Deficit financing ; Investments, Foreign - United States ; Saving and investment ; Interest rates

Michael Keran

English

Research Papers in Economics

FRBSF WEEKLY LETTER
July 6, 1984
Budget Deficits and Foreign Savings
It has recently become popularto pointoutthat
foreigners are financing a significant part ofour
federal budget deficit. Manyconsider this a
fortuitous developmentthat will allowthe U.S. to
finance a large increase in domestic investment at
the same time. The only risk they see is that this
foreign saving mightdisappear as quickly as it
apparently developed, and drive U.S. interest
rates up in the process.
This Weekly Letter explains the foreign savings
inflow as another "economic distortion" associ-
ated with large budget deficits. More specifically,
the inflow results from an increase in ourcurrent
accountdeficitbroughton by an appreciation of
the dollar. The dollar's increased strength comes
from the higher long-term interest rates, caused by
expectations of large budgetdeficits, that make
u.s. securities moreattractiveto foreign as well as
domestic investors. Because the inflow simply
mirrorsthedeterioration in ourtrade position with
the rest ofthe world, it involves costs to the
economy. Furthermore, this analysis suggests that
thewithdrawal offoreign savings can only
develop slowly and is most likely to be associated
with a fall rather than a rise in U.S. interest rates.
Deficits and long-term rates
Budget deficits affect long-term interest rates
because financial makets are forward-looking.
That is, interest rates are strongly influenced by
expectations ofdevelopments in inflation,
business cycle growth and government deficits
over the next five to ten years.
As an example, take the actions ofCongress and
the Administrationto cuttax rates and increase
defense spending in 1981. By raising expectations
offuture deficits, they also raised long-term
interest rates even though the actual deficit in
1981 was substantially less than those in the
period 1982-83. Indeed, the 20th century peak
in long-term Treasury interest rates occurred in
September 1981 (some weeks after the largest tax
cutin historybecame law) even whilethe inflation
rate was declining and the economy was in a
recession. In addition, tight monetary policy until
mid-1982 raised short-term interest rates relative
to long-term rates and thus also contributed to
generally higher in,terest rates at that time.
Chart 1 illustrates howthe gap between inflation
and long-term nominal interest rates has widened
substantiallysinceearly 1981. Surveys offinancial
market participants indicate long-term expecta-
lionsof inflation have been in the 6.5 to 7 percent
range forthe last two years. This suggests that real
long-term interest rates have been substantially
highersince 1981.
Interest rates and exchange rates
In general, the longer the maturityofthe under-
lyingU.s. dollar-denominatedasset, the largerthe
exchange rate response will be to a rise in interest
rates. This relationship is based on accepted inter-
est rate arbitrage conditions that provide a link
between long- and short-term markets. It is based
on twooffsetting factors that affectthe foreign
demand for u.s. securities: real interest income
and exchange rate risk from holdil1g U.S. assets.
The higher is the real interest incomefrom owning
U.s. relative to foreign assets, the greater will be
theforeign demandfor U.S. assets. But, thegreater
the riskofexchange rate loss aforeignermaysuffer
from holdingdollar assets, the less will be the
foreign demand for u.s. assets. A rise in U.S. real
interest rates will quickly increase the foreign
demand for U.S. assets and drivethe current
exchange value ofthe dollar above its future
expected value. At the pointwhen the extra inter-
est earned on U.S. assets just matches the extra
exchange rate loss expected from future dollar
depreciation, there will be nofurther incentives
for foreigners to increase their demand for u.s.
securities, and the dollarexchange rate will reach
at least temporary balance.
The netofthese two factors explains why long-
term rates have a bigger impacton the exchange
valueofthe dollarthan short-term rates. IfU.S.
3-month interest rates increase by 1 percent, then
the extra interest rates abroad will be one-quarter
ofa percent forthree months. In this short-term
case, the exchange rate must only rise by one-
quarterofapercentnowand beexpected tofall by
the same amountover the nextthree months for
/FRBSF
the exchange rate loss to just match the extra
interest income. However,ifU.s. lO-year interest
rates rise by 1 percent, they would increase the
extra interestincomeby 10 percentage pointsover
comparable foreign assets. For the exchange rate
loss to match this extra interest income, the
exchange value ofthe dollar must rise by 10
percentage points nowand be expectedtodecline
byone percentperyear overthe next ten years.
Expectations that budgetdeficits will rise signifi-
cantlyover the next 10years tend to raise interest
