Research

The US International Investment Position and the International Role of the Dollar

3 November 2022 10:25

Due to structural deficits on the US current account, its net external investment position is close to minus 100% of GDP. In a world, in which China is promoting the international use of the renminbi, this may have consequences for the position of the dollar.

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Introduction

Since the start of the Bretton Woods system in 1944, the US dollar has been the anchor of the global currency system – first in a formal way, then more informally after the demise of the Bretton Woods system in 1973. As the world monetary system needs a global anchor, the US dollar just kept on functioning as such. It is the ultimate reserve currency, invoicing currency, and vehicle currency. There simply wasn’t, and isn’t, a good alternative for the US dollar. Other strong currencies, for example the German mark and the Japanese yen, were simply too small. The euro, although backed by an economy that is comparable in size and sophistication with that of the United States (US), suffers from the fact that its financial markets are relatively underdeveloped. This is partly due to the absence of a common safe asset, comparable to the market in US Treasuries.

The unique position of the dollar gives the US certain privileges, as it can pay all its foreign purchases in its own currency. On the other hand, the currency may be fundamentally overvalued, which may undermine US competitiveness. The large and persistent trade deficit of the US is a good illustration of this effect. Although the ultimate demise of the dollar standard has long been predicted (Triffin, 1978), the dollar turned out to be a tough currency. Today, the international position of the dollar is even more pronounced than it was under the Bretton Woods system. This is despite a structural deficit on the US current account balance and a deteriorating international investment position. Therefore, the US is not really feeling that there may a problem.

In the words of Dooley et al. (2003): “There have been complaints from US industry about the strong dollar, but overall the US has been happy to invest now, consume now, and let investors worry about its deteriorating international investment position.” Since then, this position has not really changed.

In an earlier publication, we also concluded that the US net international investment position (NIIP), which at the time amounted to USD -9,795 billion (minus 40% of GDP), was no reason for acute worries (Boonstra, 2017). Although the US had been running a structural deficit on its current account balance, the deterioration of its NIIP was relatively slow. The reason is that the relationship between the current account balance and changes in the international investment position, or IIP, of a country is not very straightforward, and, in case of the US, the deterioration of its NIIP was slower than one would expect when looking at its cumulative account balances.

Recently, however, the US NIIP has deteriorated sharply. At the end of 2021, it stood at a staggering
-79% of GDP (USD -18,124 billion). Since year-end 2020, the US NIIP has sunk deeper into negative territory than its cumulative current account deficits. These figures are unprecedented and are raising worries about the financial solidity of the US economy. This is happening in a context in which the eurozone and China both are aiming at a strengthening of the international position of their currencies. The question to be answered is whether the dominant position of the US dollar in the world economy may come, gradually or suddenly, under pressure this time.

We will start with a brief primer on the balance of payments and the IIP of a country. Next, we will dig deeper into the relationship between the two, after which we will have a closer look at the US NIIP. Then we will conclude with an analysis of recent developments and their possible consequences for the international monetary system.

A Primer on the Balance of Payments and the International Investment Position

The Balance of Payments

The balance of payments reflects the international transactions of a country during a period. All cross-border transactions are registered on one of its subaccounts. By definition, the balance of payments is in equilibrium, with the changes in reserves (and statistical discrepancies) as the ultimate balancing items. But the subaccounts usually are in disequilibrium. The most important subaccount is the balance on the current account, which reflects a country’s national savings balance. It shows whether a country spends more than it produces or not. The current account itself is the sum of the merchandise (or goods) trade balance, which reflects the trade in goods, the balance of trade in services, and the income balance, on which all other primary and secondary incomes are registered. Capital flows (or financial flows) are registered on the financial account and may be subdivided in direct investments, portfolio investments, and other transactions, such as cross-border loans. Note that financial flows are not registered on the capital account.[1]

[1] The capital account shows capital transfers. The IMF defines capital transfers as transfers in which the ownership of an asset (other than cash or inventories) changes from one party to another, or which obliges one or both parties to acquire or dispose of an asset (other than cash or inventories), or where a liability is forgiven by the creditor. Since the fifth edition of the IMF Balance of Payments Manual (BPM5) in 1993, regular financial flows are registered on the financial account and no longer on the capital account.

