As new data on foreign investment pours in each week, I look to see whether the bail-out of our deficit continues. This week, purchases of Treasuries by foreign central banks jumped $20B. Another $2B of Agency debt was purchased. Because the last few weeks have shown very little buying, the quarterly total of buying is still much lower than it was a year ago. See my article of February 14 ,2004, where I describe this analysis in more detail.

Below is an updated chart showing foreign central bank purchases of Treasuries and Agencies held in custody at the Federal Reserve. It is the “early warning” data on how much – or how little – foreigners are purchasing.

Most of these investments are made by foreign countries that sell us goods and then reinvest the dollars they receive. The economic theory and accounting assumption is that our trade deficits come back to us in the form of investment. US trade deficits have been growing, as much manufacturing is now done abroad with cheap labor, and the cost of imports, primarily oil, have risen. Below is a look at the trade deficit and the net cross-border investment flow. In general, they move together, but the investment flows are much more volatile. The trade deficit scale is inverted. There is a lot more volatility for the investment data. This makes intuitive sense because trade is based on longer term contracts, but investment can be made or removed in a day. This is monthly data, and the investment numbers include purchases of corporate bonds and equities, both by foreigners and US entities, so this is a more inclusive tabulation than the above. The point is that investment volatility is high.

While it should be understood that the accounting for these cross-border flows is supposed to match, the actual use of dollars obtained by foreigners is a choice they can make independently. The dollar enjoys the special position of being used in reserves held by foreign central banks as backing for the issuance of their currency. Central banks then, as a matter of course, purchase Treasuries, as shown in the first chart. But should another currency such as the euro or the yen become a preferred holding, foreign central banks could exchange dollars for that currency in the exchange market. Such action would flood the market with dollars, driving the exchange rate down. It need not be central banks, but world “hot money” speculators who could move markets. This last week we saw the effects of the mere rumor that the Korean central bank might decrease their dollar holdings – the dollar’s exchange rate plummeted and gold jumped on Tuesday when US markets opened after the President’s Day holiday. As far as we know, Korea made no actual change in its holdings. So the effect of the US trade deficit can also be measured in the dropping exchange rate of the dollar. The exchange rate is a measure related to the interest rate and it is also a key indicator for interpreting the direction of markets.

My conclusion is that, although the latest jump in weekly purchases by central banks is notable for its size, it may turn out to be an isolated occurrence. The quarterly view still shows that foreigners are slowing their purchases. Interest rates are up and the dollar is down since I started this analysis, which is consistent with such a slow-down in buying.

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