The dollar and the deficit

Never before has the U.S. accumulated such staggering levels of foreign indebtedness at such a rapid pace. Over the past year, claims on the U.S. by foreigners rose by $107 trillion through August compared to U.S. investments abroad of $495 billion.

The $580 billion in net foreign capital inflows, accumulated mostly in interest-bearing liabilities, is crucial for funding the massive U.S. current account deficit. But at the same time, these unpaid claims could have calamitous repercussions.

The U.S. account deficit has continued to widen in large part because of the seemingly insatiable U.S. appetite for imports, fueled by the continued relative strength of the dollar and affordability of goods and services in foreign markets. From January through August of this year, U.S. exports of approximately $752 billion were dwarfed by imports of some $1.15 trillion in goods and services with its major trading partners, leaving a deficit of nearly $395 billion.

China plays a major role in the current deficit scenario. Less than a decade ago, the U.S. invested little in the then stagnant Chinese economy, and China’s stake in the U.S. was also relatively small. Today, China is one of the U.S.’s most important trading partners. The fastest-growing global economy, China comprises 12.1 percent of U.S. imports, compared to a mere 4.4 percent of U.S. exports to that market. Basically, U.S. consumption and investment levels continue to substantially outpace U.S. production and sales of goods and services overseas.

Our research shows the trade-weighted dollar (representing the foreign currency price, or the export value, of the U.S. dollar) has depreciated since its peak in 2002, declining by almost 20 percent from the recent February 2002 high to the end of September 2004. Meanwhile, oil prices have surged to all-time highs, troubling markets with the possibility of rising inflation.

Nonetheless, the decline in the dollar has been relatively orderly, facilitated by continued growth in productivity and gross domestic product (GDP), the recovery of U.S. financial markets, the resilience of foreign investors and, at times, the intervention of foreign central banks, which have been willing to absorb the softened dollar’s impact on trade. Central banks orchestrate monetary policy to manage
currency supplies and valuations while influencing import/export trends.