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For decades, there has been a lot of talk of the “exorbitant privilege” in which the U.S., as a provider of the global reserve currency, has the luxury of issuing virtually all of its gross liabilities in dollars, thus stabilizing its net international liability position. While economists almost unanimously agree that the exorbitant privilege is real, proving it and quantifying has not been a simple task. In this installment of Global Perspectives, we will examine some key economic data to find that the privilege does indeed exist and is substantial.

The U.S. Commerce Department recently released its annual report on the U.S. net international investment position (NIIP). This report, for the first time each year, presents estimates of the role that exchange rate movements and rate of return differences in accounting play in the accumulation of financial claims against the U.S. held by foreigners, net of the increase in claims held by the U.S. against the rest of the world. The report also contains revisions to data on the net international investment position for previous years that incorporate better information on the market value of U.S. assets abroad and foreign claims against the U.S., as well as better data on the composition of those claims. This data can help assess the size and scope of the exorbitant privilege.

Under the exorbitant privilege regime, the U.S. reaps a capital gain when the dollar depreciates, since U.S. assets abroad are mostly foreign currency denominated. We will show below that these capital gains are substantial. The U.S. has also benefited because it holds a riskier portfolio that is overweight foreign equities and foreign direct investment (FDI), relative to foreign claims against the U.S. that are more conservatively invested. However, there is ultimately “no free lunch” for the U.S. from dollar deprecation. Foreign producers who export to the U.S. are willing to absorb the weaker dollar in their profit margins to some extent, but eventually, a weaker dollar will worsen the U.S. terms of trade, slowing growth of U.S. living standards and, ultimately, U.S. demand.

Background

As a matter of accounting, the current account (CA) must equal the difference between national saving and investment (I). National saving, in turn, is the sum of private saving (S^P) by households and corporations and saving by the government, or taxes (T) minus government spending (G).

CA = (T – G) + S^P - I

The U.S. runs a large current account deficit for three reasons. First, the government is running a budget deficit, where T-G is negative and subtracts from national saving. Second, while business saving (corporate profits) is at near record levels as a share of GDP, household saving is negative so that the private saving rate in the U.S. is low by historical standards. Third, investment is inclusive of residential investment so that the sum of residential and corporate investment has been, until recently, high by historical standards.

In textbooks, it is often assumed that the change in the net international investment position of a country is just equal to the current account balance:

∆NIIP = CA

Thus, if the U.S. runs a current account deficit of -$833 billion as it did by one measure last year, we would expect the U.S. net international investment position to deteriorate by -$833 billion last year. However, this would only be true if asset prices in local currency terms are unchanged and if exchange rates are unchanged. In the real world, asset prices and exchange rates do change and as we will see, these have a large impact on the U.S. international investment position. Moreover, the impact of asset price and exchange rate changes on the net international investment position depends on the size, composition, and currency denomination of the gross holdings of U.S. assets abroad and foreign claims against the U.S. Thus in the real world we have:

∆NIIP = CA + (effect of asset price changes)
+ (effect of currency changes)

The Revised Historical Data and the Exorbitant Privilege

To provide some context before we examine the recently released 2006 data in some detail, Figure 1 reports the revised data for NIIP for the years 1995 – 2005. Interestingly, the data shown below has only become publicly available in recent years. Until June of 2005 (when they did so at my request), the Commerce department did not publish revised data on how asset price changes and exchange rate changes had impacted the NIIP. The final column reports the revised historical data on the U.S. NIIP. For example, for year-end 2004, it shows a net liability of -$2.396 trillion. In 2004, the U.S. current account deficit (adjusted) totaled -$556 billion. Yet during the year 2004, the net international investment position of the U.S. worsened by only -$57 billion. What accounted for this modest increase in net foreign liabilities in a year with such a large current account deficit? One factor was that that the local currency value of U.S. assets abroad, after accounting for their composition, went up by more than the local value of foreign claims against the U.S. This factor offset about $157 billion of the U.S. current account deficit. The second important factor was the effect of exchange rate changes. In 2004, like 2002 and 2003, the dollar fell against the currencies of its major trading partners. Because U.S. assets abroad are foreign currency denominated, but U.S. liabilities are almost entirely dollar denominated, a deprecation of the dollar tends to improve, or narrow, the U.S. net international investment liability.

