Full text of Chicago Fed Letter : Is the U.S. Current Account Sustainable?, No. 215

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ESSAYS ON ISSUES

THE FEDERAL RESERVE BANK
OF CHICAGO

JUNE 2005
NUMBER 215

Chicago Fed Letter
Is the U.S. current account sustainable?
by Michael Kouparitsas, economist

This article clearly defines what economists mean by a sustainable current account. The
author provides an estimate of the sustainable current account balance for the U.S. economy
and assesses the implications of this estimate for the existing current account and level
of foreign indebtedness.
What is the current account? The bal-

ance in the current account (CA) represents the sum of net exports (NX), net
foreign income (NFI), and unilateral
transfers (UT). A nation has a current
account deficit if the sum of these three
account balances is negative. The size of
the current account deficit reflects the
amount by which a nation’s gross domestic expenditure exceeds its income from
all sources domestic and foreign (gross
national product, GNP).

1. NIPA current account
percent GDP
2

NFI
0

UT

NX
-2

CA

-4

-6
1977 '80 '83 '86 '89 '92 '95 '98 2001
NOTES: CA is current account; NX is net exports; NFI is
net foreign income; and UT is unilateral transfers.
S OURCE: Author's calculation based on data from U.S.
Department of Commerce, Bureau of Economic Analysis,
U.S. International Transactions.

Net exports are simply exports minus
imports. If a nation has a net export deficit, then imports are greater than exports. The size of the net exports deficit
reflects the amount by which a nation’s
gross domestic expenditure (GDE, which
is consumption, plus investment, plus
government spending) exceeds the value
of its gross domestic production (GDP).
Net foreign income, which I describe
more fully later, is the balance of international income receipts and payments.
In addition to the income they generate
domestically, countries receive income
from abroad and pay income to foreign
residents. For the U.S., these international income flows are largely explained by
interest receipts on foreign assets owned
by U.S. residents and interest payments
on U.S. assets owned by foreigners.
Another important income flow is lump
sum transfers from the U.S. to foreign
countries or international organizations
and receipts by the U.S. from foreign

governments or international organizations, called unilateral transfers. These
transfers are more commonly known as
foreign aid. The U.S. typically runs a deficit on this account, meaning it pays out
more than it takes in. The sum of gross
domestic product, the balance on net
foreign income, and unilateral transfers
is gross national product.
Figure 1 plots the evolution of the U.S.
current account over the past 27 years.
According to the National Income and
Product Accounts (NIPA), the U.S. has
run a current account deficit for 24 of
the past 27 years—the exceptions being
1980, 1981, and 1991. Figure 1 reveals
that the NIPA ratio of the current account to gross domestic product is essentially driven by fluctuations in net exports,
since net foreign income and unilateral
transfers have been fairly constant percentages of GDP. In 2003, the last year
for which we have estimates of the U.S.’s
net international investment position,
the current account deficit was estimated
at 4.8% of GDP.
Foreign debt and the current account

The value of assets owned by U.S. residents held abroad (A) minus the value
of U.S. liabilities to the rest of the world
(D) is called the U.S. net foreign asset
position (NFA). If its net foreign asset
position is positive (NFA > 0), the U.S. is
a net creditor to the rest of the world.
Conversely, if NFA is negative (NFA < 0),
then the U.S. is a net debtor, because its

sharp decline in the value of U.S. foreign
assets, as indicated by the decline in the
ratio of the value of A to GDP.

2. Net foreign asset position (NFA)
percent GDP
100

D

Current and future debt levels

75
50

A

25
0

NFA
-25
1977 '80 '83 '86 '89 '92 '95 '98 2001
NOTES: A is assets owned by U.S. citizens held abroad;
D is U.S. liabilities to the rest of the world; and NFA is
net foreign assets.
SOURCE: Author's calculation based on data from U.S.
Department of Commerce, Bureau of Economic Analysis,
U.S. Net International Investment Position at Yearend.

