September 23, 2005

Slight improvement in U.S. current account deficit masks declining net payments on investments

The Bureau of Economic Analysis (BEA) announced on September 16 that the current account deficit (the broadest measure of the U.S. balance of trade in goods, services, and payments to the rest of the world) declined to $782.6 billion, at an annual rate, in the second quarter of 2005, a decrease of 1.3% over the first quarter of 2005.  The deficit declined to 6.3% of GDP from 6.5% in the first quarter.  The most striking feature in the BEA report was the rapid growth in government payments to foreign holders of U.S. treasury securities.  Government interest payments on U.S. foreign debt are certain to grow in the future as interest rates rise and the amount of debt held abroad increases.  Although the trade deficit appeared to stabilize in the second quarter, it is also likely to increase in the near term due to the soaring costs of oil imports.

The current account deficit shrank in the second quarter of 2005 because of a sharp $17.5 billion reduction in U.S. foreign aid payments, following a spike in aid payments in the first quarter.  These payments are unlikely to shrink again in the near term.  The deficit on goods and services increased $1.1 billion and net income from investments and wages fell $4.4 billion, resulting in the second quarterly income deficit on record, which reflected, in part, a deficit in employee compensation.  Though net investment income still had a $4 billion surplus in the second quarter, as shown in Figure A, it has declined sharply from a surplus of $52 billion in 2003.  This decline was driven by a $39 billion increase in U.S. government payments to foreign holders of government securities, and by a $6 billion decline in net income on foreign direct investment.  The need to finance rapidly growing U.S. current account deficits increased the net U.S. international investment deficit to $2.5 trillion in 2004.  Overall, payments to foreign investors have increased faster than payments to U.S. investors since 2003 as shown below.

Going forward, with compensation income flat and investment income declining, there will be downward pressure on the current account coming from growing deficits in both trade and income.  As a nation, we are living beyond our means.  A trade deficit must be financed by net borrowing from the rest of the world.  The United States was effectively spending about 6.3% more than it was producing in the second quarter of 2005 (about $2.2 billion every day), but it cannot continue to borrow at such high levels forever.  While the current account deficit declined in the second quarter, it remains on track to increase by at least $100 billion (15%) in 2005 over the record $668 billion deficit in 2004.  The 13.3% decline in the real value of the dollar since February 2002, primarily the 42.5% decline against the Euro (which has weakened recently), has failed to stem the increase in the current account deficit, which has increased by 1.5 percentage points as a share of real GDP since 2003.

Very rapid growth in interest payments to foreign holders of U.S. government securities has been the most important cause of the fall in net investor payments since 2003.  As shown in Figure B, government interest payments rose from $69 billion in 2003 to $108 billion in the last quarter (at an annual rate).  U.S. government payments are up sharply for two reasons.  First, interest rates have been rising since 2003.  Second foreign holdings of U.S. treasury securities have been growing rapidly.  They increased $484 billion in the past six quarters alone.  The outstanding stock of U.S. treasury securities held abroad was $2 trillion in the second quarter, and at least 64% of this amount was held by foreign central banks.1 

Net U.S. income on foreign direct investment (FDI) also declined by $6 billion between 2003 and the second quarter of 2005, as shown in Figure C.  Profits earned on U.S. FDI abroad and U.S. payments to foreign investors have both grown rapidly since 2001, but net U.S. returns on FDI have not improved significantly.  It appears that foreign investors are finally declaring dollar profits on their U.S. direct investments after years of reporting low paper returns.  Their income has risen from $57 billion in 2000 to $130 billion in the last quarter.  Other private receipts and payments on bank and non-bank securities have also grown rapidly since 2003.  Growing corporate profits and interest rates increased both inflows and outflows.  As a result, changes in these flows have offset each other recently, though the net has trended down since 1999. 

To date, the U.S. has been able to attract the capital needed to finance its current account deficits.  However, Federal Reserve chairman Alan Greenspan and others have said that the deficit is unsustainable at current levels.2  If the dollar were being supported by demand from investors who find the U.S. market attractive, then steady growth in capital inflows from private investors to finance rising deficits would likely occur.  However, private inflows have been insufficient to finance the U.S. current account deficit for the last three years.  Instead, foreign governments have served as lenders of last resort, purchasing substantial volumes of U.S. government assets.

The BEA also reported that foreign official (government) purchases of U.S. assets increased more than three-fold to $330 billion at an annual rate in the second quarter.  A bloc of Asian central banks, lead by China, made 68% of all official purchases of U.S. assets in this period.  These governments are willing to absorb the risks of financial losses from an ultimate decline in the dollar in order to make their exports more competitive against U.S. products.  If their central banks had not intervened in foreign exchange markets, then the dollar would have fallen much more than it has since 2002.  In fact, the real value of the dollar gained 1% between the fourth quarter of 2004 and the second quarter of 2005.  The dollar would have declined, and much more rapidly, especially against Asian currencies, if there had been no foreign government intervention in currency markets. If the dollar did decline fully, the prospects for shrinking the U.S. current account deficit would be greatly improved.

For more information about the current account deficit and the costs of foreign borrowing, see the December 2004 Issue Brief, Debt and the Dollar, by EPI economist L. Josh Bivens. 

This report was written by EPI economist Robert E. Scott, with research assistance from David Ratner. 

Notes
1. Department of Commerce, Bureau of Economic Analysis.  2005.  “International Investment Position” June 30; and “Balance of Payments (International Transactions).”  September 16 http://www.bea.gov/.

2. Crutsinger, Martin. 2005. Associated Press. “U.S. deficit off 1.5 pct. in 2nd quarter.” September 17. http://www.washingtonpost.com/wp-dyn/content/article/20
05/09/16/AR2005091600295.html.

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