The United States will need between $120 billion and $130 billion worth of foreign capital this year to balance the unprecedented deficit it is running in its transactions with the rest of the world. As in U.S. credit markets, the money is available, but at a price.
Part of that price will be a level of interest rates substantially higher than they otherwise would be. Another part probably will be at least a modest decline in the value of the high-flying dollar in foreign exchange markets. A drop for the dollar would add to inflationary pressures, and that, in turn, could give yet another boost to interest rates.
Investment managers here say that financing last year's American deficit, which analysts estimate at about $105 billion, was accomplished with relative ease because the return on dollar-denominated investments after adjustment for inflation was spectacularly higher than in other industrial nations. When changes in the relative value of currencies are included, the returns generally were even greater.
But net foreign saving in dollars is likely to shrink by a few billion dollars this year, after having risen strongly in 1984. Meanwhile, the demand on such savings will be going up, as the U.S. deficit in foreign transactions rises and other demand -- such as that associated with capital outflows from the United States -- increases somewhat. (See chart on H3)
Economist Brendan Brown of Phillips & Drew, a major British brokerage firm, calculates the "financing gap" between the sources of dollar savings and the demand for them at about $30 billion for 1985. Brown believes the gap will be closed almost entirely through a decline in the value of the dollar.
Like a number of other firms here that do international forecasting, Phillips & Drew expects the U.S. economy to grow this year by about 3 percent after adjustment for inflation. With the economy expanding no faster than that -- which would about match expected growth in West Germany and the United Kingdom -- the spread in real returns is apt to fall, perhaps significantly for long-term bonds, according to Brown.
If economic growth turns out to be stronger than that -- as some American economists predict it will -- then the spread in real returns may not shrink and the dollar would not decline as much, according to Brown's analysis. In other words, faster growth could mean higher interest rates, and that would make foreign investors more willing to buy dollar-denominated assets even if they did not become cheaper to make, as they would if the dollar fell.
Brown and other analysts say that another key reason that the United States has been able to attract funds is that it is regarded as a "safe haven" for investment: a nation with a stable political system and an economy strong enough to be able to afford paying the high real interest rates involved in financing its external deficit.
John L. Langton, senior executive director of Orion Royal Bank Ltd., a merchant banking firm, said the increase in Americans' own confidence in their country during the Reagan administration also has impressed European investors and made them more willing to put their assets in dollars.
However, Brown and others suggest there is a limit to the "safe haven" notion. "The view of there being only one safe haven contradicts the general principle of portfolio management: that safety is bought by diversification," he said. "There are many, and indeed a growing number of, alternatives to the dollar in international portfolios.
"ECUs European Currency Units , Euroyen and international sterling British pound bond markets have all been growing fast. The liberalization measures in the Euroyen market introduced in early December are in the long run likely to have a profound influence on international investment flows, spurring the process of the yen attaining a share of international portfolios that is more in line with the economic importance of Japan," Brown said. "The yen will probably gain its increased share at both the expense of the dollar and the mark."
The investment managers interviewed were unanimous in believing that the United States cannot reasonably expect to be able to increase its international deficit indefinitely. At some point, the inability to attract ever larger amounts of foreign capital will force an adjustment. Ultimately, that adjustment will have to come in trade in goods and services, and that will require a dollar whose value is much lower than today's, said those interviewed.
For example, Brown estimates that it would take about a 15 percent decline in the dollar over the remainder of this decade -- and perhaps 25 percent relative to the mark and the yen -- just to stabilize the United States' external deficit at a level of $100 billion. Achieving even that degree of stabilization would require reducing the trade deficit, as a share of the gross national product, by half, he said. Should inflation pick up more in the United States than in other countries, the depreciation of the dollar would have to be even greater to stabilize the deficit.
Thomas W. Blanchfield, a colleague of Langton at Orion, pointed out that the adjustment process could turn out to be pretty bumpy, too. "A slightly weaker dollar is quite acceptable. But a falling dollar could mean that you would not be able to raise a dime. Investors would want to wait for the much higher interest rates they would know were coming. They would be waiting for 14 percent," not 12 percent, Blanchfield argued.
The reason that stabilizing the external deficit appears to be so large a chore is essentially the reason that dealing with the federal budget deficit is so difficult: rising interest payments.
A return must be paid to the foreign investors who provided that $105 billion of new capital last year -- even at 10 percent, or $10.5 billion. And that has to be paid every year until the debt is retired. If another $125 billion flows in this year, then, at 10 percent, that would be $12.5 billion in payments next year, plus the $10.5 billion from financing last year's external deficit, or a total of $23 billion.
