Slide 1 - Global Finance

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					  U.S Current Account Deficit, Its
Sustainability and Implications on the
               Eurozone


                                   Group Members:
                                 Mohammad Al-Emmadi
                                    Sadegh Shirazi
                                  Harvesh Seegolam
                                    Yves Hakimian




                                      Dec 2005
                    Presented for the International Finance course
                              CERAM Sophia-Antipolis
           Table of Contents

   Introduction
   U.S Current account deficit Today
   The Implications on the eurozone
   Is the U.S CAD sustainable?
Introduction
         Balance Of Payments

   A record of all transactions made by
    one particular country during a
    certain period of time.

   It compares the amount of economic
    activity between a country and all
    other countries.
The large number of
international transactions can
be summarized into two
categories:

   1.   Current account
   2.   Capital account
       The Current Account (CA)

   The difference between the total
    exports and Imports of goods,
    services, and unilateral transfers.

   Current account balance
    calculations exclude
    transactions in financial assets
    and liabilities.
   Positive value for the current account
    is called a current account surplus.

   Negative value for the current
    account is called a current account
    deficit.
 The current account mainly consists
      of 4 types of transactions:
 1. Exports and imports of goods
    • Exports of goods are credits (+) to the
      current account
    • Imports of goods are debits (-) to the
      current account
Trade Balance = Exports of goods – Imports of goods
2. Exports and imports of services

 • Exports of services are credits to the
   current account (+)
 • Imports of services are debits to the
   current account (-).
  This category consists of items such as
  tuition paid to universities by
  international students, money spent on
  travel by tourists, banking, insurance,
  consulting services etc.
3. Interest payments on international
  investments.

  • Interest, dividends and other income
    received on U.S. assets held abroad are
    credits (+).

  •Interest, dividends and payments
  made on foreign assets held in the
  U.S. are debits(-).
4. Unilateral transfers

   Remittances by U.S. citizens working
    abroad, unilateral aid to the U.S.
    from other countries, pensions paid
    by foreign countries to their citizens
    living in the U.S. count as credits
    (+).
 Remittances by foreigners working in the
U.S., unilateral aid from the U.S. to other
countries, pensions paid to U.S. citizens
living abroad count as debits (-).
   CAN CURRENT ACCOUNT DEFICITS
INDICATE THE HEALTH OF AN ECONOMY?

   Is a country with a current account
    surplus always better off than a
    country with a current account deficit?

   ِ
    Don’t forget that the current account deficit will
    be accompanied by a capital account surplus
    of equal magnitude.
   Consider the United States in the
    late 1990s - it had a booming
    economy, rapidly increasing stock
    market and limitless growth
    prospects. As a result, it would
    attract a lot of investment from
    abroad, bringing about a KA surplus.
    However, since the U.S. government
    holds very few reserves this KA
    surplus MUST be accompanied by a
    CA deficit.
   By contrast,Russia in the late 1990s
    - a shrinking economy, rapidly
    decreasing stock market and terrible
    growth prospects. As a result, Russia
    had substantial capital flight - money
    leaving the country bringing about a
    KA deficit. If Russia had a flexible
    exchange rate (it initially did not, but
    eventually did) this KA deficit MUST
    be accompanied by a CA surplus.
Finally, consider the current state of
 Iraq. With very few exports of oil, it
 needs to import all its consumption
 needs. Iraq will therefore run a CA
 deficit, and as you see an economic
 weakness will be associated with a
 CA deficit.
   There is no relationship between
    CA deficits and the state of the
    economy.

   We only know that CA deficits are
    associated with surpluses in the
    capital account and vice versa.
The U.S CAD Today
                         The U.S CAD Today
                                  (In million US$)
                  1st Qtr    2nd Qtr    3rd Qtr    4th Qtr    1st Qtr   2nd Qtr
                  2004        2004       2004      2004       2005       2005
Trade Balance    -151,452   -163,987   -167775    -182176    -186,329   -186,929
(%Change)                                                      (23%)       (14%)
Balance on       -138,852   -152,042   -157,465   -169,221   -173,052   -173,327
G&S
Balance on       1,502       2,592      2,625      4,323      6,643        -455
Income

Unilateral       -22,271    -20,515    -15,771    -22,374    -26,259     -21,873
transfers, Net

Balance of      -146,101    -166,635   -166,982   -188,359   -198,668   -195,655
Current account                                                (36%)     (17.5%)
100000
     0




                                                                              2005f
          1960


                 1965


                          1970


                                    1975


                                           1980


                                                  1985


                                                         1990


                                                                1995


                                                                       2000
-100000
-200000
-300000
-400000
-500000
-600000
-700000
-800000

                                 Balance of CA     Trade Balance




                        6% of GDP                    750 bn$
100000
     0

          1960
                 1963
                        1966
                               1969
                                      1972
                                             1975
                                                    1978
                                                           1981
                                                                  1984
                                                                         1987
                                                                                1990
                                                                                       1993
                                                                                              1996
                                                                                                     1999
                                                                                                            2002
                                                                                                                   f 2005
-100000
-200000
-300000
-400000
-500000
-600000
-700000
-800000

