If foreigners investing in the US keep doing so badly?
That would be my question for John Makin.
I don’t doubt the superior liquidity of US markets.
I realize that there are only so many places big enough for the oil exporters to park their $500-600b savings surplus, and for China to park its $250b annual reserve increase.
But Europe’s government bond markets are not totally illiquid. Europe probably took it $300b in inflows from the emerging world in 2005.
And some folks have done pretty well giving up a bit of liquidity for higher returns. Read Philip Lane and Gian-Maria Milesi-Feretti. Try p. 19:
“Real dollar returns on foreign investment in the United States have on average been negative over the past four years and even more so when expressed in the currencies of most investor countries.”
Or think for a minute. A few years ago you, could buying a euro at 0.90 or 1.05 or something in between. That euro is now worth 1.27 plus interest. Or you could hold a dollar. For a while, the dollar had a lower interest rate. Now it has a higher rate. But the interest differential didn’t make up for the capital gain on the euro (loss on the dollar).
Ok, in 2005, the dollar did a lot better than the euro. But if you held European equities (or Japanese equities) you still did better than if you held US equities. That is why the US net international investment position didn’t deteriorate last year. Foreigners held the underperforming US market while Americans held over-performing foreign markets.
For that matter, judging from the data in the US balance of payments, returns on European FDI in the US have also been terrible. In dollar-terms. Foreigner investors would have done better in Treasuries. At least if you believe the reported data.
And to make matters worse, it is pretty clear that some countries won’t be allowed to trade their holdings of US debt for US companies. Ask China. Or ask the Emirates.
This leaves out Japan. Japanese investors who bought US bonds in 2004 have done quite well for themselves. They also would have done Ok buying Japanese stocks in 2005, as the Nikkei rose more than the yen fell.
More importantly, these calculations are all backward looking, not forward looking. Going forward, does it make sense to pay a negative risk premium – that is to the latest euphuism for losing money on investment in the US– to store your funds in the safety of the US?
I have some quibbles with the methodology used in Balakrishnan and Tulin’s study. I am not a big fan of the consensus forecast, which they use as a proxy for exchange rate expectations. But that may be my own bias: I never have liked their current account deficit forecasts … And I am not sure that I believe that investors really accept a negative risk premium just because the consensus forecast has tended to forecast dollar depreciation against major currencies in excess of interest rate differentials. Investors may just not believe the consensus forecast.
Despite my earlier comparison of returns on investing in the US and Europe, the interesting question right now isn’t whether it is worthwhile for Europeans to accept a negative risk premium (i.e. expect losses) on their investments in the US.
The interesting question is whether it makes sense for China and the oil exporters to continue to build up their dollar assets even though claims on the US already constitute a very large share of their national wealth. They should care more about the return that they will get investing in the US – and investing in Europe -- relative to investing in their own economy.
Balakrishnan and Tulin don't consider that question. But Frank Warnock's new study does.
Warnock considers how various countries would fare if the dollar fell by 10% -- against everyone -- and US bond and equity markets also fell by 10%.
He found that China would lose about 4% of its 2004 GDP on its mid-2004 holdings of US debt in the event the dollar and the US bond market both lost 10% of their value. China had about $350b in US debt in the middle of 2004 (it also had about $500b in reserves). It now as about $700b (maybe a bit less) in US debt and about $1000b in reserves. Its GDP is bigger too, but its total exposure is unquestionably larger now than then -- $700b would be around 25-30% of China’s current GDP
Some Gulf countries now have a larger share of their GDP invested abroad than China. Saudi Arabia’s monetary agency now holds close to $200b in foreign assets, well-over 50% of Saudi GDP.
Personally, I also suspect the needed move in the RMB – and many other currencies -- is a bit bigger than 10%. Consequently, Warnock's study may underestimates the losses some countries will incur storing their wealth in the US.
The $700b in current Chinese holdings of US debt is my estimate. It comes from the $540b in US debt China reported holding in the mid-2005 survey, and a guess about how many securities China has bought since then.
More generally, holdings of long-term US debt and equities probably have gone from the 5.4 trillion in Warnock’s study (the June 2004 ) to $6.3 trillion in the middle of last year to something like $7.4 trillion now (based on net inflows of $1080b from May 2005 to May 2006). Most countries have more exposure now than they did then …
Then read Makin.
And then think about who is investing in the US.
Don’t look at the capital flow data. London is not the source of most of the world’s savings. Look at who has a big current account surplus. Ask are these countries – and countries is the right term, since the countries that have big surpluses have active central banks or big oil funds -- financing the US because of the innate attractiveness of US markets? Or because for some reason they prefer to subsidize the US consumer (and their exports) than their own consumer, and thus accept losses on their vendor financing? Or simply don’t know what to do with all the cash that selling oil now generates, and are scared to start spending it because they worry that oil will crash the moment spending picks up?
In other words, is the current global flow of capital built on solid foundations – the US is as good at creating financial instruments that store wealth (claims on the US housing stock?) as Japan as is at building reliable, fuel-efficient cars -- and consequently is it something that can be forecast going forward? Or does it rest on political decisions that may change?
There isn’t much doubt that a lot of countries have been intervening massively to keep their currencies from rising. That can be expressed in another way: lots of central banks are intervening heavily to prop up the dollar. That has helped maintain the value of their dollar assets. But, at least to me, when a currency’s value depends on heavy intervention by central banks, that usually isn’t a sign that the currency is a good long-term store of value.