Financial Watch

The cause of our trade deficit goes beyond China’s undervalued currency and America’s credit binge

Last year the United States racked up a $600 billion trade deficit with the rest of the world. This represents 5% of our nation’s gross domestic product (GDP). History has shown a trade deficit this high cannot sustain itself, but figures released so far this year indicate the figure will likely surge past $700 billion during 2005. The United States trade deficit extends to just about every industrialized and emerging economy in the world. Efforts to rein in the imbalance are slowly being discussed both in the United States and abroad, but a lack of genuine urgency exists to find a solution. Participants involved in trade discussions are more concerned about protecting national interests rather than implementing measures to prevent an eventual fiscal collapse.

The groundwork for our large trade deficits began with the Asian currency collapse in 1997 and 1998. Throughout the mid 1990’s, most Asian nations piled up large trade deficits with their trading partners. Managed currencies in place throughout Asian economies prevented the financial markets from gradually restoring balance to the international trade situation. Asian central banks were able to maintain overvalued currencies by repurchasing excess money floating around in the financial markets. In late 1997, hedge funds saw an opportunity to profit by placing large bets in favor of a forced devaluation. In one nation after another international hedge funds went on the offensive against vulnerable currencies across Asia. Asian government vigorously implemented measures to ward off currency speculators, but often efforts would fail as sophisticated hedge fund managers found new vulnerabilities to take aim at.

Throughout Asia, governments had to contend with both high levels of inflation and massive numbers of bankruptcies. In response to the crisis and economic turmoil that followed, Asian governments throughout much of the continent have maintained fixed currencies at artificially cheap levels to prevent a repeat of the large trade deficits that triggered the crisis, but such measures have helped put the United States in a situation very similar to where Asia was back in the mid 1990’s. In terms of economic output, the trade imbalances presently facing the United States are similar to the deficits occurring throughout Asia in the mid 1990’s.

There are four broad reasons causing the U.S. to hold a large trade deficit with the rest of the world. In addition to undervalued currencies across most Asian nations, international barriers to American exports, slow economic growth in major export markets, and global interest rates are the reasons behind the large trade gap. Two nations, Japan and China, represent about 50% of the U.S. trade deficit. Despite China’s recent economic growth, American exports have gained little ground in the world’s most populous nation. Americans import nearly eight times as many goods as we export to China. China has been able to accumulate a large trade surplus with the United States by maintaining an artificially cheap currency and through trade barriers for American goods. U.S. firms are prohibited from freely competing in China’s financial services sector. There is little doubt that American banks and insurance companies would be gain large market shares in China were the sector to open up to international competition. A second barrier to trade facing American firms is large-scale piracy across China. For example, American filmmakers have a difficult time selling their movies in China when the product is readily available in a bootlegged version for a fraction of the real price.

Until very recently the nation in which the United States had the largest trade deficit with was Japan. The primary cause for our nation’s large trade deficit with Japan rests with the Japanese business model. Japanese firms prefer to enter into long-term relationships with their suppliers to mutually benefit from each other’s advances, whereas American firms rapidly adjust supply chains in response to changing business conditions. Over the past several decades the Japanese model has extremely successful in designing and producing products of superior quality, however globalization is starting to place pressure on the model as global competitors outsource production work and gain a cost advantage.

The second reason Japan enjoys a trade surplus with the United States is historically higher interest rates in the United States. Japanese are strong believers in conservatively spending their wealth and thus have a high savings rate. With Japanese interest rates hovering just above zero, the Japanese seek higher returns on their investment in the United States. This flow of funds from yen to American dollars places downward pressure on the yen. As we look forward, it is doubtful Japanese interest rates will move higher than American interest rates for the foreseeable future. Japan’s government is currently running a budget deficit significantly larger than the U.S. government’s deficit. This combined with a national debt representing 150% of Japan’s economic output will put the Japanese in a difficult position as its economy slowly approaches its full potential.

Europe, North America, and the OPEC bloc form a second tier of nations in which the United States has a trade deficit with. This second tier of nations collectively holds a substantial trade advantage with the United States, but no single nation stands out as having a substantially distorted trade position such as exists with China and Japan. The OPEC bloc requires very little explanation for their trade surplus with the U.S. As long as oil prices hold near $50-$60/barrel these nations will continue to see their trade surpluses move up. It is the opinion of Financial Watch that oil prices will recede in the second half of the year, which will eventually help to close the trade gap with the OPEC nations.

Until recently financial leaders within the European Union has been quite concerned about the prolonged surge of the Euro against the American dollar. Despite this surge over the past three years, very little progress has occurred with closing the U.S. trade gap with Europe. Weak economic growth within the European Union is the primary cause behind the inability for American firms to benefit from the strength of the Euro. It is not uncommon for European travelers to the United States to see lower prices here than they would in their home nation. The future direction of U.S. trade with the European Union is tough to predict. Financial Watch believes the Euro will strengthen over time as long as the United States continues to carry a large trade deficit, but recent strength in the Euro due to higher interest rates in the United States has called into question whether this prediction will be accurate. For the time-being, Financial Watch continues to hold the belief that long-term interest rates near 4% is not enough to attract the capital from Europe needed to finance the trade deficit. We believe it would take a prolonged rally in the U.S. stock markets to cause long-term weakness in the Euro.

Mexico and Canada have enjoyed tremendous benefits from the North American Free Trade Agreement. Both nations currently hold a small trade surplus with the United States. The trade figures will both nations are slightly inflated due to the present bull market in commodity prices. Mexico is an important producer of oil, and Canada is a global exporter of various natural resources. The trade relationship with both nations has been of great benefit to America. It is doubtful the United States would have been able to go through the economic boom during the 1990’s without experiencing inflationary pressures where it not for downward price pressures caused by low-cost producers of commodity goods in Mexico and elsewhere. The United States, Mexico, and Canada should continue to enjoy a strong trade relationship into the future. Mexico, in particular, should benefit greatly once China is forced to compete on a level playing field in global trade.

Earlier this Paul Volcker, former Chairman of the Federal Reserve, spoke publicly about his concerns about the growing global imbalances. Of his greatest concerns, the single imbalance standing out to him was the reliance of Asian nations on undervalued currencies to stimulate their domestic economies. He predicted that the global imbalances would create an economic crisis within the next five years. The world’s financial or political leaders should not take such an opinion lightly. Financial Watch is growingly increasingly concerned about the rising imbalances. Assuming Financial Watch is correct in predicting a housing bubble, the present resentment toward free trade will likely only grow larger should a housing correction trigger an economic recession. The current strategy on the part of many Asian financial authorities of attempting to stimulate domestic markets through strong exports may indeed severely backfire in the face of more stringent scrutiny toward international trade by Congress. While Americans may suffer a small bit in a trade war due to slightly higher prices, the real pain would likely be felt in Asia. The potential consequences in Asia could even be as great as the currency crisis in 1997/98.