Not all Current Account Deficits are Equal

Many observers are concluding that the recent run on the South African rand, the Turkish lira, the Hungarian forint and the New Zealand dollar is a function of their current account deficits. There is some befuddlement then that the US dollar, with a current account deficit above 6% of GDP, has held in so well. The answer to the conundrum is two-fold. First, what is hobbling the many of the emerging markets goes well their external deficits and second, the US current account deficit is in a league of its own.

Since nearly all the emerging market bonds, stocks and currencies are experiencing varying degrees of pressure, the first level of analysis should be on the systemic level. The general facts here are clear. Emerging markets have been among the best performing asset classes for three years. There appears to be a number of considerations behind the reversal of flows, but the important point is that there has been a tsunami of capital that has been moved into emerging market equity and bond markets—more in the first four months of this year than all of last year combined. Market positioning is a significant characteristic of the initial conditions that help explain for the violence of the reversal.

The proximate trigger of the market re-pricing risk may very well lie outside of the emerging market countries whose currencies and assets have been beaten up. In the past, emerging market pressures and sometimes crisis have been most acute during periods of rising US interest rates. What seems remarkable about the current cycle is that the emerging markets did not appear to wobble during most of the first two years of current tightening cycle. Perhaps the explanation lies in how accommodative the tilt to US monetary policy it sought to resist deflationary forces in the 2003-4 period. However, in recent months it has become clearer that central banks from around the world, with few exceptions, were committed to removing policy accommodation. In the early stage of the tightening not only in the US but in Europe as well, broad measures of money supply seemed to accelerate even as the price of money (interest rates) rose.

As the driving force of investment shifted from chasing returns to capital preservation, those places where investors were over-weighted are obviously vulnerable. As an asset class, exposure to emerging markets was clearly one sided. And all have sold off. Yet there are some more vulnerable than others. Developing countries and small countries with current account deficits are clearly vulnerable. They need to import capital at the moment in time when global capital is exiting the asset class. Countries that have large budget deficits and have a large part of this year’s financing needs still to be met are vulnerable. Turkey has about 40% of this year’s external borrowing requirement secured. Poland is another example of a country with still significant external financing needs this year that have not been met.

Countries are also vulnerable where political considerations may hamper the ability to respond to the economic challenges. In Asia, these include the Philippines where Arroya remains under pressure, Thailand where the April election was voided and now will be held in October and Taiwan, where President Chen may face a recall effort. In central Europe, October local elections are seen as a key litmus test for the new government , while Poland has a minority government and pressure on the controversial finance minister led to her departure on June 23. In Czech, a center-right coalition government is most likely, but it is not a done deal and if formed, its longevity is an open question. And this discussion does not even mention the still serious hurdles to euro entry any time soon. There are a number of elections in Latin America this year, with Mexico (July 2) and Brazil (October).

Developing countries tied to a single commodity is also vulnerable, like Chile, even though its macro-economic policies have largely been exemplar. As capital preservation become a dominant investment theme, many high flying commodities also were hit by profit-taking and countries dependent on them are also vulnerable. This would apply more to Latin America and Africa than East Asia. Rising commodity prices had been part of the attraction of developing countries. A shift in the terms of trade provided part of the economic rationale for the investing in some developing countries. While the movement of gold, silver, oil and natural gas are widely appreciated, less recognized is the 25% fall in copper since early May, corn and wheat prices have fallen 13-15%. The CRB is off 10% since record highs were posted near mid-May.

It is probably easier to find emerging markets that can be more resilient to the reversal of capital flows. Brazil stands out as a potential candidate. It enjoys a current account surplus and has met this year’s external financing needs and has begun financing next year’s. Its debt management has been exceptionally astute, reducing debt tied to the dollar and lengthening maturities. While the October election is on the radar screen, the sitting left-of-center president, is running well ahead in the polls and is expected to formally declare his re-election intentions in the coming week or so, but his orthodox economic policies suggest the market’s may not be unsettled by the prospects. Also in Latin America, Peru interesting in light of their election of Alan Garcia as president. He is positioning himself as the anti-Chavez hombre and this not only removes the political uncertainty of the election, but also may attract some investment interest.

In Eurasia, Russia is interesting. Its vulnerability comes from its reliance on commodities, but its potential for strength comes from its improved balance sheet and financial reforms. Starting 1 July, Russian officials have signaled their intention to let the ruble float. The liberalization may attract investment flows.

In Asia, China’s resilience is obvious. International political pressure, its large and growing current account surplus, and the strength of the domestic economy have allowed it to out-perform. The stock market appears to have snapped a 4-year bear market and the Shanghai Composite Index is up more than 40% year-to-date. The currency has been frustratingly stable, having appreciated by about 1.2% this year against the US dollar, but the direction seems clear. Malaysia is also interesting. The currency has slipped marginally compared to most of the others in the region.

Many commentators have suggested that the US dollar should fall because it too has a large current account deficit. It is true that during past episodes of high volatility in the emerging markets has been troublesome for the dollar on through two channels. The first is that any disruption of global capital markets threatens the smooth financing of the US current account deficit. The second is because of the Federal Reserve’s concern about system risks and its willingness to respond accordingly. However, one of the notable characteristics of the current market moves is how orderly they have been by and large. Concerns about systemic risks are surprisingly modest given the magnitude of the moves in a relatively short time period. Also insofar as Americans themselves have been a significant source of funds that have moved into the emerging markets in recent years, the unwinding of these investments may actually help finance the US current account deficit.

Also all current account deficits are not equal. The US current account deficit is exceptional on a number of different grounds that means that it should not be tarred with the same brush used to paint Turkey, South Africa, New Zealand or others. Among the key differences is that US international obligations are all in US dollars. That is simply not the case for other countries. In addition, no other country has amassed such large holdings of foreign assets. The US had claims on foreign assets at the end of 2004, the most recent disaggregated data, to the tune of more than $9 trillion.

The US trade deficit accounts for the lion’s share of the US current account deficit. Roughly half of the US trade deficit is accounted for by the movement of goods within the same company. Arguably intra-firm trade is largely financed by book entry accounting and is different than trade between two separate legal identities. Although our 19th century accounting principles call trade, in the 21st century it is really the movement of goods from one side of a factory floor or office to the other. Lastly, consider the reliability of the data. The plug factor, the line item labeled “statistical discrepancy: was nearly $53 bln in Q1 06, significantly bigger than the combined current account deficits of South Africa and New Zealand which had created such a stir in the markets.