Table 1: Summary of the US balance of payments, 2010-2021

Source: US Bureau of Economic Analysis (BEA)

If the current account of a country is not in equilibrium, this has to be compensated on the other accounts on the balance of payments. The financial account is especially important, as it shows how a national savings surplus boils down to an increase in international assets (or a decrease in external liabilities) or, conversely, how a national savings deficit is financed. It is important to realize, however, that actual gross financial flows are much larger than necessary for financing current deficits or the accumulation of net foreign assets. International capital flows have increased enormously since the liberalization of cross-border financial flows since the 1980s. Such flows move more or less independently from international trade in goods and services and are much larger. The result is that for the US both gross international assets and gross international liabilities have increased enormously, which is illustrated in Figure 1.

Figure 1: US gross cross-border assets and liabilities as a percentage of GDP, 1976-2021

Source: US BEA

The International Investment Position

The IIP of a country shows the stock of its international assets and liabilities at a certain point in time. This contrasts with the balance of payments, which shows the financial flows during a certain period, usually per quarter or per year. The composition of the IIP reflects the structure of the financial account of the balance of payments.

The Relationship Between the Balance of Payments and the IIP

One could expect that changes in the NIIP of a country depend on its balance of payments. To be more precise: A country with a surplus on its current account adds to its international assets (or repays its foreign obligations), with the result that its NIIP improves, while a country with a current account deficit sees its NIIP deteriorate due to an increase of its foreign liabilities and/or a reduction of its international assets. However, this simple relationship, which in itself is true and can be found in older textbooks, is too simplistic. Data show that changes in the NIIP of a country seldom can be explained by its current account balance. Moreover, it sometimes happens that a country with a deeply negative NIIP nevertheless has a positive capital income balance. Intuitively, this is not logical. These phenomena have been explained by statistical discrepancies or, in the case of the positive US capital income balance, by the existence of so-called ‘dark matter’ (Hausmann and Sturzenegger, 2007). The existence of this so-called ‘dark matter’ is often explained by an incomplete registration of cross-border assets and liabilities. However, these explanations are not correct. Both phenomena can be explained by a closer look at the exact data on the balance of payments and the IIP as published by the countries. This is illustrated in Box 1, in which the relationship between the current account and the IIP of a country is more formally explained. We will illustrate this by using the US as an example.

Balance-of-Payments Flows and Changes in Stocks

It is important to realize that a country’s balance of payments reflects financial flows during a period. Therefore, the value changes of a country’s international assets and liabilities are not registered on its balance of payments. This means that, once a country has acquired foreign assets and liabilities, changes in the values of existing stocks have an independent impact on its NIIP. The differences may be substantial. Financial flows completely dwarf the flows of goods, services, and income that are registered on the current account.[2] As a result, countries have built up huge gross cross-border asset and liability positions with the rest of the world. Consequently, their NIIP is simply the tip of the iceberg of their gross asset and liability positions. This is illustrated in Figure 1 for the US.

Once countries have acquired large gross cross-border assets and, at the same time, have seen their international liabilities increase, changes in the value of their international assets and liabilities become more dominant when compared to the financial flows. This is illustrated for the US in Figure 2

Figure 2 illustrates nicely that the current account balance is an increasingly bad indicator of changes in the US NIIP. Other explanations have become dominant, especially since the turn of the century. The figure also illustrates that it is often the case that a change in the NIIP has a contrary sign to that of the current account balance. However, during the last three years, the US NIIP has deteriorated much faster than can be explained by its current account deficit. This deficit, large as it is, is completely dwarfed by other factors.

[2] The data in Table 1 underestimate the size of financial flows. One should realize that, in financial markets, an enormous number of transactions occur daily. It is a continuous process of buying and selling. The gross amounts are huge. These transactions are netted for a period, which gives the balance of payment entries ‘net US acquisition of assets’ and ‘net US incurrence of liabilities.’ The consequence is that the net outflow or inflow of cross-border capital, the net financial flows, is the result of a double-netting process.

Figure 2: The US current account and changes in its NIIP (USD billion), 1977-2021

Note: ‘Other’ reflects the changes in the US NIIP due to value changes of assets and liabilities. Source: calculations based on data from the US BEA as of August 2022.

In a situation in which changes in the NIIP could be explained by the current account, the NIIP would, by definition, be the sum of all current account balances (CUMCA). This is illustrated for the US in Figure 3. This figure shows that, until 2018, the cumulative current account deficit was much larger than the actual NIIP. However, in the last three years, the NIIP has deteriorated very rapidly. Today, it is substantially larger than the sum of current account deficits since 1976 – the first year the Bureau of Economic Analysis (BEA) reported the US NIIP, which at the time was relatively close to zero.

