The U.S. External Deficit and the Developing Countries

In the absence of U.S. fiscal adjustment and a further correction of the dollar, the current account deficit is headed to $1.3 trillion by 2010 (8 to 8.5 percent of GDP) and net U.S. foreign liabilities to over $8 trillion (50 percent of GDP). According to CGD/IIE Senior Fellow William R. Cline, the rising trade deficit and associated borrowing from abroad are now financing a decline in personal saving and a rise in the government deficit. This imbalance will increasingly put the US economy - and developing countries - at risk. This working paper focuses on the impact the U.S. external deficit and a possible hard landing for the U.S. and world economies will have on developing countries. The author finds that these countries are at risk since they have relied heavily on a continuing expansion of trade surpluses with the United States as a source of demand. Developing countries with high borrowing abroad are also doubly sensitive to a spike in world interest rates - once directly, once indirectly through higher risk spreads - that might be associated with a hard landing. To avoid a disruptive hard landing, the paper urges a gradual adjustment process. Specifically, Cline urges the Group of 20 major industrial and developing nations to take the lead in coordinating a program of global exchange rate realignments that can foster U.S. external adjustment, in a Plaza II initiative. The recommendations include a credible commitment by the US to eliminate its fiscal deficit over four or five years, a halt in intervention in exchange rate markets by countries likely to avoid appreciation of their currencies, and coordination by individual country central banks to appreciate their currencies against the dollar. These actions would begin a process of guiding the dollar downwards, towards a goal of a real depreciation of about 20 percent for the dollar from its current level. This Working Paper is based on The United States as a Debtor Nation, a book published in 2005 by the Center for Global Development and the Institute for International Economics