June 18, 2008

Increase in oil prices, fall in investment income exacerbates current account deficit woes

By Robert E. Scott with assistance by Lauren Marra

The Bureau of Economic Analysis said yesterday that the U.S. current account deficit, the broadest measure of foreign trade and investment income flows, increased to $176.4 billion in the first quarter of 2008.  The deficit increased from $167.2 billion in the fourth quarter of 2007, an increase of 5.5%.  Measured as a share of gross domestic product (GDP), the current account deficit increased to 5.0% in the first quarter, up from 4.8% in the last quarter of 2007.
 
The growth of the goods and services trade deficit explained only about $1.1 billion of the $9.1 billion increase in the current account deficit in the first quarter. Much of this was dominated by oil imports, as the U.S. deficit in petroleum products was responsible for 56% of the U.S. deficit on goods and services trade in the first quarter. Soaring petroleum prices increased the U.S. trade deficit in petroleum products $10 billion (12%) in the first quarter, despite a 2% fall in the volume of petroleum imports (U.S. Census Bureau 2008). 

Non-oil imports increased less than 1% in the quarter, a reflection of the slowing U.S. economy and the cumulative effects of a lower dollar, which declined 25% between its peak in February 2002 and March 2008 in real, inflation-adjusted terms.
 
Exports increased at a very healthy 17% annual rate in the first quarter, reflecting continued growth in global demand for U.S. goods and services, also helped by the falling value of the dollar.

A sharp decline in net U.S. investment income in the first quarter, shown in the chart below, was responsible for most of the increase in the U.S. current account deficit in the first quarter.  The U.S. balance on income declined by $6.6 billion and accounted for nearly three-fourths of the growth in the current account deficit (the black line in the chart). 
 

U.S. current account deficits must be financed with foreign borrowing and/or the net sale of U.S. assets.  This growth in foreign debt implies that, over time, U.S. payments of interest and profits to foreign investors will rise.
 
These payments to foreign investors have traditionally been more than counter-balanced by very high returns earned on foreign direct investments made by U.S. companies. In the first quarter of 2008, payments to U.S. owners of FDI exceeded U.S. payments to foreign holders of U.S. FDI by $69 billion, as shown in the chart (red line).¹
  
Although still positive, this income balance declined sharply from the previous quarter, and, its decline accounted for almost the entire decline in total net investment income, and, indeed most of the decline in the U.S. current account balance.²   The drop in net FDI income likely reflects in large part the global slowdown.  The International Monetary Fund projects in its most recent Economic Outlook that growth rates in the G-7 countries will drop from 2.2% in 2007 to 0.9% in 2008.
 
The rapid growth of U.S. FDI abroad is a mixed blessing for the U.S. economy.  The increased flow of profits on U.S. FDI abroad has reduced U.S. current account deficits in recent years.  However, it also reflects the rapid growth of outsourcing and job loss.  Between 2000 and 2005, the balance of trade of U.S. multinational companies declined from a surplus of $2.8 billion to a deficit of $112 billion.  The benefits of profits gained on these investments have not offset the losses of trade, output, and jobs to the U.S. economy that result from the offshoring of U.S. factories.

References
U.S. Census Bureau.  2008.  “FT900:  U.S. International Trade in Goods and Services.”  Washington, D.C. April. 

Notes
1. Another mystery of international payments flows which contributes to the U.S. surplus on FDI payments is that U.S. holders of foreign FDI earn a rate of return that is more than twice the rate earned by foreign holders of FDI in the U.S.  One hypothesis is that foreign firms manipulate the transfer prices used to ship goods to their U.S. subsidiaries in order to minimize U.S. tax obligations.  
2. U.S. government payments (interest on foreign holdings of government securities) fell sharply in the first quarter, as U.S. interest rates dropped.

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