Account Deficit US Financial Crisis

8/7/2019 Account Deficit US Financial Crisis

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US Financial CrisisGreat Lakes- H4 G8 & 9


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-Nirmaan Parikh [FT11436]

-Omkar Barve [FT11437]

-Porag Dutta [FT11438]

-Praveen Patil [FT11439]

-Prasad Nair [FT11440]

-Priyank Sinha [FT11441]

-Purnendu [FT11442]

-Rachna Saini [FT11443]

-Rahul Jain [FT11444]

-Rahul Raj [FT11445]

Prepared by


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USA hegemony in the world today

Que stions

Current Account deficit in U SA- Why? Will the worldcontinue to fund the U S CAD?

Is Current Account deficit a cause for the financial crisis-Yes/No- Why?

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Can $ be the currency of the future? Or USA in post USAera or Is U SA over?


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The broadest measure of trade in goods and services and incomeand transfer payments. Is a sum of balance of trade, net factor andnet transfer payments.The Current Account Deficit is the country s trade deficit plusinterest payments on what the country borrows from foreigners tofinance the trade deficit.Current Account Deficit occurs when the net imports of goods,services and transfers is greater than exports of the same.

This situation makes a country a net debtor to the rest of theworld.

Q1. Cu rre nt Acco u nt d ef icit


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US consumer spending was rising rapidly due to a combination of Tax cuts

Low interest rates

Rising house prices

With rising consumer spending theUS

has been increasing the value of imports bought into the economy.

This caused a large influx of exports with a disproportionate sale of domestic products.

Decline in competitiveness: US manufactured goods have been losing

comparative advantage to Asian economies due to the wage costs in USbeing much higher. In particular China has seen its trade surplus withAmerica grow due to its low labor costs.

Cau se s o f US Cu rre nt Acco u nt D ef icit


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American corporations have moved production facilities to othercountries; greatly reducing the influence and scope of U .S . exports.Relatively high value of dollar: Dollar has not devalued as expectedfor an economy with a large current account deficit. The US hasremained an attractive location for Capital investment.This inflow of capital has financed the current account deficit andencouraged America to keep buying imports.The inflow of capital has also enabled interest rates to remain low.Because China has bought so many US government bonds the US hasbeen able to finance its national debt whilst keeping interest rates low.

Cau se s o f US cu rre nt acco u nt d ef icit contd .


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Low interest rates have encouraged consumer borrowing and consumerspending; a major cause of the current account deficit.

Other countries, especially China, are investing billions in Americanassets. US A is the world s largest debtor and China now holds a significantamount of those bonds.

In the past 12 months the dollar has been in decline but to reduce thecurrent account deficit it would need to fall by more than 20%

Cau se s o f US cu rre nt acco u nt d ef icit contd .


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Cu rre nt Acco u nt Balanc e (% to GDP)

Cou ntry 1990-94 1995-99 2000-04 2005 2006 2007 2008China 1.4 1.9 2.4 7.2 9.5 11.0 10.0

India -1.3 -1.3 0.5 -1.3 -1.1 -1.0 -2.8

Russia 0.9 3.5 11.2 11.0 9.5 5.9 6.1

Saudi Arabia -11.7 -2.4 10.6 28.7 27.9 25.1 28.9

U AE 8.3 4.6 9.9 18.0 22.6 16.1 15.8

U nited S tates -1.0 -2.1 -4.5 -5.9 -6.0 -5.3 -4.7

Euro area n.a. 0.9 0.4 0.4 0.3 0.2 -0.7

Middle East -5.1 1.0 8.4 19.7 21.0 18.2 18.8Source: World Economic Outlook Database, April 2009, International Monetary Fund.

Note: (-) indicates deficit.


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Imm e diat e Re asons f or th e Financial CrisisSub-prime lendingOriginate and distribute modelFinancial engineering, derivativesCredit rating agenciesLax regulationLarge global imbalances

Q2. Global Financial Crisis and C u rre ntAccou nt Def icit


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Fu nda m e ntal Re asonsExcessively accomodative monetary policy in the U nited S tates

after 2002 which led to the Aggregate demand surpassing theoutput and led to large account deficits; mirrored in surplus inChina and other economies.The Federal Reserve, seeking to end the technology equity bubblerecession of 2000-2002, quickly dropped its federal funds rate to

historic lows and held the rate at a low level for an extended periodof time.The US economy became increasingly overleveraged during theyears preceding the crisis. This increased the vulnerability of itsfinancial institutions to the collapse of the housing bubble andworsened the ensuing economic downturn.This excess credit was invested heavily and narrowly in the U nitedS tates through purchases of Treasury securities and investment inthe financial derivatives market, leading to a bubble in housingprices and commodities.


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Su stainability o f US Cu rre nt Acco u nt D ef icitUS CAD will be sustainable as long as foreign nations are willing tobuy American assets.Possible only if return on US assets is more than that of otherforeign assets.A large CAD is not sustainable in the long run because it increasesU .S . net debt to foreigners.Larger debts can be serviced only through higher borrowing or

higher net exports.For net exports to rise the value of the dollar must fall. This willaffect the confidence of foreign nations to invest in US assets.Thus at some point both the dollar and CAD will tend to fall.

