The $15 Trillion U.S. Foreign Debt
There has been considerable discussion of the U.S. federal debt, approaching $20 trillion, and the impact this will have on the budget deficit when Treasury rates rise. Almost no attention, however, has been paid to the fact that three-quarters of this projected debt, or $15 trillion, will be held by foreigners, and that a 3% rise in Treasury rates could cause disruption in international trade and finance.
In September 2015, of the $18.2 trillion total federal debt, $13.6 trillion, or 75%, was held by foreigners, of which $7.5 trillion was official foreign holdings and $6.1 trillion was by commercial banks and other creditors.1 The projected foreign debt will thus quadruple the $3.8 trillion debt in 2000, as a result of very large current account deficits financed through foreign borrowing and increased foreign debt. The current account last recorded a surplus of $5 billion in 1981, followed by a cumulative deficit of only $1.5 trillion through 1999. The deficit then soared by a cumulative $8.6 trillion from 2000 to 2015, with the resulting huge increase in the foreign debt.
Interest paid on the foreign debt is a debit for the current account balance, although this debit has been relatively small in recent years because of the very low or zero Treasury rates. A rise of 1% in interest paid on a $15 trillion foreign debt, however, will raise the current account deficit by $150 billion, and a 3% rise, which is plausible over the next several years, means a $450 billion increase in the deficit.
The U.S. current account deficit is now about $500 billion, or 2.7% of GDP, and rising. The U.S. trade deficit in manufactures in the first quarter of 2016, compared with 2015, rose by $7 billion, and will likely continue to grow, albeit at a slower pace than in 2015, and the trade deficit in petroleum, which had been declining thanks to lower oil prices and increased domestic shale production, will be rising again in the second half of the year as oil prices for imports are up and domestic production is down. Thus the current account deficit in 2016 will likely rise closer to $600 billion, or 3.3% of GDP, financed by further foreign borrowing and debt.
This is the disturbing setting for an anticipated substantial increase in Treasury rates, with a 1% increase leading to a $750 billion current account deficit, or 4.1% of GDP, and a 3% increase to more than $1 trillion, or 5.5% of GDP. And this will set off the IMF alarm bells and trigger official and commercial foreign creditors, projecting a decline in the dollar, to shift financial assets from dollars into other currencies, leading to a further rise in Treasury rates. This prospect has characteristics of the "southern-tier" syndrome in the eurozone, as happened from the greatly increased foreign debt of Greece and Portugal. A critical difference, of course, is that there is no IMF or European Central Bank available to bail out a $15 trillion U.S. foreign debt, which is far larger than any recorded national debt.
This financial storm cloud facing the global economy poses a fatal threat to the dollarized financial system, with potential adverse impact on trade. The critical questions are what will happen in financial markets and what should governments do in response? The directions of change ahead are transition of the still largely dollarized financial system into some form of multi-key currency relationship and a substantial decline of the dollar relative to the currencies of trading partners with very large trade and current account surpluses.
As for the multi-key currency transition, already less than 45% of international payments are made in dollars, while the Chinese yuan share is on the rise, reflecting the sharp relative decline in U.S. exports. For manufactures, which account for 75% of U.S. merchandise exports, the U.S. share of global exports has dropped from 18% in 2000 to 12% in 2015, while the Chinese share has quadrupled from 6% to 24%. The dollar still accounts for 60% of official reserve holdings, largely because the tightly managed Chinese currency has precluded offshore sovereign bonds, but this changed on May 26, 2016, when for the first time China issued the offshore sale in London of $451 million of sovereign bonds.2
The degree to which the dollar declines relative to trade surplus trading partners will depend on how governments respond, both in their domestic policies and their trade strategies. For trade strategies, regrettably, the current slowdown in global GDP growth, as usually happens, is inducing others to pursue more mercantilist trade and currency policies so as to bolster lagging domestic growth through ever larger trade surpluses, with the United States the principal "importer of last resort." And this, in turn, is provoking U.S. calls by candidates of both parties for offsetting U.S. import barriers.
The greatly increased trade imbalances, moreover, center on trade in the technology-intensive and politically sensitive manufacturing sector among the "Big Three"—the United States, China, and the EU—who together account for over half of global exports of manufactures. From 2009 to 2015, the U.S. trade deficit in manufactures more than doubled, from $300 billion to $650 billion, while the Chinese and EU surpluses also more than doubled, to $1 trillion and $500 billion. The result is that the rapidly growing Chinese and EU trade surpluses, and their resulting very large current account surpluses, are the principal driving force for the rising U.S. trade deficit and foreign debt.
The trade outlook from these growing imbalances among the three largest exporters, with considerable regional spinoff, is toward bilateral currency and trade wars, the trade-disruptive path of the 1930s. A clearly preferable course would be to restore a balanced, rules-based multilateral trading system, which would begin by integrating currency and trade policy obligations, of special importance for price-sensitive trade in manufactures. This, however, would be an extremely difficult negotiation, because the objective would be painful reductions in surpluses by the large trade surplus nations in order to reduce the U.S. trade deficit and growing foreign debt.
Such a restored rules-based trading system, in any event, can only be accomplished through strong and determined U.S. leadership, which has been exercised in the past. In 1971, the United States pressed its European and Japanese allies, including through interim import sanctions known as the "Nixon shock," to replace their greatly undervalued currency pegs to the dollar with market-based currencies free of manipulation, and within a few years the other currencies doubled or more in value relative to the dollar, leading to a sharp reversal of the growing U.S. trade deficit in manufactures back toward balanced trade.
This is the trade policy challenge, headed toward trade disputes and a growing U.S. foreign debt, that will face the next president. As for the preferred rules-based response, I have proposed such a strategy in detail in my recent MAPI Foundation study, Time to Restore a Balanced, Rules-Based Multilateral Trading System With Technology-Intensive Manufactures at Center Stage. The strategy centers on a consolidation of the spreading network of preferential bilateral and regional trade agreements into a WTO open-ended, plurilateral free trade agreement, which would include a market-based, convertible currency obligation, and could include up to 80% of U.S. exports even if China chose not to be a founding member. I encourage the candidates, or at least their trade policy advisors, to give this study a serious read.
1. The Treasury Bulletin, Table OFS-2.
2. See The Financial Times, May 27, 2016, p. 20, "Maiden London issue of China sovereign paper." The article observed that the sale attracted a "hefty demand" of $1.3 billion of orders for the three-year bonds at 3.28%. The broader question is what will happen as China moves more heavily into offshore sovereign debt, including purchases by central banks.