NBER WORKING PAPER SERIES IS THE U.S. CURRENT ACCOUNT DEFICIT SUSTAINABLE? AND IF NOT, HOW COSTLY IS ADJUSTMENT LIKELY TO BE?

Transcription

1 NBER WORKING PAPER SERIES IS THE U.S. CURRENT ACCOUNT DEFICIT SUSTAINABLE? AND IF NOT, HOW COSTLY IS ADJUSTMENT LIKELY TO BE? Sebasian Edwards Working Paper hp:// NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachuses Avenue Cambridge, MA Augus 2005 This is a revised version of a paper presened a he Spring 2005 meeing of he Brookings Panel on Economic Aciviy. I hank Ed Leamer for helpful discussions, and Robero Alvarez for his assisance. I am graeful o he ediors and o my discussans Kaharine Dominguez and Pierre-Olivier Gorinchas for heir commens. The views expressed herein are hose of he auhor(s) and do no necessarily reflec he views of he Naional Bureau of Economic Research by Sebasian Edwards. All righs reserved. Shor secions of ex, no o exceed wo paragraphs, may be quoed wihou explici permission provided ha full credi, including noice, is given o he source.

2 Is he U.S. Curren Accoun Defici Susainable? And If No, How Cosly is Adjusmen Likely To Be? Sebasian Edwards NBER Working Paper No Augus 2005 JEL No. F02, F43, O11 ABSTRACT In his paper I analyze he relaionship beween he U.S. dollar and he U.S. curren accoun. I deal wih issues of susainabiliy, and I discuss he mechanics of curren accoun adjusmen. The analysis presened in his paper differs from oher work in several respecs: Firs, I emphasis he dynamics of he curren accoun adjusmen, going beyond compuaions of he "required" real depreciaion of he dollar o achieve susainabiliy. I show ha even if foreigners' (ne) demand for U.S. asses coninues o increase significanly, he curren accoun defici is likely o experience a large decline in he (no oo disan) fuure. Second, I rely on inernaional evidence o explore he likelihood of an abrup decline in capial flows ino he U.S. And hird, I analyze he inernaional evidence on curren accoun reversals, o invesigae he poenial consequences of a (possible) sudden sop of capial flows ino he U.S. This analysis suggess ha he fuure adjusmen of he U.S. exernal accouns is likely o resul in a significan reducion in growh. Sebasian Edwards UCLA Anderson Graduae School of Business 110 Weswood Plaza, Suie C508 Box Los Angeles, CA and NBER sebasian.edwards@anderson.ucla.edu

3 I. Inroducion During he las few years a large number of analyss in academia, he privae secor and applied research insiuions have expressed increasing concerns regarding he growing U.S. curren accoun defici. There is a generalized sense ha he curren siuaion of global imbalances is unsusainable and ha adjusmen will have o ake place sooner raher han laer. The unprecedened magniude of he U.S. curren accoun defici and he growing ne indebedness of he U.S. have fueled analyss worries, wih many arguing ha unless somehing is done, he world will move oward a major financial crisis. 1 Some auhors have gone as far as suggesing an imminen collapse of he U.S. dollar, and a global financial meldown. 2 The main idea behind his view is ha if he U.S. curren accoun defici is mainained a is curren level, U.S. ne inernaional liabiliies will reach 100% of GDP, a figure considered o be excessively large. 3 In a recen paper, Mussa (2004) has said: [T]here is probably a pracical upper limi for he US ne exernal liabiliies a somehing less han 100 percen of US GDP and, accordingly...curren accoun deficis of 5 percen or more of US GDP are no indefiniely susainable. (Mussa 2004, p 114). The source of financing of he U.S. curren accoun defici has also become a source of concern. A number of auhors have argued ha by relying on foreign -- and paricularly Asian -- cenral banks purchases of Treasury securiies, he U.S. has become paricularly vulnerable o sudden changes in expecaions and economic senimens. 4 Rober Skidelsky has recenly argued in The New York Times ha he value of he dollar is one of he mos imporan sources of poliical ension beween he Unied Saes and Europe. According o him, [U]nilaeralism is no more accepable in currency maers han in foreign policy. More specifically, Skidelsky has poined ou ha, 1 Alhough mos of he alarmis discussions have come in he form of Op-Ed pieces, here have also been a few policy papers on he subjec. See, for example, Roubini and Seser (2004). 2 See, for example, Roubini and Seser (2004). For an excellen se of papers on he subjec see Bergsen and Williamson (2004). 3 See Mussa (2004) for a very clear discussion of his issue. 4 See, for example, Marin Wolf s Ocober 1 s, 2003 aricle in he Financial Times, Funding America s recovery is a very dangerous game, (page 15). 2

4 The Unied Saes is he only major counry proclaiming iself indifferen o is currency value. In counries running persisen curren accoun deficis, governmens normally -- indeed mus reduce domesic consumpion. Bu so far, he Unied Saes has relied on oher counries o adjus heir economies o profligae American spending (The New York Times, February 20 h, 2005, p.9) There is, however, an alernaive view. Some auhors have argued ha in an era of increasing financial globalizaion and rapid U.S. produciviy gains, i is possible even logical and desirable -- for he U.S. o run (very) large curren accoun deficis for a very long period of ime (say, a quarer of a cenury). According o his view, growing inernaional porfolio diversificaion implies ha he res of he world will be willing o accumulae large U.S. liabiliies during he nex few years; maybe even in excess of 100% of U.S. GDP. According o his perspecive, since he U.S. curren accoun defici does no pose a hrea, here are no fundamenal reasons o jusify a significan fall in he value of he U.S. dollar (Dooley, Folkers-Landau and Garber 2004a, 2004b). 5 The purpose of his paper is o analyze he relaionship beween he U.S. dollar and he U.S. curren accoun. In paricular, I deal wih issues of susainabiliy and I discuss he mechanics of curren accoun adjusmen. I develop a porfolio model of he curren accoun and I show ha even under a very posiive scenario, where foreigners (ne) demand for U.S. asses doubles relaive o is curren level, he U.S. curren accoun will have o go hrough a significan adjusmen in he (no oo disan) fuure. Indeed, i is no possible o rule ou a scenario where he U.S. curren accoun defici would shrink abruply by 3 o 6 percen of GDP. In order o have an idea of he possible consequences of his ype of adjusmen, I analyze he inernaional evidence on curren accoun reversals. The resuls from his empirical invesigaion indicae ha significan curren accoun reversals have ended o resul in large declines in GDP growh. The res of he paper is organized as follows: In secion II I provide some background informaion and daa. I discuss he evoluion of he U.S. real exchange rae (RER) and curren accoun during he las hree decades, and I analyze some of he saisical properies of he RER. I discuss he sources of defici financing and I analyze 5 See, also, Cooper (2004), and Caballero, Farhi and Hammour (2004). 3