Figure 3: NIIP and CUMCA, 1976-2021

Source: Calculations based on data from the US BEA

Box 1: From the current account to the NIIP – a more formal analysis

As explained above, the simplest relationship between the current account and the NIIP is when a savings surplus adds to a country’s international wealth and a savings deficit reduces it. In the words of a well-used textbook: “A country’s current account balance equals the change in its foreign wealth” (Krugman & Obstfeld, 8th edition, 2009, p. 296).

In formula:

Which means that a country’s international wealth is equal to the sum of its current account balances:

As illustrated in Figure 2, at least for the US, this straightforward relationship does not hold in practice. The reason for this, as explained in the main text, is that once a country has acquired cross-border assets and liabilities, these can change in value. These value changes are not registered on the balance of payments, which – with a few minor exceptions – registers only flows. This leads to the next formula, which tells us that the NIIP of a country at a certain point in time (NIIPt) equals its NIIP at the previous period (NIIPt-1), plus the current account balance during period (t), plus the value increases (k) of its existing foreign assets, and minus the value increases of its international liabilities during period (t).

Note that the return on assets and liabilities basically has two components: an income flow (dividends, interest income, profits) and capital changes. The first component is visible on the balance of payments (capital income balance, part of the current account), but capital changes are not.

Moreover, international assets (A) and liabilities (L) can be subdivided into their components. Both include direct investments (FDI), portfolio investments – which can be subdivided into debt securities (DEBT) and equities (EQ) – and other investments (O), which are mostly bank transactions. Moreover, international assets include the foreign exchange reserves (RES). This is reflected in the next two definitions:

The subscripts A and L stand for assets and liabilities. Following the definitions (4) and (5), we can define the capital gains on assets as:

and the capital gains on liabilities as:

The deviation of a country’s NIIP from its cumulative current account deficits is therefore dependent on various factors. First, the composition of its international assets and liabilities is important. For example, bank loans and bond investments usually offer a lower yield than direct investments and portfolio investments in equity.[3] This is the so-called ‘composition effect.’ Second, there is the ‘performance effect,’ which results from a discrepancy in the performance of international assets and liabilities within the same category. If, for example, US equities offer a better return than their international equivalents, the resultant performance effect would, all else being equal, negatively impact US NIIP. A third factor is the exchange rate. Many countries have their international debts in foreign currency, which in most cases is the US dollar. They often have to finance current account deficits by borrowing in hard currency, as most currencies are not accepted in international trade transactions. In such a context, a depreciation of a country’s currency means that its debt burden increases, which sometimes results in a financial crisis. This is the story of many emerging economies, Argentina being one of the best (or worst) examples. For the US, this is different, as most of its external liabilities are denominated in US dollars, while most of its international assets are in foreign currency. This means that the US NIIP actually improves when the dollar depreciates because its foreign assets, expressed in dollars, increase in value. Finally, of course, the starting position is relevant. When a country has a substantial net international asset or liability position, the absolute income on its assets and liabilities will by definition diverge, even if the composition of and the returns on its international assets and liabilities are equal. In this article, which discusses the US external position, this factor can be ignored, as the US NIIP was more or less zero in 1976 (the first year we have data available).

In the rest of this article, we will identify the reasons behind the acute deterioration of the US NIIP and its consequences.

See footnote, [3]

[3] Note: The registration of capital income on the balance of payments is not perfect. Not all yields abroad are repatriated.

What Drives the Value Changes?

As explained above, as the absolute size of gross international assets and liabilities grows, value changes of these cross-border assets and liabilities will have an increasingly important impact on the NIIP, which brings us to the first obvious conclusion: The larger the gross international positions, the more important value changes become. But it is not only the size that matters. The composition of these gross positions plays an important role as well. Some asset classes are more volatile than others. An obvious example is the difference between debt securities and other debt on the one hand and direct investments (FDI) and equities on the other. Bonds are relatively stable, while FDI and equities usually bring higher but more volatile returns. Next, the relative performance of asset classes is important. If, for example, US equities outperform foreign markets, this will have a negative effect on its NIIP. Finally, as explained in Box 1, US international liabilities are overwhelmingly expressed in US dollars, while its foreign assets are largely denominated in foreign currency. All these effects combined determine the impact of value changes of the NIIP of a country.

