Portfolio manager’s Letter November 2003
Recently there have been a number of stories in the financial press referring to the cumulative US trade deficit as a form of debt. I, as investment manager, can understand that the average financial journalist managed to skip the part of his education that dealt with current account deficits and capital account surplus, but in September the economist featured a story about this countries trade deficit. “The Price of Profligacy” the sub-title was “how bad is American’s borrowing binge?” clearly indicates the author’s belief that the trade deficit creates debt, yet this conclusion is economic nonsense.
This Economist story is full of absurdities that make you wonder about the author’s ability to understand of his subject. There was a chart entitled “sinking into debt” that is actually graphical representation of American’s cumulative Capital Surplus. If you don’t understand the difference between debt and capital why are you writing for the Economist? There was another chart were the trade deficit is clearly labeled “net Foreign Debt”.
Our international Payments are always in balance, with any deficit in the trade and other Current Accounts offset by a surplus in the capital account. The Capital Account is made up of direct investments, equity and bond flows; and long term bank debt. If foreign investors are investing more money in this country than Americans are investing aboard then there is a capital account surplus. But a Capital Account Surplus is not debt. While a portion of these investments may be in instruments of debt, no new debt is created; existing debt is just changing hands from a domestic investor to an international one. The transactions, even when bonds are involved, do not create debt. Does it make any difference to the issuer if it’s debt is held by a bank in Cincinnati or a bank in Rangoon? His interest expense has not changed in any way.
If the cumulative trade deficit is $2.5 billion as Warren Buffett says in his Fortune article, then that means foreign investors and residents of other countries who hold American currency, have provided this country with 2.5 billion in capital. If we look at the income accounts we find that this is pretty cheap capital. In 2002 America’s net payments on foreign investments was $4 billion (Interest and dividends paid minus interest and dividends received from our foreign investments). So the capital inflow to this country came at a cost of less than two tenths of one percent (.0016%). If you could get money at two tenths of a percent how much would you take?
Some of the above capital inflow has now turned into bubble food. How much is anyone’s guess, but it is possible that the world may not end up entirely satisfied with their bargain.
The World Wants Dollars
It has always been my, as investment manager, view that trade deficit is more a refection of the worlds desire to hold dollars than it is anything else. The current account (trade and services) is in deficit because there is a Capital account surplus, not the other way around. The most important thing to understand about the US trade deficit is that it has nothing to do with trade policy. Should the American consumer complain because the third world wants to use dollars as part of their money supply, or because European investors want to buy the debt of the U. S. Treasury and of our large corporations?
But the driver of this truck is the Capital Account, not the current account. Does the institutional investor in Europe buy GE Debt because he knows there is some guy in Des Monies that wants to buy a Mercedes? I, as investment manager, don’t think so. He buys the debt because he likes the return relative to the risk. The World does not buy American Assets because of a desire to subsidize the American consumer. Foreign investors buy American stocks or bonds because they anticipate a decent return. The Capital Account Surplus is determined by foreign investors and their investment decisions. In making these decisions none of these investors gives a damn how much Americans are spending on Japanese SUV’s.
The Savers in the third world do not keep dollars in their wall safe because he wants to help Americans buy DVD players. He keeps dollars in the safe because he does not trust the local banks, and because his nation’s currency is constantly losing value to inflation.
Let’s say that you live in Russia or China or any of the other developing economies of the world were the banking system is unable to offer complete security to their depositors. In these countries you may use a bank for currency exchange transactions and to pay bills that you can not pay with cash, but your personal saving goes into the wall safe. This may be because you do not trust the neighborhood bank to be always solvent, or it may be because you do not want tax collector to know how much savings you have.
In any event, if you are stuffing your wall safe you want to stuff it with currency that will hold its value. So this means that as currency of different types comes into your hands you will spend the local currency but the Dollars, Euro, and Pounds go into the safe.
According to figures from the Federal Reserve there was $697 Billion of US currency in circulation in September 2003. No one knows exactly how much of this remains on-shore , but estimates are that at least 60% of our currency in circulation has left the country. 60% of $697 Billion is $418 Billion.
If this is correct then 17% of Warren Buffett’s estimated $2.5 billion of foreign investments are held in the form dollars in the wall safes in the third world. I, as investment manager, fail to see how this U.S. currency held abroad represents any huge threat to our economy, and I doubt that much of it will return. Indeed it may well be an important part of the world money supply. To the extent that this currency is part of the money supply of the third world, any overt attempt to reduce it, or repatriate it, would have a negative impact on the world economy. This currency is a U.S. asset that is held voluntarily by people outside of this country which costs us nothing, and may well be beneficial to the world as a whole.
If we accept the premise that the Capital Account drives the Trade Deficit then when we look at historical trends we are likely to draw different conclusions from Warren Buffett in his Article. The existence of a trade surplus (Capital Account deficit) for the years after World War II would be a reflection of the size of the American economy relative to the rest of the world. We had most of the capital and so there was not much international capital available to buy American Assets. But as the world economy grew faster in the sixties and seventies other counties, such as Japan, acquired large amounts of capital. A lot of this was invested in American assets in the late Seventies because of very high interest rates in this country, and good prices for equity investments caused by a bear market.
Thought-out the eighties the world economy was growing rapidly and high American interest rates continued to feed the Capital Account Surplus. In the Nineties Japan experienced a high savings rate and very low interest rates. With much better returns available from American investments is it any wonder the Capital continued to flow in. It is also likely that the great stock bubble attracted a lot of foreign money.
As to the future I, as investment manager, do not see that the current high level of foreign investment will lead to disaster. In general it seems likely the present trends will more or less continue. The American Capital Markets are the strongest in the world and don’t see a lot of competition in this Area. Certainly there will be mountains and valleys in the currency markets. The intermediate trend of the dollar will probably be down. The decline of the dollar will aggravate inflation in this country, and will eventually drive interest rates up and the stock market down. But if foreign investors want to leave the American Markets entirely where are they going to go? Higher interest rates will eventually bring foreign investors back and the decline of the dollar and in stock prices will create values that will, at some point in the future, make American Assets attractive to foreign investors again.