Orthodox trade theory holds that factors of production--such as capital, labor, and natural resources--flow from regions where they're relatively ample to regions where they're scarce. Capital should, therefore, move from rich countries to poor, since the returns on capital should be highest where capital is most scarce. But in recent years, inflows are defying trade theory, moving instead into the most capital-intensive economy in the world--the U.S.
The numbers are staggering. Over the past 12 months, net foreign inflows into the U.S. have totaled $904 billion—five times the federal deficit over the period. On net, foreign investors are now financing one-third of U.S. gross investment. This flood of funds has allowed U.S. bond yields to drop since the second quarter of 2004, despite 17 rate increases by the Federal Reserve.
One disturbing result of this phenomenon is that the Fed no longer has as much control over bond yields--and perhaps the U.S. economy--as it once did. Fed Chairman Alan Greenspan's "conundrum"--the disconnect between the federal funds rate and bond yields--may become permanent, and it will operate on the down side as well as the up. Just as bond yields failed to rise as the U.S. central bank repeatedly raised rates since mid-2004, we expect yields to remain high when the Fed cuts rates, next summer most likely.
Another result, which raises other concerns, is that foreign demand has shifted to U.S. corporate bonds and away from U.S. Treasury or agency issues. This, in turn, has been a factor in holding down quality spreads in the bond market, because foreign investors are so hungry for yields. But the worry is whether they understand the risks. After all, speculative-grade bonds are now trading at only 370 basis points above Treasuries. Although this is more than the record-tight spreads of two years ago, it remains very narrow--perhaps too narrow for long-term comfort.
As Inflows Increase, Their Sources Are Shifting
The recent acceleration of capital inflows to the U.S., to $904 billion over the past 12 months from $681 billion in 2004, reflects relative returns. The source of the funding is also changing. In 2003 and 2004, 35% of the net inflow into U.S. securities came from official sources, such as central banks. The Bank of Japan alone spent ¥35 trillion on foreign exchange intervention in a 15-month period during 2003 and early 2004, which ultimately ended up in U.S. assets. In the last 12 months, though, official inflows have dropped to 15% of the total (see chart 1). It's important to note, however, that Treasury's data don't make a clear distinction between official and private purchases and probably exclude most of the purchases made by national investment corporations, such as the Saudi Investment Corp. We believe much of the rise in private purchases reflects the OPEC nations' huge trade surpluses, which are being channeled into U.S.-dollar investments.
Chart 1
Private inflows rose in 2005 and 2006 because of increased incentives for foreigners to invest in the U.S. In late 2004, when the Federal Reserve was beginning to raise short-term interest rates, bond yields had converged in most major markets. The U.S. 10-year Treasury yield was 4.0%, while 10-year euro bonds were yielding 3.9%, and U.K. gilts 4.7%. Only Japan, with a 1.4% yield, was significantly different from the world average. As the Fed tightened in 2005, however, the 10-year Treasury yield rose to 4.4%, while the yield on euro bonds fell to 3.3%, reflecting the Eurozone's weak 1.3% growth (see chart 2). The yield spread attracted more inflows of private foreign capital to the U.S., pushing the dollar higher and capping the rise in American bond yields.
Chart 2
This inflow has had a major impact on the U.S. markets. Almost all the money goes into fixed-rate instruments. Only 10.4% went into equities in 2006 through September (although that's up from 3.1% in 2004). Within fixed-rate issues, demand has shifted from Treasury and agency issues to corporates, which now account for a majority of private bond purchases (see chart 3). Note that Treasury's "corporate" category encompasses all private bond issues, including structured finance.
Chart 3
It seems counterintuitive that the yield on Treasury securities is currently only 370 basis points below speculative-grade bonds despite the shift in demand to corporates. However, the U.S. is now issuing fewer Treasuries. During fiscal 2006, the U.S. federal budget deficit was $247 billion, down from $413 billion in fiscal 2004. Still, foreign purchases of Treasuries totaled $207 billion, which was 84% of the new issuance, on net.