outstanding liabilities to the rest of the
world exceed its claims on the rest of
the world.
The U.S., like all nations, is subject to a
budget constraint that requires that the
value of U.S. gross domestic expenditures plus the change in the stock of foreign assets owned by U.S. residents equals
the value of gross national product plus
the change in the stock of U.S. debt owed
to foreigners. Combining this relationship with the definition of the current
account, it follows that the change in the
net foreign asset position is the same as
the balance on the current account (see
box 1 for details). Therefore, if the current account is in deficit (CA < 0), as indeed it is, the change in the net foreign
asset position is negative, indicating that
the increase in foreign debt was greater
than the increase in foreign assets over
the year. A negative change in the net foreign asset position is referred to as a net
capital inflow, since more capital flowed
into the country through additions to
the level of foreign debt than flowed out
through purchases of foreign assets.
Figure 2 plots the evolution of the U.S.
net foreign asset position over the past
27 years. Prior to 1986, the U.S. was an
international net creditor. Since then, it
has been a net debtor. The gap between
the value of A and the value of D widened considerably in 1999, in terms of
dollar value and as a percentage of GDP,
indicating that there has been a sizable
net capital inflow to the U.S. since 1998.
Figure 2 also reveals that the increased
net inflow in the late 1990s reflected a

In the U.S. case, net foreign income is
largely explained by interest receipts on
foreign assets owned by U.S. residents and
interest payments on U.S. assets owned
by foreigners. Therefore, future current
account and net foreign asset positions
are related to the present current account
and net foreign asset positions through
future net foreign income flows. The extent of these flows is influenced by the
rates of return on foreign assets and foreign debt. Over the past 27 years, the
rates of return on foreign assets owned
by U.S. residents and the rates paid on
U.S. debt owned by foreigners are roughly
equal for portfolio and banking investments. In contrast, the U.S. return on
foreign direct investment has on average
been 6 percentage points higher than
other countries’ return on their direct
investments in the U.S., while the return
on U.S. official investment has on average
been 4 percentage points lower than
official foreign investment in the U.S.
When weighted by their respective asset
and debt levels (the official positions being much smaller than the privately held
positions), these interest differentials
have favored the U.S., in so far as the U.S.
has been able to maintain a net income
surplus over the last 27 years, despite
growing as a net debtor over this period.
Figure 1 plots the NIPA estimate of U.S.
net income flows since 1977. During this
time, the gap between receipts (inflows)
and payments (outflows) has narrowed
as a percentage of GDP. The narrowing
gap largely reflects increased foreign net
indebtedness, rather than a narrowing
of the differential rates of return.
How do we determine sustainability?

When economists want to assess sustainability of the current account, they begin
by calculating the net exports to GDP
ratio that would be required to maintain
the current net foreign assets to GDP
ratio, NFA*. I refer to this as the critical
net exports to GDP ratio, NX*. Net exports
to GDP ratios above NX* will increase
the nation’s net foreign assets to GDP

ratio above NFA*, while net exports to
GDP ratios below NX* will decrease it.
For reasons that I explain below, negative net foreign asset positions are typically associated with a positive NX*.
Another way of stating this is that a country must give up a fraction of all future
GDP equal to NX* to maintain its current
negative net foreign asset position. A
country’s current net foreign asset position is considered unsustainable if the
associated NX* is a relatively large fraction of GDP. Similarly, a current account
deficit is considered unsustainable if it
maintains or leads to an unsustainable
net foreign asset position.
So, to answer the question of whether
the U.S. current account is sustainable,
I need to determine NX*. I do this in
box 1 by combining the nation’s flow
budget constraint with definitions of the
current account, net foreign asset position, and net foreign income. According
to this analysis, NX* depends not only
on NFA*, which is weighted by the difference between the growth rate of nominal
GDP and the interest rate on U.S. foreign
debt, but also the current ratio of U.S.
gross foreign assets to GDP, A*, which
is weighted by the difference between
the interest rates on U.S. foreign debt
and U.S. foreign assets, and the typical
ratio of unilateral transfers to GDP, UT*.
A byproduct of this analysis is the current
account to GDP ratio, CA*, that would
be required to maintain NFA*. CA* only
depends on NFA*, which is weighted
by the growth rate of nominal GDP.
Theoretical analyses typically assume that
there is no differential between the interest rate on U.S. foreign assets and debt,
and that the interest rate on U.S. foreign
debt exceeds the growth rate of U.S.
nominal GDP, which suggests that the
U.S. must shift to a net export surplus to
maintain its current negative net foreign
asset position. This is the reasoning behind much of the analysis arguing that
the U.S. must eventually run a trade surplus to finance its current level of international indebtedness. However, this
argument overlooks the fact that the U.S.
experience is inconsistent with standard
theoretical assumptions. First, as noted
above, the return the U.S. earns on its
private foreign assets exceeds the rate it