rates on 1O-year securities. They also drivethe
exchange value ofthe dollar up by approximately
10timesthe rise in the interestrate. As can be seen
in Chart 2, the weighted average exchange value
ofthedollarstarted to rise substantially in 1981, at
aboutthe same time that real interest rates started
to rise.
If, as a first approximation, one assumes that the
exchange rate will return to its purchasing power
parity (PPP) value in the long-run, deviations of
exchange rates from PPP could be explained by
real interestrate differentialsbetweentheU.S. and
abroad. A 2.5 percentincrease in U.S. reallO-year
rates over foreign 10-year rates would explain an
exchange rate 25 percent above PPP in mid-1982
and one which stays about 25 percent "over-
valued" through early 1984 (see Chart 2).
International tradeand foreign savings
When u.s. real interest rates started to rise in
1981, they led to an immediate increase in the
desire offoreigners to purchase U.5. securities
and, via the exchange rate mechanism described
above,toan immediateappreciationofthedollar.
Only as the dollarappreciation increased our
trade and current accountdeficitcould there
develop an actual inflowofforeign savings.
The U.5. current account is our broadest measure
oftrade in goods, services and transfer payments
with the rest ofthe world. In 1981, the current
accountregistered a$5 billion surplus. By 1983, it
was $40billion in deficit, and in thefirstquarterof
1984,about$78 billion in deficit(atannual rates).
While there will always be large gross flows of
funds intoand outoftheU.5., anetforeign savings
inflow can occuronly when the U.S. current
account is in deficit. Only in this way can U.S.
residents, on balance, go intodebtto foreign resi-
dents. Thisdebtis satisfied by selling U.s. assets to
foreigners. Driven bythe largefederal budgetdefi-
cit, high real interest rates in the U.S. make itmore
attractive for foreigners to purchase u.s. securi-
ties, whilethe high exchange value ofthe dollar
makes the purchase of U.5. goods less attractive.
U.S. interest rates are now most likely lowerthan
they otherwise would have been had foreign
savings inflows not increased significantly in the
lasttwoyears. As a resuIt, thecrowdingoutcaused
by budget deficits has occurred in our net export
position rather than in domestic fixed investment.
This can be seen by comparingtwo statistics.
Business investment as ofthe first quarter of 1984
is almost 1 percent above its business cycle peak
in mid-1981:That is an unusuallyfast recovery in
investmentthis soon after a recession. On the
other hand, real net exports have declined by 3.5
percentofreal GNPfrom mid-1981 to early 1984,
when in the same stage ofprevious business
cycles, ithas typically increased. The U.s. export
and import-competing sectors are now smaller
than ifthey were not being "crowded out" by
governmentdeficits.
Future courseofforeign savings
How much longer can the U.S. current account
deficitand theforeign accumulation ofU.S. assets
continue? And, are still higher interest rates
needed forforeigners to finance the $150-$200
billion cumulative U.s. current accountdeficits
forecast for the nexttwo years?
One lineofreasoning suggests thatforeigners may
soon reach a limit on the amountof U.5. assets
they desire to hold even at current high U.S. real
interest rates. To put $150-200 billion oftheir
international portfolio into U.s. assets overthe
nexttwo years presumably would require an
increased risk premium. In such acase, onlyarise
in U.s. interest rates, and/ora fall in the exchange
valueofthe dollar(thereby reducing the risks ofa
further dollar depreciation) could induceforeign-
ers to continue buying U.S. securities at a rate
equal to the size ofourcurrent accountdeficit.
However, at least with respect to the period
1984-85, the economic and political stabilityof
the United States argues thatforeigners would
require relatively small risk premiums to increase
their holdings ofU.S. securities. Given the highly
integrated international capital market, foreign
residents are probably as willing to hold an
increased share of U.s. assets as New York
residents are willing to hold ofCalifornia assets.Percent
Michael Keran
·Consumerinflationis measured by percent change of the Personal
Consumption Expenditure Deflator over one year earlier.
1984
1984
1982
1982
1980
1980
1978
1978
1976
1976
CHART 1
Long-term Interest Rates and Inflation
CHART 2
U.S. Dollar Exchange Rate
and Purchasing Power Parity
U.S. interest rates, could decline quickly in the
face ofa decline in foreign preferences for U.S.
assets. Foreign savings flows would be reversed
only slowly as the dollardeclineeventually leads
toa u.s.currentaccountsurplus. This would most
likelyprevent U.S. interest rates from falling as
much as they othE!rwise would. However, the
outflow is not likelyto be a strong independent
force in raising interest rates.
16
14
12
10 . ;-~
~~
8 ....:""""'......_-"', ~~
~.. , ~
