Yu Yongding explains why demand for foreign capital inflows to offset the US's savings shortfall may go unmet

Some US commentators have recently expressed concern about the country’s fiscal sustainability. But few have addressed America’s external sustainability, which looks increasingly questionable.

One common measure of the United States’ ability to service its debt is the current-account deficit as a share of GDP, which has mostly remained at 2-4% in recent years but is projected to rise. Of course, a high reading does not always have the expected outcomes. When America’s current-account deficit climbed to 6.3% of GDP in 2006, economists worried that foreign capital inflows would dry up, causing a balance-of-payments crisis and a sharp depreciation of the dollar. But these effects never materialised.

There is, however, another important measure of America’s external sustainability: its net foreign-debt-to-GDP ratio, which has been rising steadily, reaching around 70% at the end of 2023. This reflects the country’s staggering $23 trillion in net foreign debt. By contrast, in 2006, US foreign debt was only $1.8 trillion, or 13% of GDP.

This ratio depends on four variables: the gap between private saving and private investment, the size of the budget deficit, and investment-income levels (all measured as a share of GDP), as well as the GDP growth rate. Based on historical data, one can assume that the gap between America’s private saving and private investment, budget deficit, and investment income will be, respectively, 2%, 5%, and 1% of GDP, and US GDP growth will average 2% in the coming years. According to my rough calculations, the US foreign-debt burden could approach 100% of GDP.

A balance-of-payments crisis occurs when demand for foreign capital inflows goes unmet. With America’s foreign debt currently on track to hit 100%, will foreign investors continue to purchase US financial assets to offset the country’s savings shortfall?

The answer may be no. According to the Federal Reserve, foreign portfolio holdings of US securities totaled US$26.9 trillion at the end of June 2023, accounting for about 33% of US Treasuries, 27% of corporate debt, and 17% of equities. Indeed, the greenback would have collapsed long ago had it not been for strong demand from other countries for dollar reserves. But America’s gross debt was 122.3% of GDP in 2023, breaking the record set in 1946, and is set to swell. In December, PIMCO, one of the world’s largest bond investors, announced that it was reducing its exposure to long-term US Treasuries, citing soaring government debt and a growing deficit. All this makes it unlikely that foreign investors will continue purchasing Treasuries on the same scale as before.

In fact, official investors’ share of foreign US Treasury holdings has already been steadily declining, from 69.8% in 2015 to 53.4% in 2023. This reflects concerns about America’s external sustainability given its growing foreign debt. It also stems from the West’s decision, following the war in Ukraine, to freeze the Russian central bank’s foreign-exchange reserves, which has undermined the US government’s credibility; many no longer trust that America will honor its financial obligations. Lastly, domestic factors have led some countries, such as China, to adjust their portfolio allocations.

Foreign holdings of US equities – the largest category of foreign-owned US securities – have increased sixfold since 2009, primarily owing to the fourfold rise in US equity prices over the same period. But the concentration of market capitalisation in the so-called “Magnificent Seven” – high-flying US tech firms – and investors’ outsize appetite for risk have also played a significant role in driving up equity prices, which suggests that these gains could be reversed at any time.

A case in point is the recent stock-market selloff sparked by Chinese startup DeepSeek’s release of a low-cost large language model to rival OpenAI’s ChatGPT. In the event of a more durable shock, the large inflows of foreign capital into the US stock markets may suddenly become outflows.

Given this dynamic, it is easy to see that America’s external sustainability is on a knife-edge. And the unpredictability of Donald Trump’s second administration is exacerbating the situation – nobody knows what will happen next, leaving many foreign investors wary and perhaps more inclined to change course. China, as the second-largest foreign holder of US Treasuries and with more than $3 trillion in net foreign assets denominated mostly in dollars, must be on guard.

Yu Yongding, a former president of the China Society of World Economics and director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, served on the Monetary Policy Committee of the People’s Bank of China from 2004 to 2006. Copyright: Project Syndicate, 2024, and published here with permission.