The U.S. current account deficit -- the gap between what the United States earns abroad and what it spends abroad in a year -- is on track to reach seven percent of GDP in 2005. That figure is unprecedented for a major economy...U.S. external debt is now equal to more than 25 percent of GDP, a high level given that exports are a small fraction of U.S. GDP. More important, the United States is adding to its debt at an extraordinary pace..
In the late 1990s, the United States borrowed abroad to finance private investment. Today, however, the country does most of its foreign borrowing to finance the federal budget deficit, which is projected to be close to 3.5 percent of GDP in 2005. (In 2000, the United States had a surplus equal to 2.5 percent of GDP.) Recent economic growth has not reduced the budget deficit, but it has increased private demand for scarce savings; the net result has been even more borrowing from abroad.
In 2004, foreigners bought an amazing $900 billion in U.S. long-term bonds; the United States exported a dollar of debt for every dollar of goods it sold abroad. Looking ahead, the U.S. debt position will only get worse. As external debt grows, interest payments on the debt will rise. The current account deficit will continue to grow on the back of higher and higher payments on U.S. foreign debt even if the trade deficit stabilizes....In recent years, the rising value of existing U.S. assets abroad has in fact offset much of the new borrowing the United States has taken out to finance its trade deficit, and Levey and Brown bank on similar gains in the coming years. But this bet is unwise. Most U.S. assets abroad are in Europe. Since the dollar already has fallen by around 40 percent against the euro, further falls in the dollar are likely to be against Asian currencies, and the United States holds relatively few Asian assets.
The falling dollar also reduces the value of foreign investments in the United States. Eventually, foreign creditors are likely to demand higher interest rates to offset the risk of further decreases. Over the past few years, the United States has found a novel way out of this dilemma: rather than selling its debt to private investors who care about the risk of financial losses, it has sold dollar debt at low rates to foreign central banks.
The extent of U.S. dependence on only ten or so central banks, most of them in Asia, is stunning: in 2004, foreign central banks probably increased their dollar reserves by almost $500 billion, providing much of the financing the United States needed to run a $665 billion current account deficit. These banks are not buying dollar-denominated bonds because they are attracted to U.S. economic strength, the high returns offered in the United States, or the liquidity of U.S. markets; they are buying them because they fear U.S. weakness. If foreign central banks stopped buying dollar-denominated bonds, the dollar would fall dramatically against their currencies, U.S. interest rates would rapidly rise, and the U.S. economy would slow.
Foreign central banks have financed the United States to keep their export sectors -- heavily dependent on U.S. consumer spending -- humming. But they now must weigh the benefits of providing the United States with such "vendor financing" against the rising costs of keeping the current system going.
Now, foreign central banks with large dollar holdings are facing the prospect of huge losses as a result of the dollar's decline. A 20 percent increase in the value of the yuan against the dollar would reduce the value of China's roughly $450 billion in dollar reserves by about $100 billion -- 6 percent of China's GDP. In four years, if nothing changes, Chinese dollar reserves could reach $1.4 trillion, raising the costs of a falling dollar to $300 billion -- some 12 percent of China's GDP. In short, the longer China continues to finance U.S. deficits, the larger its ultimate losses.