5 he evoluion of he U.S. ne inernaional asses posiion. In his secion I also provide inernaional comparisons, and I pu he curren U.S. siuaion in a global comparaive conex. In Secion III I deal wih he analyics of curren accoun and real exchange rae adjusmen. The analysis presened in his secion focuses on ransiional dynamics, and goes beyond compuaions of he required real depreciaion of he dollar o achieve curren accoun susainabiliy. I develop a porfolio model of curren accoun behavior, and I discuss he response of he curren accoun o changes in inernaional porfolio choices. The model is quie general and allows for valuaion effecs semming from exchange rae changes, and for changes in he inernaional erms of rade. I show ha under plausible parameers, an increase in he demand for U.S. asses by foreign invesors resuls in an overshooing of he curren accoun defici. According o he model he curren accoun defici will increase unil, a some poin, i will experience a reversal. The reversal may, indeed, be quie abrup and significan. In Secion IV I use a large cross-counry daa se o invesigae he inernaional evidence on curren accoun reversals. In paricular, I invesigae wheher counries ha have experienced significan and rapid reversals have faced real coss in he form of a decline in he rae of GDP growh. I argue ha in spie of he uniqueness of he U.S., as a large counry whose currency is a he cener of he global financial sysem, his comparaive analysis provides useful informaion on he likely coss an evenual U.S. curren accoun adjusmen. The paper closes wih Secion V, where I discuss some global policy challenges and I offer some concluding remarks. II. The U.S. Dollar and he Curren Accoun: A Thiry Years Perspecive In his secion I analyze he evoluion of he U.S. real exchange rae and curren accoun since he adopion of floaing exchange raes in he early 1970s. The secion is divided in hree pars: 6 Firs, I discuss he evoluion of he U.S. real exchange rae (RER) and curren accoun during he las hree decades, and I deal wih he changing 6 Due o space consideraions I have no discussed in deail some imporan issues, such as he saionariy of he RER and is (changing) volailiy hrough ime. Mos recen analyses based on panel daa have found ha he RER is saionary and ha is half-life cycle is lower han he 3 o 5 years radiionally considered as he consensus view. See Choi, Mark and Sul (2005). An analysis of U.S. RER volailiy indicaes ha for he complee period ( ) he U.S. real exchange rae index exhibied one of he highes volailiies in he sample. Only he Briish pound, he Japanese yen, and he euro have higher volailiies. Second, RER volailiy for he U.S. dollar was highes in This period corresponds, mosly, o he rapidly depreciaing Phase III in Figure 2. 4

6 naure of he U.S. rade-weighed RER index. I argue ha i is possible o divide he las hiry years of RER behavior ino six disinc phases. Second, I discuss he mos recen daa on he U.S. curren accoun, including is sources of financing. And hird, I provide some inernaional evidence on curren accoun imbalances during he las hree decades. This comparaive analysis allows o place he U.S. recen experience in a hisorical conex. II.1 Six Phases of Real Exchange Rae Behavior In Figure 1 I presen quarerly daa for he U.S. curren accoun balance as percenage of GDP, as well as on he evoluion of he Federal Reserve rade-weighed index of he U.S. dollar real exchange rae for he period ; in his Figure as in he res of his paper --, an increase in he RER index represens a real exchange rae appreciaion. Several ineresing feaures emerge from Figure 1: Firs, i shows ha deficis have become increasingly large since Second, Figure 1 shows ha for he firs decade of floaing exchange raes ( ), he US ran, on average, a small curren accoun surplus of 0.04% of GDP. In conras, for he period he average curren accoun balance has been a defici of 2.4% of GDP. Figure 1 also shows ha during he period under consideraion he RER index experienced significan movemens: is mean was 105.3, is minimum 91.2, and is maximum was Finally, Figure 1 shows a paern of negaive correlaion beween he rade-weighed real value of he dollar and he curren accoun balance. Periods of srong dollar have ended o coincide wih periods of (larger) curren accoun deficis. Alhough he relaion is no one-o-one, he degree of synchroniciy beween he wo variables is quie high: he conemporaneous coefficien of correlaion beween he (log of he) RER index and he curren accoun balance is 0.53; he highes correlaion of coefficien is obained when he log of he RER is lagged hree quarers (-0.60). Recen policy debaes on he value of he U.S. dollar illusrae he massive changes ha have occurred in U.S. rade relaions during he las hree decades. While in he early 1970 s dollar-relaed discussions deal almos exclusively wih bilaeral exchange raes boh nominal and real -- wih respec o he indusrial counries, more recen debaes have increasingly focused on he behavior of emerging counries currencies, including he Chinese renminbi, he Korean won, and he Malaysian ringgi. 5

