The Pulse of Capitalism

Issue 98-4, January 1999

THE UNITED STATES INTERNATIONAL INVESTMENT POSITION

In July, the Bureau of Economic Analysis published its annual revision of U.S. international transactions accounts. The revision incorporated new source data and revised estimates based on several bench-mark surveys based on the year 1994. Previous estimates had been benchmarked to 1989 surveys. As a result of the revision, the net U.S. international investment position at the end of 1996 was revised from $-870.5 billion to $-767.1 billion. This is a large revision but not surprising in view of the inherent difficulty of measuring the millions of transactions affecting the U.S. international investment position. The underlying trend of the U.S. net position was unchanged.

For clarification, it should be kept in mind that there are two principal measurements for U.S. international transactions. The first is the current account balance (discussed in Pulse #97-3), which measures net transactions for one year resulting from trade in goods, trade in services, investment income, and unilateral (or unrequited) transfers. The second is the U.S. international investment position, which measures capital flows out of the U.S. to acquire assets abroad and capital flows into the U.S. to acquire assets in the U.S. The cumulative difference between these two flows comprises the U.S. net international investment position.

The international investment position can be thought of as a balance sheet that lists all U.S. owned assets located abroad plus certain official assets available to meet claims from abroad, then all foreign owned assets located in the U.S. In both cases, the assets are listed under two headings: "official" or governmental and "other" or private. U.S. official assets include gold, special drawing rights, reserve position in the International Monetary Fund, and foreign currencies. There are also other classes of U.S. official assets. Foreign official assets comprise U.S. government and other U.S. securities as well as certain other U.S. liabilities. Other or private assets include direct investment, securities, and claims or liabilities reported by banks and nonbanking concerns. The BEA now reports the U.S. investment position on two bases. One values direct investment at current cost (to reproduce) while the other values direct investment at current market value (stock market). In this discussion, current cost will be used, including data in tables. The source for all data may be found in the July 1998 Survey of Current Business, pages 24-34 and 47-57.

The current account balance and the net investment position are, of course, closely related. When the current account is negative, foreigners acquire dollars, and most of those dollars eventually return to the U.S. to be invested in various U.S. assets - direct investment in plants or real estate, bank or nonbank claims, stocks, bonds, etc. At first thought one might wonder why foreigners don't use their dollars to buy more of our wonderful goods, thereby balancing the trade in goods. The fact is that they have surplus capital, and they can buy all the goods they want either in their own economy or in foreign economies other than the U.S. economy on better terms. On the simple measure of the balance on merchandise goods, the U.S. is not highly competitive in the world market.

Data on these two measures of U.S. international transactions is presented in the following tables:

The current account balance turned negative in 1982 at $-11.4 bn. and by 1985 exceeded the $-100 bn. level. The change from positive to negative was due to a surge in imports over exports beginning in 1983 and continuing to the present; the deficit for the first half of 1998 totaled $-103.4 bn. In 1980, the U.S. earned a net $30.1 bn. in investment income, but by 1997 this had shrunk to $-5.3 bn. due to the large increase in foreign investment in the U.S.

The net international investment position of the U.S. turned negative in 1987 at $-33.7 bn. This represented an erosion from the 1980 positive position of $392.5 bn. That decline, however, is dwarfed by the decline from 1990 to 1997 that totaled $-1.0 trillion. In just the past two years, the negative position has doubled, with most of the additional foreign investment concentrated in U.S. securities. The changes for the past year are as follows:

The net change for 1997 resulted from both official and private holdings, primarily of U.S. securities. Direct investment and bank and nonbank claims and liabilities changed little. Capital flows accounted for $254.9 bn. of the net change, with the remainder due to various valuation changes. If this rate of capital inflow continues over the next four years, the U.S. net position will deteriorate another $1.0 trillion. If we plot a graph of the net position, both U.S. assets abroad and foreign assets in the U.S. have been rising at increasing rates since about 1985. The acceleration in the past two years has been especially sharp.