Will the world continue to fundthe US CAD?


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The depreciation of dollar could result in an economic slump.Nations could start looking out for diversifications of theirinvestments.Russia expressed desire to start increasing the amount of Euros itholds.Japan s holding of U .S . treasuries is also on the decline.The massive current account deficits of the past several years hasput the well being of US economy in foreign hands.

Foreign nations will become less willing to hold dollar denominatedassets if the CAD continues to grow.In such a case, US will be forced to increase the interest rates toattract foreign investments.

Will the world continue to fundthe US CAD? (contd.)


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If few foreign countries begin to diversify their dollar holdings therest might follow suit.Other nations could see their dollar denominated holdings beingdevalued and might begin to sell them.With few buyers, the dollar falls sharply and interest rates riserapidly.The falling dollar causes imports to become more expensive,inflation spikes, and gold prices soar.

The probability of this happening increases as the current accountdeficit continues to increase.Hence, it is not likely that the world would continue to fund the UScurrent account deficit.

Will the world continue to fundthe US CAD? (contd.)


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Due to overbuying of U .S . Treasuries by Foreign investors, the yieldon those investments dropped to a level where foreign investorssought out riskier assets to improve their return- real estate. Todiversify the systemetic and credit risks, they invested in derivativeinstruments. Thus the explosion in mortgage-backed securities andderivatives, and the hedge funds that traded them, may find anexplanation, at least in part, in the current account deficit.The regulatory framework did not keep pace with financialinnovation, such as the increasing importance of the shadowbanking system, derivatives and off-balance sheet financing. Lawswere manipulated or enforcement weakened in parts of thefinancial system leading to overlending.


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Q3. Cu rre nt sc e nario o f US Econom y

The U .S . need to take steps immediately to protect itself fromthe potential loss of the purchasing power of its U .S . Dollars. Ithas a $12.3 trillion national debt, $55 trillion in unfundedobligations (programs such as Social Security, Medicare andMedicaid) and total Federal Reserve and Treasury bailoutcommitments now stands at $11.8 trillion.

The Government s stimulus packages, financial bailouts, theneed to support liquidity in Treasuries, keeping interest rates at

the lowest level under the circumstances of low economicgrowth, high unemployment and low tax collection make it printmore dollars. This leads to a high risk of substantial inflation, orhyperinflation in a long-run.


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Fu nda m e ntals o f US Econom yPaul Krugman stated that a country whose fundamentals are persistently and predictably deteriorating will necessarily have a crisis (financial) at some point.

National D e btIncrease in the upper limit of national debt from $12.394 trillion to$14.294 trillion.The excessive debt results in slower economic growth anddampening wages, and shrinking the government s ability to reducetaxes, invest, or provide a safety net.

Une mp loym e ntIn January, the unemployment rate fell from 10.0 to 9.7 percent.Gallup reported in the end of February 2010 that 19.9% of the U .S .workforce was underemployed during the month of January,translating to close to 30 million Americans who are working less thantheir desired capacity.


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Fu nda m e ntals o f US Econom y- Contd .Bu dge t Def icit

The budget deficit of US reached a record $1.415 trillion in 2009.The excess of spending over revenue in the U .S . was $42.6 billionin January 2010, as opposed to a deficit of $63.4 billion in January2009.

Econo m ic imp act o f U.S. int e rnational m ilitary o p e rationsThe so called war against terror in Iraq and Afghanistan pushedthe budget into the red. One of the basic non-monetary reasonsof inflation is the existence of significant non-productivegovernment expenses such as military expenses

China s Pe g to th e dollarChina s peg to the dollar makes imports into the U .S . cheaper. Thissupports high level of unemployment in America.


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W ay Ou tSome economists suggest that the U .S . anti-inflation strategy shouldincludeSuppression of inflation expectations and stimulation of savingsReaching balance between budget receipts and expendituresIncreasing the mass of commodities, and

S trengthening national currency by establishing anunconditional priority of inflation targeting over othergovernment programs (such as military expenses,unemployment rate regulation, influencing the nationalcurrency market, etc.)


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US future in post America worldThe various reasons why future of US A in post America worlddoesn t look very promising are-

S lowing down Global investment in US assetsReducing consumer spending powerDepreciating dollarDecreasing US stock pricesIncreasing interest rates in US Govt. securities


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US future in post America world contdThe emerging economies of the world like China and India will becomepowerful in post US era.

China with huge market potential, rich labour resources has acomparative advantage in terms of labour cost, sound corporategovernance and stable government and society, leading to fast growth of economy.

China is the second largest foreign holder of US treasury securities whichgives it economic leverage over US . Also the rising middle class income of China and India will move major consumption market from US to thesenations.

Competitions for resources will increase leading to increased demand forenergy.

