case-2-US-current-account

DoNotC[e-mail]617-783-7860.9-706-002REV:NOVEMBER27,2007________________________________________________________________________________________________________________ProfessorsLauraAlfaroandRafaelDiTellaandResearchAssociateIngridVogelpreparedthiscase.Thiscasewasdevelopedfrompublishedsources.HBScasesaredevelopedsolelyasthebasisforclassdiscussion.Casesarenotintendedtoserveasendorsements,sourcesofprimarydata,orillustrationsofeffectiveorineffectivemanagement.Copyright©2005–2007PresidentandFellowsofHarvardCollege.Toordercopiesorrequestpermissiontoreproducematerials,call1-800-545-7685,writeHarvardBusinessSchoolPublishing,Boston,MA02163,orgoto—electronic,mechanical,photocopying,recording,orotherwise—withoutthepermissionofHarvardBusinessSchool.LAURAALFARORAFAELDITELLATheU.S.CurrentAccountDeficitInthefallof2007,investorsandpolicymakersthroughouttheworldwereconfrontedwiththechallengeofdecidingwhetherandhowtorespondtoglobaleconomicimbalancesexemplifiedbythelargeandgrowingcurrentaccountdeficitintheUnitedStates.Alreadyin1998,manyanalystsbelievedtheU.S.currentaccountdeficit—which,at$215billion,wasequivalentto2.5%ofGDP—wasonanunsustainabletrajectory.1Defyingforecasts,thedeficitcontinuedtoclimb.By2006,itwas$811billion,equivalentto6.2%ofGDP,andshowednosignsofabating.Sincethemid-1970s,amongtheworld’sindustrialcountries,onlysmallereconomiessuchasAustralia,NewZealand,andIrelandhadexperiencedcurrentaccountdeficitsexceeding5%ofGDP.2YearlycurrentaccountdeficitswereaccompaniedbysubstantialcapitalinflowsfromabroadasforeignersfinancedU.S.spendinginexcessofincome.Astheseinflowsaccumulated,thegapbetweenU.S.holdingsofforeignassetsandforeignholdingsofU.S.assets(knownasthenetinternationalinvestmentposition)waswideningtounprecedentedlevels.By2006,itstoodat-16.2%ofGDP,upfrombalancein1989.3MostU.S.policymakersdownplayedtherisksimpliedbythegrowingcurrentaccountdeficitandnetinternationalinvestmentposition(NIIP).TheyinsistedthatthedeficitandNIIPsimplyreflectedtheattractivenessoftheU.S.economyasadestinationforglobalinvestment.Forexample,the2006EconomicReportofthePresidentfocusedonthecurrentaccount’scounterpart.A24-pagechapterofthereportentitled“TheU.S.CapitalAccountSurplus”noted:“WhatfactorsencouragelargeandpersistentU.S.foreigncapitalinflows?Severalfactors,whichreflectU.S.economicstrengths,encouragetheseinflows.Inparticular,ahighrateofU.S.growthencouragesforeigncapitaltobe‘pushed’towardtheUnitedStates.”4Manyanalystsagreedthatthecurrentaccountcouldcontinuetobefundedatmuchhigherlevels,focusinginparticularonthe“insatiableappetite”ofAsiancentralbanks—mostnotablyChina—toinvestinU.S.assetsasameansofkeepingthedollarstrongandsupportingU.S.spendingonAsianexports.5In2006,China’scurrentaccountsurpluswas$250billion(upfrom$69billionin2004)whileitsincreaseininternationalreserves(themajorityinU.S.dollarassetssuchasTreasuries)wasover$245billion.6OtherobserverswerelessoptimisticabouttheimplicationsofthewideningU.S.currentaccountdeficit.TheybelievedtheUnitedStateswasmortgagingitsfutureinfavorofconsumptioninthepresentandarguedthatdelayingadjustmenttoendU.S.externalimbalanceswouldonlyincreasetheseverityoftheeventualinevitableadjustment.7BerkeleyeconomistMauriceObstfeldandHarvardeconomistKennethRogoffremarked:“Inourview,anysoberpolicymakerorfinancialmarketDoNotC[e-mail]swordofDamocleshangingovertheglobaleconomy.”8Theyforecastedfurtherdepreciationofthetrade-weighteddollar,whichfellbyroughly20%betweenearly2002andJune2007.9TheWorldBankwasalsoconcernedaboutthestrongdollar.Its2005GlobalDevelopmentFinanceReportidentifiedthe“gravestrisk”foremergingmarketsasadeepanddisorderlydollardeclinethatwouldcreatefinancialmarketvolatilityandpushupinterestrates.Furthermore,itwasnotedthathighlevelsofexternalindebtednessmadetheU.S.financialsystemvulnerabletoalossofmarketconfidencethatcouldinducea“suddenstop”incapitalinflows.Ofcourse,unlikeemergingeconomiesmorecommonlyassociatedwithsuddenstops,theU.S.couldborrowinitsowncurrency,meaningthatitcouldpasstheriskoffuturerealdepreciationsontoitscreditors.10Evenso,formerU.S.TreasurySecretaryRobertRubinwarnedthat“thetraditionalimmunityofadvancedcountrieslikeAmericatothird-world-stylecrisesisnotabirthright.”11Manyglobalinvestorsappearedtobeinagreementwiththeseconcerns.BerkshireHathaway,aholdingcompanyrunbyworldfamousinvestorWarrenBuffett,increasedthevalueofitsforeignexchangecontracts,consistingpredominantlyofshortpositionsagainstthedollar,from$12billionin2003to$21billionin2004.BythetimeofBerkshire’sannualshareholdermeetinginMay2006—giventheclimbofthedollarin2005—suchpositionshadcostthecompanyaround$500million.12Evenso,Buffettcontinuedtoemphasizetheneedtoprot