On The USD's Demise
Last week the BEA published it preliminary take on the international investment position (IIP) of the country. As Citi's FX team note, the IIP measures foreign investment assets minus native assets owned by foreigners. In the US, the IIP has been negative (meaning the US is a debtor nation) since 1985. The US’s IIP deficit reached USD 4.03trn in 2012, up sharply from 2.47trn in 2011. As a share of nominal GDP, the IIP deficit reached a record (for the US) of -27%.
US-based investors hold 41% of their foreign assets in equities and direct investment (property, plant and equipment for foreign subsidiaries). Foreigners have only 26% of their US assets in those two categories. The result of this distinction is that a global equity market downturn will hurt US-based investors more, which means the US IIP deteriorates when equities fall.
Citgroup G-10 FX: Implications for the dollar
Commonly accepted wisdom based on a combination of models and experience is that an IIP bigger than +30% of GDP or smaller than -30% is a problem.
- On the IIP surplus side, having too big of a net creditor position leads to a perennially strengthening currency that chokes out industry and stokes deflation (think JPY).
- On the IIP deficit side, having too big of a net debtor position leads to a debt spiral. High debt leads to reluctant external creditors charging ever high interest rates, which leads to economic stagnation and ultimately crisis. This blueprint has played out a number of times in emerging market economies.
The US dollar is not an emerging market currency, of course. It is not like any other G10 currency, either. As the global numéraire, it is has been able to remain the undisputed principal reserve currency despite the US being a net debtor nation since 1985. With that in mind, it seems likely that the IIP deficit threshold that would put the US in a debt spiral is higher than for other countries. At present, with the US bond market still able to attract foreign investors at 10Y yields below 2%, a crisis appears a long ways away. The US may not be able to run another dozen years of 3-6% current account deficits without starting to look like a ponzi scheme, but it can probably run another few years without problems, particularly if there is no other reasonable alternative as a reserve currency. At this stage, EUR is not credible and CNY is not ready in terms of FX liquidity or capital market depth and transparency.
If/when the US finally gets close to the critical IIP deficit threshold that makes foreign investors nervous, two things should happen. First, the USD should cease to appreciate during bouts of global risk aversion and begin to depreciate. Perhaps at an early phase the ‘beta’ of the USD relative to global equities will start to evolve from distinctly negative towards positive. There are no signs of this happening. The second thing that should happen as the US approaches an external debt spiral is that US rates should rise rather than decline during risk aversion episodes. At this stage, there is no evidence of even a moderation in the ‘beta’ of US bond yields relative to global yields.
While risk aversion flows (and rates) suggest there is little to worry about, we have noted again and again the moves behind the scenes in global trade flows to shift away from the world's current numeraire.