7 During he las few years he Mexican peso has also become an imporan currency in deermining he rade-weighed value of he U.S. dollar; his was no he case in 1973, when he Smihsonian Agreemen was abandoned. Beween 1995 and 2005 China s weigh in he Federal Reserve rade-weighed real exchange rae index has gone from 5.67% o 11.35%; Mexico s weigh has increased from 6.95% o 10.04%. On he oher hand, during he same period, Japan s weigh has declined from 16.54% o 10.58%. Overall, oday s rade-weighed U.S. RER is dominaed by he Asian naions as a group, he Asian counries (excluding India) have a weigh in he index of 38.8%. Commodiy currencies, as a group, are also very imporan, wih a weigh of 24.6%. Finally, he launching of he Euro in 1999 has marginalized he Briish pound. Alhough a weigh of 5.2% is sill quie respecable, he pound is no any longer among he op 5 currencies in he index. The siuaion was quie differen in 1998, when he weigh of he Briish pound was higher han ha of all, bu one, of he currencies ha evenually would conform he euro (in 1998 he German mark had a weigh of 6.4% and he Briish pound had a weigh of 5.9%). 7 As may be seen from Figure 1, i is possible o disinguish six disinc phases in U.S. dollar real exchange rae behavior for he hiry-year period A brief analysis of hese six phases provides a summary of he hisory of he inernaional financial sysem since he incepion of floaing: 8 Phase I: 1973Q1-1978Q4. This period includes he early years of floaing, and was characerized by a depreciaing rend of he U.S. RER. The accumulaed depreciaion amouned o 18.1% during 24 quarers. During his period he sandard deviaion of he monhly log differences of he RER index was During he early par of his phase ( ) he curren accoun was in surplus. This, however, urned ino a small defici in he years 1977 and Phase II: 1979Q1-1985Q1. During hese 26 quarers he U.S. dollar RER experienced a 49.3% appreciaion. During his phase he curren accoun 7 In 2005 he euro has a weigh of 18.80%; in 1995 he currencies ha conformed he euro had a combined weigh of 17.30%. 8 Figure 1 presens he Fed broad RER index. The same six phases are observed if alernaive indexes are used. 6

8 wen ino defici, reaching 2.9% of GDP in he hird quarer of The sandard deviaion of he monhly log differences of he RER index was 0.022, slighly higher han ha of Phase I. In view of he subsanial srenghening of he dollar and he relaed increase in he U.S. curren accoun defici, on Sepember 25 h 1985 he members of he G-5 (The Unied Saes, Japan, he Unied Kingdom, France, and Germany) decided o implemen concered and coordinaed inervenions in he foreign exchange marke. As par of his agreemen known as he Plaza Accord he G-5 counries commied hemselves o pu in place coordinaed macroeconomic policies ha would reduce he coss of he global adjusmen process. 9 Phase III: 1985Q2-1988Q4. During his period he dollar real exchange rae experienced a rapidly depreciaing rend. The peak-o-rough change in he index was -28.7%. Real exchange rae volailiy increased subsanially during his 16 quarer period; he sandard deviaion of he monhly log differences of he RER index was , subsanially higher han in he previous wo phases. The curren accoun defici coninued o grow, unil in mid 1987 i sabilized a around 3.6% of GDP. From ha poin onward he curren accoun began o improve, and by he fourh quarer of 1988 he defici had declined o 2.4% of GDP. On February 22, 1987 he Minisers of Finance and Cenral Bank Governors of he G-6 (G-5 plus Canada) released a communiqué known as he Louvre Accord -- informing he public ha significan progress had been made in achieving global adjusmen, and ha furher subsanial exchange rae shifs among heir currencies could damage growh and adjusmen prospecs in heir counries The Louvre Accord communiqué wen on o say ha he G-6 counries agreed o cooperae closely o foser sabiliy of exchange raes around curren levels. 10 Phase IV: 1989Q1-1995Q2. During his Phase he real value of he dollar coninued o depreciae, bu a a much lower rae han in he preceding Phase; during hese 27 quarers he dollar depreciaed in real erms by 10%. During 9 10 For he ex of he Plaza Accord communiqué, see hp:// See he ex of he Louvre Accord a hp:// 7

9 his period he sandard deviaion of he monhly log differences of he RER index was During his phase he curren accoun balance coninued o improve, unil in he firs quarer of 1991 he U.S. posed is firs curren accoun surplus in many years. During Phase IV he average curren accoun balance was -1.15% of GDP. Phase V: 1995Q3-2002Q1. This is phase is characerized by a rough-opeak real exchange rae appreciaion of 33.4% (noice from Figure 1 ha beween he fourh quarer of 1998 and he fourh quarer of 1999 here was a shor lived period of real depreciaion). Ineresingly, during his phase real exchange rae volailiy declined significanly; he sandard deviaion of he monhly log differences of he RER index was This phase was characerized by an increasingly larger curren accoun defici. While in lae 1995 early 1996 he defici was in he order of 1.5% of GDP, by early 2002 i was hovering jus below 4% of GDP. In 1999, and for he firs ime in many years, he U.S. federal governmen posed a surplus. Phase VI: 2002Q2-2004Q4. This phase is coninuing a he ime of his wriing. Beween he second quarer of 2002 and he fourh quarer of 2004 he real value of he dollar experienced a 14% accumulaed depreciaion. The curren accoun defici coninued o widen, exceeding 5% of GDP owards he end of he sample. Real exchange rae volailiy increased slighly during his period; he sandard deviaion of he log differences of he RER index was Oher imporan macroeconomic developmens during his phase include he worsening of he U.S. fiscal posiion, and he siff increases in he price of oil and oher commodiies. In Figure 2 I go beyond he curren accoun, and I presen daa from 1973 hrough 2004 for: (a) he balance of rade of goods and services as a percenage of GDP; (c) he balance of rade in (non financial) services as a percenage of GDP; (c) he income accoun, also as a percenage of GDP and (d) he ransfers accoun as a percenage of GDP. A number of imporan facs emerge from hese figures. Firs, as Panel A shows, large and persisen rade deficis have preceded in ime he era of large curren accoun 8