   Balance of CA                                              Balance of G&S
   Balance on Income                                          Unilateral current transfers, net
100000

     0




          2005 f
           1980
           1981
           1982
           1983
           1984
           1985
           1986
           1987
           1988
           1989
           1990
           1991
           1992
           1993
           1994
           1995
           1996
           1997
           1998
           1999
           2000
           2001
           2002
           2003
           2004
-100000

-200000

-300000

-400000

-500000

-600000

-700000

-800000

      Balance of CA       Balance of G&S
      Balance on Income   Unilateral current transfers, net
          World Banks Projection
   The U.S. current account deficit is expected to stop
    rising and gradually decline – reaching 5.3 percent of
    GDP in 2007.
   Several factors are expected to contribute to
    this development:
    • Both U.S. short- and long-term interest rates are
      projected to continue rising up to 5% in 2007.
    • A modest tightening of U.S. fiscal policy is
      projected.
    • Continued strong growth in developing economies
      and robust demand for imports will increase U.S.
      exports.
 Effects Of The Deficit on the rest of
              the world
2 schools of thoughts exist:
      - beneficial effect
      - does more bad than good

How is the US deficit beneficial?
      - Very important supporting force for global
economic expansion.
      - Example: during the 1990s International
Financial Crisis, the buoyant US imports demand
was THE driving force to bail out many
developing countries from recessions.
Effects Of The Deficit on the rest of the
                world

              Why is the deficit bad?

      To counterpart the persistant US trade
       deficits, a steady inflow of foreign capital is
       required into the US.
      Corresponds to a drainage of savings for the
       rest of the world
      This therefore increases growth in the US
       while diminishing development in other
       economies.
      Thus creating larger inequalities in growth
       and living standards between the US and
       other countries.
             Implications of the deficit
   To analyse the implications of the US deficit, we
    first need to understand how the deficit will
    actually be adjusted over time.

   Different scenarios have been proposed as to
    how this adjustment will take place. We will
    focus on two main scenarios proposed by the
    United Nation’s Department of Economic and
    Social Affairs, namely:

          A sharp adjustment scenario
          An over optimistic scenario
         A Sharp Adjustment scenario
   Under this scenario, adjustment will be mainly
    accomplished by a large correction of the private
    sector savings-investment imbalance.

   Deficit reduction mainly induced by decreasing
    imports demand in the US.

   What can trigger this kind of a sharp reversal of the
    deficits?
         Sudden shift of the Consumer and business

           confidence.
         Have been on a downward trend since the peak

           levels of 2000.
       Implications of a Sharp Adjustment

   Direct consequence:
         Reduction of the world trade exports.



          Impact for the Eurozone:
               Significant reduction of the trade
                surpluses.

                  According to a recent work by the
                   UNDESA, if around $400 billions of the
                   deficit was to be forced to rebalance in
                   2 years, it would imply a reduction of
                   about $90 billions in the trade balance
                   of the Euro zone.
         An over-optimistic scenario
   This scenario assumes that the adjustment will
    be accomplished mainly by an increase in foreign
    demand of US goods and services.

   Main question:
    • What would be additional economic growth
      required from the rest of the world to generate
      enough external demand for US exports to
      correct the deficit?
Implications of an over-optimistic adjustment
   According to the UNDESA, if around $400 billions
    of the deficit were to be forced to rebalance in 2
    years purely on increased external demand, this
    will necessitate a rise in GDP by about 8% for the
    rest of the world.

   This implies that the Eurozone alone, will have to
    grow by more than 5% annually.

   And we all know that this is simply not attainable.
           Forecasts
Source : LINK Global Forecasts, UNDESA.
                       Main implication

   Euro zone has a role to play in reducing global imbalances.

   Edwin M. Truman from the Institute for International
    Economics (IIE):

        “Euro area is expected to bear more than its
          proportionate share of the US external adjustment.”

            • WHY?
                other areas of the world are even less well

                 positioned to absorb this adjustment

                  flexibility of euro exchange rates.
                     Main Implication

   Will the Euro zone live up to its expectations?

          According to April 2005 edition of World Economic
           Outlook, the International Monetary Fund (IMF) the
           Euro zone is expected to provide a relatively small
           amount (about 0.4 percent of its own GDP) as
           compared to other areas of the world.