Exorbitant Privilege Doesn’t Include a Free Lunch

The fact that the current account deficit could grow so much with only a modest concurrent increase in net international liabilities is one manifestation of the exorbitant privilege enjoyed by the provider of the global reserve currency. We see that in 2002 – 2004, this privilege was significant. In 2004, the dollar deprecation produced a net capital gain to U.S. residents worth $269 billion. The privilege was even more valuable in 2003, when it was estimated to be worth $416 billion. In total, dollar depreciation in the 2002 – 2004 period resulted in a capital gain of more than $900 billion. This capital gain offset more than half of the cumulative current account deficit during this period.

During the “strong dollar” period 1996 – 2001, and again in 2005, when the dollar appreciated, the privilege was a curse (at least for unhedged investors) as the strong dollar inflicted capital losses on U.S. assets abroad. For example in 2005, the strong dollar worsened the U.S. net international investment position by -$390 billion. However, this capital loss was more than offset by a $1 trillion net capital gain that U.S. investors earned on their investments abroad. As mentioned above, this was due in part to the fact that the U.S. holds a riskier portfolio that is overweight foreign equities and FDI, relative to foreign claims against the U.S. that were more conservatively invested. Because 2005 was a year in which equity and FDI investments generated high returns, these mark-to-market gains themselves were more than enough to offset the effect of the U.S. current account deficit on the NIIP.

Since 2001 – notwithstanding the run of record U.S. current account deficits – the U.S. net international investment position has remained roughly stable (see Figure 2) in dollar terms and has actually declined as a share of U.S. and world GDP. This does not imply that it will remain stable forever if current account deficits persist. But it does confirm that the U.S. has benefited from the exorbitant privilege, and that this has delayed the adjustment that would have otherwise begun to occur in the absence of such a privilege.

 

Thus far, the evidence suggests that little of recent years’ dollar depreciation has been passed through to higher import prices – instead it has been absorbed by the profit margins of foreign producers. If, however, the weaker dollar does start to raise import prices, it will translate into a terms of trade deterioration and lower the real incomes of U.S. households. Thus a weaker dollar produces a one time capital gain to U.S. investors abroad, but also a potentially permanent reduction in U.S. real income from current production. Thus in open as in closed economies, there is no “free lunch” from dollar depreciation.

The 2006 Data

In 2006, the U.S. began the year with gross assets abroad of $12.6 trillion, and during the year purchased $1.05 trillion worth of foreign assets, as seen in Figure 3. However, the mark-to-market capital gains on existing U.S. assets abroad that carried into the year were huge. Because of higher local currency equity and bond prices on foreign assets, these capital gains were worth more than $1 trillion. The weaker dollar delivered a $409 billion capital gain, while net capital gains on FDI were worth about $130 billion.

We now look at the gross flows and mark-to-market value of foreign holdings of U.S. assets in 2006, seen in Figure 4.

The rest of the world began with gross claims against the U.S. of $14.7 trillion, and during the year purchased $1.8 trillion worth of U.S. assets. The mark-to-market impact – in local currency (dollar) terms – on existing gross foreign holdings of U.S. assets carried into the year were worth $522 billion. We note that the revaluation of FDI in the U.S. was worth $193 billion, which was worth more than the revaluation of U.S. FDI abroad.

Pulling it all together, we see that notwithstanding a record current account deficit in 2006 of -$833 billion, the U.S. net international investment position was essentially unchanged, as seen in the “beginning” and “ending” columns of Figure 5. The story of 2006 was a record current account deficit that was more than offset by local currency gains on U.S. assets abroad and a weaker dollar.

The Bottom Line
U.S. Current account deficits of nearly 7% of GDP are not likely to be sustained. However, the U.S. net international investment position has stabilized in recent years – and has even declined as a share of GDP – notwithstanding these deficits. Although no single measure of the value of the exorbitant privilege is exact, the comparison of the growing U.S. current account deficit with a concurrently stable U.S. net international investment position in recent years confirms that the privilege does indeed exist and is substantial.