U.S. Foreign Debt
Shows Its Teeth
As Rates Climb
MARK WHITEHOUSE/ Wall Street Journal, September 25, 2006
Net Payments Remain Small
But Pose Long-Term Threat
To Nation's Living Standards
Over the past several years, Americans and their government enjoyed one of the best deals in international finance: They borrowed trillions of dollars from abroad to buy flat-panel TVs, build homes and fight wars, but as those borrowings mounted, the nation's payments on its net foreign debt barely budged.
Now, however, the easy money is coming to an end. As interest rates rise, America's debt payments are starting to climb -- so much so that for the first time in at least 90 years, the U.S. is paying noticeably more to its foreign creditors than it receives from its investments abroad. The gap reached $2.5 billion in the second quarter of 2006. In effect, the U.S. made a quarterly debt payment of about $22 for each American household, a turnaround from the $31 in net investment income per household it received a year earlier.
The gap is still small within the context of the $13 trillion American economy. And the trend could reverse if U.S. interest rates decline. But economists say America's emergence as a net payer illustrates an important point: In years to come, a growing share of whatever prosperity the nation achieves probably will be sent abroad in the form of debt-service payments. That means Americans will have to work harder to maintain the same living standards -- or cut back sharply to pay down the debt.
"Our net international obligations are coming home to roost," says Catherine Mann, a senior fellow at the Institute for International Economics. "It's as if on our personal MasterCards we have run up large obligations and never had to make payments. You can't believe that's going to last forever."
If the trend persists, it could also raise concerns about the nation's creditworthiness, putting pressure on the U.S. currency. "It's an additional challenge for the dollar," says Jim O'Neill, chief economist at Goldman Sachs in London. "Economists have been warning about this for so long that people have gotten bored, but now we're starting to see the deterioration."
Since the end of 2001, when the current economic expansion began, the nation's consumption, investment and other outlays have exceeded income by a cumulative $2.9 trillion -- the largest gap on record. That current-account deficit contributes directly to the nation's total foreign debt, the value of all the U.S. stocks, bonds, real estate, businesses and other assets owned by non-U.S. residents. As of the end of 2005, total U.S. foreign debt stood at $13.6 trillion -- or about $119,000 per household. Net foreign debt, which excluded the $11.1 trillion value of U.S.-owned foreign assets, was $2.5 trillion.
Exactly how the U.S. has managed to load on so much debt without seeing its net payments rise remains something of a mystery. Even in the second quarter, the U.S., in effect, was paying only a 0.4% annualized interest rate on its net debt. "It's still quite a good deal," says Pierre-Olivier Gourinchas, an economics professor at the University of California, Berkeley.
In a recent paper, Harvard economists Ricardo Hausmann and Federico Sturzenegger went so far as to suggest that the U.S. might not be a net debtor at all. Instead, they surmised, the U.S. might actually have income-producing assets abroad, such as know-how transferred to foreign subsidiaries, that have evaded measurement -- assets they call "dark matter," after a similarly elusive quarry in physics. Mr. Sturzenegger says the latest data haven't changed his view.
Most economists, however, see a more prosaic explanation: Foreigners have been willing to accept a much lower return on relatively safe U.S. investments than U.S. investors have earned on their assets abroad. Take, for example, China, which since 2001 has invested some $250 billion in U.S. Treasury bonds yielding around 5% or less -- part of a strategy to boost its exports by keeping its currency cheap in relation to the dollar.
By contrast, U.S. direct investments abroad -- which would include things like glass maker Corning Inc.'s liquid-crystal display plants in Taiwan or Intel Corp.'s chip-making subsidiary in Ireland -- have returned an average 8% since 2001, according to U.S. Commerce Department data. Meanwhile, U.S. investors in emerging-market stock funds earned an average annual return on their investments of 22.3%, according to financial-research firm Morningstar Inc. (The Commerce Department counts only part of that as income).
Because the U.S. has tended to borrow in bonds and similar interest-bearing instruments while investing in stocks and longer-term foreign projects, it has benefited vastly from the low interest rates of recent years. "The U.S. has been exceptionally lucky," says Goldman's Mr. O'Neill, "It's like the world's biggest hedge fund. It's borrowing cheap money and getting leveraged returns from the things it's investing in."
Foreigners' willingness to lend at low rates has also encouraged Americans and their government to borrow and spend. By buying U.S. Treasurys, foreign investors put up more than four-fifths of the $1.3 trillion the federal government has borrowed since 2001 to help pay for tax breaks, the new Medicare prescription-drug benefit and wars in Afghanistan and Iraq. Over the same period, foreigners put more than $700 billion into various types of U.S. mortgage-backed securities, providing the money for millions of Americans to buy new homes -- or extract cash from their existing homes to spend on goods such as washing machines and Hummers.
Now, the interest-rate picture is changing. Long-term rates remain low, but the Federal Reserve has raised short-term rates to 5.25% from a low of 1% in June 2004. As a result, payments on U.S. government debt, much of which is short-term, have risen. In the second quarter, for example, the government's debt payments to foreigners rose 10% to $36 billion, accounting for most of the change in the balance of income.
The nation's growing debts have made its finances more vulnerable to interest-rate changes. Cedric Tille, an economist at the Federal Reserve Bank in New York, estimates that a mere one-percentage-point rise in the relative return on U.S. foreign debt would increase the country's net debt payments by 1.1% of gross domestic product. Back in 1995, when the U.S.'s foreign liabilities were smaller, the effect would have been only half a percentage point.
Even without any major changes in rates, economists expect the burden of foreign-debt payments to rise. Estimates of that burden 10 years from now range anywhere from 0.5% to 2% of GDP, depending largely on whether the U.S. manages to curb its current-account deficit. If the deficit expands significantly and the U.S. stops earning a premium on its investments abroad, the burden could reach 5% of GDP, according to calculations made by John Kitchen, an economist in the White House's Office of Management and Budget.
The size of the nation's debt payments matters because it represents a share of income that American consumers, companies and government won't be able to spend or save. The higher the debt payments, the harder it will be for the U.S. to prosper.
"Your standard of living is going to be reduced unless you work much harder," says Nouriel Roubini, chairman of Roubini Global Economics. "The longer we wait to adjust our consumption and reduce our debt, the bigger will be the impact on our consumption in the future."
To be sure, by some measures the U.S. foreign debt is still relatively manageable. As a share of GDP, for example, the nation's net debt stood at about 20% at the end of 2005, compared with the 15% average of the 12-nation euro zone. The United Kingdom's net debt is 17% of GDP. Mexico's is 44%.
Among economists' biggest concerns, though, is the fast pace at which the U.S. is accumulating new debt. As that leads to larger interest payments, it will make the current-account deficit harder to control -- a vicious cycle that could accelerate if worried foreign investors demand higher interest rates to compensate for the added risk.
"You end up having to pay more and borrow more," says the University of California's Prof. Gourinchas. "Things could get out of hand very quickly."