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Snapshot for March 22, 2004 (revised June 30, 2004)

Foreign government intervention keeps the value of the dollar artificially high

The Bureau of Economic Analysis announced on June 18 that the current account (the broadest measure of the U.S. deficit in trade of goods, services, and payments to the rest of the world) reached an all-time quarterly high of $145 billion in the first quarter of 2004, an increase of 14% over the previous quarter. This trade deficit was 5.1% of U.S. gross domestic product (GDP). A major factor contributing to the rising trade deficit is the purchase of large amounts of U.S. assets by foreign governments, especially those in Asia, in order to influence the value of the U.S. dollar.

A trade deficit must be financed by net borrowing from the rest of the world. The United States was effectively spending about 5% more than it was producing in the first quarter, but cannot continue to borrow at such a high rate indefinitely. Worse yet, the trade deficit is growing each year as a share of GDP. The recent decline in the value of the dollar-which has fallen by 9.7% since February 2002, primarily against the Euro-indicates that foreign lenders are less willing to supply new credit.

If the dollar were being supported by demand from investors who find the U.S. market attractive, then steady growth in capital inflows from private investors to finance rising deficits would likely occur. However, private inflows have fallen in the last three years. Instead, foreign governments have been intervening in foreign exchange markets by purchasing a rapidly growing volume of U.S. government assets (shown as foreign government assets in the United States in the figure below). These inflows reached an annual rate of $501 billion in the first quarter of 2004, or 86% of total capital inflows. Official government inflows were 47% of the total in 2003.

Asian governments made 94% of all government purchases of U.S. assets in the first quarter of 2004. Other governments were not intervening significantly in foreign exchange markets because they expected the dollar to fall and did not want to make money-losing investments. Asian governments, especially Japan and China, are willing to absorb these risks in order to support their exports to the United States.¹  If these governments had not been intervening in foreign exchange markets then the dollar would have fallen much more rapidly than it did in this period, and the U.S. trade deficit would begin to decline.

1. For more information, see the October 30, 2003 Economic Snapshot on China’s reserves.

Source: U.S. Bureau of Economic Analysis, “Balance of Payments (International Transactions),” http://www.bea.gov; EPI analysis of Bureau of Economic Analysis data.

This Snapshot was written by EPI economist Robert E. Scott.