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When I was on the sell-side as a research analyst, I loved looking up the institutions and individuals that owned the stock of the companies that I covered. It allowed me to know who to spend the most time talking to. To the extent that I was bullish on the stock, I'd call those that weren't already up to their teeth in the stock to get them to buy it. Ah, the sell-side; how I don't miss thee.

PHDC is the mnemonic on the Bloomberg for this function; I used it religiously. The only problem was (and still is) that the data is updated only quarterly. Not only did I wish they be updated faster than quarterly, but I wished it could tell me who owned all manner of financial instruments beyond stocks: bonds, agencies, derivatives, and currencies.

Though much of the market's attention has been riveted on the expanding stock market, be sure to keep your eye on the US $; the DXY index rallied from a new low in June of 92, went to 99 in August, and has now retraced more than 50% of that move. And it's done so pretty quietly I might add: every day drip drip drip lower. You already know why the dollar is important: its negative 87% correlation with gold over the last decade; its measure of foreigners' confidence in the US economy and government; its ability to help those that export in dollar-denominated goods; and its emerging fulcrum as a "weapon" of economic parity (read: competitive currency devaluations and the China question).

Unfortunately, when I type in USD PHDC GO in my Bloomberg, it doesn't tell me if China or Japan is buying US Treasuries. I wish it did.

You already know that the US runs a record current account deficit; we import far more than we export (i.e. we spend more than we save). In Q2 it was $138.7 billion. That's $1.5 billion per day, $554 billion per year, in required investment from foreigners in US assets: stocks, bonds, real estate, new and existing businesses, US Treasuries, and, of course, the US$. The "hard" part of the required investments is called foreign direct investment; bricks and mortar investments in businesses and plants. Everything else is just simply paper: stocks, bonds, GSE's, and of course, actual dollars.

Of course, expecting foreigners to increase their holdings of US stocks, bonds, dollars, and businesses to the tune of $500+ billion per year indefinitely is simply fantasy. So it probably makes sense to figure out who has been doing the buying and what, exactly, they have been buying. After all, it would be nice to know what entities and what types of investments are offsetting this historic current account deficit. Maybe that will give us some insight about when the pay-the-piper moment will come for the US$ and, by extension, US Treasuries (not to mention the US economy and the US consumer balance sheet).

First, let's look at how much of and what type of investment foreigners are making in the US.

In Q2, net purchases of US Treasury and Agency debt by non-domestic private sources rose to $129 billion in the quarter, nearly as much as the entire sum from Q2:02 to Q1:03. Add to that about $70 billion in corporate bonds and about $20 billion in equity purchases by foreigners. So foreigners purchased $222 billion in US paper assets. For reference, those same folks purchased about $13 billion in hard goods (defined as foreign direct investment or FDI); these are investments in businesses and manufacturing plants for example. So foreigners invested a total of $235 billion in the US in Q2. Precisely 5.5% of that total investment was in actual businesses; 5.5% invested for the "long term" in the health of the US economy. The other 94.5% is invested in our paper assets. To put it another way, for every one dollar in fixed, long term investment, foreigners invested $17 in paper assets. Just for perspective, of the total flow of funds by foreigners into the US, FDI used to make up 34% in 2000 and before that was routinely in the 40%+ range. Now its down to 5%.

Why is this important? Because FDI is an investment that's much harder to pull out if things go awry. If you owned a carpet manufacturing plant in Ohio, you'd be hard pressed to up and sell it quickly. But if you owned a bunch of US$-denominated Treasury, agency, and corporate debt? Heck, those markets are so liquid, you could sell them in a heartbeat. So if, for whatever reason, you're a foreign investor who decides that having dollar denominated assets is a touch riskier than you recently believed, you could monetize them instantly.

So who owns all of our debt? As of July, Japanese investors - private and government - held the most Treasury debt: $444 billion, up 21% from end of 2002. China, the third largest holder, owns $126 billion (up 22%). The UK is the # two holder, with $142 billion. Note that these figures are only Treasury debt and not agency or corporate debt. And note, too, their growth rates.