10 deficis. Already in he lae 1970s he rade accoun was negaive, and since mid 1976 i has had only one surplus quarer (1992Q2). 11 Second, since 1996 he rade surplus in non financial services has declined seadily; in 2004 i was only 0.3 percen of GDP. Third, Panel C shows ha he income accoun coninues o be posiive. Since for quie some years now he U.S. inernaional invesmen posiion has been negaive ha is, he U.S. has been a ne debor --, he fac ha he income accoun is sill posiive may seem surprising. The reason for his is ha he reurn on U.S. asses held by foreigners has been sysemaically lower han he reurn on foreign asses in hands of U.S. naionals. Finally, Panel D shows ha he ransfers accoun has been negaive since During he las few years ransfers accoun defici has been sable a approximaely 0.7% of GDP. II.2 Recen Curren Accoun Imbalances In Table 1 I presen daa on he curren accoun as a percenage of GDP, and is financing for he period As may be seen, during he las few years he naure of exernal financing has changed significanly. In paricular, since 2002 ne FDI flows have been negaive. This conrass wih he period when FDI flow conribued in an increasingly imporan way o defici financing. Also, afer four years on ne posiive equiy flows ( ), hese became negaive in As he figures in Table 1 show, during 2003 and 2004 he U.S. curren accoun defici was fully financed hrough ne fixed income flows. Official foreign purchases of governmen securiies (Reserves (ne), in Table 1) have played a paricularly imporan role in he financing of he 2003 and 2004 curren accoun deficis. A number of analyss have argued ha by relying on foreign cenral banks purchases of Treasury securiies, he U.S. has become paricularly vulnerable o sudden changes in expecaions and economic senimens. 12 Curren accoun imbalances are refleced in changes in a counry s ne inernaional invesmen posiion (NIIP): deficis resul in a deerioraion of he NIIP, and surpluses resul in an improvemen in he U.S. NIIP. In Figure 3 I presen he evoluion 11 Mann (2004) shows ha mos of he U.S. rade defici is explained by a defici in auomobiles and consumer goods. 12 See, for example, Marin Wolf s Ocober 1 s, 2003 aricle in he Financial Times, Funding America s recovery is a very dangerous game, (page 15). 9

11 of he U.S. NIIP as percenage of GDP. As may be seen, his has become increasingly negaive: in 2004 U.S. ne inernaional liabiliies reached 29 percen of GDP. An imporan feaure of he NIIP is ha gross U.S. inernaional asses and gross U.S. inernaional liabiliies are held in differen currencies. While more han 70% of gross foreign asses held by U.S. naionals are denominaed in foreign currency, approximaely 95% of gross U.S. liabiliies in hands of foreigners are denominaed in U.S. dollars. This means ha he ne liabiliies as a percenage of GDP are subjec o valuaion effecs semming from changes in he value of he dollar. A dollar depreciaion reduces he value of ne liabiliies. As a resul of his valuaion effec, he deerioraion of he U.S. NIIP during was significanly smaller han he accumulaed curren accoun defici during hose wo years; see Table 2 for deails. A key quesion in curren accoun susainabiliy analyses and one I discuss in deail below refers o he reasonable long run equilibrium value he raio of U.S. ne inernaional liabiliies; he higher his raio is, he higher will be he susainable curren accoun defici. According o some auhors he curren raio of almos 30% of GDP is excessive, while ohers believe ha a NIIP o GDP raio of up o 50% would be reasonable. 13 One of he firs hings undergraduae sudens of open economy macroeconomics learn is ha he curren accoun is he difference beween savings and invesmen. Through ime a number of auhors have argued ha a worsening of a curren accoun balance ha sems from an increase in invesmen is very differen from one ha resuls from a decline in naional savings. Some have gone as far as arguing ha very large deficis in he curren accoun don maer, as long as hey are he resul of higher (privae secor) invesmen (Corden, 1994). As Figure 4 shows, he recen deerioraion of he U.S. curren accoun has largely been he resul of a decline in naional savings, and in paricular of public and household savings. A simple implicaion of his rend and one ha is emphasized by mos auhors is ha an improvemen in he U.S. curren accoun siuaion will no only imply a RER adjusmen; i will also require an increase in he naional savings raio, and in paricular in household savings. Symmerically, a 13 See Obsfeld and Rogoff (2004) and Mussa (2004). 10

12 correcion of curren global imbalances will also require a decline in Europe s and Japan s savings raes and/or an increase in heir invesmen raes. II.3 The U.S. Curren Accoun Defici in Inernaional Perspecive How large is he U.S. recen curren accoun deficis, from a comparaive poin of view? And, how large is he U.S. ne inernaional liabiliies posiion when compared, from a hisorical vanage, o ha of oher advanced counries? In Table 3 I presen daa on he disribuion of curren accoun balances in he world economy, as well as in six groups of naions Indusrial, Lain America, Asia, Middle Eas, Africa and Easern Europe for he period As may be seen, a almos 6% of GDP he U.S. defici is very large from a hisorical and comparaive perspecive. I is in he op decile of deficis disribuion for all indusrial counries in he firs hiry years of floaing. As he daa in Table 3 sugges he U.S. looks more like a Lain American or Asian counry, han like an indusrial naion. Since 1971 he U.S. has been he only large indusrial counry ha has run curren accoun deficis in excess of 5%. This reflecs he unique posiion ha he U.S. has in he inernaional financial sysem, where is asses have been in high demand, allowing i o run high and persisen deficis. On he oher hand, his fac also suggess ha he U.S. is moving ino unchared waers. As Obsfeld and Rogoff (2004), among ohers, have poined ou, if he defici coninues a is curren level, in weny five years he U.S. ne inernaional liabiliies will surpass he levels observed by any counry in modern imes. During he las 30 years only small indusrial counries have had curren accoun deficis in excess of 5% of GDP: Ausralia, Ausria, Denmark, Finland, Greece, Iceland, Ireland, Mala, New Zealand, Norway and Porugal. Wha is even more sriking is ha very few counries eiher indusrial or emerging -- have had high curren accoun deficis ha las for more han five years. In Table 4 I presen a lis of counries wih persisenly high curren accoun deficis for In consrucing his able I define a counry as having a High Defici if, in a paricular year, is curren accoun defici is higher han is region s ninh decile. 14 I hen defined a persisenly high defici counry, as a counry wih a High Defici (as defined above) for a leas 5 consecuive 14 Noice ha he hresholds for defining High deficis are year and region-specific. Tha is, for every year here is a differen hreshold for each region. 11

