After a year in which the nation’s financial center was attacked by terrorists, equity markets continued a two-year slump and U.S. corporate integrity imploded, foreign investors have grown jittery about U.S. markets. So far, however, there are no signs of panic. Foreign investors “are looking at us with a little bit more reticence,” notes Mark Zandi, chief economist at economy.com. “We’re not the screaming buy we were a couple years ago, but we’re still attracting our fair share of foreign money.”
Wharton faculty and other analysts say that the U.S. current account deficit is unsustainable and has been supported only by strong foreign investment during the last few years, especially since 1997. A gradual withdrawal of foreign investment could trigger an inevitable readjustment. That could mean higher interest rates, lower share prices and a weaker dollar, all of which could rein in U.S. consumers who for years have been spending more abroad than they are saving.
A sudden shock, however, could create chaos in world markets, considering the size of the U.S. economy and the importance of the dollar as a global currency. “There is definitely concern,” Zandi adds. “The value of the dollar would not be off as much as it is except for skittishness on the part of foreign investors. But they are not running for the doors. Their caution is manifest in the fact that they are buying assets that have less risk, either treasury or mortgage-backed debt.”
The dollar has declined about 10% against the yen and the euro this year. Meanwhile, net foreign investment in the U.S. was $1.75 trillion in the first quarter, down from nearly $2 trillion in the same quarter last year, according to Zandi’s research firm.
Foreign investors own about 13% of the U.S. equity market, 24% of U.S. corporate bonds and 40% of U.S. treasuries, totaling roughly $8.4 trillion, according to the Bank of New York. In a recent report, the bank pointed to a Federal Reserve study that suggests the sustainable level of the current account deficit is no more than 5% of GDP. Last year, The U.S. current account deficit was 4.1% of GDP, up from 1.7% in 1997.
Most recently, some have expressed concern that Saudi investors might be pulling out of U.S. investments because they fear a military attack on Iraq in addition to lawsuits filed by families of the victims of the World Trade Center attacks.
Finance professor Franklin Allen, co-director of Wharton’s Financial Institutions Center, says Saudis have $700 billion to $800 billion in assets overseas. “That is a significant portion,” he notes. “Depending on what happens with Iraq – and anything could happen – my guess is they could take out a substantial amount over time. If we attack Iraq, a lot of that investment could go to Europe, London in particular.” He says there are also questions about the holdings of investors from other Middle Eastern nations including Kuwait and Bahrain.
Allen downplays the effect of this summer’s corporate accounting scandals on foreign investor confidence. “European markets have gone down more,” he says. “I think it’s difficult to make too much of that argument …”
Allen’s greatest concern is the situation in Japan.
A paper by Adam Posen, senior fellow at the Institute for International Economics in Washington, argues that Japan will finally face a financial reckoning in the form of default on some forms of government debt no later than 2005 and possibly as soon as September. While Japan remains a rich country – a crisis there would not be as painful as the one in Argentina – the crisis in Japan would have greater global implications because of Japan’s far greater global economic weight, Posen writes. He forecasts the crisis would last about a year or two, and include a declining yen, depreciating asset prices and sharply higher interest rates. In the next three to six years, Posen suggests, the Japanese economy would stabilize, more closely resemble the U.S. economy and include broader foreign participation.
Allen said he tends to agree with Posen’s assessment. “Unless they do something, at some point the Japanese people will realize they have to get their money out of the country. There will be a big rush out and a big rush in after the crisis and that’s a very worrying effect.”
Indeed, a gradual adjustment in the whopping U.S. trade imbalance with the rest of the world is inevitable, analysts argue. “What is happening, we believe, is that we are in the middle of a secular decline in the dollar,” says Michael Woolfolk, currency strategist at the Bank of New York. “This is a good thing as long as it is controlled. It is consistent with a recovery in the economy and possibly in the U.S. stock market. The risk is if the U.S. dollar depreciates more quickly.”
The bank, which administers $5 trillion in custodial assets, noticed speculative-like buying of euro-based assets in July that could have been driven, in part, by bad news about Enron and other U.S. companies, according to Woolfolk. “There was a heightened concern among global investors about the safety of U.S. equities during the late June and July reporting period,” he says. “The concern was there would continue to be investigations and corporate malfeasance … The degree to which corporate surprises continued to be announced were a drag on investor sentiment, whipping up speculative activity against the U.S. dollar that seems to have largely been squelched recently.”
But he says that since November there have been signs of a pullback in fixed income investment. “The data we have is consistent with foreign selling of U.S. fixed-income securities. It is plausible that Saudis may have taken a step down in their position in U.S. fixed income. If that’s the case, much of this move may already be over. Any further selling is going to be trivial.”
In addition to the purchase of bonds and stocks, foreign direct investment in the U.S. – the purchase of companies, plants and equipment – is also off, falling from $301 billion in 2000 to $124 billion last year.
Foreigners are also shifting to different kinds of direct investment, particularly those that appear less risky, says Zandi. “They are more interested in consumer oriented companies and less interested in tech companies. Not only is investment off but what they are buying has changed dramatically.”
Foreign investment surged into the U.S. following the global currency crises of 1997 and 1998, when the dollar was perceived as a safe haven. The current shift comes following the end of the Clinton administration which endorsed a strong-dollar policy.
Zandi says the current administration is “agnostic” about the dollar. “Politically [the Bush administration] gets support from manufacturers. And big business has been hammered by the strong dollar so from that perspective the sinking dollar is no problem. But the administration would not want the dollar in free flow. That would be very hard on the investor class.”