pays on its private foreign debt. While it
is true that the reverse holds for returns
on official assets and debt, they have a
very low weight since the U.S. has a relatively small official foreign asset position.
Ignoring other factors for the moment,
if these interest differentials were to persist at their present levels, the U.S. could
maintain a stable negative net foreign
asset position, while running a persistent
net export deficit. Second, on average,
rates of return on most classes of U.S.
foreign debt have been roughly equal
to the growth rate of nominal GDP. The
only exception is the return on direct
investment in the U.S. by foreign residents, which has averaged below the
growth rate of nominal GDP. As it turns
out, the U.S. has a positive, net foreign
direct investment position, so this term
offsets the interest differential term, but
only slightly because the net asset position is relatively small when compared
with the gross asset position.
Assuming that the rates of return of the
past 27 years will persist, I calculate that
the U.S. could maintain its current net
foreign debt position of about 22% of
GDP by running a persistent net exports
deficit of about 0.9% of GDP (see box 1).
The associated critical current account
deficit is 1.3% of GDP. Although these
estimates imply that both the net exports
and current account deficits are sustainable, they are sustainable at levels that
are considerably lower in absolute terms
than the headline net exports and current account deficit to GDP ratios of
4.5% and 4.8%, respectively, reported
for 2003 in the NIPA.
The differences between the critical current account and the headline current
account to GDP ratios imply that the
U.S. net foreign asset position decreased
by about 4% of GDP in 2003. One of the
problems associated with this asset position calculation is that the headline current account figures reported by the
U.S. Bureau of Economic Analysis (BEA)
come from the NIPA and they only include realized returns on foreign assets,
while the BEA’s foreign asset and foreign
debt stock estimates reported in its
annual Net International Investment
Position (NIIP) release take into account

the unrealized capital gains from both
changes in local currency prices and exchange rate adjustments. This would not
be an issue if the revaluations to the
stocks of U.S. assets abroad and U.S. liabilities to other countries washed out over
time, but it is well-known that the U.S.
has enjoyed significantly higher capital
gains on its foreign assets than have foreigners on their assets held in the U.S.1
In 2003 the net effect of these price revaluations raised the value of the U.S. NFA
position by 3.2% of GDP, which is sizable
when you consider that net purchases of
foreign assets (U.S. purchases of foreign
assets minus foreign purchases of U.S.
assets) implied by the current account
represented 4.8% of GDP (with foreign
purchases of U.S. assets exceeding U.S.
purchases of foreign assets). If one were
to include these unrealized gains as an
item in the foreign income account, U.S.
NFI would have been roughly 3.5% of
GDP and the U.S. current account deficit for 2003 would have been just 1.7%
of GDP, which is only 0.4 percentage
points above my estimate of the critical
current account deficit to GDP ratio.
This suggests that the U.S. current account to GDP ratio is actually close to its
sustainable level, with the relatively high
net exports deficit being offset by a relatively high NFI surplus. Adding some
credibility to this estimate is the fact that
the actual change in the NFA to GDP ratio reported in the NIIP was a decrease
of 0.8 percentage points in 2003, well
below the 4.8 percentage points implied
by the NIPA current account.2
These revaluations also have implications
for the rates of return used in calculating
the critical net exports to GDP ratio. Using these returns, I calculate a sustainable
critical net exports deficit of 1.4% of GDP
(see box 1). This is some 0.5 percentage
points above the estimate based on NIPA
NFI data alone. Revaluations have no
bearing on the critical current account
deficit, which remains at 1.3% of GDP,
roughly 0.1 percentage points below the
critical net exports to GDP ratio.
Conclusion

Regardless of the method used to calculate it, the size of the net exports deficit

that would allow the U.S. to maintain its
current level of international indebtedness as a percentage of GDP is well below
that of the current net export deficit. My
estimates suggest that the U.S. net export
deficit must fall by 3% to 3.5% of GDP to
maintain the current net foreign asset
to GDP ratio. However, I also note that
if the U.S. continues to enjoy relatively
high rates of return on its foreign assets,
the resulting net foreign income surplus
would allow it to run relatively large net
export deficits without much change
in the net foreign asset to GDP ratio.
1