13 years. 15 As may be seen in Table 4 he lis of persisenly high defici counries is exremely shor, and none of hese counries is large. This illusraes he fac ha, hisorically, periods of high curren accoun imbalances have ended o be shor lived, and have been followed by periods of curren accoun adjusmens. In Table 5 I presen daa on ne inernaional liabiliies as a percenage of GDP for a group of advanced counries ha have hisorically had a large negaive NIIP posiion. 16 As may be seen, he picure ha emerges from his able is differen han ha in Table 4 on curren accoun deficis. Indeed, a number of advanced naions have had and coninue o have a significanly larger ne inernaional liabiliies posiion han he U.S. This suggess ha, a leas in principle, he U.S. NIIP could coninue o deeriorae for some ime ino he fuure. Bu even if his does happen, a some poin his process would have o come o an end, and he U.S. ne inernaional liabiliies posiion as percenage of GDP would have o sabilize. I makes a big difference, however, a wha level U.S. ne inernaional liabiliies do sabilize. For example, if in he seady sae foreigners are willing o hold he equivalen of 35% of U.S. GDP in he form of ne U.S. asses, he U.S. could susain a curren accoun defici of (only) 2.1% of GDP. 17 If, on he oher hand, foreigners ne demand for U.S. asses grows o 60% of GDP which, as shown in Table 5, is approximaely he level of (ne) foreign holdings of Ausralian asses --, he U.S. susainable curren accoun defici is 3.6% of GDP. And if foreigners are willing o hold (ne) U.S. asses for he equivalen of 100% of GDP a figure ha Mussa (2004) considers o be implausible he susainable U.S. curren accoun defici can be as high as 6% of GDP approximaely is curren level. Since here are no hisorical precedens for a large advanced naion running persisenly large deficis, i is exremely difficul o have a clear idea on wha will be he acual evoluion of foreigners demand for U.S. asses. Give his lack of hisorical preceden, a reasonable sraegy is o ask wha would happen o he curren accoun and 15 For an economeric analysis of curren accoun deficis persisence see Edwards (2004). See also Taylor (2002). 16 For he U.S. he daa are from he Bureau of Economic Analysis. For he oher counries he daa are, unil 1997, from he Lane and Milessi-Ferrei daa se. I have updaed hem using curren accoun balance daa. Noice ha he updaed figures should be inerpreed wih a grain of sal, as I have no correced hem for valuaion effecs. 17 This calculaion assumes a 6% rae of growh of nominal GDP going forward. See subsecion III for an analyical discussion and for he relevan equaions. 12

14 real exchange rae dynamics if, as posied by Dooley e al (2004a) among ohers, foreigners demand for U.S. asses coninues o increase. This is precisely approached I follow in Secion III of his paper. III. The Analyics of Curren Accoun and Real Exchange Rae Adjusmen The curren accoun and he (real) exchange rae are endogenous variables joinly deermined in a general equilibrium conex. This means ha from a policy poin of view he key quesion is how will hese wo variables move as a resul of a given exogenous shock a decline in capial inflows, say --, under he assumpion ha oher variables, including growh and he rae of unemploymen, do no deviae significanly from heir long erm equilibrium pahs. A number of auhors have recenly addressed his issue using a variey of simulaion and economeric models. Mos of hese sudies have asked wha is he real exchange rae adjusmen required o achieve a cerain curren accoun balance. Some auhors, such as Obsfeld and Rogoff (2000, 2004) and Blanchard, Giavazzi and Sa (2005), have considered he case where he defici is compeenly eliminaed. Ohers, including Mussa (2004) and Roubini and Seser (2004), have considered he reducion of he defici o a posiive, bu smaller han curren, level. In Table 6 I provide a summary of seleced sudies on he subjec. As may be seen, hese works use differen mehodologies, and reach differen conclusions. 18 Wha hey do have in common, however, is ha hey find required adjusmens in he rade-weighed value of he U.S. dollar is quie high according o Blanchard, Giavazzi and Sa (2005) as high as 90%. Ineresingly, he esimaed figures for required dollar depreciaion summarized in Table 6 are much higher han he figures discussed in mos invesmen banks newsleers and in he media. 19 III.1 A Porfolio Model of he Curren Accoun and he Real Exchange Rae From an analyical perspecive he process of curren accoun adjusmen may be deconsruced ino wo componens: (a) The dynamics of ne inernaional foreign asses; and (b) he ransfer associaed wih changes in a counry s ne foreign asses posiion. 18 See also he sudies by Mann (2003, 2004), where she exends her pioneering 1999 model. 19 While praciioners do believe ha he dollar will weaken, hey end o consider more moderae adjusmens. See, for example, he forex publicaions of major invesmen banks. 13

15 Changes in inernaional invesors willingness o hold U.S. asses will affec oal absorpion and relaive prices, including he real exchange rae. An increase in foreigner s rae of accumulaion of domesic asses will allow he counry o increase absorpion, generaing a curren accoun defici and a RER appreciaion. In a similar way, a reducion in he rae a which foreigners accumulae he counry s asses or, worse ye, a reducion in heir holdings of domesic asses -- will resul in a drop in absorpion and a decline in he relaive price of nonradables, or RER depreciaion. These changes in absorpion, and he concomian adjusmen in relaive prices, are reminiscen of discussions on he ransfer problem ha go back, a leas, o he debaes beween Keynes and Ohlin during he 1920s. In large counries such as he U.S., however, his sory is more complex. Firs, changes in relaive prices have valuaion effecs on ne foreign asses holdings ha will feed back ino he dynamics of ne foreign asses accumulaion or de-accumulaion. 20 Second, in a large counry changes in aggregae expendiure are likely o affec he inernaional erms of rade, and hus he general equilibrium oucome of he original shock. III.1.1 The Basic Model Consider he following bare bones porfolio model of he curren accoun: 21 Equaion (1) is he basic exernal secor equaion (in domesic currency) and saes ha he curren accoun defici (CAD) is equal o he rade defici (TD), plus he income accoun (ne income paymens o he res of he world) ( ia ), plus ne ransfers o he res of he world (NT). 22 (1) CAD = TD + ia + NT, The income accoun, in urn is equal o: ia = id i F, f d 20 This effec has been emphasized by Lane and Milessi-Ferrei (2002, 2004a, 2004b), Tille (2003) and Gourinchas and Rey (2005), among ohers. For a discussion of valuaion effecs in he conex of emerging markes curren accoun susainabiliy, see Edwards (2003). 21 In order o concenrae on he problem a hand and o keep he analysis racable, I have made a number of simplificaions; I have made no aemp o consruc a full general equilibrium model. Recen papers ha have consruced porfolio models of he curren accoun include, Blanchard, Giavazzi and Sa (2005), Edwards (1999, 2002), Gourinchas and Rey (2005) and Kraay and Venura (2002). 22 Noice ha I have defined he defici as a posiive number. In equaion (1), hen, negaive numbers refer o a surplus. 14

