Hamish McRae: US spending spree could spell trouble for the dollar

By 2006, the US may need to borrow abroad to pay the interest on its overseas debt. That way lies disaster

The faster the US economy turns up the better for the rest of the world – but the worse for the still-massive imbalance in the country's external accounts.

There is little doubt now that, thanks to the determined spending by American consumers through the last part of last year, some sort of US recovery is in place. The consumer should keep spending as job growth has resumed and unemployment may start to fall – job insecurity was one of the main forces that potentially undermined the consumer boom. It looks pretty clear too that US-led growth will spread to Europe and East Asia. Business confidence is rising in both regions, though this has yet to translate itself into a secure recovery.

But this good news carries dangers, for US growth, however welcome, will increase the US current account deficit and hence the US dependence on capital imports. In a sense the US needed a proper recession in order to correct this imbalance. It has only experienced a very brief one – on the usual definition maybe not one at all – and so has not had time to make the adjustment.

The widening current account deficit over the past 20 years is shown in the top graph, together with some Goldman Sachs forecasts for the deficit to 2006. The deficit is now equivalent to 4 per cent of GDP and Goldman forecasts that it will grow to 6 per cent of GDP in four years' time.

The effect of this string of deficits has been to turn what was, 20 years ago, the world's largest creditor nation into the world's largest debtor, as the middle graph shows. Looking ahead the situation gets much worse. External debt would on these current account forecasts would approach 50 per cent of GDP.

You can argue reasonably enough that much of the build-up over the last few years has simply been a reflection of the perceived strengths of the US economy. It is a place where foreigners – individuals, investment funds and corporations – want to put their money. Provided both performance and confidence is maintained there is no reason why this flow of money should slow, let alone be withdrawn. And there are several reasons to expect that the superior underlying growth performance of the US vis-à-vis both Europe and Japan will be sustained. Since the money is coming mostly from Europe and Japan that would appear to be fine.

But look where the money is going (bottom graph). Some of the additional money has gone into equities, with the result that foreigners now hold around 12 per cent of US shares. Some has gone into corporate bonds, where the holding is some 24 per cent of the total. But proportionately the largest amount is in short-term US treasury securities, where some 37 per cent are now foreign owned.

I have not seen a national breakdown of these assets but I would expect this last segment to reflect the lack of opportunities in Japan for short-term investment. The sharp take-off started in 1995, when short-term interest rates in Japan dropped from over 2 per cent to 0.5 per cent. Nothing wrong with that; and I would not expect an early rise in Japanese interest rates so there is little reason to expect that these funds will suddenly be withdrawn. But you see the key point that much of the money going into the US is not going into commercial opportunities but into government securities. This flow is not reflecting US commercial excellence but the secure status of the dollar and the unattractive nature of opportunities elsewhere.

Goldman's point is that this is not sustainable.

Now Goldman made the same point – as many of the rest of us have – in 1999 and look what has happened: far from weakening the dollar has got stronger. The reasons for that are well known. Neither the yen nor the euro are attractive because of the relatively poor performance of the Japanese and eurozone economies. Sterling, the only other significant candidate, has been held down in part by fears that it might at some stage enter the eurozone.

But just because an expected adjustment has not taken place yet does not mean that it will never take place. The greater the foreign debts the greater the payment of interest to the holders of that debt. If the Goldman team is right there could be a deficit equivalent to 1 per cent of GDP on investment income by 2006. The US would be borrowing abroad to pay the interest on its overseas debt. That way lies disaster for the debt suddenly runs away with you. The Goldman conclusion is that "the long-term outlook for the dollar remains very precarious".

But when, oh when? A general rule in financial markets is that things take longer to happen than you would expect and then occur more suddenly.

There are a couple of precedents in the fall of two other dollars: the Canadian and Australian ones. Both were supported by large capital inflows only to enter secular bear markets. In the case of Australia the rise in foreign debt over the last 20 years (going from 20 per cent of GDP to 60 per cent) has been associated with a steady fall of the currency. In the case of Canada, even the move of the current account back into surplus, has not protected the Canadian dollar from steady depreciation. In the 1960s it traded at a premium to the US dollar and even in 1980 it was above $1.20 to the US dollar. Now it is close to $1.60 – great if you want to have a holiday in Canada but not great if you are paid in Canadian currency.

My guess is that any big adjustment is still a couple of years' off. The alternatives, in particular the euro and the yen, have to look more attractive than they do now. There would have also to be some trigger, some external shock that would suddenly make the US seem a less safe haven for foreign funds. Such shocks, by their very nature, are impossible to predict. The core point is that the longer the adjustment is delayed the more likely it is that it will come suddenly and with greater force.

And of course from the point of view of the world economy a slightly weaker dollar would be most welcome – while a sharply weaker one most certainly would not.