The US external deficit and associated shifts in international portfolios

Introduction

The unprecedented capital inflows into the United States since the early 1980s have produced marked shifts in countries' international asset and liability portfolios: in the United States a huge increase in its external liabilities, which are now larger than its external assets; and in the rest of the world very substantial additions to claims on the United States.

The prospect that the United States will, barring a recession, continue to run large deficits on the current account of its balance of payments - and this is at present the general consensus of official forecasts - means that the rest of the world will go on adding substantially to its net claims on the United States. On what terms will private investors in the rest of the world be willing to accept the consequent changes in their asset portfolios? The view has been expressed that this may not be possible without disturbances in financial markets - that is, volatile movements in the prices of financial assets - that could have damaging effects both on the health of financial institutions and on the real economy. In its extreme form, this view is that beyond a certain point there could be a decline in foreigners' willingness to invest in the United States so sharp that it would produce a 'hard-landing' for the dollar and possibly also for the world economy.

In this extreme scenario the 'hard-landing' of the dollar would come about through the exchange rate effects of a sharp reduction in private foreign demand for dollar assets. The view that an abrupt fall in the dollar's exchange rate might be associated with a hard-landing of the world economy is based on various considerations: firstly, that it might trigger a sharp drop in US equity prices which could be transmitted to other stock markets, and which, contrary to what happened in October 1987, would have contractionary effects on economic activity; secondly, that it would certainly lead to increases in US interest rates which, depending on their magnitude, could depress economic activity in that country; thirdly, that a major appreciation of other currencies against the dollar would lead to a slowdown of economic growth and a deterioration of business sentiment in other industrial countries; and fourthly, that the impact of a sharp dollar depreciation on US interest rates and economic activity in industrial countries would further complicate the debt problems of developing countries.

These concerns about possible future limits to private foreign financing of US current-account deficits have usually been related to the absolute nominal size of the needed further additions to private foreign holdings of US assets. This paper looks at the matter from a somewhat different perspective, namely that of the share of US assets in foreign private portfolios. It presents estimates of the extent to which that share has already increased since the US current account moved into deficit in 1982; and it addresses the question of the extent to which continued financing of such deficits through private capital inflows might further increase the share of such assets in non-US portfolios. In other words, what likelihood is there that in the next few years increases in that share might be large enough to trigger financial instability, or even the sort of 'hard-landing' sketched above?

There are very considerable difficulties, both statistical and analytical, in trying to answer that question. Firstly, there are major statistical problems in trying to measure past changes in the share of claims on the United States in foreign portfolios. The appendix to this paper describes the methods used to estimate these changes. Here it will be enough to indicate some of the major problems involved. One is that data on total stocks of foreign assets worldwide are very weak. This is shown by the fact that for the world as a whole there is every year a sizable excess of current-account deficits over current-account surpluses. The main source of that discrepancy is underestimation of the income countries receive on their foreign assets, which itself reflects underrecording of the stocks of those assets. Stocks of foreign assets for the world as a whole have therefore been estimated by aggregating data on foreign liabilities. Another statistical problem is the lack of data from creditor sources on countries' US assets. Published data on the geographical breakdown of US external liabilities have therefore been used as a proxy for those assets. For these, and other, reasons the past portfolio shifts shown in this paper represent at best rough orders of magnitude.

Secondly, there are analytical questions about what types of assets should bc compared in estimating these portfolio shifts. For one thing, there are surely differences in the extent to which exchange risk considerations, which are at the base of concerns about the financing of future US payments deficits, are likely to affect foreigners' willingness to invest in different types of US assets. Investments in purely financial assets, that consist of a fixed nominal amount of dollars and the income on which is fixed in nominal dollar terms, are likely to be particularly affected by changes in market sentiment about the dollar; foreign direct investments in the United States, on the other hand, are usually based on longer-term considerations. For practical reasons this paper does not attempt to take account of these differences. The asset and liability data used to estimate portfolio shifts therefore include direct investments. Another question about the types of assets.to be compared in estimating portfolio shifts relates to the fact that US assets form only a part, although the most important one, of the rest of the world's total dollar assets. Private investors in the rest of the world hold a large volume both of dollar deposits in the Euro-market and of Euro-dollar bonds. For reasons - both statistical and analytical - given in Part III of this paper, it is very difficult to estimate the share of total dollar assets in private non-US residents' portfolios, but an attempt has been made to do so, as at end-1988, and to simulate possible future changes in that share.

Thirdly, the simulations of future changes in the share of US assets and, more broadly, total dollar assets in foreign portfolios given in Part III of the paper clearly depend heavily on the assumptions which underlie them, in particular assumptions about the future course of US current-account deficits and of private asset accumulation in the rest of the world.

The paper is in four parts: the first part summarises US balance-of-payments developments from 1982 onwards and quantifies the impact that the large increases in its liabilities to private foreigners have had on the international investment position of the United States; the second part estimates the increase during the same period in the share of claims on the United States in the private portfolios of investors in the rest of the world; the third part illustrates the extent to which, on certain assumptions about the future course of US current-account deficits, the share of US assets, and of total dollar assets, in the rest of the world's private portfolios would have to increase between now and the end of 1993 if those deficits were to he entirely financed through inflows of foreign private capital; and the fourth part summarises the paper's main points and conclusions.