The Current US Account Deficit Matters

Axel Merk, May 23rd 2006

Is the dollar at risk because of America's enormous current account
deficit? Many "experts" are spreading information that is
confusing, outdated or simply not applicable. Yes, the current account
deficit puts the dollar at risk; at the same time, however, a lower
dollar will provide no long-term solution to the current account
deficit.

The current account deficit is the trade deficit plus certain financial
flows. It is precisely the amount foreigners must acquire in US
denominated assets to keep the dollar from falling. In 2005, foreigners
picked up the tap of over $800 billion - or more than $2 billion a
day. If we buy sneakers from China, but have nothing to sell to the
Chinese, it makes the current account balance worse; if our government
issues debt that is not acquired by domestic taxpayers, foreigners are
lending a helping hand to finance our spending. The current account
deficit is now about 7% of gross domestic product (GDP) -
historically, currencies have caved in when the current account deficit
has been above 5% for an extended period.

Some say in the grand scheme of things, even a $1 trillion deficit a
year does not matter because America has tens of trillions in assets.
That analysis compares apples with oranges. If you earn $100,000 a
year, but spend $120,000 a year with $1 million in the bank, of course
you are not going to be broke tomorrow. Indeed, if you spend the
$120,000 to invest in a new business, you may justify carrying negative
cash flow until you reap the rewards of your investment. But if you use
the $120,000 to consume, you should seriously think about how
sustainable your lifestyle is. America's savings rate turned negative
last year.

The more relevant aspect, however, is that one cannot mix cash flow
items with balance *** items. It may well be that we have untapped
reserves - there may be lots of family silver we can still sell. But
the current account deficit must be financed every single day at a rate
of over $2 billion a day; otherwise, the dollar will fall.

Some argue that the reasons foreigners finance the current account
deficit because they like investing in the US. Almost: foreigners
invest in dollar denominated assets because they perceive it in their
interest. Asia over the past years has been highly dependent on export
to the United States. By buying dollar denominated assets, they can
keep their currencies weak: when the Chinese sell sneakers to American
consumers, you receive dollars in return; the Chinese in return have to
decide what to do with the dollar they receive. If they were to sell
dollars and buy Chinese yuan, there would be upward pressure on the
yuan. If, however, they re-invest their dollars in denominated assets,
they can keep their own currencies weak to have more competitive
exports.

Those who say foreigners like to invest in the US forget an important
aspect: the daily financing requirement. We don't need foreigners to
sell dollars for the dollar to fall, we just need them to buy less.
Because of the current account deficit, the US has become extremely
vulnerable. If we alienate foreign investors, they might just allocate
some of their new investments elsewhere.

And that's where the crux of the issue lies: do we do enough to make
the US an attractive place to invest in? US companies seem to prefer
deploying their large cash holdings by expanding overseas. Assume that
the US economy will slow down - will foreigners be as inclined to
invest in the US as they have over the past couple of years? Assume
protectionist sentiment continues to increase, won't foreigners be
tempted to establish new trading channels?

We have focused many of our writings in recent months on the threat of
a US slowdown and rising protectionism because we see these as
instrumental warnings flags for a possible further fall of the dollar.
It doesn't matter that other countries may be less open than the
United States - these countries have their own set of issues, but
they do not have a $800 billion current account deficit that needs to
be financed daily.

The general perception is that foreigners, in particular central banks,
mostly purchase US Treasuries. In my view, any analysis that is
published now and focuses on this point should include that there has
been a qualitative shift in the interest of foreigners. Over the past
year and a half, it has become increasingly clear that Asian
governments are looking for ways to secure their future resource needs.
Since then, red flags have been raised by American politicians when
foreign companies want to acquire resources that may be considered of
strategic importance to the US. The attempt by the state-controlled
Chinese oil conglomerate CNOOC to acquire the (non-US) assets of US
based Unocal caused a firestorm that caused the transaction to be
abandoned. The CNOOC/Unocal transaction was the first in a series that
has highlighted that the rest of the world is not interested in buying
US made sneakers, but technology and resources that we are reluctant to
export. As the world tries to keep the global boom going, we see
increased friction with a serious potential to have protectionism
escalate. And there has been an alarming up-tick globally that may spur
a tit for tat game: most recently, Bolivia announced it will
nationalize its oil & gas industries; in Peru, there are threats made
against the mining industry; in China, Citigroup was told it cannot
take control of a Chinese bank. Protectionism does not rise out of thin
air - it is a human reaction to a threat that is perceived to come
from the outside; we say "perceived" as the roots are far more
complex and domestic policies tend to be as much to blame as
foreigners. Textbooks warn about the threat of protectionism because of
the experience during the Great Depression; yet when times are tough,
it is all too easy to blame foreigners.

But it is just as human to fight the symptoms rather than the disease.
Strikingly, if you look at Federal Reserve (Fed) Chairman Ben
Bernanke's book analyzing the Great Depression, you will find
discussions on how too strong a dollar due to the gold standard made
the Depression more severe; you will find a discussion on monetary
contraction during the Depression. But what about a discussion of the
dangers of the credit expansion that set the stage for the Depression
in the first place? Similarly, we have had extremely accommodating
monetary and fiscal policies (low interest rates and taxes) for years;
the focus in an upcoming economic slowdown will likely be on how to put
growth as the number one priority on the agenda.