Looking at the totals a little more closely is also revealing. In Q2, foreign central banks, in aggregate, added $43 billion to their holdings of US Treasury and agency debt, bringing the total purchases by foreign central banks for 2003 to date up to $71 billion. Foreign private entities have all sorts of reasons to own and buy our debt: better returns, exposure to relatively faster economic growth rates, stable government, whatever.

But why would foreign central banks be buying our debt at such a fast clip? Currency market intervention. The Japanese have sold $78.3 billion worth of Yen thru July of this year to keep the value of the Yen low against other currencies, most notably the US$ and the Euro. What do they do with all those US$s they buy on the foreign currency markets? They plow them into, among other things, US Treasuries and agency debt.

Apropos of all this; news hit the tape this morning that the Group of Seven (who are meeting in Dubai through the weekend) are expected to release a statement urging member governments to let market forces determine currency exchange rates. To wit: "In the context of exchange rates, we will strengthen the dialogue with other major economic areas to promote a smooth adjustment of international imbalances, based on market mechanisms," is the expected statement to be released.

Note the explicit reference to "adjustment of international imbalances"; that is code for "the massive US current account deficit." They are basically saying that the US $ should go down.

So there the stage has been set: our massive current account deficit, currently at a record 5.14% of GDP, is being "balanced" by investments from foreigners. But that balance is precarious indeed: as of now, less than 10% of the investments made in the US to offset this current account deficit come from long term direct investment (foreign direct investment), 50% or so come from private foreign purchases of US Treasury and agency debt, and the remaining 30% from foreign central banks, intervening to weaken their own currencies. Just for perspective, in the late 1990s, foreign direct investment made up 75% or more of the investments needed to offset our then current account deficit.

I read many economists that suggest that our current account deficit is huge and has been for a long time, so what's to worry about? The logic being that such imbalances could go on like this for a lot longer, so why worry now?

To this I would respond with two things. (1) Foreigners were more than happy to fund our current account balance in the 1990s because our economy was growing so strongly. The US consumer balance sheet was relatively healthy, and the employment picture for those consumers was downright healthy. That's why foreigners were investing in long term, bricks-and-mortar kind of investments to the tune of 75% of all foreign investment made in US assets. And (2) such logic ignores the fact that the nature of the foreign "support" of our account deficit has changed radically in the last two years and even more so in the last two quarters. Now the investment support comes in the form of liquid Treasury and Agency purchases and from foreign central banks' intervention in the currency markets. This support could end tomorrow, literally (see the G7 statement above).

Ordinarily such matters as the current account deficit are of academic interest. Indeed, for a good read on the issue, please see the Fed's working paper analysis of adjustments in account imbalances and how they played out in the past. But given the highly volatile ingredients of (1) a credit-driven but ultimately weak US expansion, (2) our historically high current account deficit, and (3) the "weak" support of this deficit almost entirely by the purchase of US Treasuries, agency debt, and central bank currency intervention, academics aren't the only ones who should be highly interested in how this issue plays out on the world stage.

Only small changes in either central bank currency intervention or foreign private purchases of US Treasuries or agencies would cause more than just a hiccup in the value of the dollar. The possible causes for such a change are myriad, as this AM's G7 press release suggests.

A rapidly falling dollar means higher interest rates here in the US and more expensive goods for US consumers (except if they are from China, who pegs its currency to the US$, but you already know the debate going on there). This at a time when the US expansion has been walking entirely on the crutches of mortgage refis and tax rebates. One need not leap too far to limn the effects of such a thing: a slowdown in consumer spending, more retrenchments in employment, a weakening of the nascent capex rebound, and another recession. I need not tell you what stock prices would do in such a circumstance.

There are plenty of things that could intervene in the above scenario, but the oft-repeated idea that the current account deficit doesn't matter is simply no longer true. It does matter. Dilating on that is important for more than just curiosity's sake.

Watch the dollar index. Closely.

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