By area, the largest U.S. holdings of foreign stocks are Western Europe, Japan, and Latin America; the largest holdings of foreign bonds are Western Europe, Latin America, and Canada. The largest foreign holders of U.S. stocks are the United Kingdom, Canada, and Switzerland; the largest holders of U.S. bonds are Japan, United Kingdom, and Germany. By contrast, the largest U.S. trade deficits are incurred with members of OPEC, Japan, and China. These divergences are testimony to the free flow of capital in today's world. Money invested from London or the Caribbean may well come originally from Saudi Arabia, China, Venezuela, or even the U.S. itself. It moves freely and leaves few trails.

During the first half of 1998, the U.S. net position further deteriorated by $115.8 bn, about the same rate as incurred in 1997. U.S. exports are now faltering as demand from East Asia declines, while imports rise due in part to a strong dollar. These developments raise the question of how long such deficits can continue to be incurred. The U.S. essentially is doing the same thing that the East Asian and Latin American countries did - import capital while the ability to repay that capital deteriorated. This has been possible so far because the U.S. is the world's wealthiest nation and its currency enjoys universal acceptance. But not even the wealthiest man or nation can accumulate obligations indefinitely. Eventually creditors become unsettled and start to call in their claims. This eventuality is raised in the following words from International Investors Gold Fund 1998 Third Quarter Report:

"The U.S. trade deficit grew to a record in August and may grow worse. The IMF in its latest World Economic Outlook added its concern about the dollar exchange rate to those raised earlier this year by the OECD and the Bank for International Settlements (BIS). It predicts the U.S. current account deficit will exceed $290 billion next year, 3.3% of national income and almost double the figure recorded in 1997. If investors were suddenly to question the sustainability of this imbalance, the consequences for financial markets and the world economy could be alarming."

The continued deterioration of the U.S. net position calls into question the viability of the present international exchange rate system. Prior to the Great Depression, the gold standard provided a discipline on nations to balance their international accounts. If a nation incurred persistent trade deficits, foreign creditors began to draw down its gold reserves, thereby weakening its currency which was convertible into gold. To avert this outcome, nations quickly took actions such as raising tariffs, imposing quotas, or raising interest rates designed to bring their accounts back into balance. In today's world, the major currencies float according to market demand with no tie to a tangible asset such as gold. Most other countries tie their currencies to one of the major ones, especially the U.S. dollar. Most international trade in commodities is conducted in U.S. dollars, capital moves freely from country to country, and tariffs, quotas, etc., are controlled by international agreements. Thus, nations have few options left to control their own accounts. Imbalances continue until creditors perceive a risk of default. When they attempt to withdraw their capital, the currency and the securities markets of the nation in distress collapse, and it must be "rescued" by emergency loans from the International Monetary Fund. These loans may save the creditors from major losses, but the people of the affected nation are saddled for years with the burden of repaying the loan.

In the case of the U.S., the trade imbalance has been addressed in the feeblest of ways: "jawboning". Other nations, especially Japan are accused of "unfair trade practices." Usually, these consist of cultural preferences, such as the European preference not to eat hormone fed beef, or the Japanese preference to eat home grown rice. These nations are then pressured into admitting a larger amount of some particular product, and the outcome is considered proof that the U.S. is "serious" about solving its deficit problem. Meanwhile the deficits continue to mount.

The likelihood that U.S. exports will ever rise enough to reverse the trade imbalance diminishes with every year that passes. Tariff and quota actions are now severely restricted while exchange rates can be influenced but not controlled by governments. The only effective counter measure would be to shrink domestic demand. This would be political suicide and not likely even to be considered. Meanwhile, the Federal Reserve pursues a policy aimed at "calming" securities markets and shoring up the international financial system. Expanded credit will further increase the demand for imported goods (as well as stock shares), thereby exacerbating our two great weaknesses - the current account deficit and bloated valuations in the stock markets. Thus, we are almost committed to a policy of "full speed ahead and damn the consequences." Does this foreordain another great currency crisis, to be followed by another Bretton Woods Conference? Time will tell.

Real GDP growth decelerated in four of the five economies in the first three quarters of 1998. The largest declines were in Canada and in Japan, which is now classified in recession. Industrial production picked up a bit in Canada, Germany, the U.K., and the U.S. Retail sales volume fell except in the U.S.

