedged foreign currencies. These capital flows led to rapid credit growth that financed high, possibly overopti- mistic, levels of investment." (Jane Sneddon Little and Giovanni P. Olivei)

The ensuing collapse in 1997-98 was much like a run on a bank. When creditors became worried about the safety of their funds, they withdrew them, and the countries, (bank) did not have the cash to pay them. As a consequence, the most troubled Asian countries experienced an $80 billion reversal in capital flows, much of it in bank flows that left the banking sector greatly weakened. Their GDP fell from 6 to 8 percent in 1998, amid widespread social suffering, and unrest emerged.

In most respects, the U.S. economy has little in common with the economies that have incurred capital flow crises over the past two decades. One is mere size. Many U.S. banks are larger than the entire banking system of the smaller countries. Others are the existence of a strong, well regulated banking system, extensive disclosure requirements, an independent monetary authority, deep capital and securities markets, stable political traditions, etc.

But in one respect, the U.S. resembles very closely the crisis-hit economies: it has been the recipient of a huge inflow of foreign capital in a very short time period. This inflow is shown in the following graph:

This inflow was not in the form of bank loans denominated in foreign currencies. Rather, it has been in the form of investments in U.S. assets - stocks, bonds Bank deposits, U.S. currency, direct investment, etc. Europe has contributed most to the inflow, but Latin America, the Caribbean, and Asia have also participated. Most of the inflow occurred after 1988 and accelerated after 1992, the same period in which the current economic boom began. This, too, is a parallel with the East Asian countries as their economic booms coincided with the inflow of foreign capital. As a result of the inflow, the net U.S. international investment position changed from a positive 13.0% of GDP in 1980 to a negative 11.6% of GDP in 1999.

The Privileged Position of the U.S. Dollar

The U.S. enjoys several advantages over other countries in the world capital market. Because it is the world's largest economy and military power, the U.S. dollar is used as the principal official reserve asset by most foreign central banks. Thus the central banks have an inherent self interest in a stable U.S. dollar, and this encourages private interests to invest in dollars also. Moreover, most raw materials including oil are sold in dollars. The price for U.S. businesses does not fluctuate due to exchange rate volatility whereas the price for foreign businesses does change with the exchange rate of their currencies. This also constitutes a continuing source of demand for U.S. dollars.

When currency goes into circulation from bank vaults, bank reserves are lowered, and the Federal Reserve buys Treasury securities to replenish them. This constitutes an interest-free loan to the Treasury since most of the interest paid to the Federal Reserve on the securities it holds is returned to the Treasury under the caption "interest on Federal Reserve notes". About one-half of U.S. currency in circulation is held outside the U.S. and constitutes an interest-free loan from those sources. No other country benefits from this "seigniorage" on the scale that the U.S. does.

Dangers

Although U.S. indebtedness is not in the form of bank loans, it could produce large capital outflows if confidence factors were to reverse. This raises two questions: to what extent has the American boom resulted from the capital inflow?, and what would be the consequences if it were reversed?

Tom de Swaan, discussing the sequencing of reforms in emerging markets, identifies "unjustifiable large capital inflows that might temporarily lead to impressive but unsustainable growth rates." But could not such inflows produce a similar result in a large country?

Paul Volcker notes that the better a country's policies, the more capital it is likely to attract - and the more likely a bubble, eventual collapse, and the conclusion that the country actually had bad policies.

Economic Reform (Toronto, 11/00) comments: "The United States has not had a positive balance of trade with the rest of the world in thirty years. To finance this growing trade deficit, foreign ownership of American assets has grown from $191 billion in 1976 to a current value of $8.65 trillion, exceeding the foreign assets held by U.S. citizens by $l.47 trillion.

"To keep this influx of capital which not only finances U.S. prosperity but keeps the limping Wall Street miracle afloat requires from the Fed not only adroitness, but a good chunk of luck. And of course, keeping the foreign funds coming in depends on ongoing performance by Wall Street. The role of the U.S. dollar as the world's primary reserve currency helps immensely in this. With every foreign currency that collapses, the demand for U.S. dollars increases. That strengthens the U.S. currency, and that automatically weakens the euro."

Finally, John C. Van Eck (International Investors Gold Fund, Third Quarter 2000 Report) comments:

"Third, the dollar may be at a peak and may be vulnerable. The perception that dollar investments are the world's best values has brought huge flows of capital to the U.S. Foreigners own a record 38% of the Treasury market and a large proportion of the U.S. corporate and equities markets. There is a danger that the dollar may gradually lose its supreme credibility in a transition period to slower growth. The U.S. current account deficit is projected to grow to 4.3% of GDP this year, the largest imbalance in recorded history, and to 4.4% of GDP in 2001. The current rate of inflation is higher in the U.S. than in Europe or Japan. U.S. assets may be over-owned by foreign entities, and the federal budget surplus might shrink."