The spreads on U.S. speculative-grade bonds look profitable now because default rates are at a record low, with only 0.8% of such bonds having defaulted over the past 12 months. But the default rate isn't likely to stay this low. Several factors have held it down: record corporate profits; the 9%-plus default rates of 2001 and 2002, which took out many questionable loans; and the fact that bonds issued since 2002 haven't yet had time to default. We expect the default rate to rise gradually toward normal levels of 3.5%, in response to a weaker economy and the aging of outstanding bonds.
What If The Inflows Turn Off?
The key question at this point is: Will the inflows of funds continue? If they don't, the dollar will drop sharply, and U.S. bond yields will have to rise in order to attract the financing needed to fund the trade deficit. The higher yields would slow capital spending and deepen the housing downturn, risking a recession. The dollar would weaken, causing higher inflation, since import prices will rise. But the negative impact on growth would be balanced by stronger exports, reflecting an improved competitive position for U.S.-based producers.
Fortunately, there are no signs that the inflows are drying up. Although the dollar has drifted lower in recent weeks, bond yields are declining rather than increasing, because the market expects relatively quick easing by the Fed. Threats that China will diversify its reserves, thus hurting U.S. bond yields, seem empty. China has more to lose than the U.S. if the dollar drops--especially since the main U.S. complaint about China is that the renminbi is undervalued. If China sells dollars, that would send its currency up against the dollar, accomplishing what China has been trying to avoid.
The real danger to the U.S. economy is from a shift in private flows. If the dollar starts to decline, the yield differential will be quickly offset by currency translation losses. Investors would bail out of dollar assets, with each trying to be first out the door. Unless central banks intervene as forcefully as the Asian banks did in 2003 and 2004 during the region's currency crisis, the dollar will decline precipitously. And if the banks do jump in, that will allow speculators to make some easy profits in the longer run.
No matter what happens to capital flows in the near term, the U.S. trade gap is likely to continue. Although everyone agrees that it's unsustainable in the long run, the long run may be rather extended. The problem is that the world trade account must balance. OPEC's trade surplus of more than $300 billion in 2006 isn't likely to disappear quickly. Japan's trade surplus is over $150 billion, and the country is unwilling to trim it. China's surplus is the same size as Japan's, and although China has said it's committed to balance in the long term, it hasn't said when that day might come. Add in large oil-fueled surpluses in Canada and Russia, and all the countries in the black on trade are running a combined surplus of approximately $1 trillion.
Since the world trade account has to balance, someone has to have the offsetting deficit, and the U.S. has been willing to volunteer. America's current account deficit is expected to reach $850 billion this year, offsetting most of the world surplus. However, the U.S. may be reaching its limit. Excluding oil, the country's trade deficit has shrunk over the past year, and we expect the overall deficit to do so again next year because of lower oil prices and the slowdown in the domestic economy.
The world still has to balance, however, so something else has to change. And that's Europe, where countries are moving from surplus into deficit, with a combined European Union deficit of $49 billion expected for 2006, compared with a $49 billion surplus in 2004. Although this doesn't change the economics, it does change the politics. Europe has previously considered this a U.S. problem. Now it will probably join the U.S. in calling for more balanced policies in Asia.
Guess Who's Filling America's Savings Gap
The U.S. trade deficit is one consequence of the capital inflows, since the capital and trade accounts have to balance each other. Another consequence is the divergence between saving and investment in the U.S. economy. Gross saving in America has dropped to only 10% of GDP, down from 15% in 2000. The household saving rate is now below zero, but corporate saving is high because of strong profits. Gross private investment in the U.S., however, has remained stable, near 17% of GDP. Saving has to equal investment in an economy, but the difference is filled by the saving coming from abroad (see chart 4). If these inflows dry up, either investment will have to drop sharply as a share of GDP or U.S. saving rates will have to rise. In any event, the economy will slow in response, although a narrower trade gap could partially offset it.
Chart 4
Eventually, the U.S. trade account will have to balance, and the massive inflows into the U.S. will have to cease. However, this is unlikely to happen quickly. It's in no one's interest for rates and flows to change dramatically, because Asia and the U.S. are locked onto a pattern of codependence, with Asia needing U.S. markets and the U.S. needing Asian capital. The pattern isn't healthy, but it seems to be stable--at least for a while.
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