Either that $23 billion has to be borrowed from abroad, or the United States must sell that amount of additional exports, above and beyond any rise in imports, to get the money. Selling the added exports would require a decline in the dollar's value to make the goods a better buy in foreign markets.
Under these circumstances, a steadily rising share of American income will have to be sent abroad each year to pay interest on the past debt and to insure that ever greater amounts of foreign capital are available. And there will be less available in the United States for consumption or investment.
This is the process that the investment managers think cannot continue. "I feel very sorry for the next administration," Orion's Langton declared. "That money has to be repaid."
The initial shift toward such a large net inflow of foreign capital was the result not of a surge in foreign investment here so much as of a virtual cessation of American money going abroad. Many Third World countries that had received that U.S. money -- particularly in the form of bank loans -- found themselves unable to repay past loans and so got new ones only to the extent necessary to keep them from defaulting completely on the old ones. In addition, the high real rates of return that were attracting foreign investment to the United States were just as attractive to American investors, who kept their money at home.
But the amount of foreign money coming in also has risen, and it has come in a bewildering array of forms: Stocks, bonds, U.S. Treasury securities, real estate, options, futures, bank deposits -- those and other vehicles have drawn the foreign money. An increasing share of the assets has been purchased directly in the Eurodollar market rather than in the United States, particularly since a change in law last year eliminated a withholding tax on dividends and interest payments to foreigners on most types of securities.
Many top U.S. corporations, such as Exxon Corp. and International Business Machines Corp., have floated dollar-denominated bonds in Europe. The Federal National Mortgage Corp. is a regular borrower there. An IBM issue earlier this month was priced so aggressively that the borrowing cost was about three-tenths of a percentage point below the yield on comparable-maturity U.S. Treasury securities.
And with the elimination of the withholding tax, the Treasury has begun to revamp some of its securities to make them more attractive to foreign buyers.
According to estimates by Salomon Brothers, a New York investment firm, the gross volume of Eurodollar bonds issued last year was $64.4 billion, and another $29.2 billion worth of Eurodollar floating-rate notes was sold, too. The $64 billion figure surpassed U.S. domestic corporate bond issuance "by a substantial amount," Salomon Brothers' economist Henry Kaufman said.
Just as elimination of the U.S. withholding tax made it more attractive for foreign investors, so did changes over the last two or three years make it easier for foreigners to send their money abroad. For instance, until 1981, United Kingdom investors had to pay a special dollar premium on certain types of investments in the United States. That tax had been imposed to help support the value of the pound by keeping British capital at home.
Since then, many UK pension funds and insurance companies have boosted the dollar-denominated assets to about 15 percent of their portfolios, and investment managers think that they will maintain that level by continuing to invest about 15 percent of their cash flow in the United States each year. But that actually will mean a slowdown in U.S. investment, because the adjustment to the new higher level will have been completed.
Other changes of that sort lie behind Brown's assessment that the United States will have more trouble financing its external deficit this year than it did last year. Brown said that Japanese purchases of dollar-denominated bonds and loans probably will go up only about $2 billion, rather than the $14 billion of 1984, to a total of $30 billion. He also expects the acquisition of dollar reserves by countries other than the major industrial nations -- particularly in Eastern Europe and the Far East -- to be about $10 billion, down from $16 billion last year.
Meanwhile, the U.S. economy will be growing more slowly than it did last year, and the economies of some other countries -- especially West Germany and the UK -- will be growing faster than before. With growth rates tending to converge, the large U.S. advantage in real rates of return may be reduced.
The foreign perception of the higher real rate of return available in the United States strengthened in the second half of 1984 when an expected increase in U.S. inflation failed to materialize, another investment manager noted. The actual spread between real returns on comparable investments in the United States and, say, West Germany, shrank, but with the change in the inflation outlook, the perceived spread widened in real terms, he said.
That probably is one reason that the sharp decline in short-term interest rates in the United States in the last five months did not weaken the dollar as most economists had thought it would. That drop in rates had reduced the spread between U.S. interest rates and those in Japan and West Germany by about two full percentage points.
Like their American counterparts, analysts in Europe have been expecting a drop in the dollar for most of the past two years, and that is still the consensus forecast. That expectation is another reason for the big spread in yields: The higher the spread, the greater the decline of the dollar relative to an investor's home currency can be before the investor would be better off not investing abroad.
No one here doubts that, by paying whatever is required, the United States can attract whatever foreign capital is needed to cover its external deficit. After all, the United States is not a Third World nation with a soaring inflation rate and a huge international debt. But it does have the largest trade deficit in the history of the world by far, and it has wiped out a net foreign investment position of $150 billion in a scant three years.
Those trends cannot continue for long. As Langton said, "That money has to be repaid."