World’s Largest Deficit Nation Can Still Lure Investors
The old axiom of financial theory that capital always flows from surplus (saving) to deficit (borrowing) units is a handy guide to anticipate directions of major capital movements in the world economy. These movements are crucially important for economic and financial forecasting because they drive the business cycle and asset prices.
So, who are the big borrowers and the big savers at the moment?
The United States remains by far the largest deficit country in the world. India is the distant second, followed by the U.K. and Brazil. Based on the latest data available, the total current account deficit of these four countries is about $690 billion. That is the amount of foreign savings these countries have to import to balance their books.
Among the big savers, China is running the largest external surplus, followed by the euro area, Southeast Asia, Russia and Japan – in that order of magnitude. This group of countries is presently showing a total current account surplus of $657 billion. These are excess savings that will be invested in deficit country assets.
(Read More: Weak Yen Puts Japan Current Account Back in Black)
What we have here is a good approximation of the world's balance of payments. The difference of $33 billion between surpluses and deficits is accounted for by the rest of the world (which is not included in this calculation) and by what national accounts statisticians call "statistical discrepancy."
The most important – and the most reassuring – evidence here is that the global balance of payments is roughly in balance, i.e., it is approximately zero. For those of you who might be theoretically inclined, this is also called Cournot's Law, in recognition of Augustin Cournot, the 19th century French mathematician, economist and philosopher who formulated this relationship.
Safe Haven U.S.A.
Here are some examples of how this concept can be used by investment analysts to anticipate the likely movements in exchange rates and asset prices.
Let's start with the U.S., a country which might need this year some $500 billion of foreign savings to finance its expected current account deficit. (Remember, the sum of current and capital accounts has to be equal to zero.) To attract this large amount of capital, the U.S. will have to compete in global financial markets on the basis of expected risk-adjusted returns on assets it will be offering to foreign investors.
The all-important factor here is the expected risk-adjusted return. This means that the (expected) real price of U.S. assets – which can be calculated on the basis of a set of "hard" numbers (financial variables) - also includes aspects such as creditworthiness, safety and liquidity of America's dollar-denominated investment instruments.
To see how important that is, just think of how much investors valued creditworthiness, safety and liquidity when they stepped up their demand for dollar assets as the euro area once again gravely damaged its credibility during the Cyprus crisis.
(Read More: Troika Risking Its Credibility on Cyprus: El-Erian)
Normally, the large U.S. current account deficit should have triggered rising U.S. interest rates – i.e., falling dollar asset prices. In fact, the opposite happened: prices in U.S. fixed-income markets rose and are showing remarkable resilience (in spite of a hugely expansionary monetary policy), while equity markets hit new record-highs. All that is reflected in the fact that over the past 12 months, the dollar's trade-weighted exchange rate was driven up by more than 6 percent.
But that is history. The question now is: Can the U.S. remain an appealing investment destination in the months ahead?
It most probably can, partly because its main competitor, the euro area, has become a large capital exporter with increasingly unattractive financial markets, where recessions and rising unemployment are serious obstacles to fiscal consolidation.
In addition to that, the euro area has (a) worsening problems of political instability (Italy without government, unfolding corruption scandals in recession-hit Spain and France), (b) dysfunctional banking systems (weak banks and their impaired lending activities despite ample liquidity supplied by the ECB) and (c) lingering uncertainties about the financial system's credibility (problems with depositor and investor protection).
(Read More: France Appeals for German Leniency on Deficit)
India and Brazil: Paying More to Attract Capital
But the other two large deficit countries - India and Brazil - will be unlikely to attract foreign capital flows, at current asset prices, to close their savings-investment gaps, estimated at between 3.5 percent and 4 percent of their respective gross domestic products (GDPs). Their declining currencies against the dollar (8-9 percent over the past 12 months), falling stock market values since the beginning of the year and high (India) and rising (Brazil) bond yields are reflecting their funding difficulties.
In view of this, it is puzzling that these countries complained about "currency wars," alleging that the "monetary tsunami" unleashed by the U.S. and the euro area was threatening their competitive positions by pulling up their currencies, when, in fact, the real and the rupeewere falling against the dollar and the euro.
At any rate, India and Brazil will most probably have to raise their interest rates to reduce their high inflation, and to prop up their currencies to stem imported inflation pressures. That will also be the condition for an orderly financing of their external deficits.
And, if they still want to complain about "currency wars," India and Brazil will have much to fear from the Japanese "monetary tsunami" – if Japan's money printing machines are allowed to keep sinking the yen. My guess is that Japan's trading partners won't allow that. The yen has already gone down more than 16 percent against the dollar since the beginning of the year, and it is now down 12 percent in trade-weighted terms compared with the year before.
(Read More: Yen Selling May Become an 'Avalanche,' Soros Says)
I, therefore, doubt that the yen's further depreciation will be tolerated by a recession-ridden euro area. And with a slow-growing economy and large trade deficits, Washington will probably be even less tolerant of an onslaught of Japanese exports.
In conclusion, I believe that global capital flows will continue to favor the relative safety, depth and the breadth of the vast dollar currency area. But Europeans will rue the day when they decided to bail in bank depositors and investors, instead of properly regulating and supervising their banking systems.
Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia