The dollar’s strength in 2005 was a bit of  a puzzle to those who worried about  the scale of the US current account deficit.  Afterall, a growing current account deficit – and the deficit grew by around $130b in 2005 – implies a growing need for external financing, and the world’s willingness to extend credit to the US (presumably) is not infinite.    Yet in 2005, a growing deficit was financed with few obvious signs of financial strain.

One way to finance a current account deficit is to sell off your existing assets.  We saw a bit of this on Monday -- when investors pulling out of emerging markets provided a source of support for the dollar.    Back in 2005, though, US investors were piling into emerging economies, not running away. 

But the US was able to finance a larger current account deficit in 2005 than in 2004 while placing less debt abroad?  Why -- as I will argue below, a fall in FDI outflows meant that the US received net equity inflows for the first time in several years.  Foreign FDI and foreign portfolio equity investments in the US (purchases of US stocks) exceeded US FDI and US portfolio equity outflow largely because US FDI fell to zero. Since the US invested less abroad in 2005 than in 2004, more of the funds flowing in to the US could be used to finance the current account deficit. 

I suspect the fall in US FDI stemmed from the Homeland Investment Act, a one-off tax break that encouraged US firms to bring funds home, not a sustained reduction in the desire of US firms to invest abroad.  

The implication: the US will need to place a lot more debt abroad in 2006 than in 2005.  See the charts below.