Sunday, December 05, 2004

Executive summary

This Economist article is the best summary I have seen yet of the US current account situation and its likely effect on the dollar.

An interesting point about a looming reversal in net payments:
So far America's hefty debt has not been a burden on its economy, mainly because it has pulled off an extraordinary trick. Although it is a large net debtor, it does not have to make net payments of interest and dividends to the rest of the world. Instead, America still enjoys a net inflow of investment income because it earns a higher average return on its foreign assets than it pays on its liabilities. Returns on foreign direct investment and equities are higher abroad than at home, and America has benefited from unusually low interest rates on its borrowing in recent years. Unlike in previous periods of dollar decline, bond yields have remained low—largely thanks to those huge purchases by foreign central banks. But as interest rates rise in future and net foreign debt mounts, America's net investment income is likely to turn negative, probably next year. Not only will that swell its current-account deficit, but it will also exert an increasing drag on the economy.

I expect the dollar-yuan exchange rate to follow the pattern below in the next decades. This is why, assuming further progress in China, the PPP exchange rate is a better indicator than the current pegged exchange rate.

Net foreign liabilities are about $3 trillion, or 30% of GDP. Half of this is held by Japan and China.

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