October 24, 2004 Copyright © 2004, Greenwich Financial Management Inc., a registered investment advisor.  Securities offered exclusively through Purshe Kaplan Sterling Investments of Albany, NY, a NASD member firm.

The Federal Budget Deficit, Postscript:
Dollar Crisis in the Making?

            It is a major event when a multinational corporation goes into the market to raise one billion dollars. However, as our expected federal deficit for 2004 is approximately $477 billion (4.2% of est. GDP), the U.S. Treasury must on average go into the market every day to raise over one billion dollars.  This alarming situation represents a dramatic reversal from the budget surplus that the U.S. enjoyed from 1998 to 2001, when the national debt was actually declining and there was a net refunding of US Treasury bonds.

            As we wrote last week, a significant decline in foreign investment could have a severe negative impact on US assets, particularly for US Treasuries, about half of which are now held by foreign central banks and private investors (see http://www.greenwichfinancial.com/wm43.htm ).  In recent years, the United States has been experiencing large capital inflows that have helped us to finance our trade imbalances with other countries and our mushrooming federal budget deficit.  We Americans are spending more than we are earning, or to say the same thing in a different way, domestic investment is greater than domestic saving.  The foreigners have been making up the difference.  As a result, our economy is hyper-sensitive to any slackening in foreign demand.

            Foreign holdings of US Treasuries amount to some $1.8 trillion (including official and private investment), according to data brought to my attention by economist Gary Evans (see http://www.ustreas.gov/tic/mfh.txt ).  Of this amount, almost half is held by two countries, Japan ($721.9 billion) and Mainland China ($172.3).  The Japanese government has intervened vigorously in the market, buying US Treasuries, in an attempt to keep Yen revaluation from hurting exports; the Chinese government has intervened to preserve its currency peg against the dollar, for similar reasons.  However, no government is rich enough to fight the currency markets for long, if economic fundamentals run against their policy.

            According to data just released by the Treasury Department ( http://www.treasury.gov/press/releases/reports/ticpressnoticeaugust04.pdf ), net capital flows into US Treasuries from foreign private investors during August of this year were minus $4.4 billion, a precipitous drop compared to positive $18.3 billion the previous month.  Fortunately, foreign governments invested more heavily in Treasuries in August, or this shift by foreign private investors might have caused a serious weakening of the dollar.  As can be seen in the accompanying chart, investment by private sources actually decreased from the twelve month period ending August 2003 to that ending August 2004.  Notice however the tremendous increase in purchases by foreign governments of US Treasuries, rising from $66.5 billion to $211.9 billion over that same one year period.  But if the private investors start to lose their appetite, how long will the governments stand in line for more?

		Capital Flows in Long-Term US Securities
		(in billions of dollars, not seasonally adjusted)
							12 months ending		12 months ending
							Aug-03		Aug-04
1		Gross purchases of domestic securities					14,361.4		16,223.7
2		Gross sales of domestic securities					13,641.9		15,368.8
3		Net domestic securities purchased (Line 1 - Line 2) 1					719.5		854.9
4		Private, net investment 2					627.1		604.5
5		Treasury Bonds & Notes, net					188.6		156.6
6		Government Agency Bonds, net					183.4		166.8
7		Corporate bonds, net					225.1		264.1
8		Equities, net					30.0		17.0
9		Official, net investment					92.4		250.5
10		Treasury Bonds & Notes, net					66.5		211.9
11		Government Agency Bonds, net					21.7		31.0
12		Corporate bonds, net					4.2		8.3
13		Equities, net					0.0		-0.7
14		Gross purchases of foreign securities					2,799.1		3,564.5
15		Gross sales of foreign securities					2,818.6		3,643.9
16		Foreign securities purchased, net (Line 14 - Line 15)					-19.5		-79.4
17		Foreign bonds purchased, net					37.9		-6.2
18		Foreign equities purchased, net					-57.3		-73.3
19		Net Long-Term Flows (line 3 + line 16) 3					700.0		775.5
Source :  U.S. Treasury Department, Office of Public Affairs ( October 18, 2004 )
1 Net foreign purchases of U.S. securities (+)
2 Includes international and regional organizations
3 Net U.S. acquisition of foreign securities (-)

            On September 9 th , US dealers were stunned to learn that the US Treasury 10 Year Note auction found almost no foreign buyers.  However, from an investment perspective, it's not hard to understand why foreign investors might hesitate.  Effectively, we are offering foreigners a chance to invest in our Treasury debt in an environment where interest rates are rising (thus lowering the price of existing bonds), the dollar is weakening, and the credit-worthiness of the US government (using orthodox measures) is declining.  Such a deal!

            Financial markets are built on confidence.  It is the confidence of foreigners in our dollar and our economy that has allowed the United States to fund increasingly large deficits in its current account. However, the extent of our dependence on foreign capital is potentially creating a hair-trigger situation.  A deep devaluation of the dollar, perhaps engendered by a crisis of confidence in U.S. fiscal policy, would reverberate through our whole economy.  While a much weaker dollar would spur U.S. exports and dampen demand for imports, it could also trigger higher interest rates and inflation--while likely deflating U.S. stocks and possibly real estate as well.  In this way, the federal budget deficit could backfire on all of us.

 

Andy Szabo, CFA, is Managing Director of Greenwich Financial Management Inc., a Registered Investment Advisor, which advises individuals and companies on investments, insurance and employee benefits.  Questions or comments welcome by phone at 203-531-2877 or e-mail: Szabo@GreenwichFinancial.com.