Speaking before the Economic Club of New York on March 2, 2004, Alan Greenspan, Chairman of the Federal Reserve, stated that neither the huge U.S. trade deficit (a major cause of the depreciation of the dollar against other currencies) nor the large currency interventions by Asian Central Banks (to support the dollar against their currencies) posed a serious problem. He continued that people around the world were increasingly willing to invest outside their own countries and that this tendency would allow the U.S. to borrow much more money than in the past.[1] However, by early May, he warned that ballooning federal and trade deficits may be the biggest threats to the long-term economic stability of the U.S. He suggested that the twin deficits could begin to slow down economic growth as interest rates begin to rise and as fewer benefits can be gained from global trade and investment due to the devalued dollar.[2]
What occurred during this two-month interval to change the chairman’s mind? What are the implications of these events to future economic growth in the U.S.? What actions should U.S. businesses take to prepare for the future? These are the questions this paper will address.
The Twin Deficits
The Trade Deficit
A trade deficit is created when the aggregate imports of a country exceed its aggregate exports. The cumulative U.S. trade deficit set an annual record during 2003 of $489.4 billion, or 4.5 percent of GDP.[3] As the U.S. economy picked up steam, the deficit continued to grow driven by higher oil prices and growing demand for foreign goods.[4] A country with a trade deficit must compensate for that deficit either by reducing its capital reserves or by attracting foreign capital. In other words, the inflow of foreign capital allows a country to import more, yet still finance its trade deficit. The size of the trade deficit has made the U.S. dependent on attracting foreign capital.
The Budget Deficit
A budget deficit is created when a government’s expenditures exceed its revenues. The brief surplus of the Clinton Administration has been replaced by the deficit of the Bush Administration. Tax cuts to stimulate the economy were followed by increased government spending on the wars in Afghanistan and Iraq. The deficit is forecast to pass $400 billion in 2004 and to stay high even though economic growth should increase tax revenues. To finance this deficit, the U.S. Government will have to issue an estimated $500 billion worth of Treasury securities.[5] The size of the budget deficit presents a drain on both domestic savings (capital) and foreign capital.
Note: Although we imply that the twin deficits are independent in the explanations above, they are interrelated. For example, an inflow of foreign capital to finance the budget deficit increases the trade deficit if all other flows stay constant.
Financing the Deficits
Normally, to attract foreign capital to finance a deficit, interest rates must be equal to (or greater than) comparable rates in other countries. However, the U.S. has been able to hold rates at 45-year lows – below comparable rates in other countries except for Japan – and still attract the foreign capital necessary to finance the twin deficits. What has caused the flow of foreign capital to continue?
Traditionally, capital has flowed into the U.S. through direct foreign investment such as Daimler Benz’s investment in Chrysler. However, capital flows increasingly not from foreign investors, but from Asian central banks, which have become major purchasers of U.S. Treasury securities. The central banks have increased their dollar debt in an effort to curb the appreciation of their own currencies against the dollar and to protect the competitive prices of their exports to the U.S. market. Japan and China have been particularly active, but governments in Thailand, Korea, Singapore and other Asian countries have followed similar strategies on a smaller scale. The flow of funds from Asian central banks has allowed the U.S. to finance the twin deficits without paying the cost of higher interest rates.
In March Mr. Greenspan stated that the Japanese government has acquired an “awesome” volume of foreign exchange reserves in its attempt to protect its currency (and exports to the U.S.) against a devalued dollar.[6] However, several events have led Greenspan to question whether the U.S. can continue to depend on Asian central banks to finance the ballooning twin deficits. These events include the possible end of Japanese intervention and the economic problems in China.
The End of Japanese Intervention?
The Japanese believe that the growth of exports during the last, very difficult decade kept their economy afloat. Intervention to support the dollar was necessary to stabilize the exchange rate between the dollar and the yen and to limit price increases on items exported to the U.S. As the dollar continued to show weakness against the yen during 2003 and the first months of 2004, the Ministry of Finance acquired foreign exchange reserves totaling $650 billion dollars.[7]
However, the Japanese economy is beginning to show signs of life, and consumer spending, which accounts for 60 percent of Japanese GDP, appears to be increasing.[8] Exports continue to soar, thereby increasing Japan’s trade surplus to the highest level since 1998. More significantly, Japan had a trade surplus with China in February for the first time in almost a decade. Interesting to note is that Japan’s surplus with the U.S. fell for the 14th straight month, although the U.S. remains the largest market for Japanese exports.[9]
Given the overall increase in exports while exports to the U.S. were decreasing, we pose the question whether changes have occurred which make the Japanese economy less sensitive to the yen-dollar relationship than it was in the past. The output and profit of the Japanese economy may be less affected by the swing in the value of the dollar for the following reasons. First, Japanese businesses have shifted their production to key international markets such as the U.S. In addition, they have increased local procurement of inputs. Therefore, goods can be produced in the U.S. – or other markets – with production expenses denominated in dollars and the final product priced in dollars. No foreign exchange transaction is required, and Japan has minimized its foreign exchange risk.
Second, companies in Japan have increased their business in other Asian markets, particularly China. Exports to China and capital spending connected to export industries accounted for one-third of Japan’s GDP growth in 2003.[10] It is predicted that Japanese exports to China will overtake exports to the U.S. within the next two years.[11] In addition, Japanese owned factories in China now sell goods to the U.S., the result being a steady flow of profits back to the Japanese “parent.” Third, through years of restructuring, Japanese factories have trimmed costs and reduced job growth. The increased efficiency provides a cushion allowing Japan to absorb at least some of the shock from a stronger currency. Lastly, Japan also has benefited from a decline in the value of the yen against the euro. This decline has lowered the price of Japanese goods in Europe and has substantially increased Japan’s exports to the eurozone.
