The Deficit and Your Portfolio

For example, you'd expect that Asian central banks would have been selling dollar assets recently. After all, the euro has picked up better than 20% against the dollar since the start of 2002, and investors who switched currencies have seen a sizable profit. But instead, Asian central banks, which have about 75% of their reserves invested in dollar-denominated assets, mostly U.S. Treasury notes, have actually been buying more dollar-denominated assets.

According to CrossBorder Capital, an investment research company, foreign central banks have increased their holdings of U.S. Treasuries by about 10% in the last six months of 2002. Much of that buying has come from Japan, China and South Korea.

It's all part of a global economic deal -- these countries buy our Treasury notes, which keeps the dollar relatively strong vs. their own currencies, and U.S. consumers buy their products.

But this isn't a deal that can withstand all pressures. Foreign holders of dollar-denominated assets do see the value of those assets erode if the value of a dollar sinks vs. the value of their local currency. At some point, the losses from a falling dollar become large enough that U.S. Treasuries become a harder and harder sell, unless they pay a higher rate of interest.

Different groups of overseas investors and institutions reach that switching point at different moments. Individual investors, who aren't charged with protecting their country's trade surplus, already have started to re-evaluate their willingness to hold dollar-denominated assets.

Foreign central banks are still on board, because taking currency losses is less important -- as long as the losses are reasonable -- than making sure that a rising yen or yuan or won doesn't price Japanese, Chinese or Korean goods out of U.S. markets.

But even central banks don't have endless patience. The disquieting thing about the White House budget numbers, to an overseas investor or banker, is that the deficit doesn't come down very fast or very far over the next five years. The fiscal 2004 shortfall of $307 billion does indeed sink to just $208 billion in 2005. But then it sticks there, falling to $201 billion in 2006 and finishing the period at $190 billion. Five years is a long time if you're a banker watching the value of your reserves slowly decline because the U.S. government can't get its deficit down.