A LETHAL COMBINATION
When it comes to reading the pulse of the international market place there are precious few in the same league as Joe Quinlan at Morgan Stanley Dean Witter. We checked in with Joe late last week and found him worried about "a lethal combination " of declining foreign capital inflows and America's widening current account deficit.
Now, Joe's the first to admit that running a constant, yawning current account deficit need not wreak havoc on a country's exchange rate or monetary policy as long as the deficit is adequately and abundantly financed with international financial flows. The US had enjoyed these benefits of this bounteous union since the beginning of 1996, but now, alas, it has come to a sudden end.
Foreign capital inflows all but collapsed in the third quarter of this year, with aggregate (net foreign purchases of stocks, bonds and DRI) inflows totaling just $26.4 billion. Foreign direct investment inflows, at $27.1 billion, dominated total flows. Net foreign purchases of U.S. stocks and bonds actually fell by about $600 million in the third quarter, as central banks and institutional investors in Asia and Latin America liquidated their dollar positions in an attempt to shore up their own currencies and financial markets.
Against this backdrop, foreign capital outflows exceeded inflows for the first time since 1995, the climax, by the way, of dollar weakness in this decade against the yen and other major currencies.
Remember that the current account deficit measures all U.S. international transactions and must be offset by international financial flows. "In other words," Quinlan explains "a rise in the deficit must be matched by a rise in foreign financing." If the capital or financing is not available at prevailing exchange rates, either the exchange rate is adjusted downward, or the trade balance undergoes a sharp period of adjustment.
"This is a critical point to understand," Quinlan counsels, "since the U.S. current account deficit, which ballooned to $61.3 billion in the third quarter, is expected to continue to rise in the year ahead at the same time that foreign financing is deteriorating."
Indeed, for first time in four years, the current account deficit exceeded the net inflow of foreign financing in the third quarter. That had a predictable impact on the dollar, which took a beating.
"The key risk is that the United States now is running a current account deficit that is not sustainable based on prevailing levels of foreign capital inflows, a development that represents a clear and present danger to both the dollar and the U.S. financial markets in the months ahead."