6 ~.... #fl.' .,. '-; . ,
4 Consumer Inflation·',, ...
2L......L.--I_..L......._ ....................I1.... ---I
(Source: Morgan Guaranty 'World Financial Markets')
• Trade weighted index of foreign wholesale prices relative to U.S.
wholesale prices.
1975 = 100
125
120
115
110
105
100
95
90 L....&._.l.--L_-'---II--.;.a.._........L_............
Another lineofreasoning suggests that a foreign
savings inflowof$150-200 billion overthe next
twoyears, whileunprecedented, can be sustained
because itwouId represent onIy6-7percentofthe
netsavings ofother industrial countries ofthe
world. Ifsuch were the case, the only reason that
foreigners would reduce their demand for U.S.
assets is iftherewereafall in U.s. real interestrates
or a rise in the expected rate ofU.S. inflation
brought on by a change in U.S. monetary orfiscal
policy. IfCongress and the Administration signifi-
cantly changed fiscal policy by reducing the bud-
get deficit, they would permita decline in both
real and nominal interest rates. The desire offor-
eigners to hold u.s. securities would correspond-
inglydeclineand result in an immediatefall in the
exchange value ofthe dollar. Real interest rates
and exchange rates would fall together, reversing
their parallel rise since 1981. This would be a
healthydevelopmentbecause itwould helpelimi-
natethe dollar'scurrent"over-valuation"without
the need for a significant easing in monetary
policythat may increase fears offuture inflation.
The alternative is forfinancial marketstothinkthat
the expected large future deficits would be
financed by an increase in the money supply and
higherfuture inflation. Such an expectation would
reduce real interest rates by shifting the burden of
financing goverment spending away from indus-
tries that are significantly affected bytight credit
markets toward those households whose after-tax
incomes rise by less than the inflation rate.
This decline in real interest rates would probably
not be associated with a decline in nominal
interest rates, which would ultimately have to
increase to reflect the rise in inflation expecta-
tions. In this case, foreigners would lose confi-
dence in the real purchasing poweroftheir U.S.
assets, as occurred in 1977-78, and therefore
reduce their demand for such assets. The
exchange value ofthe dollar would decline
promptly as itdid in the earlier period.
Conclusion
This analysis suggests thatthemost likelysource of
a change in the foreign desire to hold u.s. assets
would be a change in U.S. monetary orfiscal
policythat significantly alters real interest rates or
inflation expectations. But while policy changes
can quickly affectthe desire to hold U.S. assets,
actual foreign savings flows can change only
slowly, through adjustments in the U.S. current
account balance. Thus, exchange rates, but notBANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollaramounts in millions)
.J!ll!:) 'o:>spUl!J::I Ul!S
lSL·ON IIWH:ld
mVd:l9VISOd·s·n
llVWSSVl:> ISHI::I
aUHOS:lHd
Selected Assets and Liabilities
Large Commercial Banks
Amount
Outstanding
6/20/84
Change
from
6/13/84
040PI !!omoH O!UJoJUO) ouozPtJ 0>1soltJ
O)SI)UOJj UOS
JO ~U08
aAJaSa~ IOJapaj
~uew~Jodea lpJOeSe~
change from 12/28/83
Percent
Dollar Annualized
Loans, Leases and Investments1 2 180,698 625 4,673 5.5
Loans and Leases1 6 161,371 617 6,016 8.0
Commercial and Industrial 48,875 354 2,912 13.1
Real estate 60,118 57 1,219 4.3
Loans to Individuals 28,407 127 1,756 13.7
Leases 4,988 - 15 - 75 - 3.0
U.S. Treasury and Agency Securities2 11,953 14 - 554 - 9.2
OtherSecurities2 7,375 - 5 - 788 - 20.0
Total Deposits 187,138 -1,434 - 3,859 - 4.2
Demand Deposits 44,290 - 637 - 4,947 - 20.8
Demand Deposits Adjusted3 28,482 -1,748 - 2,849 - 18.9
OtherTransaction Balances4 12,039 - 396 - 736 - 11.9
Total Non-Transaction Balances6 130,809 - 400 1,824 2.9
MoneyMarket Deposit
Accounts-Total 37,361 -1,702 - 2,236 - 11.7
Time Deposits in Amounts of
$100,000ormore 39,403 - 68 1,238 6.7
Other Liabilities for Borrowed MoneyS 23,661 5,888 654 5.9
Weekly Averages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+)/Deficiency (- )
Borrowings
Netfree reserves (+)/Net borrowed(-)
Period ended
6/18/84
45
131
86
Period ended
6/4/84
32
115
83
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading account securities
3 Excludes U.s. governmentand depository institution deposits and cash items
4 ATS, NOW, Super NOWand savings accounts with telephone transfers
S Includes borrowing via FRB, TI&L notes, Fed Funds, RPs and other sources
6 Includes items notshown separately
Editorialcommentsmaybeaddressedtotheeditor(GregoryTong) ortotheauthor••..Freecopiesof
Federal Reserve publicationscan beobtained from the Public Information Section, Federal Reserve
Bank ofSan Francisco, P.O. Box 7702,San Francisco 94120. Phone (415) 974-2246.

Budget deficits and foreign savings

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Budget deficits and foreign savings

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