No end to the exorbitant privilege
13 February 2018
Most analysis of international transactions and external balances focus on the current account balance – (receipts from exports of goods and services minus payments for imports of goods and services) plus (income receipts from assets owned by US residents abroad minus income payments on assets owned by foreigners at home). However, it is also interesting to consider the capital flows associated with these balances, which are governed by the identity FA=-(CA+KA+SD) and says that the financial account (FA) balance is of equal and opposite sign to the sum of the current account (CA) balance, capital account (KA) balance and a statistical discrepancy (SD). Because the capital account balance and the statistical discrepancy both average close to zero over the long-term, this equation says that countries running current account deficits must receive offsetting net capital inflows from the rest of the world, and that countries running current account surpluses will export capital to the rest of the world.
With the US having run a current account deficit every year since 1991, it has naturally received enormous net capital inflows over this period, allowing foreigners to build up a large stock of assets. But what can we say about its size and composition as well as how each has evolved over time? A few things stand out. First, net capital inflows have increased slightly over the past year from 1.7% of GDP in four-quarter moving average (4qma) terms to 2% of GDP. This is little different from the post-crisis average but 2.4 percentage points (ppts) below the average of the 10 years before the financial crisis. The reduction in capital inflows is consistent with the substantial narrowing of the current account deficit in the post-crisis period. Interestingly, net capital inflows are usually dominated by portfolio investment. Over the past four quarters, foreign direct investment (FDI) abroad averaged 1.7% of GDP, a little above the rate of inward FDI of 1.6% of GDP. By contrast, portfolio investment abroad was 2.6% of GDP, 1.6ppts below inward flow of 4.2% of GDP. This is broadly consistent with the long standing patterns – average net FDI has been +0.3% of GDP since the crisis, and was close to zero in the 10 years before the crisis. By contrast, net portfolio investment has averaged -1.4% of GDP since the crisis and -3.8% of GDP in the 10 years beforehand (see Chart 2). The upshot is that most of the US current account deficit is and has been funded by portfolio investment.
Given the importance of portfolio investment, it is worth looking at its composition a little more. A breakdown of portfolio investment flows have only been available since 2003, but over that period the acquisition of foreign portfolio assets has been fairly evenly split between equity and debt instruments. Debt has taken a slightly larger share over the past year, but it remains the case that US residents maintain fairly balanced foreign investment portfolios. The same cannot be said for foreign residents’ US portfolio decisions. Their acquisition of US portfolio assets is dominated by debt securities (see Chart 3). In simple terms, America’s ‘safe haven’ and reserve currency status means foreigners tend to invest in lower yielding US assets more than Americans do when investing abroad. This enables the US to run a net income surplus within the current account despite its large and growing net foreign liability position.