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Global Imbalances and "Sustainability"

Brad Setser thinks about "sustainability":

RGE - The more the dollar falls, the more dollars you need to buy: That, more or less, is the conclusion of “portfolio balance” models of global capital flows.

The dollar tanks. Its share of your portfolio falls. So sell euros (or RMB) and buy dollars to keep the dollar share of your portfolio up.... The worse the US does (financially speaking), the more financing it gets from the rest of the world. A new IMF paper by Guy Meredith includes a graphic illustration of this.

The US has run huge current account deficits for the past few years. In dollar terms, the rest of the world’s claims on the US are growing. But because the dollar has depreciated and US markets have underperformed, the share of US assets in foreign portfolios has been constant at around 40% of the rest of the world's GDP over the past few years.... The worse US financial assets do, the more financing the US gets -- at least so long as foreigners care more about maintaining a constant dollar share of their portfolio than little things like the actual return on dollar assets....

A portfolio balance model does a better job of explaining ongoing inflows to the US than other models over the past few years. It fits the data.

And one of the strengths of Meredith's paper is that the paper tries to match the model with actual stylized facts in the data. For example, Meredith correctly note that the “US deficits reflect fast growth in the US” story doesn’t hold up.... He notes that much of the financing for the US deficit has come from central banks.... And he note that observed return (looking at the income line on the US balance of payments) on foreign investment and lending to the US has been very low – and well below the observed return on US investment and lending abroad. Throw in valuation losses from the dollar’s fall and low interest/ earnings on US investment and certainly those financing the US haven’t been doing so to make money....

Of course, a portfolio balance model cannot explain the surge in inflows to the US in the late 1990s, when US markets outperformed foreign models. Remember, in these models, outperformance is a reason to get the hell out and move into underperforming places....

If you assume, based on a portfolio balance model, that big falls in the dollar will generate both big valuation gains on US investment abroad and ongoing inflows into the US as foreigners struggle to keep the dollar share of their portfolio constant in the face of a sliding dollar;

If you assume, based on historical norms, that some of the inflows that the BEA measures in the TIC data will disappear from the survey data, reducing the measured US debt stock in the net international investment position (this is Daniel Gros’s explanation for “other valuation changes” otherwise known as statistical manna from heaven);

And if you assume that the US will continue to attract large net inflows even though US investment abroad continues to generate more interest/ dividend income than foreign investment in the US;

Then the US external position looks pretty good for quite some time so long as the US trade deficit doesn't get a lot bigger....

The only question I have is whether these assumptions make sense over time.

But I grant that they do fit the post-2002 data.

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