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Monday, January 09, 2006

Martin Feldstein: Capital Inflows Primarily from Foreign Governments, not Private Investors

Martin Feldstein says the optimistic view that capital inflows to the U.S. are the result of the attractiveness of investment is wrong and arises from a misinterpretation of the data. A proper interpretation of the data reveals that the source of capital inflows is primarily foreign governments, not foreign private investors. Furthermore, Feldstein says, "If they decide to buy fewer dollar bonds, the US current account deficit could not continue to be financed at current exchange rates and interest rates." He believes a 30% decline in the dollar is necessary to get the current account down from 6% of GDP to a more sustainable level of 3% and that much larger changes are possible.  Finally, he says the only thing holding up the dollar currently is the belief that interest differentials that make U.S. financial investment attractive will persist. He adds, "That sanguine belief may, however, reflect a serious misunderstanding of the magnitude and nature of the capital flow to the US.":

Uncle Sam’s bonanza might not be all that it seems, by Martin Feldstein, Commentary, Financial times: A major reason for the dollar’s current overvaluation is the widespread misunderstanding of the nature of capital flows to the US. The business press and many financial analysts provide the reassuring message that the flow of capital to the US substantially exceeds the amount needed to finance the US current account deficit, and that that inflow is coming primarily from private investors who are attracted by the strength of the American economy.

This optimistic analysis of the capital inflow is wrong. It results from a misinterpretation of the data provided by the US Treasury... It is easy to see why analysts reach this wrong conclusion. Recent ... press releases stated that the capital inflow was $278bn in the third quarter of last year, or $82bn more than the current account deficit for that quarter. The Treasury also reported that $257bn of this capital inflow came from private buyers.

In reality, there is no excess capital inflow and private investors are almost certainly not the primary source of the funds coming to the US. The figures..., while technically correct, are misleading for two reasons. First, the .. release refers only to transactions in long-term securities... It excludes bank deposits and bank lending, and flows of foreign direct investment into the US and by American investors to the rest of the world. A comprehensive measure of the capital inflow and outflow would show that the total net inflow is almost exactly equal to the amount needed to finance the current account deficit. ... If the total net inflow were larger than the current account deficit, the US would be accumulating large reserves of foreign exchange. In fact, reserves are virtually unchanged from year to year and are actually lower than they were two years ago. So it is wrong to conclude that the net capital flow to the US substantially exceeds the current account deficit. ...

A second source of confusion in the ... report is an easily misunderstood classification of whether the funds coming to the US are from governments or private sources. The ... measure of inflows from “private” sources overstates the actual private investment because it does not distinguish between a purchase by a private buyer for its own account and a purchase executed by a private institution on behalf of a foreign government. For example, if the Chinese government purchases US bonds through JPMorgan or another private bank, these funds will be recorded in the ... data as a private purchase. ...

My own belief, based on widespread conversations with officials and with private bankers, is that the inflow of capital that now finances the US current account deficit is coming primarily, perhaps overwhelmingly, from governments and from institutions acting on behalf of those governments. ...

The very large current account deficits are now being financed by bonds and shorter term fixed-income funds. Some of this has recently come from OPEC governments and other oil producers that are temporarily placing revenue in dollar bonds and bank deposits until they can spend those funds on investment or consumption. Much of the inflow in recent years has come from Asian governments that wanted to accumulate foreign ex-change to eliminate the risk of speculative attacks of the sort that hurt those countries in the late 1990s. A large amount is coming from China and other Asian governments to stop a falling dollar reducing their net exports. If they decide to buy fewer dollar bonds, the US current account deficit could not continue to be financed at current exchange rates and interest rates.

The US current account deficit increased ... in the first three quarters of last year and is widely predicted to move much higher in 2006. This unprecedented level is equal to 6.4 per cent of US gross domestic product. Experts estimate that the real trade-weighted value of the dollar must fall by at least 30 per cent just to shrink the trade deficit to a more sustainable level of 3 per cent of GDP. Much larger dollar declines are also possible. ...

The current small interest rate differences in favour of US bonds are not nearly enough to compensate investors for the fall in the dollar that is likely over the next few years. ... The dollar must fall faster than these small interest differentials in order to prevent the current account deficit from increasing more rapidly than GDP. ... At some point, that will trigger a shift away from the dollar. Private investors and the governments ... will inevitably shift at some time from dollars to euros or yen ... That that has not happened already reflects investors’ belief that it is still possible to benefit from the interest differentials before the dollar depreciates. That sanguine belief may, however, reflect a serious misunderstanding of the magnitude and nature of the capital flow to the US.

[UpdatePGL at Angry Bear has more.]

    Posted by on Monday, January 9, 2006 at 02:01 PM in Economics, International Finance, International Trade | Permalink  TrackBack (1)  Comments (20)

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    The real trade-weighted value of the dollar must fall by at least 30% to halve the US trade deficit to a more sustainable level of 3% of GDP, writes Harvard's Martin Feldstein in today's Financial Times, Uncle Sam's bonanza might not be all that it see... [Read More]

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