The U.S. has a chronic and growing external deficit, an addiction to foreign goods and services, that can only be corrected through abrupt changes in the value of the dollar and this will occur in a series of disruptive episodes as the trade deficit will only gradually respond to changes in currency values. It will take a much bigger discount in the value of the dollar in order to trigger a positive response in our trade accounts, and this will in turn heighten interest rate volatility.

                         The Hemorrhaging in the U.S. Trade Accounts is a Structural Problem

The widening of the U.S. trade deficit has its roots in structural problems such as lack of competitiveness, a low savings rate, fiscal deficits and structural changes in other economies around the world as in the case of China, which is gaining greater influence over the global flow of goods and services.

Due to a number of factors that have not yet been fully understood, the U.S. is becoming more dependent on imports. This encompasses both the production process, through offshore sourcing of inputs, as well as consumption, as U.S. consumers reveal a marked preference for imports, specially when they can buy them on credit. The volume of imports of goods and services has jumped, from 5.7 percent of our GDP in 1970 to 16.0 percent in 2004, and it continues to rise. The trend from the 1990's is even more worrisome, as it shows U.S. dependence on imports has almost doubled from 8.5 percent of GDP in 1990 in just 15 years. The structure of imports has been shifting towards capital and consumer goods imports.

Exports on the other hand, have not kept pace as their proportion of GDP has risen much more moderately from 7.8 percent in 1990 to 10.4 percent in 2004. The growing trade imbalances have so far remained outside the policymakers’ radar screens, since the rest of the world seems more than willing to extend the U.S. all the credit it needs. Of course, basic principles of finance would indicate that the external debt ratios for the U.S. are also approaching unacceptable levels, although this trend has been overlooked since interest rates have been at historically low levels during the past several years.

Normally, a recession is good medicine to bring down the trade / current account deficits. However, the 2001 recession hardly made a dent in the current account deficit as it declined marginally from 4.6 percent of GDP to only 4.2 percent. And then as the economic recovery gathered momentum in 2002, the deficit began to widen noticeably. This is a symptom of a structural dependence on imports that is not easily fixed with the economic swings of the business cycle.

                                  The U.S. Looks to Foreign Financing as a Blank Check

When a country runs a current account deficit, it has to rely basically on foreign investment and loans to cover the gap. While foreign direct investment would be the preferred choice of financing, the U.S. has been relying increasingly on short and medium-term borrowing. In 2004, direct foreign investment - the purchase of U.S. productive assets - represented only 7.4 percent of total financial inflows into the U.S., a steep decline from 42.3 percent in 1998.The offset has been provided by foreign governments’ and central banks’ purchases of U. S. Government securities, which represents 21.6 percent of total financial inflows in 2004; also by U.S. bank liabilities to foreigners, 22.4 percent; and by foreign purchases of U.S. corporate bonds, 17.0 percent.

The U.S. is thus relying on a riskier type of financing. The largest increase in financing has been in the form of purchases of U.S. government securities by the monetary authorities of those countries that are predominantly running trade surpluses with the U.S., the flip side of the trade coin. If those countries were to need those resources for investment in infrastructure for example, they would have to sell part of their holdings of U.S. government securities. Or if the central banks that are holding dollars as part of their reserves were to conclude that the value of the dollar was likely to fall, they would logically sell their dollar holdings and buy what they expect will be the stronger currency. Interestingly, the U.S. PATRIOT Act has been creating bigger hurdles for banks to attract foreign depositors, who in turn, have been moving their funds to other countries. And with corporate bonds considered a higher risk than U.S. government bonds, a sell off of U.S. governments could trigger a run on the corporate bond market. Any one of these possibilities would create unwanted turbulence in the currency markets.

                           The Domino Effect of a Currency Crisis on Financial Markets

Despite the huge trade deficits, the dollar has been quite resilient, with the Euro falling to a low of US$1.17 in November. But only a year ago the Euro had reached $1.34, clearly a sign of increasing volatility in the currency market. Sometimes governments intervene to bring about a desired adjustment in currency values as occurred in September 1985, with the Plaza Accord, when the Finance Ministers of the major industrial countries declared that the dollar was too strong, and the markets swiftly reacted to those remarks by pulling down the value of the dollar. Other times, the adjustment occurs abruptly, as investors react in a knee jerk fashion to negative market signals.

Some analysts question how the dollar can weaken in terms of other currencies when the economies of the other principal trading areas of Europe and Asia are still in a lethargic mode. We think the magnitude of the trade imbalance in the U.S. is of such gigantic proportions that the problems of our trading partners pale in comparison.

The key question is when will market participants begin to bail out in anticipation of a much needed correction in the value of the dollar. With a projected U.S. external financing gap of moderately below a trillion dollars next year, we think money market investors are going to feel pretty nervous about taking a dollar position. The magnitude of the projected deficit is huge, about 7.0 percent of GDP, and thus even a modest shortfall in available financing could bring down the value of the dollar. We think the value of the Euro could reach $1.48 next year. In addition, China holds the wild card in terms of the relationship between the dollar and the Chinese yuan. If the yuan were allowed to float freely, its value could rise by as much as 35 - 40 percent with respect to the dollar.

As money market investors scramble to sell their holdings of U.S. government securities, interest rates will consequently rise, and if the 2006 Federal budget deficit is higher than expected, the government may have to pay even higher rates on its financing. Higher interest rates will in turn feed the current account deficits, since the U.S. will then have a much heavier debt service burden to foreign lenders. Unfortunately, we think it will get worse in the U.S. international trade and currency markets before it gets better.

Latin American Economies

Special Report - Recent Election Outcomes and the Outlook for 2006

The beginning of the 21^st Century marked a cyclical tilt to the left in South America’s politics. Lula da Silva, a leftist labor union leader, was elected President of Brazil in 2002. Since his election, he has been following a very pragmatic approach to governing and to the management of economic policy. In neighboring Argentina, Nestor Kirchner was elected President in 2004. He belongs to the left of center faction of the governing Partido Justicialista. Kirchner has been cranking up the volume of his criticism against U.S. policies and the IMF, and has lately been seeking closer ties with Venezuelan President Hugo Chavez. Tabare Vazquez, a leftist and former urban guerrilla, recently won the Uruguayan Presidency in a landslide, including solid Congressional support. The most aggressive leftist leader in the region, Venezuelan President Hugo Chavez, keeps amassing personal control of the nation with the approval of a rubber-stamp Congress. The Venezuelan opposition parties refused to participate in the recently held local and Congressional elections, due to lack of transparency in the electoral procedures. The most recent addition to the Club-Left is Evo Morales, a former leader of coca growers in Bolivia, who obtained an undisputable majority in the first round of Presidential elections.

Ten new Presidents will be elected in Latin America during 2006. The following is a synopsis of the electoral campaigns and the positions of the presidential hopefuls.