We now hear every day how US policy makers want a weaker dollar - how
the Chinese are "unfairly" subsidizing their currency. Under
Greenspan's reign, Fed officials would never discuss the dollar.
Bernanke has done so already on a couple occasions, not succeeding at
doing so only indirectly when discussing the current account deficit.
In our view, the new Fed has no credibility when it comes to the
dollar, and policy makers should be very careful what they wish for.
Most recently reported import prices were up over 2% month over month;
the most recent unemployment report showed slowing job growth with
increasing pressure on wages.

To top all these fears off, the US now pays more in interest to
overseas investors on their investments in the US, than the US receives
in interest from its investment overseas. A relationship more typically
associated with a third world country means that higher interest rates
in the US do not automatically make the dollar more attractive as we
owe foreigners even more in interest payments.

There are those who argue that Americans mostly invest in
infrastructure overseas, whereas foreigners tend to buy interest
bearing securities. As a result, we will reap the benefits in years to
come. Maybe, but again, we are mixing apples and oranges - as far as
the dollar is concerned, we need to worry about the current account
deficit to be financed today.

Those worried that the budget deficit puts additional pressures on the
dollar may be correct in the long-term, but these deficits do not carry
the same urgency as the current account deficit.

The current account deficit could be reduced by an increase in foreign
consumption and a decrease in foreign savings; by a decrease in
domestic consumption or an increase in domestic savings; or by an
increase in domestic real purchasing power. Let us examine these:

Bernanke talks about a global savings 'glut' - what he means is
that e.g. the Chinese that save up to 40% of their income are not
consuming enough. The focus on an increase in consumption in the rest
of the world is understandable. It would allow the current account
deficit to shrink without many of the feared negative side effects,
such as a severe recession or a much weaker dollar. Part of the reason
the Chinese are such excellent savers is because their capital markets
are still in their infancy; the Chinese trust their savings accounts.
While a middle class in China is growing, we doubt that the pickup in
worldwide consumption will be fast and sufficient enough to rescue the
current account deficit. It also remains to be seen what these
consumers will consume - what consumers goods do we produce in the US
that are attractive to Chinese consumers? Let us also not forget that
the growth policies pursued worldwide have created bubbles not just in,
say, the US housing market, but also in Asia. Asian economies are
rather vulnerable right now; much of the reason why Asia is supporting
the dollar is precisely because of their own bubble economies -
policy makers are concerned about severe local recessions should their
currencies strengthen. We have stayed away from Asian currencies in the
Merk Hard Currency Fund because we do not trust that Asian central
banks will stand by and see their economies falter if and when the US
economy slows just as upward pressure on their own currencies
increases. Asian central banks will be tempted to engage in competitive
devaluation of their own currencies.

What about saving the current account deficit with decreased domestic
consumption? That sounds nice on paper, but translates to
'recession' in plain English. It is a likely scenario, not one
favored by policy makers. Indeed, part of the reason why gold has
performed so well is that many expect that a weakening economy will be
fought with further fiscal and monetary stimuli; the fear here is that
inflation, which has been progressing through the production pipeline,
will not be contained. The reason why inflation has not shown up in the
'core' government statistics is because globalization has held back
inflation on anything we can import from Asia.

What about an increase in domestic savings? It would help, but unless
we have it accompanied by real wage growth, we will have to reduce
consumption to increase savings. Indeed, we expect that the savings
rate has to go up as investors can no longer extract equity from their
homes as the real estate market abates. We do not need the real estate
bubble to burst for home owners to take stop taking money out of their
homes; all we need is for the market to be stagnant - especially in a
rising interest rate environment. And while globalization has so far
held back inflation, it has also kept back real wage growth. We like to
cite the example of an American based producer that is squeezed by both
high commodity prices (courtesy of global overproduction) and low
pricing power (courtesy of cheap imports and high consumer debt): the
prudent manager will put an increased emphasis on outsourcing to remain
competitive. This is the reason why job and wage growth have lagged in
this economic expansion.

The beauty of the US economy is its flexibility. Workers in debt with
only limited unemployment benefits must find a new job quickly. As a
result, new businesses that are able to cope and thrive in this new
environment are created. However, we are concerned that the policies in
place over the past couple of years will at some point cause a
political backlash. Many workers - and not just blue collar workers
- feel that they have to work harder than ever while not earning more
money. We are concerned that such an environment will be a breeding
ground for populist politicians and increased protectionism. And as we
impose barriers on trade, we will be penalizing foremost those firms
who have learned to adapt to the current environment. This is not the
place to argue what a fair trade policy should be, but we want to put
out the warning that one has to be very careful when we politicians
impose solutions on the market.

A lower dollar will not resolve the structural challenge the US is
facing. A lower dollar will not re-create the US manufacturing
industry. A lower dollar will not turn America into a nation of savers.
We believe the pressures on the dollar will persist as long as there
are not fundamental changes that will truly promote savings and
investments. And to make it perfectly clear, we do not have an
"ownership society" as long as the banks are the ones owning our
homes.

We manage the Merk Hard Currency Fund, a fund that seeks to profit from
a potential decline in the dollar. To learn more about the Fund, or to
subscribe to our free newsletter, please visit www.merkfund.com.

Axel Merk
Manager of the Merk Hard Currency Fund, http://www.merkfund.com/

The Merk Hard Currency Fund is a no-load mutual fund that invests in a
basket of hard currencies from countries with strong monetary policies
assembled to protect against the depreciation of the U.S. dollar
relative to other currencies. The Fund may serve as a valuable
diversification component as it seeks to protect against a decline in
the dollar while potentially mitigating stock market, credit and
interest risks-with the ease of investing in a mutual fund.

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