Overview

The dollar’s status as the world’s reserve currency has become a facet of U.S. power, allowing the United States to borrow effortlessly and sustain an assertive foreign policy. But the capital inflows associated with the dollar’s reserve-currency status have created a vulnerability, too, opening the door to a foreign sell-off of U.S. securities that could drive up U.S. interest rates. In this Center for Geoeconomic Studies Capital Flows Quarterly, Francis E. Warnock argues that a sell-off came close to happening in 2009. How the United States uses this reprieve will affect the nation’s ability to borrow for years to come, with broad implications for the sustainability of an active U.S. foreign policy.

Introduction

In 1961, the Belgian economist Robert Triffin described the dilemma faced by the country at the center of the international monetary system. 1 To supply the world’s risk-free asset, the center country must run a current account deficit and in doing so become ever more indebted to foreigners, until the risk-free asset that it issues ceases to be risk free. Precisely because the world is happy to have a dependable asset to hold as a store of value, it will buy so much of that asset that its issuer will become unsustainably burdened. The endgame to Triffin’s paradox is a global, wholesale dumping of the hcenter country’s securities. No one knows in advance when the tipping point will be reached, but the damage brought about by higher interest rates and slower economic growth will be readily apparent afterward.

For a long time now, the United States has seemed vulnerable to the fate that Triffin predicted. Since 1982 it has run a current account deficit every year but one, steadily piling up obligations to foreigners. Because foreigners have been eager to hold dollar assets, they have willingly enabled this pattern, pouring capital into the United States and financing the nation’s surplus of spending over savings. The dollar’s status as the world’s reserve currency has become a facet of U.S. power, allowing the United States to borrow effortlessly and sustain large debt-financed military commitments. Capital has tended to flood into the United States especially readily during moments of geopolitical stress, ensuring that the nation has had the financial wherewithal to conduct an assertive foreign policy precisely at moments when crises demanded it. But the capital inflows associated with the dollar’s reserve-currency status have created a vulnerability, too, opening the door to a foreign sell-off of U.S. securities that could drive up U.S. interest rates and render the nation’s formidable stock of debt far more expensive to service.

Late last year, this potential danger came close to becoming reality. Largely thanks to homegrown pressures, unrelated to Triffin’s dilemma, the world’s risk-free asset, the ten-year U.S. Treasury bond, was sagging. With sizeable budget deficits, the prospects of an ever-increasing amount of government debt, the end of the Federal Reserve’s crisis-driven program of accumulating Treasury bonds, and an uptick in inflation expectations, the ten-year Treasury yield increased by fifty basis points from 3.25 percent to 3.75 percent. And further increases were likely. Such increases would not only substantially raise the cost of future government borrowing, but would also threaten any recovery in housing and other interest-rate-sensitive sectors.

At the same time, moreover, foreigners seemed poised to drive U.S. borrowing costs higher. The dollar was falling sharply. Early in 2009 it fetched almost eighty euro cents in Frankfurt or Athens; by autumn it was worth sixty-seven euro cents. Foreign investors, who held more than half of the U.S. Treasury market, were getting nervous. Luo Ping, a director-general at the China Banking Regulatory Commission, summed up the angst:

Except for U.S. Treasuries, what can you hold? Gold? You don’t hold Japanese government bonds or UK bonds. U.S. Treasuries are the safe haven. For everyone, including China, it is the only option. We know the dollar is going to depreciate, so we hate you guys, but there is nothing much we can do. 2

Was Triffin’s endgamesudden reserve diversification, or the act of foreign governments abruptly shifting their funds from dollars to other currenciesabout to become a reality? If so, the likeliest benefactor was the eurozone. Prominent economists opined that the euro would become the world’s reserve currency by as early as 2015. 3 Through the first half of 2009 global investors seemed to agree: net inflows into eurozone debt instrumentsthat is, the rest of the world’s purchases of eurozone bonds less euro-area purchases of foreign bondssurged to record levels. The related plummeting of the dollar relative to the euro added to the fear that global investors were abandoning the center country.

But then began the eurozone phase of the global financial crisis. This has provided the U.S. government with a timely respite from both domestic forces and Triffin’s endgame. U.S. policymakers need to understand that this is not a reset, not a new beginning; it is a lucky break. How the United States uses this reprieve will affect the nation’s ability to borrow for years to come, with broad implications for the sustainability of an active U.S. foreign policy.

In what follows we will walk through the domestic pressures on U.S. long-term interest rates, the role of global investors, the respite provided by the eurozone crisis, and policy implications. The story will be told primarily through pictures. For those interested in the methodology used to measure foreign official flows and a more detailed perspective on U.S. capital flows, a box and appendix are also provided.