After almost two years of massive intervention, no dollars were bought by the Japanese Ministry of Finance during the month of April, and the yen was allowed to surge against the dollar. The ministry has denied rumors that it has abandoned its effort to curb the strength of the yen and insists that there has been no change in its policy. However, because of the aforementioned factors, the Japanese government may believe that the economic recovery is broadening and is not solely dependent on exports to the U.S. If Japan determines that it no longer needs to support the dollar to protect its economic recovery, who will pick up the slack?
The Economic Problems in China
In 2003, the U.S. trade gap with China–the amount that imports from China exceeded exports to China–established another record, reaching $489 billion.[12] The media generally focuses on the massive flow of imports from China. However, U.S. exports to China have also been rising significantly and account for 20 percent of the $30.9 billion increase for all U.S. exports. It should be noted that while China has a merchandise trade surplus with the U.S., its trade figures with the rest of the world are quite balanced, with exports about equal to imports.
Most analysts believe that the Chinese yuan is currently undervalued, given its rising reserves and the large surplus on its “basic balance” – the sum of its current account surplus and the net inflows of long-term capital, such as foreign direct investment.[13] Exports from China to the U.S. are now 5.7 times the value of imports, a gap that many experts say is caused by China’s refusal to float its currency and allow the price of its exports to rise.[14]
The Chinese argue that the yuan cannot be allowed to float freely until China’s wobbly banking system is reformed. A February 13, 2004 meeting of Chinese economic officials ended with the endorsement of a series of steps to reduce the risk in the financial system. Steps include accelerating bank reorganization, slowing the growth of money and lending, easing restrictions on the outflow of money, and possibly later altering exchange rate controls.[15]
By holding its currency down, China risks inflaming global protectionism. In a thinly veiled reference to China, the finance ministers attending the February meeting of the G-7 stated, “More flexibility in exchange rates is desirable for major countries or economic areas that lack such flexibility.”[16] In the U.S., protectionist sentiment has been rising along with the U.S. current account deficit with China. Senator Charles E. Schumer introduced a bill in September 2003 calling for American tariffs against Chinese imports until the yuan is allowed to float. China has finally agreed to meet with U.S. officials to discuss the yuan, but the outcome of these meetings is still in question.
If China allows its currency to float against the dollar, we can expect two results. First, U.S. imports from China will increase in price, and U.S. exports to China will decrease in price. Exports to China should increase due to decreasing prices. The result could be an improvement in the trade deficit. However, U.S. government restrictions on the export of high security and high technology equipment to China may limit the growth in U.S. exports. Second, the size of the Chinese intervention into the foreign exchange market may decrease as the Chinese limit their support of the dollar against the yuan. This decreased intervention could limit the amount of foreign capital into the U.S. to support the twin deficits. Chinese policymakers are trying to cool down the overheated Chinese economy. Its current account surplus could turn into a deficit. Then China would no longer need to buy U.S. Treasuries to hold down the yuan.
Conclusion
What does it all mean? Asian economies with their export-led growth models have kept their exchange rates stable by protecting their currencies against the depreciating dollar. These economies financed more than half of the U.S. current account in 2003. By propping the dollar up, the currency interventions of Asian governments are delaying the necessary adjustment of global imbalances. The financial market is distorted, with the value of the dollar artificially high and the U.S. cost of capital artificially low. Both U.S. private and public sectors are allowed to remain extravagant since they are able to borrow more without the usual warning sign of rising bond yields.
How long can this situation last? What if the U.S. issues Treasury securities and the Japanese and Chinese governments don’t show up? The U.S. Treasury will have to increase the interest rate on its debt to attract more foreign capital to fund its twin deficits. This increase can add to the dollar’s vulnerability. So far, the decline of the dollar has been orderly. A gradual decline of the dollar is required to minimize any disruption in the global economy.
What can U.S. businesses expect in the future? Interest rates will rise. Greenspan began to prepare the economy for this eventuality after the May meeting of the Federal Open Market Committee. The dollar will remain fragile against other currencies. Management of debt costs and hedging against currency risk will be imperative until the twin deficits are tamed.
But what will it take to tame the twin deficits? Will the economy face high interest rates, inflationary pressures, and low economic growth? Greenspan has learned from the past and is warning us about the future. Congress and the President must act responsibly and control the budget deficit. Interest rates must rise enough to force prudent spending in both the private and public sectors. The question is, in an election year, will the President and Congress be willing to make the tough decisions?
[1] The New York Times, March 3, 2004, p. C4.
[2] The Los Angeles Times, May 7, 2004, p. C4.
[3] The New York Times, February 14, 2004, p. B3.
[4] The Financial Times, May 13, 2004, p. 1.
[5] The Economist, March 14, 2004.
[6] The Los Angeles Times, May 7, 2004, p. C4.
[7] The Economist, February 5, 2004.
[8] The Financial Times, May 3, 2004, p. 5.
[9] The Financial Times, March 26, 2004, p. 6.
[10] The Economist, May 15, 2004, p. 11.
[11] Business Week, February 16, 2004, p. 51.
[12] Business Week, March 1, 2004, p. 29.
[13] The Economist, February 5, 2004.
[14] The New York Times, February 14, 2004, p. B3.
[15] Ibid, p. B3.