From these comments it is clear that a mere change in investment preference on the part of foreign investors could wreak havoc on the American economy. It is another area that must be watched with great care.

The first three quarters of 2000 were prosperous in all five economies in the table, with increases in GDP in all countries except Britain which was unchanged. Industrial production rose in all five, notably including Germany and Japan which had been lagging. Retail sales growth, however, slackened in the U.S., Britain, and Japan but was strong in Germany.

Consumer prices increased more than 3 points in the U.S. with lesser increases in the others except Japan which registered a decline. The prosperity is reflected in unemployment figures which either fell or remained unchanged. Interestingly Britain's unemployment rate is now lower than the U.S.'s, contradicting the ideologues who like to blame high rates on social protection plans. Interest rates rose during the period, with the U.S. rate 1.6 points higher than the euro rate.

The year 2000 may be remembered as the year in which the bull market for stocks ended. Four of the five indices were lower on September 27 than at the close of the preceding year, and that weakness has continued into the present year.

Canada's current account balance has moved from negative to positive, but Germany and Britain remain negative. The U.S. negative balance for 3 quarters of 2000 was almost double the imbalance for all of 1998. The euro and British pound weakened during 2000 whereas the yen and the U.S. dollar rose.

Real GDP increased 2.4 percent in the third quarter of 2000 after increasing 5.6 percent in the second quarter and 4.8 percent in the first quarter. Private investment slowed sharply and Federal Government spending also turned down.

Industrial production continued to rise in 2000 despite declining automobile production; monthly declines did occur in July and October. Capacity utilization also increased during the year but fell in October.

Manufacturers' shipment of goods reached a peak in June of 2000 that has not been equalled since, mainly due to durable goods. New orders have been more volatile than in previous years, and they, too, reached a peak in June. New construction expenditures rose a little less strongly than in 1999, and the contracts index slowed somewhat more.

Real gross investment rose strongly through the third quarter thanks largely to business investment in equipment and software; residential investment declined in the third quarter.

Business and retail sales remained strong through the first three quarters, but the rate of advance declined after June. Inventory-sales ratios were little changed. Sales growth was supported by a continuing rise in real personal consumption expenditures.

The employment data is quite interesting. From June through August payroll employment declined, but in September and October it rose again. The steady uptrend that prevailed from 1996 through 1999 definitely faltered after June, 2000. The change of trend was in services and government, as goods-producing employment has been fairly constant.

National income registered quarterly gains in excess of 2 percent from the third quarter of 1999 to the first quarter of 2000. But the second quarter gain was 1.9 percent and the third quarter rate was 1.4 percent. Real per capita income registered a gain of 3.5 percent in the fourth quarter of 1999 but did not approach that rate in 2000. This deceleration is even more apparent in real weekly earnings, which fell in every month after April, 2000.

Thanks to business and government saving, gross saving rose more in the first three quarters of 2000 than in 1999. Personal saving fell to -17.2 billion in the third quarter, or -.2 percent of disposable personal income.

The weakness of commodity prices continued with non food agriculturals the weakest and metals the strongest components. The pace of producer price increases quickened, led by consumer goods including food and energy.

Corporate profits made one of their steepest gains ever in the first three quarters of 2000 - a year in which stock prices languished! The 10-year Treasury rate stayed above 6 percent during most of the period but ended the year near 5-1/2 percent.

The M-3 money supply growth peaked in 1998 at 11.0 percent and then declined to 8.2 percent in 1999. This deceleration continued in 2000, noticeably after May.

Total bank credit growth accelerated to 8.4 percent through September compared with 5.2 percent in 1999; in October, however, it fell. Consumer credit rose $95 billion through September, the steepest rise since 1995. Credit market debt growth decelerated sharply due to a 7.4 percent decline in federal government indebtedness.

The U.S. trade position deteriorated sharply through September, 2000. Imports of goods rose considerably more than exports of goods, while exports of services (in which the U.S. still is in surplus) tended to grow less than imports of services. As a result, the negative balance on goods and services for all of 2000 is likely to be double what it was in 1998.

The U.S. capital position deteriorated just as much as the trade position. Capital inflows exceeded outflows by $333.3 bn, a larger amount than in any previous full year.

For the second consecutive year, foreign private interests were sellers of Treasury securities but major buyers of other U.S. securities - despite the weakness in U.S. stock markets. U.S. interest rates were higher than those in Japan or Europe.

Copyright © Andrew Caughey, 2001

The Pulse of Capitalism is published quarterly. Comments may be sent to Pulse Publication, P.O. Box 140, Gibsonia, PA 15044. Telephone: (724) 443-2396
Material may be reprinted with acknowledgement of the source. Economic statistics are revised routinely and may, therefore, differ from one report to another.

Published February 2001