Domestic Pressures on Long-Term Rates

In the autumn of 2009 at least three factors were weighing heavily on U.S. Treasury bond prices, driving interest rates (or yields) upward. Significantly, none of the three factors has diminished.

The first factor is the hangover from the financial crisis. On top of tax cuts and spending increases over the past decade, the stimulus spending and the decline in tax revenues resulting from the recession worsened the U.S. fiscal situation. The budget deficit reached 10 percent of potential GDP in 2008, and even the baseline Congressional Budget Office forecast, which implausibly assumes that Congress will allow various temporary tax relief measures to expire, has U.S. public debt skyrocketing toward 100 percent of GDP (Figure 1, left panels). 4 Various economic theories provide a link from increases in either government debt (a stock figure) or budget deficits (a flow) and increases in interest rates, be it through the crowding out of private investment or through Keynesian increases in demand. Whatever theory one prefers, Thomas Laubach showed that for each percentage point rise in the projected deficit-to-GDP ratio, longer-term interest rates increase by about twenty-five basis points (or 0.25 percent); alternatively, each percentage point rise in the public debt-to-GDP ratio increases long rates by three to four basis points. 5 Combining deficit (or debt) projections with the Laubach analysis, one might expect the fiscal situation to lead to a full percentage point (or even much greater) increase in long rates.

The second domestic factor exerting upward pressure on long rates is that demand from one sourcethe Federal Reserveis likely to be scaled back. In 2009, the Fed purchased $300 billion in long-dated treasuries (Figure 1, right top panel). To the extent this put downward pressure on rates, the cessation of the Fed’s credit-easing policy might be expected to lead to higher long rates.

A third factor on the radar screen is inflation expectations. An increase in inflation expectations can have a one-for-one impact on long-term nominal interest rates. Longer-term inflation expectations (Figure 1, right bottom panel) have been on a post-crisis upward march, putting yet more upward pressure on long rates.

In the autumn of 2009, the one domestic factor that was pulling rates lower was anything but comforting: concerns about a potential double-dip recession. As the U.S. recovery has strengthened, this factor has grown less significant. The result is that the balance of domestic forces in the United States now points to higher borrowing costs for the U.S. government. Adding together the pressure from large deficits, the cessation of the Fed’s crisis-response policies, and rising inflation expectations, one might expect the ten-year Treasury rate to be at least one hundred basis points higher than it was a year ago. Oddly, and perhaps ominously, the actual ten-year Treasury rate at the start of June 2010 languishes at 3.4 percent, roughly unchanged from a year ago, implying plenty of room for an upward spike.

Figure 1 (Click for larger image)

The Role of Global Investors

Not too long ago many were skeptical that foreign accumulation of U.S. debt securities materially affected U.S. rates. The view that such intervention did not matter was summed up concisely by the chief economist of an investment bank: U.S. bond yields. have fluctuated over a wide range in response to many factors. but foreign buying. ha[s] simply not had much impact. Foreigners don’t have much influence. 6

At a July 2005 briefing, Senator Richard Shelby (R-AL) asked Federal Reserve chairman Alan Greenspan if foreign flows could affect long-term U.S. interest rates. In Greenspan’s response to the senator, he noted that while foreign accumulation probably lowered long-term U.S. interest rates, the effect was likely small, and so the unwinding of those positions, were it to occur, would only add a small amount to long rates.

But at that time no one had a good sense of the dynamics of foreign demand for U.S. bonds. To calculate the effect of this demand on Treasury rates, economists seek to isolate the portion of foreign demand that comes from governments: Unlike private foreign purchases, which may fluctuate in response to Treasury rates, foreign government purchases are presumed to be insensitive to Treasury rates, so that changes in those rates can be presumed to be driven by government buying rather than the other way around. Greenspan’s response to Senator Shelby was based on calculations that used data on bonds held at the New York Fed on behalf of foreign governments. But, while governments use the New York Fed’s custodial services for some purchases, they also hold U.S. bonds elsewhere, so the analysis was based on partial data. And while there have been many user-friendly improvements over the past few years, international capital flows data remain hard to navigate. (For a discussion of various sources of data on foreign governments’ purchases and sales of U.S. securities, see Box 1).

