How Trade Policies Lead to U.S. Debt
From the early 2000s up to the financial crisis, debt levels surged in the United States. Borrowing allowed American households to consume not only from current income but from future income as well. The economy surged, but the borrowing led to problems and slower growth later on. But why did debt surge as it did? One possible explanation is that a growing trade deficit with China, and China’s rising trade surplus with the United States, was a root cause.
Recall that China has long been producing far more than Chinese households consume. Savings, in other words, is just the unconsumed portion of a country’s production. Either this amount gets directed into domestic investment or gets shipped abroad. When China exports more than they import, they run a trade surplus, and China’s trading partners run a trade deficit. China, in essence, imports demand from overseas to soak up excess domestic production and funds the imported demand by buying foreign assets.
It doesn’t stop there, however.
Trade Deficits, Capital Surpluses, and Debt
Every dollar the Chinese get in payment for exports must also leave China. Dollars must go because China can only use dollars to purchase something else in dollars abroad or to buy a U.S. asset — typically U.S. government bonds. Because of this simple fact, China’s trade surplus must be matched by an equal amount of capital leaving the country. A capital deficit offsets China’s trade surplus. The United States, on the other hand, runs a trade deficit and a capital surplus (chart, below left).
A persistent deficit must be funded somehow. In the United States, it is easy to see that debt provided much of the funding in recent years. The mortgage boom of the early 2000s and the rise in government debt since 2008 closely matched the accumulated deficit (chart, below right), for example. The surge in U.S. debt can, therefore, be linked directly to trade and trade policies between the United States and China. When China adopts policies that cause them to run a trade surplus against the United States, rising U.S. debt was the natural consequence.
That debt allowed consumption here to rise faster than it would have otherwise and faster than underlying income and output. Rising debt encouraged growth in GDP, but a dollar growth in debt did not equate to a dollar increase in production. Public and household debt in the United States rose by $25 trillion between 2000 and today, but output grew by only $11 trillion (chart, below left). This relationship is not sustainable long-term.
The United States seemed to reach a tipping point in 2010. The rise in U.S. federal government debt after the financial crisis led Standard and Poors’ to downgrade United States’ debt to AA+ from AAA in April 2011. After that, the ratio of debt to GDP leveled out as appetite for more borrowing waned (chart, below right). The United States, in essence, could not or would not continue to incur an ever-rising debt burden since then.
Impact on Interest Rates
In 2005, before he became the Chairman of the U.S. Federal Reserve, Ben Bernanke delivered a speech wherein he laid out his “global savings glut” hypothesis. He said that capital outflows from emerging to advanced economies were responsible for driving up the price of safe assets like government bonds, which also pushed global interest rates down. In essence, trade policies and forced excess savings in places like China were forcing down global interest rates below levels suggested by macroeconomic fundamentals.
If he is right, the fact that much of the global government bond market continues to have negative interest rates seems to point to the continued imbalances. The imbalances lie at the heart of United States-China tension and tensions within the European Union.
There is a clear and well-established link between trade imbalances and debt. Debt has grown far faster than productive capacity both here and in China. This buildup of excess debt is unsustainable over the long-run. The introduction of large amounts of excess debt into the global financial system increases risk, especially for governments, households, and firms that rely on leverage. Leverage creates a fixed cost, interest, and amplifies swings in profitability to owners of assets. Creditors to levered governments, households, and businesses are also at risk as a rise in debt in a borrowers capital structure increases the likelihood of default.
Separately, the period of ultra-low global interest rates is also not likely to persist. If the “global savings glut” proves to be unsustainable — as we expect it eventually will — macroeconomic fundamentals should assert themselves in global bond markets. In this case, it is important to avoid chasing “yield for yield’s sake” investments. Equity investments should be based on the expected future earnings power of businesses, and not based on “current yield.” Careful consideration of a firms capital structure and debt serviceability of the issuer should be paramount in selecting bonds. Lastly, portfolios should be able to adapt to sudden or unexpected fundamental changes in the economy.
Kevin Caron, CFA, Senior Portfolio Manager
Chad Morganlander, Senior Portfolio Manager
Matthew Battipaglia, Portfolio Manager
Steve Lerit, CFA, Client Portfolio Manager
Suzanne Ashley, Analyst
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