16 where i is he ineres rae paid on (gross) domesic asses in hand of foreigners and i is he ineres rae on (gross) foreign asses held by domesic residens equaion (1) is expressed in domesic currency, F = E F. d d Where E is he nominal exchange rae defined as unis of domesic currency (U.S. dollars) per uni of foreign currency, and f D, d F. Since d F denoes (gross) foreign asses held by domesic residens, expressed in foreign currency. Equaion (1) can hen be rewrien as follows: d (1 ) CAD = TD + iδ + ( i i ) F + NT. f d Whereδ are ne domesic asses in hands of foreigners ( δ = D F ). The erms iδ and (i i ) F d capure he effec of valuaion effecs on he curren accoun, recenly emphasized by a number of auhors including Lane and Milesi-Ferrei (2004), and Gourinchas and Rey (2005), among ohers. Equaion (2) is a porfolio equaion ha summarizes he ne inernaional demand for he counry s assesδ. Domesic and foreign asses are assumed o be imperfec subsiues. α is he percenage of foreigners wealh ha inernaional invesors are willing o hold in he form of he domesic counry s asses; W is world s wealh and W is he domesic counry s wealh. α jj is he domesic counry s asse allocaion on is own asses. I assume ha here is home-bias in porfolio decisions; his is refleced in he fac ha α and 1 α ) are below inernaional marke shares of domesic and j ( jj foreign wealh. There is no need, however, o assume ha foreign and domesic invesors have he same degree of home bias. c c (2) δ = α( W W ) (1 α ) W, jj c An imporan quesion is wha deermines he asse allocaion shares α and sandard porfolio heory, α and α jj α jj. Under will depend on expeced real reurns (i and i), 15

17 perceived risk ( µ, µ ), and he degree of segmenaion of inernaional financial markes (Equaion (3)). (3) α = α( i, µ ) ; α α (, µ jj = jj i ). In his paper, however, I make he simplifying assumpion ha foreign and domesic asses have zero subsiuabiliy. This is equivalen o assuming ha α and exogenously deermined, and no affeced by i or i. This assumpion allows me o focus on he effecs of exogenous changes in porfolio allocaion on ne asses dynamics and he curren accoun. However, in subsecion III.2.2 I discuss he way in which he resuls will be alered if some degree of subsiuabiliy beween domesic and foreign asses is allowed. W W = E World wealh in foreign currency α jj are W and in domesic currency W are relaed by. Domesic and foreign ineres raes are relaed hrough he following e de equaion: i = i + + ( µ µ ) + k, where E de e is he expeced rae of depreciaion of E he domesic currency, and k is a erm ha capures he effec of capial conrols; in a world of full capial mobiliy, k = 0. I is imporan o noice ha in his model he erm invesors refers boh o privae and public invesors, and include foreign cenral banks. Indeed, and as poined ou in he preceding secion, recen discussions on he U.S. curren accoun defici have emphasized he key role played by foreign (and especially Asian) cenral banks in helping finance he defici. The counerpar of a curren accoun defici CAD is he change in he counry s (ne) asses in hand of foreigners: (4) CAD = δ. Equaion (5) defines he rade defici. m x (5) TD = pi mi pi xi. m pi and x pi are prices of imporable and exporables in domesic currency. mi is he demand for imporables, which is assumed o depend on he real exchange rae (e), he inernaional price of imporable goods, he counry s real income (y), and oher facors, 16

18 including he degree of proecionism (v). Expors, on he oher hand, depend on he real exchange rae, he inernaional price of exporables, he res of he world real income (y) and oher facors (u). (6) mi = mi ( e, y, v) ; xi = xi ( e, y, u). mi and x i, in urn, may be inerpreed as excess demand (supply) for imporable (exporables), in he domesic counry. In he basic version of he model i is assumed ha he law of one price holds for imporables and exporables: p = Ep p = Ep. In he simulaion exercises alernaive assumpions can be made, however, including ha exporers and imporers price o marke. Equaion (7) is he equilibrium condiion for he nonradable goods marke in he home counry, where N S m i m i ; x i x i is he supply of nonradables in period, assumed o depend on he real exchange rae and oher facors z, and demand for nonradables: N N (7) S e, z ) = D ( e, y ). ( N D is he The domesic price level P is assumed o be a geomeric average of he nominal prices of radable goods (imporables and exporables) and nonradables: m a x b N ( 1 a b) P = ( p ) ( p ) ( p ). Equaion (8) is he real exchange rae. P (8) e =, E P where, P is he foreign counry price level. As before, an increase in e represens a real appreciaion; a decrease in e is a real depreciaion. The working of his model is simple. The domesic counry can only run a curren accoun defici o he exen ha foreign invesors are willing o increase heir ne holdings of domesic asses ha is, o he exen ha δ > 0. Once δ is known, and for given values of oher key variables, i is possible o derive he real exchange rae (e) consisen wih he prevailing curren accoun defici (surplus). A paricularly ineresing exercise, given he curren U.S. siuaion, is o analyze how changes in porfolio preferences ha is, changes in α and/or real exchange rae. α jj --, will affec he curren accoun and he 17