See P. R. Lane and G. M. Milesi-Ferretti, 2001,
“The external wealth of nations: Measures
of foreign assets and liabilities for industrial
and developing countries,” Journal of International Economics, No 55, pp. 263–294, and
C. Tille, 2003, “The impact of exchange rate
movements on U.S. foreign debt,” New York
Fed Current Issues in Economics and Finance,
No. 9, pp. 1–7, for detailed discussion of the
size and history of valuation effects for the
U.S. and other nations.
2
See P. R. Lane and G. M. Milesi-Ferretti, 2002,
“External wealth, the trade balance, and the
real exchange rate,” European Economic Review,
No. 42, pp. 1049–1071, and P. O. Gourinchas
and H. Rey, 2005, “International financial
adjustment,” National Bureau of Economic
Research, working paper, No. 11155, and references therein for a more complete discussion of the longer term relationship between
the U.S. net exports deficit and revaluations
of the U.S. net foreign asset position.
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David Marshall, Vice President, macroeconomic policy
research; Richard Porter, Senior Policy Advisor,
payment studies; Daniel Sullivan, Vice President,
microeconomic policy research; William Testa, Vice
President, regional programs and Economics Editor;
Helen O’D. Koshy, Editor; Kathryn Moran,
Associate Editor.
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Bank of Chicago. The views expressed are the
authors’ and are not necessarily those of the
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Reserve System.
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Box 1: Calculating the critical NX to GDP ratio

All nations are subject to a flow budget constraint, which in the U.S.
case requires that the value of U.S. gross domestic expenditure
(GDE) plus the change in the stock of foreign assets owned by U.S.
residents (A – A–1 ) equals the value of gross national product (GNP)
plus the change in the stock of U.S. debt owed to foreigners (D – D–1),
where a –1 subscript denotes the value of the stock in the previous
year. After some manipulation it follows that:
(GDP – GDE) + NFI + UT = (A – D) – (A–1– D– 1).
Substituting in the definition of the net export balance (NX = GDP –
GDE) and net foreign asset position (NFA = A – D), this simplifies to:
NX + NFI + UT = CA = NFA –NFA–1,
which says that the change in the net foreign asset position is the
sum of net exports, net foreign income, and unilateral transfers or the
balance on the current account.
Another important definition is net foreign income, which in the U.S.
case is essentially the difference between interest earned on foreign
assets and interest paid on foreign liabilities:
NFI = rAA–1 – rDD–1,
where rA is the rate of interest U.S. residents earn on their foreign
assets and rD is the rate of interest that the U.S. pays on its foreign
liabilities. In textbook examples there is no distinction between rA and
rD, because they assume there is only one traded asset. However,
this assumption is far from reality, so it is important to allow for
differences between rA and rD:
NFI = (rA – rD)A–1+rD(A–1 – D–1 ) = (rA – rD)A–1 + rDNFA–1.
Substituting this expression into the one above, it follows that:
NX = NFA – (1 + rD)NFA–1 – (rA – rD)A–1 – UT.
Dividing through by the level of GDP and imposing the foreign debt
sustainability condition that the ratio of NFA to GDP be constant at
NFA*, we find that the critical net exports to GDP ratio, NX* at the
current gross foreign asset to GDP ratio A* and typical unilateral
transfer to GDP ratio UT* is
NX* = (g – rD)NFA* – (rA – rD)A* – UT*,

where g is the growth rate of nominal GDP. Through a similar
analysis, one can show that the critical current account to GDP
ratio CA* is:
CA* = gNFA*.
Rates of return differ significantly across different types of assets,
so I divide the total net foreign asset position and stock of foreign
debt into three categories: foreign direct investment (DI); other
private foreign investment (PI); and government or official investment
(G). Using the same approach used above it follows that:

NX * =

∑

i = DI ,PI ,G

(g − ri D )NFA *− (ri A − ri D )A * − UT * .
i

i

With the exception of 1991, the balance on unilateral transfers has
been negative for the past 27 years with an average balance of
around 0.5% of GDP, so UT* = –0.005. The average percentage
growth rate of nominal GDP over the past 27 years has been 6.9%,
so g = 6.9. According to the latest NIIP release:
NFA * = 0.05, NFA * = −0.08, NFA * = − 0.19, A * = 0.19, A * = 0.44,
DI

PI

G

DI

PI

and = A * = 0.02 in 2003.
G
Average implicit percentage rates of return over the past 27 years
A
D
A
are as follows: Based on NIPA: rDI = 10.3, rDI = 3.9, rPI = 7.3,
D
A
D
rPI = 6.7, rG = 2.1, and rG = 6.2.
A
D
A
D
A
Based on NIIP: rDI = 11.0, rDI = 4.9, rPI = 11.1, rPI = 8.5, rG = 5.6,
D
and rG = 7.4.

Combining these inputs, the NIPA returns imply a critical net export
deficit of 0.9% of GDP, while the NIIP returns imply a critical net
export deficit of 1.4% of GDP.