TIC Tock

Global
TIC Tock
February 16, 2007

By Stephen S. Roach
Stephen S. Roach is Managing Director and Chief Economist of Morgan Stanley.
New York

The US Treasury’s latest report on international capital flows came as a shocker. Net foreign inflows into longer-term US securities fell to just $15.6 billion in December 2006 -- the weakest monthly reading in nearly five years. This stands in sharp contrast to America’s enormous external financing needs -- about $3.5 billion of foreign capital inflows each business day required to fund a current account deficit that was running at close to an $875 billion annual rate in the first three quarters of 2006. Does an external financing shortfall of this magnitude finally spell trouble for the seemingly Teflon-like US dollar?

Probably not -- or, at least not yet. The monthly Treasury International Capital (TIC) data are not exactly the most reliable piece of intelligence in the US statistical system. The figures are extremely volatile -- expect a big bounce-back next month -- and quite often they do not match up well with capital flow data provided by other nations. In addition, the coverage pertains mainly to foreign investment in longer-term securities -- thereby ignoring the nearly 15% of overseas holdings in instruments with shorter-term (less than one-year) maturities. Moreover, as others have pointed out, the TIC data suffer from major classification biases that often confuse foreign sourcing between official and private investors (see Martin Feldstein’s op-ed in the 10 January 2006 Financial Times, “Why Uncle Sam’s bonanza might not be all that it seems”).

Notwithstanding these flaws, the TIC data should not be ignored. Over time, the Treasury statistics do a reasonably good job in tracking the international investment transactions embedded in the US balance of payments. As such, TIC reports can be helpful in pinpointing the tensions arising between America’s external financing requirements and foreign willingness to provide the requisite capital. And there can be no mistaking a worrisome build-up of tensions on several fronts: First, the United States has made no effort to reduce its chronic saving shortfall. Reflecting persistent structural government deficits and the first back-to-back years of negative personal saving since the early 1930s, the US net national saving rate has held at a record low of 1% of national income over the past three years. Lacking in domestic saving, America has placed heavy demands on the rest of the world -- absorbing about 70% of global surplus saving over the past couple of years -- to fund its ongoing economic growth.

Second, the rest of the world is waking up to the notion that there are alternatives to low-yielding dollar-denominated assets. That’s especially the case in the poor countries of the developing world, who collectively hold over $2.5 trillion in excess foreign exchange reserves -- that is, reserves above and beyond those which would be required to pay off some $550 billion of short-term external indebtedness. A year ago, former US Treasury Secretary Larry Summers gave a speech in India that challenged reserve managers in the developing world to seek higher returns on their increasingly large asset pools in order to help meet urgent social and economic imperatives (see “Reflections on Global Account Imbalances and Emerging Markets Reserve Accumulation,” L. K. Jha Memorial Lecture, Reserve Bank of India, March 24, 2006). The Summers message galvanized attention on this issue -- especially in Asia, where the bulk of excess reserves are held. Talk of portfolio diversification intensified, ultimately culminating in China’s recent announcement that it would allocate around $200 billion of its more than $1 trillion in reserves toward the start-up of a Singapore-GIC-style multi-asset fund. With most reserve managers having massive overweights in dollar-denominated assets, such diversification strategies can only complicate America’s external financing needs.

Third, Washington continues to flirt with a protectionist response to America’s outsize bilateral trade imbalance with China. I spent some time in Washington this week discussing trade issues with congressional leaders, and I came away with the distinct impression that the die is cast for a much more aggressive approach to US-China trade policy (see my 13 February Special Economic Study, “The Politicization of the US-China Trade Relationship”). Under Democratic leadership, there is a higher probability that ongoing Chinese trade frictions could result in more serious legislative efforts than was the case when the Republicans were in control. Moreover, with such initiatives enjoying broad-based bi-partisan support, the only real question, in my view, is whether the margin of passage will be large enough to override a likely presidential veto. Should such legislative “remedies” be enacted, I have little doubt that Chinese participation at upcoming Treasury auctions would be sharply reduced -- a hugely negative development for the dollar.

There are, of course, many other considerations weighing on the dollar -- ranging from a likely narrowing of cross-border interest rate spreads and relative equity returns to reserve diversification strategies of Middle East and other Asian reserve managers. At the same time, the three largest surplus savers in the world -- China, Japan, and Germany -- are all hard at work trying to stimulate internal consumption. To the extent those efforts bear fruit -- and, in my view, it’s only a matter of when -- they will then draw down their surplus saving and have less excess capital to send America’s way in the form of investments in dollar-denominated assets.

Despite these dollar-bearish conclusions, I stand by my view that a currency realignment should not be viewed as the principal means to rebalance an unbalanced world (see my 9 February dispatch, “The Currency Foil”). Instead, significant adjustments are needed in the mix of global saving -- more from the US and less from China, Japan, Germany, and the Middle East. A currency realignment is, at best, a circuitous route to such an endgame. At the same time, I still believe that the day is coming when the dollar will be hit by global portfolio adjustments, as foreign investors demand significant financing concessions -- either in the form of a weaker dollar and/or higher longer-term real interest rates -- for their heretofore open-ended buying of dollar-based assets.

A monthly TIC report can hardly be viewed as a decisive verdict on anything. But the December collapse in foreign demand for longer-term US securities also coincided with a sharp widening of the monthly trade deficit to $61 billion -- drawing the narrowing trend of the preceding three months into question. With America’s external financing needs remaining huge by any standard, it becomes tougher and tougher for the US to attract the requisite capital inflows under the best of conditions. It may well be that we will look back on the December 2006 TIC report as a warning shot of what was to come -- an increasingly difficult external financing climate for a saving-short US economy. The clock is tic(k)ing.

Stephen S. Roach