US deficit good for rest of the world

By Mthuli Ncube

THE United States Federal Reserve (Fed) has been on a drive to tighten monetary policy, resulting in the hike in interest rates to 4% on November 1.



na, Arial, Helvetica, sans-serif”>While there are obvious reasons for rate hikes such as dealing with the risk of higher inflation also fuelled by a high oil price and buoyant economic growth, there is a less obvious link to the state of the US current account deficit, of over 5% of GDP.


Larry Summers (1995) once argued that a current account deficit of over 5% of GDP is unsustainable for a country. The US current account deficit is unsustainable at these current levels, and poses a long-term risk to the US dollar. But so it seems.


The Fed seems to be using monetary policy by hiking interest rates so that the current account deficit becomes sustainable, or at least lower the risk of “current account un-sustainability”.


How does a current account deficit arise?


One way to answer this is to go back to the economic argument that the deficit is a result of dis-saving by the US economic agents, which includes government, as evidenced by the huge US government deficit. Excessive aggregate consumption in the US economy is causing higher demand for imports in excess of exports receipts, therefore resulting in a deficit.


Furthermore, a current account deficit can be viewed as the aggregate of future growth in the economy. It is as if the economic agents are giving up future economic growth in exchange for current consumption in the form of higher import demand which translates into a current account deficit.


How is the US deficit being funded?


The deficit is funded through capital inflows mainly from Asian countries such as China and Japan who buy US treasury bills and other money market instruments.


As the Fed hikes interest rates, the interest rates on these money market instruments goes up, raising the attractiveness of the instruments to foreign investors. The rate hikes are boosting the demand for US money market instruments, resulting in capital inflows into the US which fund the current account deficit.


In a sense China’s relationship with the US is a vicious circle where exports receipts from Chinese exports are used by China to fund the US budget deficit and current account deficit. The US deficit becomes more sustainable and demand by the US for Chinese imports is therefore encouraged.


The US current account deficit is also distributing growth around the world. The excessive demand for goods from other countries by US economic agents is translating into positive economic growth in the exporting countries, such as China among others.


A US deficit is therefore good for the rest of the world. However, it will only remain good provided US money market instruments continue to be attractive to those investors who are indirectly funding the deficit.


In other words, it does seem that for the “party to continue” the Fed has to keep raising interest rates, just like it has done for the last 12 successive times, while the rest of the world keeps a lid on interest hikes.


* Mthuli Ncube is professor of finance at Wits Business School. He holds a PhD in finance from the University of Cambridge, UK.

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