SPECTER OF TWIN DEFICITS RETURN, WITH A TWIST / BARRON´S ( VERY HIGHLY RECOMMENDED READING )

TUESDAY, DECEMBER 22, 2009

UP AND DOWN WALL STREET

Specter of Twin Deficits Returns, With a Twist

By RANDALL W. FORSYTH

The current-account isn't too small; the real risk is monster budget gaps for years to come.

HERE'S A FRIGHTENING THOUGHT: there aren't enough dollars floating around the globe to buy all the Treasury securities Uncle Sam's government is going to have to peddle.

That's the specter conjured by a senior Chinese official. Because of America's shrinking current-account deficit, the rest of the world has fewer dollars to buy more U.S. Treasuries, Zhu Min, deputy governor of the People's Bank of China told an academic audience, ShanghaiDaily.com reported Monday.

Because of the U.S. fiscal deficit, Zhu contended the dollar would keep declining in value because of continued issuance of Treasury to finance the budget gap.

Zhu's comments should be heard given China is the world's largest foreign holder of U.S. government debt. And also because China has been on something of a buyer's strike since midyear. Indeed, Treasuries sold off sharply Monday following Zhu's remarks, though no market commentator I ran across took note of them or tied them to the market's decline.

But the prospect the U.S. current-account deficit is too small to facilitate funding the budget is surely puzzling to anybody who has followed the debate over the so-called twin deficits over the years. The two are supposed to move together; an expanding fiscal gap supposedly leads to widening current-account deficit.

The basic arithmetic goes like this:

The current account is the broadest measure of international transactions, consisting of trade and financial flows. As such, it represents the difference between what the nation produces and earns and what it consumes. A current-account deficit means a nation consumes more than it produces and borrows the difference, just as a household would.

That also means that domestic savings are less than investments (in the real sense, such as spending on business plant and equipment and residential housing.) A budget deficit represents negative savings since the government is spending more than it's taking in.

Thus, in that way does a budget deficit contribute to a current-account deficit; that is, if, as economists are fond of saying, all else is equal. Which it isn't.

The fiscal deficit has soared to over 10% of gross domestic product while the current-account deficit has fallen about in half from its peak to around 4% of GDP. How could that happen? The Great Recession explains the anomaly.

Even without all the spending on the Troubled Asset Relief Fund, the budget deficit has soared past $1 trillion because of the collapse of tax receipts. But with Americans curbing their spending, the current-account gap has shrunk, reducing the inflow of capital to cover it. (The current account and the capital account have to balance each other; that's why it's called the balance of payments.)

The surfeit of dollars received by exporting nations -- notably China and the oil-exporting countries -- has been recycled largely into U.S. Treasury securities. China's purpose in purchasing U.S. assets is to prevent the rise in the value of its currency, the renminbi. In the process, the dollar is supported and U.S. interest rates are held down.

China clearly has become restive about this arrangement. Earlier this year, officials called for a super-national currency that would at least supplement and eventually supplant the dollar as the world's main reserve and transaction currency.

And the Chinese have acted in accordance with their widely voiced misgivings about the dollar and Treasuries by virtually calling a halt to their purchases and diversifying their reserves into other currencies.

While China purchased $115 billion in Treasuries in the 12 months to October, virtually all of that was from last October through May. Ed Yardeni, the head of the eponymous Yardeni Research noted in a recent research briefing. (Actually, the Chinese did purchase $49 billion since May, only they resided in Hong Kong rather than the Mainland, he adds.)

Even so, Treasury auctions have all attracted ample bids despite the absence of demand from China. That's because U.S. investors have stepped up their buying of Treasury debt.

Banks aren't lending but are accumulating government securities, reaping a handsome profit margin between what they earn in interest and what they pay on their deposits and other liabilities. A 200 basis point (two percentage point) spread between the cost of borrowing (or carry) and what intermediate notes yield can be multiplied many times over with leverage. And regulators are pleased by the improvement in bank asset quality (although the White House is miffed by the lack of lending by "fat cat" bankers.)

Similarly, consumers are saving instead of spending, and are plowing a portion of those savings into Treasuries, either directly or through bond funds. Or if they're paying off borrowings, the banks are plowing the payments into government securities.

So, cross a shrinking U.S. current-account deficit off your worry list. But Zhu and everybody else have reason to be concerned about federal budget deficits that are projected to run at $1 trillion a year through the end of the next decade.

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