19 In order o close he model, i is necessary o specify a number of clearing condiions, including he savings and invesmen equaions in he world economy; and he world clearing condiions for each imporable and exporable good. These equilibrium condiions deermine endogenously ineres raes, and all relevan radable goods prices. Doing his, however, would make he model significanly more complex han wha is required for dealing wih he problem a hand. For his reason, insead of solving he full model, I work wih a parial equilibrium version of i; in he simulaions ha follow I make differen assumpions regarding hese variables behavior. 23 Before coninuing, however, i is imporan o emphasize ha curren accoun adjusmens will no only imply changes in he real exchange rae; hey will also require changes in savings and invesmens in he home counry (he U.S.) and he res of he world. From a policy perspecive hese adjusmens in domesic savings would be grealy faciliaed by an increase in public secor savings. III.1.2 Porfolio Equilibrium, Dynamics and Curren Accoun Susainabiliy Exernal susainabiliy requires ha a counry s ne exernal liabiliies sabilize a a level compaible wih foreigners ne demand for hese claims, as specified by equaion (2). Assuming ha he home counry s wealh is a muliple λ of is (poenial or full employmen) GDP, and ha is wealh is a fracion β of world s wealh W, i is possible o rewrie he (inernaional) ne demand for he counry s asses as f (1 β ) EW δ = ( αθ (1 α jj )) λy, where, Y is (poenial) GDP, and, θ = = c β W, where f W is res of he world wealh expressed in foreign currency. Denoingγ = ( αθ (1 α )) λ, hen, δ = γ Y. This means ha in long run jj equilibrium he ne inernaional demand for he home counry s asses can be expressed as a proporion γ of is (poenial or susainable) GDP. The deerminans of his facor of proporionaliy γ depend on relaive reurns and perceived risk of counry j and he res of he world, as well as on he degree of inegraion of inernaional financial markes. 23 Mos recen models on global imbalances and he U.S. curren accoun have used a parial equilibrium framework in he simulaion phase. 18

20 Assuming ha g is he counry s susainable rae of growh, and π is he counry s (long erm) rae of inflaion, he susainable curren accoun defici o GDP raio is given by: CAD (9) = ( g + π )( αθ (1 α )) λ = γ ( g + π ) Y jj. Noice ha ifαθ ( 1 α ) < 0, domesic residens demand for foreign asses exceeds jj foreigners demand for home counry asses. Under hese circumsances he counry will have o run a curren accoun surplus in order o mainain a sable ne exernal asses o GDP raio. Mos auhors ha have sudied he susainabiliy of he U.S. curren accoun have used equaions of he ype of (9) in heir analyses. Mussa (2004), for example, argues ha in long erm equilibrium γ is likely o be around In long run equilibrium he susainable rade balance will be given by TD Y = ( g r) γ. In his model, as in he models by Edwards (1999) and Kraay and Venura (2002), addiional savings will be allocaed in a way ha mainains domesic and foreign asses in he same proporion as in he original porfolio. Kraay and Venura (2002) have shown ha models ha combine his assumpion wih he assumpion of ransacion coss in invesmen go a long way in explaining inernaional curren accoun behavior in a large number of counries. If he degree of riskiness of he home counry declines, here will be an increase in α and, hus, in γ. As a resul, he susainable curren accoun defici will increase, or he susainable surplus will decline (see equaion 10). Equally imporan, changes in porfolio allocaion, generaed by changes in α or α jj, will generae a dynamic adjusmen process, during which he curren accoun will differ from is long run susainable level. This ransiional dynamics can be incorporaed ino he model hrough he following equaion: CAD CAD (10) = ( g + π ) γ + ψ ( γ γ 1 ) κ ( g + π ) γ. Y Y 1 24 See, also, Edwards (1995), Ades and Kaune (1997), and O Neill and Hazius (2004) for his ype of curren accoun susainabiliy analyses. 19

21 According o equaion (1) shor erm deviaions of he curren accoun from is long run level can resul from wo forces. The firs is a radiional sock adjusmen erm ( γ γ ) 1 ha capures deviaions beween he demanded and he acual sock of he counry s asses in hands of foreign invesors. ψ is he speed of adjusmen, which will depend on a number of facors, including he degree of capial mobiliy in he counry in quesion. The second force affecing his dynamic process, which is capured by - CAD κ ( g + π ) γ in equaion (10), is a self-correcing erm. This erm plays he Y 1 role of making sure ha in his economy here is some form of consumpion smoohing. The imporance of his self correcing erm will depend on he value of κ. 25 Wheher he dynamic represenaion in equaion (10) is appropriae is, in he final analysis, an empirical maer. As I show in subsecion III.2, below, under cerain paramerizaion his model does a (very) good job in racking he curren accoun behavior in he U.S. during he las few years. The dynamic behavior for he ne sock of he home counry s asses in hands of foreigners, as a percenage of GDP, will be given by γ CAD Y 1 = [ γ 1 + ( ) 1 ](1 + g + π ). Consider he case where for some reason he home bias in he res of he world is reduced ha is, α in he porfolio equaion (3) increases. This will resul in an increase in he susainable curren accoun defici (see equaion 9). I will also unleash a dynamic adjusmen process capured by equaion (10). During his ransiional period he curren accoun defici will exceed is new long run (higher) susainable equilibrium; ha is, during he ransiion he curren accoun defici will overshoo is new susainable level. During he ransiion he rade accoun will move according o he following equaion: TD Y CAD = Y ( iγ ) ( i i F ) Y d NT Y. From equaions (5) hrough (7) -- and afer making some assumpions regarding he behavior of oher key variables such as he inernaional erm of rade --, he following equaion for he curren accoun 25 If ψ = κ = 0, he curren accoun will jump from one susainable level o he nex. There are many reasons o assume ha boh ψ and κ are differen from zero, including he exisence of adjusmen coss in consumpion. 20