A Closer Look at US External Assets and Liabilities

In the years between 1976, when IIP was first reported, and 2010, the NIIP of the US was better than one would expect when looking at the cumulative current account balance. In most years, the net effect of value changes partly compensated the negative impacts of the US current account, which was structurally in the red. After 2010, however, when ‘dark matter’ peaked, the situation rapidly reversed. Since then, cumulative value changes have had a huge negative impact on US NIIP, an effect that was substantially larger than its cumulative current account deficits. In 2019, there was a break-even point, as the US NIIP was identical to its cumulative current account balances. In 2020 and 2021, there was a further rapid decline due to cumulative negative value changes of over 20% of GDP, a development that may have continued in 2022.

There are several explanations for this development. First, the composition of US external liabilities has changed. In the not-so-far past, US liabilities had a strong emphasis on the categories ‘bonds’ and ‘other,’ which offer relatively low yields. Its foreign assets, on the other hand, traditionally consist of the categories ‘direct investments’ and ‘portfolio equity investments.’ This difference (the composition effect explained in Box 1) can explain both the positive capital income balance of the US and the fact that value changes due to stock market gains benefited the US more than other countries. Since 2010, this situation has gradually changed. On the asset side, the differences are not spectacular. The US emphasis on direct investment and equities has not changed; their shares have even significantly increased (Figure 4 left panel). The spectacular developments are on the liabilities side (Figure 4 right panel), where the shares of direct investments and equities have strongly increased and the emphasis on bonds is strongly reduced. Due to this development, foreign investors today own more direct investments and portfolio equities in the US than the other way around.

Figure 4a: US international assets

Source: US BEA, IMF

Figure 4b: US international liabilities

Source: US BEA, IMF

A further explanation is the development of the US dollar. As explained in Box 1, US external liabilities are overwhelmingly expressed in dollars, whereas external assets are denominated in foreign currency. If the dollar depreciates, the US NIIP improves; a stronger dollar results in a deterioration. This effect (illustrated in Figure 5) is, as expected, especially visible on the asset side of the US external balance sheet. In the years in which the dollar appreciates, we see a significant negative exchange rate effect, and in years with a weaker dollar, the exchange rate effect is positive. On the liability side, it is negligible.

Figure 5a: Changes in US international assets explained

Source: US BEA

Figure 5b: Changes in US international liabilities explained

Source: US BEA

The Consequences

Let’s start with the good news, which is of course that worldwide there still is a lot of confidence in the strength of the US economy. This is illustrated by the fact that foreign direct investment flows into the US have strongly increased and today are larger than US investments in these categories abroad. At the same time, it is to be expected that, as a consequence of this development, the US net investment income balance will deteriorate further. This has, all else being equal, a further downward effect on its current account balance.

Is the leading position of the US dollar in the world economy under threat? The US is still one of the largest and most advanced economies in the world. Although the share of the US dollar in the world financial markets today is much larger than the weight of the US economy in global GDP, there still is simply no alternative for the dollar. The euro is still an incomplete currency, and despite the size of the eurozone economy and the fact that the euro is the world’s second currency, its international role has, nevertheless, been more or less stagnant since its introduction. Although Europe’s policymakers have declared that they want to strengthen the international role of the euro, these words, so far, turn out to be rather empty. The international use of the Chinese renminbi, the third currency of the three big economies, so far is lagging far behind.

Figure 6: International reserve currencies (share in %), 1990-2021

Note: Euro data for 1990 are based on the shares of the major European currencies in the Exchange Rate Mechanism. Source: ECB

Nevertheless, the real threat for the dollar comes from China. Although the renminbi is still a relatively minor currency, Chinese authorities work hard on its further development (Overholt et al., 2016). China has already developed into a world player, with an economic, political, and military clout that challenges the US position. It is also developing into the informal leader of an anti-western coalition, with Russia as partner. China and Russia are already working hard to create an alternative to SWIFT, the global payments system. And China is far ahead in the development of a digital version of its currency, DCEP, which from the start can be used for cross-border transactions and may be a good alternative for trade transactions. The international role of the renminbi as a trade, investment, and reserve currency may increase substantially in the near future, first at the expense of the euro and secondly maybe also the US dollar. This means that, while the financial and political pillars under the dollar’s international position are shrinking, that position will increasingly come under pressure from the renminbi.

It should be remembered that today the US is more or less dependent on the special role of the dollar. Without this status, it might not have been able to finance all its external liabilities in its own currency. Therefore, the deeply negative NIIP of the US looks alarming. For any ‘normal’ country, a negative NIIP of almost 80% of GDP might possibly forebode disaster. However, so far the US is not a ‘normal’ country, as its currency, the dollar, is still the world’s reserve currency. The unique international position of the dollar is the most important reason why the US could neglect its external deficit and debt position for decades. In nominal terms, the US will always be able to meet its international obligations.

