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October 14, 2016
Cumulative U.S. Trade Deficits Resulting in Net Profits for the U.S. (and Net Losses for China)
The United States has run trade deficits for decades (1976 is the last year with a recorded surplus). To illustrate this, chart 1 depicts the cumulative U.S. trade deficit since 1980, which now surpasses $10 trillion. As a result, a drastic deterioration in the U.S. net foreign asset position—the difference between the amount of foreign assets owned by U.S. residents and the amount of U.S. assets owned by foreigners—has occurred. That is, as Americans borrow from the rest of the world to finance the recurring trade deficits, the national net worth goes deeply into the red. Not long ago, many commentators predicted that as a result of this increasing U.S. foreign debt, the U.S. dollar was set to collapse, which would trigger a stampede away from U.S. assets. Of course, this has not happened.
Much of the rising U.S. deficit is the by-product of deficits with one country in particular: China. Chart 2 shows that U.S. bilateral trade deficits with China have been growing steadily during these years. In 2015, the total U.S. goods trade deficit was about $762 billion, and the goods deficit with China alone made up nearly half of that total ($367 billion). This situation is not unique to the United States, as many countries find themselves in similar trade positions with China. During the last few decades, China has been running protracted trade surpluses with the rest of world and has accumulated a positive and sizeable net foreign asset position.
Yet, despite accumulating a positive and sizeable net foreign asset position, China is facing increasing losses in net income on its foreign assets. Put differently, China has been accumulating negative returns on its increasingly large portfolio of foreign assets. Chart 3 shows this observation, made in a paper by Eswar Prasad of Cornell University at a recent conference cosponsored by the Atlanta Fed and the International Monetary Fund.
The net income on foreign assets measures the return a nation receives from the foreign assets it owns minus the return paid on domestic assets held by foreigners. In sharp contrast to China, however, the U.S. international net financial income has remained positive and has even increased. This increase comes despite the fact that the United States has consistently run trade deficits, and its net foreign asset position has deteriorated. Chart 4 shows the U.S. income from foreign assets and foreigners' income on U.S. assets, which is reported as a negative number for this series because it is regarded as a liability for the United States. The difference between these amounts is depicted by the middle line, which shows the net foreign income of the United States.
How is this possible? Ricardo Hausmann (Harvard University) and Federico Sturzenegger (currently, the chairman of Central Bank of Argentina) came up with an explanation more than ten years ago: the United States gets a far higher return on its foreign assets than the other way around. Indeed, U.S. foreign direct investments (FDI) often generate a relatively high rate of return. In part, U.S. FDI are benefiting from business expertise, brand recognition, and research and development in new product and service lines. Comparatively, foreigners tend to earn substantially less return on the American assets they own. Foreigners often desire to hold their dollar assets in the form of safe, liquid assets, which—following the "low-risk, low-return" principle—have relatively low returns.
To see this, chart 5 shows the sources of the net financial income of the United States. The U.S. government net income is negative—mostly the by-product of interest payments in government debt held by foreigners. The U.S. gets most of its financial return from FDI. Although much has happened in the world economy during the last decade, the implications of Hausmann and Sturzenegger's analysis remain intact. In sum, the differential return from these foreign assets and liabilities appear to largely compensate for the trade deficits.
Eswar Prasad also showed that China is in a starkly different situation. Most of its foreign liabilities are in the form of FDI, while the vast majority of the foreign assets are reserve assets and foreign exchange reserves—not surprisingly, largely U.S. dollars and U.S. Treasury securities. The rate of return foreigners make on Chinese assets is around twice the rate of return China gets on its foreign assets.
This analysis suggests that focusing on a country's net foreign asset position conveys an incomplete picture of the profitability of foreign assets because it fails to account for the differences in rates of returns that countries earn on their foreign assets. Overall, the United States makes a sufficiently high return on foreign assets that it maintains positive net income on foreign assets. The situation is similar to role leverage in investing; debt can be profitable if you can devote it to purposes that earn a higher rate of return than your cost of borrowing it. Therefore, when viewed in terms of the net income earned on foreign assets the United States holds, the sizable U.S. trade deficits may not be as much of a concern as commonly thought.
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