The U.S. Trade Deficit and Asian Central Banks

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The U.S. Trade Deficit and Asian Central Banks

• Japan Pays for Low U.S. Interest Rates WSJ
  (3/18/2004)

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A symbiotic relationship between Asia and the
U.S.

• Relatively weak currencies have helped sell Asian
  exports in the U.S. and kept economic growth high
  for many Asian countries. The export earnings
  also enable Asian central banks to accumulate a
  lot of international reserves most of which are
  held in dollars. The bulk of these dollars have
  been spent on U.S. Treasury bonds and bills.
• On the other hand, Americans import much more
  goods and services than they export, leading to
  an increasingly large trade deficit. Since
  Americans do not save enough, the U.S. must rely
  on foreign capital flows (especially those from
  Asian countries) to finance the widening trade
  deficit. In 2004, Japan alone financed about 40
  of net U.S. Treasury-market borrowing.
• We have a co-dependent relationship between Asia
  and the U.S. American consumers have great
  appetite for imported goods from Asia, and Asian
  countries are eager to satisfy the import demand
  and willing to fund the trade.

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Risks and problems with the symbiotic
relationship

• Asian central banks are taking risks to have
  their foreign reserve holdings concentrated
  primarily on U.S. bonds. The value of their
  reserve holdings could fall substantially if U.S.
  interest rates rise or the dollar declines.
• It is also risky for the U.S. to rely so much on
  Asian purchases of Treasury debt. Such purchases
  have helped to keep U.S. bond rates significantly
  lower than what would otherwise be. However,
  Asian central banks may choose to diversify their
  reserve holdings away from dollar assets. If
  they become less willing to hold or buy U.S.
  assets, U.S. bond yields would go up
  dramatically.
• The co-dependent relationship, even if it can
  continue, is not healthy. It reduces incentives
  for the U.S. to address its trade deficit and
  budget deficit problems. It also takes the
  pressure off Asian countries to find an
  alternative engine for long-term growth.

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There are still strong incentives for Japan, the
largest buyer of U.S. debt, to continue financing
the U.S. trade deficit

• With Japanese interest rates being at close to
  zero, the returns available on U.S. bonds look
  relatively attractive. Japan can actually earn
  more in interest income on the dollar assets.
• Since interest rates are already so low in Japan,
  exchange rate policy is one of the last ways the
  government can fight deflation. Dollar purchases
  can weaken the yen against the dollar, and that
  will help boost Japans exports to U.S. one of
  the worlds largest consumer markets.
• If Japan unloads U.S. bonds, it would cause U.S.
  interest rates to surge, seriously damaging the
  U.S. economy. A worsened U.S. economy would hurt
  Japanese exports and kill the economic recovery
  in Japan.
• Due to the massive size of Japans holdings, it
  is not possible to unload them without serious
  financial losses. Any significant reduction in
  U.S. bond holdings by Japans central bank would
  cause not only U.S. bond prices but also the
  dollar to plunge. This would result in enormous
  investment losses for the Japanese government and
  Japanese financial institutions alike.