22 may be derived (in order o simplify he noaion, he broad impors and expors caegories): mi and xi have been aggregaed ino (11) CAD Y + ( σ m = ( iγ ) + ( i i σ )( π π ) + σ x F ) Y η g σ m y d x ε + y g NT Y + σ pˆ m + { σ (1 + ε ) σ m x σ pˆ x x e ( σ m m (1 + η )}ˆ e σ )( g + π ). x e Where σ m and σ x are impors and expors o GDP raios; η e, ε e are he price elasiciies of impors and expors, respecively ( η e < 0, ε e > 0 ). η y, ε y are he elasiciies of impors and expors wih respec o domesic and foreign income, respecively. g, g represen real GDP growh a home and in he res of he world; π,π is domesic and world inflaion; p ˆ m, p ˆ are he raes of changes in inernaional prices of impors and x expors, and ê is he rae of change of he real exchange rae. From his equaion i follows ha in order for a real devaluaion o improve he rade balance (and, wih oher hings given, he curren accoun) i is required ha σ (1 + ε ) σ (1 + η )} >0. 26 { x e m e Alhough equaion (11) is no a reduced form equaion, his model is useful for underaking a number of simulaion exercises. For example, form equaions (2), (4), (10) and (11) -- and under assumed values of growh, inflaion, ineres raes and inernaional erms of rade changes --, i is possible o analyze he way in which changes in porfolio preferences will affec he curren accoun and real exchange rae rajecories. III.2 Simulaion Resuls The bare bones model developed above may be used o compue he curren accoun and real exchange rae adjusmens consisen wih shifs in porfolio preferences by foreign and domesic invesors, including a reducion in he exen of home bias in porfolio invesmen decision. 27 A firs sep in his analysis is he calibraion of he model. In Table 7 I presen he parameer values used in he base-case simulaion; mos 26 Under balanced iniial rade, his expression becomes he radiional Marshall-Lerner condiion. 27 In fac, here are indicaions ha he process of inernaional capial markes inegraion will coninue in he fuure, as some of he larges emerging counries including China are increasingly allowing heir naionals o inves abroad. See, for example, he Financial Times, February 28, 2005 (p.6): China o Seek Full Currency Conversion. 21

23 of hese values are aken form exising sudies of he U.S. and world economy. In he calibraion I seleced he values of ψ and κ ha bes racked he acual dynamics of he curren accoun beween 1996 and 2004; he bes resuls are obained for ψ = 0.30 andκ = I also assumed ha foreigners demand for U.S. asses α has increased gradually from o 0.30 beween 1996 and 2004 (see he values for α Hisorical, and α jjiniial in Table 7). As may be seen from Figure 5.A, for he assumed parameer values he model racks acual curren accoun behavior for quie closely. One of he limiaions of his ype of simulaion exercise is ha i is difficul o forecas how foreign invesors ne demand for U.S. asses will behave in he fuure. I is precisely for his reason ha a number of auhors have eschewed he issue, and have compued he RER adjusmen required o eliminae compleely he curren accoun defici. 28 In his secion I ake a differen approach: insead of assuming ha he curren accoun defici has o be reduced o zero or o any oher arbirary number --, I analyze he dynamic of he curren accoun under alernaive assumpions regarding foreigner s ne demand for U.S. asses. I am paricularly ineresed in undersanding wha is likely o happen under an opimisic scenario, where foreigners demand for U.S. asses coninues o grow in he fuure. Wha makes his approach paricularly ineresing is ha even under his opimisic scenario, i is highly likely ha in he no oo disan fuure he U.S. curren accoun will undergo a significan reversal. As may be seen in Table 7.A, in hese simulaion exercises I assume a gradual porfolio in he nex five years: More specifically, I assume ha α increases from is curren value of 0.30 o 0.40 by 2010; I also assume ha α jj goes from 0.73 o 0.71 during he same period. This adjusmen implies a reducion in he exen of home bias boh in he res of he world and in he U.S. In he base-case scenario he assumed porfolio adjusmen is equivalen o foreigners doubling heir ne demand for U.S. asses o he equivalen of 60% of U.S. GDP. This is a very large number. Indeed, i implies 28 Obsfeld and Rogoff (2000, 2004). For similar approaches see Mussa (2004) and Blanchard, Giavazzi and Sa (2005). 22

24 ha, under he assumpions of g = 0.03, π = , during he nex five years ( ) he U.S. NIIP would deeriorae by a furher $5.72 rillion. Before proceeding, he following assumpions made in he base-case scenario deserve some commens (See Table 7 for deails): (a) I have assumed ha he U.S. and he res of he world grow a he same rae ( g = g ). Implici in his assumpion is he idea ha while he U.S. will grow faser han Europe and Japan, he res of he world including China and India will coninue o grow a very rapid raes. In a number of alernaive simulaions I considered differen values for growh. (b) The values of he key elasiciies have been aken from exising sudies on he U.S. and global economies. 29 These values reflec wo imporan characerisics abou hese elasiciies: he income elasiciy for U.S. impors is higher han ha for res of he world impors (he so-called Houhakker-Magee effec), and he real exchange rae elasiciy of U.S. impors exceeds (in absolue erms) he real exchange rae elasiciy of expors by a magniude of 3. Finally, i is worh noing ha in he base case scenario I assumed ha he adjusmen had no effec on he inernaional erms of rade ( p ˆ pˆ = 0) ; in alernaive simulaions, m = x however, I considered ha case where here are changes in he erms of rade. The resuls obained from his base-case exercise are presened in Figure 5. In hese simulaions period 8 should be inerpreed as he iniial period ; he shaded area represens recen hisory. Panel A depics he curren accoun defici (for he firs few years he acual defici is also presened); Panel B presens he rade defici; Panel C presens he evoluion of ne U.S. asses in hands of foreigners, as a percenage of U.S. GDP; and Panel D conains he simulaion for he rade-weighed U.S. RER index. The mos salien feaures of he base-case simulaion may be summarized as follows: Under he (deliberaely) opimisic assumpion of a furher increase in foreigners ne demand for U.S. asses, he defici coninues o increase during he nex four years, unil i peaks a 7.3% of GDP. From ha poin onwards he defici declines owards is new seady sae of 3.18% of GDP. 29 See Hooper, Johnson and Marquez (2001). 23