Study Report on U.S. Current Account Deficit: Unsustainable imbalance calls for urgent action to restore fiscal health
Possibility of drastic dollar depreciation looms closer

Faculty Fellow, RIETI
Professor, Hitotsubashi University

The current account deficit of the United States is continuing to expand. Because it is no easy task to drastically reduce the fiscal deficit, which has brought about the current account deficit, the possibility is looming that adjustments may occur through substantial depreciation of the dollar. Given this prospect, it is imperative to forge a framework for regional coordination in exchange rate policies within East Asia so as to avoid a situation where countries are exposed to profoundly different impacts of the weakening of the dollar.

The U.S. current account deficit has been continuously expanding since the latter half of the 1990s, reaching a level equal to 6.4% of the gross domestic product (GDP) in 2005. The present severity of the U.S. current account deficit is clear considering that it stood at 3% of GDP at the time of the 1985 Plaza Accord when the Group of Five (G5) industrialized countries agreed to drive down the grossly overvalued dollar.

Concerns are growing worldwide over the eventual impact of the U.S. external imbalance, over what will happen to the value of the dollar as the key currency and how it will affect the global economy. The Japan Center for Economic Research (JCER) has undertaken comprehensive research on background factors underlying the expansion of the U.S. current account deficit, its sustainability, and policy measures that may be taken to counter the problem. (I served as project leader of this research project.)

Primary balance impacting current account deficit

A country's external current account balance is equal to the sum of the domestic investment-savings balance of the private sector and the fiscal balance of the government (IS balance approach). A current account deficit, the net flow of money resulting from trade in goods and services, conversely creates a capital account surplus. That is, a country's shortage of capital, caused by investment in excess of savings within the country, is financed by capital inflows from overseas.

As to the background behind the expansion of the U.S. current account deficit, concerned watchers across the world are looking to U.S. domestic factors such as increased private sector investment during the information technology (IT) boom of the later half of the 1990s, deterioration of the fiscal balance from 2001 onward, and the recent fall in private savings.

In contrast, U.S. Federal Reserve Board Chairman Ben Bernanke has been focusing on external factors, contending that the mounting current account deficit has nothing to do with the government's expenditures. Specifically, he points to the excessive savings elsewhere in the world, particularly in Asian countries, which are financing investment in the U.S.

Other factors cited for the continuous foreign capital inflows into the U.S. include the high expectations for the future growth of the U.S. economy and international investors' significant reliance on U.S. financial assets as a means of safe investment.

Yet, based on the standpoint of the IS balance approach, the primary factor behind the growing U.S. current account deficit is merely deterioration of the investment-savings balance of the U.S. private sector and of the U.S. government's fiscal balance.

We examined the impact of the primary balance (the balance of revenue less proceeds from the issuance of bonds and expenditures less debt servicing costs) on the current account balance from the first quarter of 1973 through the first quarter of 2005. Our findings have confirmed that the deterioration of the fiscal balance can be blamed for the current account deficit both in the 1980s when the so-called twin deficits emerged as an acute problem and from 2002 onward when the U.S. fiscal situation was sharply aggravated in the aftermath of the Sept. 11 terrorist attacks and the preparation for the Iraq war.

No guarantee for robust capital inflows to last forever

To what extent is the current trend of expanding the current account deficit sustainable? Using a method called "cointegration analysis," we examined whether the level of the current account balance is "stationary" (a state in which the variables are converged into a certain level without divergence) as well as whether a long-term stable relationship can be observed between components of the current account balance, for instance, between the trade and service accounts and the income accounts.

As it turned out, no long-run stable relationship between them was recognized meaning that the U.S. current account deficit will not be sustainable. Furthermore, we applied another analytical method known as the "Markov-switching model" to calculate the probability of unsustainability of the present state of current account deficit (as of 2005), and found it stands as high as 95%. As such, the continuous capital inflows from the rest of world sufficient to cover the current account deficit is the reason why the U.S. economy, despite the enormous U.S. current account deficit, has been kept afloat without falling into a balance-of-payment crisis.

If the U.S. continues to receive the capital inflows of an amount equal to its current account deficit, the balance of payments can be maintained in reasonable equilibrium at the current level of exchange rates and thus there will be no substantial depreciation of the dollar. The cointegration analysis focusing on portfolio investments, which account for a significant portion of capital inflows, has found that a long-run stable relationship does exist between the U.S. current account deficit and portfolio investments into U.S.