China and India will be major suppliers of manufactured goods in World.Russia will lead the raw material market, making Asian nations self-sufficing


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Future TrendsW-shaped recovery Th ere are 30-40% c h ances* t h at t h e USeconomy will dip into recession in t h e second h alf of 2010. t h eFederal Exit plan from stimulus can trigger t h is event.Reduced Bank Lendings B anks will start h oarding cas h to get ridof t h e toxic assets. Rising loan defaults will furt h er fuel t h is trend.Th is will lead to furt h er decline in bank lendings.Decline of Dollar Th e dollar will see a fut h er weakness due toth e $13 trillion US debt. Th is h igh debt may lead t h e US to let t h e

dollar decline. A weak dollar will also keep t h e Dow afloat andwill boost export.Tamed Inflation W ith drawl of stimulus will absorb any excessmoney w h ic h h as been pumped by t h e government. Th is willcurb inflation even if t h e Fed Fund rates are kept at near zero.U ncertainity I ncreased economic uncertainly on a global levelwill remain a big issue . Th is uncertainty will cause increased

volatility. Gold and oil prices will rise and fall, depending oninvestors' moods. Wh at it means to you - prepare for spikes in gasprices, w h ic h could translate to food prices.


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4. Can $ b e cu rre ncy o f fu tu re?Dive rsif ication o u t o f th e dollar (B RIC)

A long-term trend of official reserve diversification away from U .S .dollars, especially among the fast-growing, reserve-hungry emergingand developing economies can be seen. Dollar nowadays significantlydepends on such developing countries as China, India, Brazil, Russia,and others. These countries accumulate very large dollar reserves andU .S . debt.

China- largest foreign holder of U .S . debt, diversifying its reservesand protecting from weakening dollar.India- the IMF sold 200 metric tons of gold to India in thebeginning of November 2009. The $6.7 billion sale is the biggestsingle central-bank purchase.Brazil-considering the gradual elimination of the U .S .dollar intrade with China, Russia and India.Russia- is increasing the share of Japanese Yen and Swiss franc inreserves.


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Can $ b e cu rre ncy o f fu tu re? (contd)

Weak fundamentals of the US economy

National DebtU nemployment

Budget deficit

Economic impact of U .S . international military operations China s peg to the dollar

Investor lack of confidence is adefining feature of a currencycrisis.

Post recession the world has lostits confidence in the US economyresulting in dollar depreciation.

Lack of Confidence


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W hat can driv e $ as a fu tu re cu rre ncy?

It has been the international currency for the last 70 yearsand it will take time for an alternate currency to take itsplace.Currently, dollar does not seem to have a strong alternate,

although Euro, Yuan and Yen could be alternates of thefuture.


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Possible alternates to the U S Dollar

Reserve Currencies as a Percentage of GlobalCurrencies


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Possible alternates against the DollarEuro:

Currently about 28 % of Global Currency Reserves are in EuroRepresented by 16 countriesGDP and trade openness of Euro Zone comparable to the U .S .economy

The European Central Bank has kept inflation in checkHowever, Euro's increase in the share of the worldwide currencyreserve basket has slowed considerably since the year 2007The market share of European trade is likely to fall significantlyover the next two decades, largely due to emerging Asian

countries


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Possible alternates against the Dollar

Yu an / Ye n / British Po u nd:Present currency reserve share of these 3 currencies puttogether is less than 10 %Yuan s exchange rate is not market driven. Hence this may notbe accepted as a world currencyIf Chinese Yuan becomes market driven then it may hampertheir export competitiveness.


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What can drive $ as a futurecurrency?

It takes significant re-architecture of world economy trade and timefor a currency to become a global currency. Eg. U .S Dollar took almost80 years to replace Pound as a global currency.Present currency reserve share of the U .S Dollar is about 62 % which isway above Euro and other currencies.Currently, it does not seem to have a strong alternate for at least 10-15 years, although Euro, Yuan and Yen could be alternates of thefuture.


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1. http://useconomy.about.com2. http://econ.economicshelp.org3. http://www.catalogs.com4. The U nited S tates current account deficit and world markets - Professor WarwickMcKibbin5. The US as a Net Debtor: The Sustainability of the US External Imbalances -Nouriel Roubini, S tern School of Business,6. http://rawfinanceblog.com7. http://www.iie.com/research/8. http://www.globalcrisisnews.com/usa/the-future-of-the-u-s-dollar/id=1450/9. http://www.iie.com/publications/pb/pb09-21.pdf 10. International Monetary Fund -http://www.imf.org/external/pubs/ft/fandd/2000/03/mann.htm11. Global Financial Crisis: Causes, Consequences and India s Prospects -RakeshMohan, Deputy Governor, Reserve Bank of India12. http://www.globalcrisisnews.com/usa/the-future-of-the-u-s-dollar/id=1450/13. http://www.iie.com/publications/pb/pb09-21.pdf 14. http://www.globalcrisisnews.com/usa/the-future-of-the-u-s-dollar/id=1450/15. India and the Global Financial Crisis Y. V. Reddy

References


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Referenceshttp://www.globalcrisisnews.com/usa/the-future-of-the-u-s-dollar/id=1450/http://www.iie.com/publications/pb/pb09-21.pdf http://en.wikipedia.org/wiki/Reserve_currency


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Account Deficit US Financial Crisis

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