With the U.S. current account deficit at a record high, concerns have increased about how long financing conditions will remain favorable and how the expected external adjustment will eventually take place. Particularly in light of increasing globalization, how that adjustment takes place has important ramifications for the rest of the world as well as for the United States. A recent IMF Working Paper takes a closer look at the reasons that U.S. assets have remained attractive and the implications for resolving global imbalances.
Following a steady widening since the early 1990s, the U.S. current account deficit reached a record-high 6.5 percent of GDP in 2005. Although the deficit has been financed without putting significant pressure on U.S. interest rates, many analysts and policymakers have cautioned that the current trajectory of U.S. net foreign liabilities is unsustainable, suggesting that market sentiment toward U.S. dollar assets could weaken significantly.
Prominent economists like Olivier Blanchard and Paul Krugman have suggested that a 2-4 percent annual real depreciation of the dollar over the medium term will be necessary to achieve a sustainable current account position. Yet long-term real interest rates in the United States are not 2-4 percentage points higher than in other major industrialized regions, suggesting that investors are accepting low or negative risk premiums on dollar assets. Is this irrational, and, if so, will the dollar have to depreciate faster than markets expect to make the U.S. net foreign asset position sustainable?
Accepting a lower return
The study defines a dollar risk premium as the difference between one- or two-year interest rates on assets denominated in U.S. dollars and interest rates on assets with corresponding maturities denominated in other currencies, adjusted for consensus forecasts of the respective bilateral dollar exchange rates. A negative risk premium implies that investors accept a lower expected return on U.S. assets than on assets denominated in nondollar currencies. The risk premiums on U.S. dollar assets estimated against various currencies are also used to construct global risk premium measures.
The authors find that risk premiums on the U.S. dollar have generally been negative in recent years, possibly reflecting such advantages of U.S. financial markets as their depth, liquidity, innovativeness, and robust investor protection. Overall, risk premium movements generally reflect swings in expected exchange rate changes. In the past few years, however, the extraordinary increase and subsequent withdrawal of monetary stimulus in the United States has also been an important part of the story (see chart, this page). When measured against the Japanese yen and the euro, the dollar premium shows large fluctuations. Specifically, the risk premium on the dollar vis-à-vis the euro declined to about–10 percent in 2000 but has now moved closer to zero. The dollar risk premium against the yen has generally been positive but has turned negative in recent years—consistent with studies that find Japanese home bias (an apparent preference among Japanese investors for domestic over foreign assets) declining from extremely high levels in the past.
Negative risk premiums, rising capital flows
Data from the U.S. Treasury International Capital System suggest that capital flows have been increasingly directed toward fixed-income securities, which were purchased largely by investors in the euro area, Japan, and emerging Asian economies. European investors acquired mainly corporate bonds and equity, whereas Japan and emerging Asia invested primarily in U.S. treasury bonds.
The fact that capital flows continued—and, indeed, increased to record-high levels—amid negative risk premiums (see chart, next page) suggests that other factors have helped drive capital flows apart from interest differentials on government debt and expected exchange rate changes. Investigating further, the authors find that risk premiums appear to be largely unrelated to macroeconomic developments, such as debt sustainability indicators and economic growth differentials between the United States and other countries.
In the negative
Expectations of dollar depreciation since the late 1990s have led to negative risk premiums.
Citation: 35, 22; 10.5089/9781451968637.023.A011
Note: Global risk premium, interest rate, and expected appreciation measures are trade-weighted averages of their bilateral measures against pound sterling, Canadian dollar, euro, and Japanese yen.
Data: Consensus forecasts and IMF staff estimates.
On the other hand, differences in regional risk appetites, and the aftermath of the Asian crisis, appear to have had a measurable influence on dollar sentiment. In particular, an increase in risk appetites in the United Kingdom and the euro area—as measured by investors’ revealed preference for purchasing corporate bonds over safer U.S. treasury assets—has tended to go hand in hand with a decline in risk premiums on the dollar.
The Asian financial crisis created a large pool of savings searching for relatively riskless investment opportunities.
The relationships seem to fit the euro more closely than the yen, something that other studies find when trying to estimate the role of capital flows in exchange rate equations. One potential explanation is that, given the fragility of the Japanese financial system, banks or insurance companies may have been more focused on their capital bases than on maximizing rates of return. This may have been compounded by structural impediments to portfolio outflows—such as restrictions on holdings of foreign assets by government-run financial institutions and the pension system—leading to a high level of home bias. Reassuringly, some of these impediments have been removed, and home bias is declining in Japan.
Capital inflows reached record-high levels despite negative risk premiums.
Citation: 35, 22; 10.5089/9781451968637.023.A011
Data: U.S. Treasury International Capital System.
Continued attractiveness of U.S. assets
The presence of negative dollar risk premiums amid record-high capital inflows could mean that investors may favor U.S. assets for structural and other reasons. Of course, some analysts and policymakers have suggested that markets could have simply been irrational by investing in U.S. assets despite the negative expected returns, given prevailing interest rates and exchange rate expectations. The study sets forth another explanation, however—namely, that the Asian financial crisis created a large pool of savings searching for relatively riskless investment opportunities. This need was met by deep, liquid, and innovative U.S. financial markets with robust investor protection. These same strengths could also help explain the continued attractiveness of U.S. financial markets to European investors, who were, by contrast, searching for riskier investment opportunities.
External adjustment: orderly or disorderly?
Looking ahead, adverse adjustment scenarios would include a risk that foreign investors might buy fewer U.S. treasury bonds unless risk premiums on the dollar increase sharply, driving dollar depreciation as well as increases in relative interest rates in the United States. In particular, official flows into treasury bonds may decline as some major emerging market central banks approach their desired levels of reserves.
The risks of such an adverse scenario are likely to be reduced, however, by the dollar’s role as a reserve currency and by the attractiveness of the U.S. financial system. Of course, this will require U.S. financial markets to continue innovating to retain their advantage over other financial markets. An orderly scenario for resolving global imbalances would also be supported by improving economic prospects and, consequently, increasing risk appetite in other regions, which should lead to a demand for riskier U.S. assets; and a continued reduction in home bias in Japan, which could lead to substantial portfolio flows, including to the United States.
Ravi Balakrishnan and Volodymyr Tulin
IMF Western Hemisphere Department
This article is based on IMF Working Paper No. 06/160, “U.S. Dollar Risk Premiums and Capital Flows.” Copies are available for $15.00 each from IMF Publication Services. Please see page 272 for ordering details. The full text is also available on the IMF’s website (www.imf.org).