Consumer prices continue to rise but at somewhat lower rates, and unemployment declined slightly except in Japan. Interest rates have been rising except in the U.S. Most stock indices were weak during the third quarter but went on to recover their losses by the end of the year.

The U.S. current account imbalance swelled to the $200 billion level, annual rate, in the third quarter. The Japanese surplus passed $100 billion again, while the other three economies were little changed. The U.S. dollar was strong against the mark and the yen but has weakened since then. The Canadian dollar has continued to weaken, and the pound rose a little.

Real GDP increased 3.9 percent in the third quarter after rising 1.8 percent in the second and 5.5 percent in the first. The increase of 3.9 percent is above the 3.0 percent average annual rate for the current expansion that began in 1991.

Industrial production overall has risen about as much as in 1997, but there are some areas of weakness. The mining index is below 1997, the non-durable index is falling, and capacity utilization is below both the 1996 and 1997 levels. Manufacturers' new orders confirm this trend; non-durable goods orders have not risen in 1998, and unfilled orders are below the 1997 level.

New construction expenditures showed no such weaknesses; all sectors advanced except public construction, which was stable. The value index, however, has fallen since July when it reached 150. Real domestic investment also continued strong with advances in all major categories except nonresidential structures.

Manufacturing and retail sales growth was about as strong as during 1997. Inventory growth continued at recent rates. The strong economic indicators have been underpinned by rising personal consumption expenditures, which have been made possible by increased disposable income and a drop in the savings rate, which fell to an all-time low of .2 percent of disposable income in October.

In turn, the rising income resulted from continued high growth in employment, almost entirely in the services sector.

National income grew at about a 6 percent annual rate in the first three quarters, about the same as in the two preceding years. The rise results from strong job growth and continued high business activity. Per capita income rose 1.9 percent, unchanged from the preceding two years. Real weekly earnings also rose, aided by low inflation.

Although gross saving has changed only moderately over the past three years, two of its components have shifted radically. Government saving has more than doubled since 1996 while personal saving has fallen in every quarter since the second quarter of 1997. At annual rates, personal saving fell from $73.0 bn in the first quarter of 1998 to $15.6 bn in the second to $9.6 bn in the third.

The depression in commodities prices deepened in the third quarter with an index of 86.7, 21.8 percent lower than a year earlier. Metals have faired the worst with an index of 68.9 while food has faired best at 98.7. This weakness has now spread to producer prices which have fallen for the first time since l986. Interestingly, the area that has held up the best in this downturn is consumer foods.

Corporate profits peaked in the third quarter of 1997 at $840.9 bn and have remained in the $820-30 bn range since then. Much of the weakness is due to "profits from the rest of the world," reflecting, of course, the deterioration in the world economy. Interest rates fell steadily through 1998; by December 5, the yield on the 10 year note was only .22 percent higher than the yield on a 3 month bill, an unusually narrow spread.

M-3 money supply growth of 7.5 percent is more than double the GDP growth of 3.5 percent. Federal Reserve operations were essentially neutral through August. The interest rate cuts did not occur until October.

Bank credit growth continued at 1997's high rate, led by securities and commercial and industrial loans. Consumer credit actually declined at banks but expanded overall a little more than in 1997. Credit market debt growth accelerated after two years with little change.

The imbalance on goods and services worsened markedly in the first three quarters after little change in the prior two years. Exports of goods slumped considerably, both agricultural and nonagricultural. The decline in exports of services was much smaller and was related to travel and passenger fare receipts. Imports of goods rose sharply, and imports of services increased slightly. These changes were all related to the slump in Asia and currency rate changes.

Capital flows both into and out of the U.S. slowed from the high levels of 1997; the net yearly change should fall somewhere between the results for 1996 and 1997.

The decline in acquisition of Treasury securities reflects net liquidation by foreign official sources plus weak purchases by private interests; in two years, these purchases have declined by a quarter of a trillion dollars, but purchases of other U.S. securities have continued to mount. If these shifts had not occurred, interest rates would have been even lower, while the stock market might have been less strong.