The relationship between trade imbalance and the ballooning debt to other countries

We constantly hear warnings about the ballooning US debt to other countries. The warnings go on to say that the US will eventually find itself unable to pay back the debts. Same warnings forget that the US debts to foreigners are always in US dollars.

The ballooning US debt is actually partially a consequence of the trade deficit. When other countries choose to sell more than they buy, they end up with surplus US dollars, while the US, because of the deficit, has a dollar deficit. Where do the other countries put the net US dollars they earn, since they have their own currencies at home? They won’t convert it to their own currency if they want to avoid an appreciation of their own currency. They will want to recycle most of it back to the US, where it actually gets used. So the surplus trade countries end up buying the US debt, which the US can always pay back by issuing more US dollars. Now it's up to those other countries if they want to continue selling more to the US for money it just continually prints. For as long as the US trade deficit continues, incurring debt will have to continue. This is something that will continue going on unless we stop the global trade imbalance.

I had a post 14 months back that put on a thought experiment, to try and understand the mechanism better. I’m reposting it now word for word, except, now I name actual countries in the experiment. (Maybe doing the thought experiment in complete abstract is hard to follow for some).

Let’s start the thought experiment with the country with the default global currency, which we know to be the USA. USA trades with another country, China. To simplify matters, for now let’s only look at countries USA and China, but know that there are a multitude of other countries that also trade with them and each other, also using USA’s currency.

Now when USA imports more than it exports, it incurs a deficit vis-à-vis China. Because the trade was settled in USA’s currency, China acquires foreign reserves (The reserves will be of course be in USA’s currency). USA, meanwhile, being the issuer of default currency, doesn’t have to do anything more than ‘print’ more currency.

Now what happens when it’s the other way, and China is the one that incurs the deficit? Because its currency is not the default, China has to buy USA’s currency to settle the trade. It therefore borrows in USA’s currency. The more deficits it incurs, the more borrowings it has to make in a foreign currency.

Now over the longer term, if China continually incurs a trade deficit, the net borrowings of China should depreciate its currency vis-à-vis USA’s, which should make its exports cheaper in terms of USA’s currency. Therefore, in the longer term, the balance should tilt back towards China exporting more to USA than USA exporting more to it.

But when China is the surplus country, it ends up holding more of USA’s currency as reserves, and its currency should go up vis-à-vis USA’s currency. Therefore, longer term, USA’s exports should become cheaper when converted to China’s currency. Longer term, in a normal scenario, USA’s imports from China should go down and its exports to China should go up.

PEGGING TO US CURRENCY

Now China has pegged its currency to USA, largely because doing so makes its exports to USA, as well as to the other countries, cheaper. Its continuous surpluses enables it to accumulate more reserves of USA’s currency. But to keep its currency from rising, it will lend its reserves back to USA rather than allowing it to disseminate in it local economy. USA then gets more money to finance even more deficits. China does not lend to USA because USA needs the money (Why would it need more of what it can just print?). China lends to USA because the act of lending enables China to maintain its peg to USA. It is therefore not in China’s interest to stop lending, even when USA’s constant deficits results in USA’s currency depreciating. For one, China needs to keep lending if it wants to keep the peg. Two, precisely because of the peg, China's currency also goes down vis-à-vis other countries’ currencies.

BORROWING IN A’S CURRENCY

Now, let’s suppose a 3rd country, think of any third world country. For this experiment, let’s use a country with substantial USA dollar borrowing vs its GDP, the Philippines. PHL has had a history of deficits with other countries, and therefore, has a sizeable borrowing in USA’s currency (the currency which settles the trades). PHL, therefore, cannot afford a significant depreciation of its currency in terms of USA's, because that would make its debt servicing more expensive. Then again, a depreciation in PHL's currency makes its exports cheaper in terms of USA’s currency, and therefore enables PHL to export more, and to acquire more of USA’s currency to pay down its debt. The best risk mitigating strategy for PHL is therefore to accumulate more and more reserves of USA , by incurring a trade surplus vi-a-vis the USA. Thus, to make sure it always has the ability to manage potential fluctuations in its currency’s conversion to the USA’s, and therefore always have the ability to pay down its debts, PHL will want to accumulate ever rising reserves of USA. Thus, PHL ‘s demand for USA’s currency provides even more opportunities for USA to finance even more deficits.

Now, USA, even if it eventually acquires significant borrowings from China and PHL, again need not worry much. As far as it’s concerned, either of two things can occur: 1) China and PHL could suddenly stop financing more debts, in which case, USA will just stop incurring deficits. But then USA’s currency will correspondingly fall, which will enable it to export more, and things balance out again, or 2) China and PHL will stick to their original objectives, China continues the peg and they both try to accumulate more USA’s reserves, which means USA will be able to continue financing deficits. Also, whether scenario 1 or 2 happens, USA will always be able to meet its objectives just by printing more money.

USA never has to borrow in anyone else’s currency, or even if it wanted to, can never borrow in most other countries’ currencies because 1) other countries’ currencies are never in sufficient enough supply, and 2) there is not much use for anybody else’s currency when all trades are priced and settled in USA’s currency.

GETTING TO THE GDR (Global Depositary Receipts)

Now, how would a move to a global currency change things? Let’s go back to the thought experiment.

When USA incurs a deficit with China, it has to buy the GDR to finance the deficit. China has to sell GDR currency to get paid the net surplus in its own currency. Over time, USA’s currency goes down in terms of the GDR, while China’s goes up vs. the GDR. Longer term, this should balance things, because the new currency values would eventually lead to China importing more from USA than USA from China.

Because all trades are already in GDR, there is no longer an incentive for China to peg its currency to USA. Even more so, China cannot peg its currency to the GDR because it’s actually a basket of everybody’s currencies. Pegging to GDR causes China to have an endless loop with its own currency. So no more successful pegs.

Because all trades are already in GDR, PHL, which has significant borrowing USA’s currency, will still have an interest in exporting more, so that it has the USA reserves necessary to keep its currency from depreciating. However, because USA will also need to buy the GDR to settles its trades, USA will now no longer have an incentive, or the infinite capability, to continue incurring deficits. This means less opportunities for PHL to accumulate USA reserves. If PHL already had a sizable reserve to begin with, then maybe it will already be safe. But if PHL had accumulated a very sizable borrowing in USA’s currency, then the prevalent use of the GDR will probably cause PHL to have trouble sourcing USA currency, and keeping up with its debt servicing. The only way that PHL can continue to pay is to continue incurring surplus with USA. Thus, maybe USA and PHL will continue settling in USA’s currency, and PHL will continue to finance USA’s deficits, until it feels it has enough reserves to maintain a stable currency.

So net, the GDR will constrain USA’s ability to, in Tom Hickey’s words, “foster the development of emerging nations, by making capital and technology available where it is needed”. It will also stop USA's population from continuing to enjoy spending more than they produce, out of everybody else's need to acquire its currency. It will also entail a (probably temporary) difficulty for countries that have sizable foreign debts. But over-all, it will probably result in less global imbalances.