Over the past few years, the U.S. trade deficit has been one of the driving factors of the currency markets. Or has it? The U.S. dollar has seen a drop in value of 26% relative to a basket of currencies since January of 2002. Strategists attribute the move to a deteriorating trade deficit as well as lower interest rates. Although the trade deficit has swelled to the worst in history, this has not been the reason for the drag down in the dollar's value.

The past week saw the release of U.S. international trade figures at a record deficit $66.1 billion. This week, the U.S. Treasury will release their TIC report showing net portfolio purchases of U.S. residents and foreigners. Though both sets of data are important, showing flows of funds in and out of the U.S., they fall short of the complete story. The Bureau of Economic Analysis's U.S. International Transactions shows the complete story of flows of capital into and out of the United States.

The BEA's data goes beyond the Current Account information to include the Capital Account and Financial Account. The resulting bottom line of all the data shows a negative balance of $53.379 billion for the second quarter of 2005, an improvement over the $53.980 from the first quarter. That is a negative flow of capital out of the United States of $107 billion for the first six months of 2005, and yet the U.S. dollar has strengthened relative to a basket of currencies during that same time period. With a negative flow of funds out of the U.S. of some $17 billion per month, why hasn't the dollar in fact collapsed?

The first question is, with more money flowing out of the U.S., there must be demand for the "extra" money sitting in foreign banks? In order for the dollar to not fall, this money must be absorbed in a manner that lifts the currency, i.e. a demand for the extra money. Without the requisite demand, only a lower price would bring buyers to the market for the added supply of dollars.

The U.S. dollar has long been the reserve currency of the world. But, this status has come into question with the decline of the dollar, as well as potential diversification of substitution currencies, such as the euro. Still, the dollar has remained strong over the past couple of months.

Could it be possible that in fact there is a market, or demand, for reserves in the U.S. dollar? Consider the People's Bank of China: China is quickly becoming an economic powerhouse in the world's economies. However, the Chinese banking system has not been able to develop as quickly to match the unparalleled growth that the country has seen over the past two decades. The Chinese banking system has fallen short of being able to finance its economy and float its currency. The PBOC is, however, preparing its financial system for this gradual transition.

The Bank has increased its reserves of U.S. dollars to $711 billion for the year ending in June, up 51% from the year prior. This amassing of reserves is a crucial first step to a more stable banking system, and the PBOC is continually accumulating reserves for this. The reserves are projected to reach the $1 trillion mark as early as June 2006 making the People's Bank of China the largest holder of U.S. reserves.

The second question to ask when viewing the negative trade flows is the product that the U.S. produces vs. the products that it purchases from abroad. Since World War II, the U.S. has slowly declined in the amount of products manufactured domestically, evolving from a manufacturing society into a service economy. Foreigners have gladly begun to take over the role of manufacturer in exchange for another product that our economy provides, our financial markets.

As evidenced by the continued demand from foreigners in our bond markets and the ever present financing of our trade deficit, the U.S. has gone through another transformation from a service related economy into a financial economy. This transformation has produced a market for government debt for those seeking the highest rated fixed incomes in the world. This demand for a high quality interest bearing debt is the very reason that the dollar has been supported in the face of a declining trade deficit.

Over the past three years, the world had shunned the U.S. dollar because of the interest rates that investors were earning here in the United States. Demand for fixed income has declined, and so has the value of the U.S. dollar. Now that interest rates have begun to move higher here in the U.S., the value of the dollar has followed suit. With expectations of rates moving higher here in the United States, the dollar will also likely push in the same direction.

The actual trade deficit itself cannot be used to determine the direction of the dollar because foreigners are trading their manufactured goods in for a product that the U.S. "produces", our debt. Instead, to determine the direction of the dollar, strategists should look more closely at the central bank reserves, and what these banks will be earning when they invest their reserves.

Resources:
http://bea.gov/bea/newsrel/transnewsrelease.htm
http://www.bea.doc.gov/bea/ARTICLES/2005/07July/0705_ITAQ_Web.pdf
http://www.cityweekend.com.cn/en/beijing/cib/2005_10/foreign-exchange-china-s-hidden-forex-dangers.html

David Andrew Taylor, Managing Partner, Aspen Peak Fund