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COLUMN-U.S. external financing requirement falls: John Kemp

-- John Kemp is a Reuters columnist. The opinions expressed are his own --

LONDON, Dec 4 (Reuters) - Tuesday’s column discussed the U.S. dollar’s unanticipated resurgence over the last six months, even as the banking crisis has worsened and the economy has slid deeper into recession [ID:nL2203333].

The attached charts (here) show the external position of the United States on a flow basis, and are adapted from the September 2008 edition of the "Flow of Funds Accounts of the United States" published by the Federal Reserve (Table F.107).

Chart 1 shows the total foreign funding requirement of the United States (below the line) arising from the current account deficit and net purchases by U.S. residents of overseas assets.

Entries above the line show the volume of funding obtained from overseas investors (in the form of equities and bonds sold to foreigners, bank credits, or the sale of companies and real property).

As an analytical matter, the funding requirement and sources of funding must match (allowing for minor timing and recording differences). One institution’s asset is another institution’s liability; the same is true for nations.

BORROWING TO BUY ASSETS

The funding requirement below the line has arisen partly from the massive deficit in merchandise (goods) transactions, which has dwarfed the small net surpluses which the United States makes from selling services abroad and on income from its overseas assets.

But as the chart makes clear, a much larger share of the financing requirement is attributable to the acquisition of overseas assets by U.S. residents.

The United States cannot fund these overseas asset acquisitions from current funds, because the current account is in deficit, so foreign asset purchases have been funded by borrowing even more from the rest of the world.

In effect, the United States has used the rest of the world’s money to buy the rest of the world’s assets.

U.S. financial institutions and the other major investment banks were the crucial intermediaries in this international flow - arranging overseas mergers and acquisitions, funding the resulting obligations by issuing record volumes of corporate and bank debt, and securitising mortgages for sale to the rest of the world.

WHEN THE MUSIC STOPS

As the charts show, the total volume of flows has been strongly cyclical. Flows peaked in 2000 (at the end of the long boom and the technology bubble) and more recently in 2007 (at the end of the most recent expansion and the height of the mortgage and credit boom).

Peaks were followed by sharp downturns during the 2001-2002 recession and again in 2008.

Since investment banks have been the principal intermediaries, the cyclical behaviour of international flows is matched by the cyclical performance of investment bank earnings.

Banking activity and profits surged in the late 1990s, and again in 2005-2007, followed by sharp contractions as international intermediation fell.

THE CURRENCY CYCLE

Chart 2 shows the same flow of funds but superimposes the value of the U.S. dollar (taken from the Federal Reserve’s trade-weighted index against a broad basket of currencies).

The dollar strengthened sharply during the late 1990s against both the other major currencies and the currencies of emerging markets. Its strength reflecting enthusiasm for U.S. assets during the alleged productivity and technology miracle of the late 1990s, as well as the devaluation of Asian and emerging market currencies in the wake of the Asian financial crisis in 1997.

The dollar actually reached its zenith in February 2002 (at the trough of the last recession).

But since 2002, renewed expansion in the United States has coincided with a persistent slide in the currency’s value.

The decline in the currency’s value has been fundamentally linked to the growth rate and the net funding requirement:

(1) On the current-account side, faster growth in the United States increased the country’s appetite for imports in excess of its export performance, worsened the trade deficit, and increased the net volume of U.S. assets that needed to be offered to the rest of the world.

Moreover, by raising the dollar price of oil and other commodities, rapid growth in the United States and the rest of the world worsened the U.S. terms of trade, and made both the current account deficit and the net foreign-financing requirement even larger than they would have been otherwise.

(2) On the capital side, fast growth was associated with increased appetite for risk, rapid credit expansion and massive balance-sheet growth among U.S. banks, households and corporations. Some of this balance-sheet growth leaked abroad in the form of increased purchases of foreign equities, bonds and corporations. Since it could not be financed from current-account earnings, the overseas element of balance-sheet growth had to be financed by the net offer of even more financial assets to the rest of the world.

Unlike the late 1990s, when the net offer of dollar-denominated U.S. assets to the rest of the world was met by strong appetite from overseas investors, and the dollar actually rose, the most recent surge in U.S. issuance seems to have overwhelmed tepid demand, and the dollar has fallen.

Only a steady devaluation of the dollar, making U.S. assets cheaper for prospective foreign purchasers, ensured this surging net issuance found sufficient foreign buyers.

Even so, most of the net offer of U.S. assets to the rest of the world appears to have been absorbed by central banks in China, the rest of Asia and the Middle East, rather than demand from private investors.

The threat of persistent dollar devaluation seems to have limited commercial demand. Only the essentially non-commercial demand from foreign central banks kept the recycling going and averted an even steeper fall in the dollar’s value.

A BRAVE NEW WORLD

The dollar’s value hit a trough in Q2 2008. The currency’s massive appreciation since then has coincided with the credit crunch (reducing the offer of U.S. assets to the rest of the world to finance overseas asset acquisitions on the capital account) and a slowdown in the economy (reducing import demand and cutting the price of imported oil and other commodities on the current account).

The sharp slowdown in international fund flows and the net offer of U.S. financial assets to the rest of the world is immediately apparent from the charts, and looks set to be sustained over the next few quarters.

In Q2 2008, the current account deficit was largely unchanged, running at around $700 billion per year. But U.S. residents disposed of $41 billion worth of overseas assets on a net basis, helping cut the financing requirement to just $503 billion per year, the lowest level for more than five years. The balance is a statistical discrepancy.

Since then, the sharp reduction in crude oil prices has started to trim the import bill and the associated current account deficit, while asset disposals have probably accelerated.

The next update of the “Flow of Funds Accounts”, scheduled for December 11, is expected to show a further decline in both the overall funds flow and the external financing requirement during the three months from July to September - consistent with the dollar’s continued rise in this period and the intensifying pressures on the investment banking sector.

While the “National Income and Product Accounts” are more famous, and the associated measures of GDP have become a yardstick of economic success and failure, the “Flow of Funds Accounts” tell an equally fascinating story. One of rapid growth, a falling currency, record banking profits and rising indebtedness - which have suddenly and brutally gone into reverse when the music stopped.

Editing by Andy Bruce

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