However, a 2005 Federal Reserve discussion paper pointed to a better answer than the one that was generally accepted at the time of Shelby’s question. 7 The paper began by showing how reported capital flows data could be adjusted for use in empirical analysis. Briefly, because of a bias in the Treasury International Capital data collected by the U.S. government, flows from foreign official institutions were often reported as being from private investors. Infrequent but high-quality snapshots of stocks (as opposed to flows) do not suffer from this bias (although they are subject to a less severe bias, described in the box) and so can be used to correct flows data. Armed with such data, the authors found that foreign official purchases of treasuries had little if any impact on shorter-term U.S. rates (which are well anchored by the Fed Funds rate) but a substantial impact on U.S. long-term interest rates. The accumulation of U.S. treasuries (and near substitutes) by foreign official institutions, then running at about $400 billion per year, lowered long-term U.S. interest rates by anywhere from fifty to one hundred basis points; if foreign governments ceased adding treasuries to their portfolios, U.S. long-term rates could spike upward by the same amount. The increase would be much greater if foreign governments actively sold existing Treasury positions. Equally, a cessation of purchases or a sell-off by foreign private investors could add even more to the upward pressure on U.S. interest rates, since foreign private investors remain large buyers.

The potential impact on the United States resulting from a sell-off has not diminished since the original discussion paper calculations, because foreigners have not reduced the size of their positions. Foreigners now hold over half of the Treasury bond market and almost a fifth of the corporate debt market. Table 1 summarizes foreigners’ share of various U.S. asset classes.

Table 1. Foreign-owned Long-term U.S. Securities ($billions) (Click for larger image)

Note: Data are from Table 2 of the Treasury’s Foreign Holdings of U.S. Securities documents. 2000 is from the June 2008 report; 2002-2009 are from the June 2009 report.

www.treas.gov/tic/bltype.txt line 37. Corporate and other debt: Flow of Funds L212 row 16, plus two-thirds of L211 row 12 (other one-third assumed short-term).

The Near Miss of 2009

The large foreign holdings of U.S. assets presented in Table 1 are only a threat to the United States if there is a risk that foreigners might abandon past patterns and decide to put their money elsewhere. In 2009, with domestic conditions pointing toward a surge in Treasury yields, major investors were thinking aloud about doing just thatwitness the concern expressed by China’s Luo Ping that his country’s accumulation of risk-free dollar assets was anything but risk-free. At the same time, other senior foreign officials were actively debating the future of the dollar as the global reserve currency. On a visit to Beijing in May 2009, Brazil’s president, Luiz Inбcio Lula da Silva, picked up on his hosts’ frustration with the U.S. currency. Calling for a new economic order, he suggested that it was time to stop denominating trade in dollars.

Sure enough, foreign flows into U.S. Treasury bonds declined steeply in the first months of 2009. Yet they remained positive, and recovered in the second half of the year (Figure 2). While not as pronounced as in 2003-2004, foreign appetite for the reserve asset remained at a high level.

Figure 2 (Click for larger image)

Even though foreign appetite for U.S. treasuries remained healthy, this did not eliminate the risk to the United States. The reason was that U.S. debt issuance was increasing sharply, and foreigners were holding a smaller share of outstanding U.S. bonds (Table 1 and Figure 3). This raised the specter of a future in which the United States would likely have to issue more and more bonds, but foreign demand might not keep pace.

Figure 3 (Click for larger image)

Figure 4 (Click for larger image)

Last data point: 2009 Q2.

At the same time, the eurozone was experiencing an unprecedented increase in net bond inflows (Figure 4). Global fixed income investors had warmed to the euro area. Luo Ping’s lament that foreigners have no choice but to accumulate U.S. assets seemed to be less true. If the euro was emerging as a popular reserve asset, was an abandonment of U.S. bonds the next step?

In sum, by the autumn of 2009 the scene was set for a wholesale abandonment of U.S. debt markets. But then the eurozone’s crisis accelerated. Spreads between Greek and German long rates skyrocketed, and net bond flows into the euro area fell sharply (Figure 5).

Figure 5 (Click for larger image)

Last data point: 2009 Q4.

The eurozone crisis seemed to remind investors of a point that had been obscured by the credit crisis: For all their imperfections, U.S. capital markets have powerful advantages over foreign rivals. To be sure, U.S. private institutions had hidden their weaknesses by holding them off their balance sheets, but the Greek government proved that European sovereigns were capable of an even greater lack of transparency. Moreover, the crisis reminded investors that there still is not a unified eurozone sovereign debt market that global investors can comfortably move in and out of. The U.S. Treasury market, in contrast, is large, homogenous, and liquidfeatures attractive to investors needing to place a large amount of funds. 8

The effect of the eurozone crisis on U.S. bond flows is striking. Flows into U.S. bonds have surged (Figure 6).