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Recent Shifts in Financing the U.S. Current-Account Deficit 1 (July 2005)

handle is hein.congrec/cbo9478 and id is 1 raw text is: A series ofissue summaries from the Congressional Budget Office JULY 12, 2005 Recent Shifts in Financing the U.S. Current-Account Deficit When the United States runs a current-account deficit, its spending exceeds its income. Such excess spending is possible only as long as foreigners finance the deficit. That financing is provided by net capital inflows-the total net purchases of U.S. assets by foreign entities, both private and governmental (or official). An increase in the supply of such financing helps widen the current- account deficit by boosting the value of the dollar and the prices of U.S. assets (such as real estate, stocks, and bonds), thus enhancing the ability of U.S. residents to make purchases.' A decline in the supply of such financ- ing has the reverse effect on the dollar, on U.S. asset prices, and on the current account. For most of the past decade, foreign investors increased their holdings of U.S. assets substantially, which contrib- uted to the rise of the U.S. current-account deficit. In 2001, however, private foreign demand for U.S. assets began to weaken. In 2002, central banks in several Asian countries stepped up their purchases of U.S. government securities to restrain the downward pressure on the value of the dollar relative to their currencies. Thus, the total supply of foreign financing continued apace. By 2004, the current-account deficit had reached a record level of $668 billion, or 5.7 percent of gross domestic product (GDP). If official inflows should start to wane while private demand for dollar assets remained weak, there would be downward pressure on the value of the dollar and on the price of U.S. assets. Such a development would help re- duce the current-account deficit. However, because pri- vate investors still hold the vast majority of foreign claims on U.S. assets, how the dollar and U.S. asset prices 1. A rise in the dollar's value makes imports cheaper (and exports more expensive), while an increase in asset prices boosts U.S. residents' net wealth and their ability to borrow. For a more detailed discussion, see Congressional Budget Office, The Decline in the U.S. Current-Account Balance Since 1991 (August 2004). evolved would ultimately depend on the decisions made by private investors. The Rise and Decline of Private Financing Private capital inflows include direct investments (invest- ments that foreign multinational companies make in their subsidiaries in the United States) and portfolio in- vestments (primarily purchases of U.S. stocks and bonds by foreign individuals and companies, as well as loans extended to U.S. businesses and deposits in U.S. banks). Similarly, private outflows include direct investments that U.S. firms make in their foreign subsidiaries and portfo- lio investments that private entities in the United States make abroad. For more than a decade in the United States, private cap- ital inflows have risen more than outflows, and both have grown much faster than the economy. For example, as a percentage of GDP, private capital inflows grew from 1.6 percent to 8.9 percent between 1991 and 2004, while private capital outflows rose from 1.2 percent to 7.3 per- cent during the same period. Flows of private capital change in response to expected re- turns and risks. Capital flows to the United States when investors believe that investments here offer returns that, after adjusting for risk, are larger than those available elsewhere. Foreign investors' demand for U.S. assets is also motivated by the desire to diversify away from their home currencies (and thereby minimize any currency risk inherent in their portfolios) and by the attractiveness of dollar-denominated assets (attributable primarily to the depth and liquidity of U.S. markets, the dollar's role as the main currency for international transactions and transfers, and the U.S. political and legal systems). From 1997 to 2000, net private inflows to the United States surged (see Figure 1). That surge reflected a sharp rise in demand for U.S. assets by foreign investors,

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