          “ The Euro area cannot carry the brunt of
           adjustments in exchange rates, ” as Mr Koch-Weser,
           the German deputy finance minister said at last
           month’s IMF and World Bank meetings.
Who Finances the
  US.CAD ?
   The United States runs a current account
    deficit of more than $600 billion per year.
   In recent years, foreign central banks,
    especially those in Asia, have made
    substantial purchases of U.S. government
    securities to add to their foreign exchange
    reserves.
   It is partially because of these
    interventions that the current deficit
    continues to widen and the necessary
    adjustment is being delayed.
   In International Finance, it is relative
    valuations that matter for
    international capital flows and
    international adjustments, and the
    growth differential between the US
    and its major trading partners has
    not narrowed much in recent years.
             Why the US?
   It is true that the dollar plays the
    role of a vehicle currency
   It is also true that U.S. financial
    markets are efficient
   Also the U.S. monetary policy is very
    credible.
   But is that the only reason for the
    huge international capital inflow?
   A report from the Bank of International
    Settlements (BIS) shows that foreign
    central banks financed 75% of the U.S.
    current account deficit in 2004, providing
    an inflow of $498 billion.
   Foreign governments served as the lender
    of last resort to the United States in 2004,
    as they did in 2003. Most of that capital
    came from China, Japan, and other Asian
    countries, which sought to reduce
    pressure on their currencies to appreciate
    against the dollar.
   Without that intervention, the dollar,
    which declined 5.8% in 2004 in Real
    terms, would have fallen more
    rapidly than it did.
   If the dollar had declined, the
    competitiveness of U.S. export-
    competing industries would improve,
    and production and jobs in industries
    in manufacturing and other sectors
    would strengthen.
    Risky Asian Gov.Interventions
   The longer the dollar value remains high, the
    greater the risk of a sudden break in the dollar,
    which would be disruptive to U.S. financial
    markets.
   The best way to avoid this threat is to bring
    about a large sustained reduction in the real,
    trade-weighted value of the dollar.
   Such a reduction would lower import growth,
    increase exports, and reduce the trade deficit.
   By intervening in U.S. currency markets to
    prevent dollar and trade adjustment, Asian
    governments are raising the risk of serious
    disruption to the economies of the
    United States and the rest of the world.
   A bloc of Asian governments made
    purchases equal to 132% of all net
    government purchases of U.S. assets in
    the first quarter of 2005. Thus, these
    governments were willing to offset net
    official sales of U.S. assets by
    governments in the rest of the world. The
    unwillingness of other foreign
    governments to continue holding large
    stocks of U.S. government assets
    highlights the determination of Asian
    governments to serve as lenders of last
    resort in financial markets.
   These governments, especially China, Japan and
    Korea are willing to absorb the risks of financial
    losses from an ultimate decline in the dollar in
    order to make their exports more competitive
    against U.S. products.

   The dollar would have declined much more
    rapidly, especially against Asian currencies, if
    there had been no foreign government
    intervention in currency markets.
   If the dollar did decline fully, the prospects for
    stabilizing or shrinking the U.S. current account
    deficit would be greatly improved.
   We know that the US current account deficit reached an all-
    time high of $780 billion in the first quarter of 2005, an
    increase of 15% over the fourth quarter of 2004. The
    deficit reached 6.4% of gross domestic product (GDP), also
    a record level. The U.S. dollar has declined 14.9% since
    the first quarter of 2002.

   The rapid and continuing growth of the current account
    deficit, despite the sustained decline in the dollar since the
    first quarter of 2002, is a major sign of weakness in U.S.
    traded goods industries. Unfortunately, the deficit is still
    likely to get worse in the near term.
   The declining dollar should make U.S. exports more
    competitive and imports more expensive. Thus the growth
    of exports should accelerate, and the rate of growth of
    imports should fall. However, because the trade gap is so
    large, stabilizing or reducing the trade gap will be very
    hard.
The U.S. dollar has declined 14.9% since
        the first quarter of 2002
   Imports were 47% larger than exports in the first
    quarter of 2005 meaning Imports increased
    10.7% in the first quarter. However, exports
    increased only 8.8%.
   In order to keep the current account gap from
    growing, exports would have had to increase
    78% faster than they actually did. In other
    words, exports would have had to increase by
    15.6% last quarter just to keep up with the
    10.7% growth of imports. Future exports will
    have to grow much more rapidly to shrink the
    current account as a share of GDP.
   In order to stabilize or reduce the current
    account gap, the dollar will have to fall
    substantially more than it has since early 2002
                    Sources
   Bank of International Settlements (BIS)
   International Monetary Fund (IMF)
   Bureau of Economic Anlysis (BEA)
   US Federal Reserve Board
   The Federal Reserve Bank of Chicago
   National Bureau of Economic Research (NBER)
   World Bank
   UN – Department of Economic & Social Affairs
   Institute of Internatinal Finance (IIF)
   Institute for International Economics (IIE)
   OECD

				
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