What if Japan pulls the plug on the US deficit?

THERE HAS, for several years, been a recurring nightmare that has disturbed the financial markets. It is that, for some reason or other, Japan would stop financing the US current account deficit (and by the same token, the fiscal deficit) and repatriate its funds.

Up to now nothing like that has happened. The US has been able to fund its current account deficit because other countries, in particular Japan, have been prepared to carry on investing in the States. Inflows on capital account have matched, or frequently exceeded, the outflow on current account.

As a result the US has been transformed from being the world's largest creditor nation to the world's largest debtor (see left-hand graph). However, the inward flow of capital postponed any day of reckoning: those of us who believed that the current account deficit would eventually result in a dollar collapse have so far been proved wrong.

Meanwhile, the long US boom, now into its eighth year, has ended the other US deficit, the fiscal deficit. Rising tax revenues and falling welfare payments have succeeded where Congress failed.

Or so it seemed. The fiscal outlook remains benign but the external deficit has suddenly become a serious concern. One of the reasons for the sharp falls of the dollar in the last few days has apparently been a worry about the sustainability of the current account deficit.

Why does a problem that has been simmering for years suddenly blow up? There seem to be at least three reasons for this change of mood. First, the sudden further deterioration of the current account last year as East Asian exports to the US soared and exports fell. Second, the launch of the euro. And third, the surge in bond yields in Japan.

Last year the current account deficit was running at an annual rate more than $200bn - we don't have final figures but the third quarter was a deficit of $61bn. That is very large, of course, but no worse as a percentage of GDP than it was in the late 1980s. There was, however a qualitative difference from the 1980s deficit. Quite aside from the trade deficit there was, for the first time, also a deficit on investment income. The interest on all those debts was now being added to the principal.

In other words, America is now borrowing to pay the interest on its borrowings. You do not need a degree in international economics to appreciate that this is not a sustainable situation. Yesterday Goldman Sachs drew attention to this phenomenon, and used that word "unsustainable" - which is interesting, because up to now US commentators have tended to be relatively relaxed about the mounting US indebtedness. They have seen the inflow of capital as a statement of faith in US competitiveness and stability (which of course it is), rather than a reflection that Americans live above their means.

The second new event is the euro. In theory the euro ought not to make much difference to international investment patterns, for it is only the amalgam of the various European currencies. Anyone investing in it now could have achieved much the same effect by investing in marks, francs, lire and so on in the appropriate proportions.

But in practice the euro does change things, because it creates a simple practical alternative to the dollar. Any non-US, non-European investor has another place to pop funds, backed by the output of an economy of more or less similar size to the States. And "Euroland" has a current account surplus too.

So expect some dollar weakness and some euro strength in the months ahead as portfolio managers gradually rebalance their portfolios.

Third, there is Japan. The Japanese, as noted above, have been the principal investors in the US and particularly in US Treasury securities. One of the forces propelling Japanese money is that it would earn a much higher return in the US than it could in Japan. Ludicrously low Japanese interest rates were the culprit. In the last six weeks, while short-term money market rates have remained very low, there has been a doubling of the yield available on Japanese government bonds - a rise from below 1 per cent to nearly 2 per cent (see right-hand graph).

To Americans and Britons, 2 per cent may not sound very much, but since deflation has a firm grip, the real yield is perhaps 3.5 per cent, which is actually higher than the real yield of either US or UK securities - or euro ones for that matter.

Add to this the need for Japanese financial institutions to sell liquid assets to repair their balance sheets after the devastation of bad debts, and suddenly there is a practical case for repatriating funds from America.

We are still some way from the doomsday scenario, where a withdrawal of Japanese funds leads to a collapse in US financial markets. Nevertheless it was significant that earlier this week, Eisuke Sakakibara, the Japanese Ministry of Finance official known as "Mr Yen", said that the US economy was "fairly bubble-like". That does not quite constitute an instruction for Japanese holders of US securities to sell, but it does indicate a rising concern in Japan at the durability of the long US boom.

There are a couple of rules that anyone trying to explain the movements of financial markets need to follow. One is that it is always very difficult to get the timing right - in fact you know you will get the timing wrong - so that even when something is inevitable you may have to wait years for it to happen. The other is that momentum is an immensely powerful force in markets, so that they tend to overshoot.

Put these two together and apply it to the Japan/US financial imbalance which has continued now for more than 15 years and what do you say? Simply that we may be moving at last into the end-game for the US current account deficit and that Japan will play the key role in the correction to come.