What's the tipping point?
ASK THIS | December 17, 2004
At some point, won't foreign central banks stop financing us? The third of five questions reporters should be asking about who's lending us all this money, why, and for how long?
By Brad Setser
Q. Why is the U.S. running a large trade deficit, and who is financing that deficit?
Q. Why are foreign central banks investing in the U.S., if not for high returns?
Q. When will foreign central banks stop financing the U.S.? When will the tipping point occur?
No one really knows. But there is little doubt that many in the markets are starting to get a bit nervous. They are watching the data that show central bank purchases of Treasury bills very, very closely for any signs that foreign central banks are losing interest in the U.S. If the dollar starts to fall – or if the price of Treasury bonds starts to fall (corresponding to higher interest rates) – foreign central banks holding Treasuries risk big losses. The way to avoid those losses is to get out before everyone else. But if too many central banks stop new lending to the U.S., let alone start selling their bonds, the whole system of vendor financing will unravel.
The tipping point could come quickly. But the system of central bank financing could also last for a while longer, particularly if China keeps its exchange rate pegged at the current low level and Japan resumes large scale dollar purchases to keep its currency from rising against the dollar. But I have a hard time seeing how the current system survives for much longer than two years.
Since the U.S. currently relies on foreign central banks for between $450 and $500 billion in annual financing, keeping the system for another two years would imply that foreign central banks would have to lend the U.S. another trillion dollars on top of the close to a trillion that they lent to the U.S. over the past two years.
That, first, is a lot of money. The U.S. is running up its external debt very rapidly, and at 30% of our GDP, our external debt is no longer small. Second, every dollar foreign central banks lend to us increases the size of the losses they would take should the dollar fall in the future. Yet it is hard to see how the U.S. can reduce its need to borrow from the rest of the world unless the dollar falls: no country can import about 15% of its GDP and export less than 10% of GDP indefinitely. Over time, our imports will have to fall (relative to our GDP) unless our exports rise. Our fastest growing export right now is debt. That cannot last forever.