When we look at the geographical composition of foreign investors investing in the U.S. securities (bond and stock) markets, we can see that capital inflow from Japan and other Asian countries has sharply increased in the past several years to overtake that from Europe; Asia's share in investments in U.S. securities increased from 22.8% in 2000 to 41.2% in 2004 whereas Europe's share fell from 64.4% to 39.7% during the same period.

Meanwhile, an analysis of factors affecting capital inflow into the U.S. has found that investments from non-member countries of the Organization for Economic Cooperation and Development (OECD) are subject to the influence of the expected inflation rate in each country and real interest rates in the U.S. Investments in U.S. securities have been kept at a level sufficient to finance the current account deficit because real interest rates in the U.S. have remained at a relatively high level.

In recent years, we have witnessed a considerable increase in dollar reserves held by Asian central banks and this also has been contributing to the steady capital flows into the U.S. Empirical analysis of the determinants of dollar reserves suggests that countries' foreign reserves have been increasing not only in tandem with the size and development of their economies but also as a result of central banks' interventions in the foreign exchange market, aimed at ensuring export stability. The findings also underscore the tendency of Asian central banks, which have become more risk-sensitive after experiencing a major currency crisis, to accumulate more foreign reserves as a preventive measure.

Thus, interest rate movements and various changes in the economic environment have been guiding the flow of global capital into the U.S. securities markets. Depending on the future development of the U.S. and/or global economy, however, the ongoing trend of increasing capital inflow into the U.S. may come to a sudden halt. In such an event, reduction of the U.S. fiscal deficit would be of foremost importance.

Asian currency cooperation is indispensable

According to published forecasts, the U.S. fiscal balance is expected to swing into surplus in 2012. However, President George W. Bush's promise to cut the fiscal deficit in half by fiscal 2009 hardly seems achievable when reexamined based on more realistic budgetary assumptions, which are: (1) non-security discretionary spending would be kept unchanged in terms of percentage of the GDP; (2) additional costs of stationing troops in Iraq would be included; and (3) appropriate changes would be made to the alternative minimum tax (AMT), an individual income tax that is supposedly applicable to the people with high incomes but being more of a cause for the overestimation of future tax revenue (see figure).

U.S. fiscal balance forecast and variations based on different assumptions

Based on JCER's medium-term forecasts, the U.S. primary fiscal deficit measured in terms of percentage of GDP would decrease by slightly less than 2% over the next 10 years. We applied this figure on the basis of the aforementioned realistic assumptions to analyze how the improved fiscal balance would impact the current account balance. The resulting finding is that the degree of improvement in the current account balance would be as minimal as a reduction of less than 1% in deficit measured as percentage of GDP.

If it is unrealistic to expect any sizable improvement in the fiscal balance, the next possible option would be to fix the current account deficit through foreign exchange rate adjustments. However, it has been said that the pass-through effect of foreign exchange rate changes into import prices has been decreasing, and thus so has been the capacity of foreign exchange rates as a tool for trade balance adjustments.

An analysis using a "new open economy macro model" has in fact found that the occurrence of a certain permanent shock, such as productivity improvement, amid the decreasing pass-through effect would expand the degree of foreign exchange rate changes required for an adjustment of the current account balance.

That is, a drastic depreciation of the dollar is needed to bring the U.S. current account deficit down to a sustainable level. A dollar depreciation equivalent in scale to the one that took place following the Plaza Accord would reduce the current account deficit measured as percentage of GDP only by 2.5%.

The dollar's depreciation against all other major currencies would have asymmetric impacts on the currencies of East Asian countries that have different foreign exchange systems, thereby expanding the disequilibrium among the regional currencies. In particular, the currencies of countries maintaining the de facto dollar peg system, such as China, would depreciate against those of countries adopting a more flexible exchange rate system. In order to keep such potentially disturbing effects to a minimum, it is necessary for the monetary authorities of East Asian countries to coordinate exchange rate policies.

>> Original text in Japanese

* Translated by RIETI.

April 14, 2006 Nihon Keizai Shimbun

May 11, 2006