As explained above, a direct result of this scenario is the fact that a strong depreciation of the dollar would translate immediately into an improvement of US NIIP (measured in dollars and percentage of GDP). This, of course, would also mean that the rest of the world would suffer a major loss on their US assets, which may sooner or later further undermine confidence in the US currency. Since the establishment of the Bretton Woods system, US-made financial crises have happened several times. Compared with these earlier crises, today’s situation has two major differences. First, the US external position has never been in such bad shape as today. And, second, there was no realistic alternative to the US dollar. Neither the German mark nor the Japanese yen was ever a serious challenge for the US dollar. German and Japanese policymakers also never had the ambition to replace the dollar with their respective currencies. Moreover, both Germany and Japan never had an economic, political, and financial clout that was comparable with that of the US.

In 1971, when the US cut the link between the dollar and gold, the US Secretary of the Treasury, John Connally, reportedly told the delegates of other countries: “the dollar, our currency, your problem."[4] But once there is a credible alternative to the US dollar, the problem may shift to the US itself. The country may be forced to finance its current account deficit in foreign currency. This happened before, in the 1980s, when the US briefly issued bonds in Japanese yen, and earlier, during the Bretton Woods crisis, when it issued the so-called Roosa bonds, which were part of a swap transaction and had to be repaid in foreign currency (De Vries, 1976).This would turn the US into a ‘normal’ country that would feel the disciplining pressure of world financial markets much more than it does today.

[4] This quote is taken from the memoirs of Jelle Zijlstra, at the time President of the Dutch central bank.

Conclusion

The debate about the international role of the US dollar and the sustainability of the dollar as the anchor of the international monetary system goes back to the 1950s. Nobody at the time could foresee how lasting this position would be, despite American external deficits and debts, the size of which defies the imagination of the early 1970s. As long as there is no alternative currency large and strong enough to take over this role, the dollar appears to be the safe option. However, China clearly has the ambition to develop such an alternative, and, as said, the country is already challenging US dominance in many respects. Neither the German mark nor the Japanese yen was ever as much of a threat to the US dollar’s dominance as the renminbi may turn out to be. Meanwhile, the ruble was not convertible when it was the currency of the USSR, and it has never been developed into a ‘weapon’ to challenge US financial dominance. And China is working very hard on its relations with emerging markets in the Asia-Pacific region, developing economies in Africa and Latin America, and, not to forget, traditional opponents of the democratic world such as Russia. This geopolitical factor, which was hardly present during earlier ‘dollar crises’ makes the fast deterioration of the US external investment position even more worrying. The US dollar may be approaching the end of its absolute reign of the global monetary infrastructure. However, it may still take years, if not decades, before the dollar standard comes to an end. Moreover, it is unclear what the future system may look like, as a renminbi-based system would not be acceptable for western democracies. A bi-currency standard, on the other hand, is suboptimal for the world economy, as global trade is most efficient when international tradable goods are priced in one standard currency. A system based on the Special Drawing Rights, which may be preferable, would require agreement among all major international countries. As a result, the only hard conclusion is that the financial fundamentals supporting the dollar in its role as anchor of the global monetary system are gradually but certainly weakening.

References

Boonstra, W.W. (2017), The US external debt is no cause for concern, yet, VOX EU, August 2017.

De Vries, M.G., (1976), The International Monetary Fund 1966-1971, Volume I: Narrative, IMF, Washington, 1976.

Dooley, M.P., D. Folkerts-Landau, and P. Garber, An essay on the revived Bretton Woods system, NBER Working Paper 9971, Cambridge MA, US, September 2003.

Hausmann, R. & F. Sturzenegger (2005-b): U.S. and global imbalances: Can dark matter prevent a big bang?, www.cid.harvard.edu, November 2005.

Overholt, W.H., G. Ma, and C.K. Law (2016), Renminbi rising: A New Global Monetary System Emerges, Wiley and Sons, Chichester, UK.

Triffin, R. (1978), The international role and fate of the dollar, Foreign Affairs, 1978, Vol. 57, No. 2 (Winter, 1978), pp. 269-286.

Triffin, R. (1978), Gold and the dollar crisis: yesterday and tomorrow, Essays in international finance, No. 132, Princeton University, December 1978.

Zijlstra, J. (1992), Per slot van rekening: Memoires (in Dutch), Contact Publishers, Amsterdam.