Japs are buying $$$
Global: Balancing on a Pin
Rebecca McCaughrin (New York)
At the start of this year, some analysts feared that the US would be unable to meet its ambitious capital needs. A number of factors fueled those fears: First, demand for US assets dipped sharply during January-February, coinciding with the emergence of the first of a string of corporate accounting scandals. Second, by the end of 2001, portfolio rebalancing in preparation for EMU that had buoyed demand for US assets was showing signs of coming to an end. European demand for US assets — a key pillar of support for US inflows — began to dwindle during Q4 01, and continued to diminish early in 2002. Third, the end of the M&A boom resulted in a drying up of massive global FDI flows that had previously targeted the US and supplemented portfolio inflows. Fourth, the poor performance in US equity markets sparked a deceleration in foreign demand for US equities, shifting the burden of support to fixed income inflows. At the same time, questions about corporate accounting practices and less attractive returns began to shift flows away from US corporate bonds, leaving the heavy lifting to government securities. Compounding the fears was the threat that US residents would shift funds overseas as the relative attractiveness of US assets declined.
In aggregate, these concerns threatened to stymie foreign investment in the US just as the current account was on track to balloon, nearing the critical 5% threshold. However, with the year nearly over, while some of those fears materialized, they have not suppressed overall inflows. Indeed, foreigners have snapped up record amounts of US securities this year, while repatriation of capital by US investors has bolstered net aggregate inflows.
Foreigners Shift into Government Securities
Annualized US Treasury data through September confirm that the US is on track to post $518 billion in net aggregate long-term portfolio inflows — net acquisitions by foreign residents of securities in the US less net acquisitions by US residents of securities abroad — more than sufficient to single-handedly cover the estimated $496 billion current account deficit.
Net foreign purchases of US securities have held steady thanks to robust demand for US fixed income instruments, with demand for agencies and US Treasuries ramping up in recent months. During the first three quarters, foreigners significantly increased investment in agencies in particular, buying up $134 billion. Over the past few years, agency bonds had been growing in importance as viable alternatives to US Treasuries because of their similar quality and liquidity, but this year, they’ve also proven to be a viable alternative to corporate bonds and equities.
After retrenching from US Treasuries during 1997-2001, foreigners have migrated back this year, with inflows accelerating in recent months as geopolitical tensions have intensified. In September alone, foreigners bought $26.3 billion of US Treasuries, their largest monthly purchase in over seven years. Federal Reserve weekly data on custody holdings for foreign official institutions confirm that demand for Treasuries continued to trend higher through the end of November.
While corporate bonds have posted respectable inflows so far this year ($138 billion), demand has clearly weakened since reaching a peak last year. In September, corporate bond inflows slipped to just $4 billion, compared to a monthly average of $15.3 billion this year. We may still see an upward tick in November data, coinciding with the usual year-end surge in issuances, but investors have clearly been demonstrating a preference for lower-risk government securities.
Not surprisingly, demand for US equities has seen the sharpest fall this year, declining by 58% YoY, reflecting plunging share prices and concerns over restated earnings and corporate accounting and governance issues. Demand in September fell to the weakest level since September 2001, with foreigners selling $6.5 billion of US equities. We are likely to see modest relief in coming data, consistent with the rally in US markets, but in our view annual inflows will most certainly fall to levels not seen since 1995-96.
Regional Favorites
Just as investment has increasingly targeted a narrower set of assets this year, the origin of inflows has also shifted, with rising Asian flows helping to offset diminished inflows from Europe. September was no exception: Asian investors accounted for 48% of total US inflows, compared to 33% from Europe. Although European investors are still larger holders of US securities, the gap has sharply narrowed over the course of this year.
Within Asia, flows have been roughly evenly split between Japanese and Asia Ex-Japan (AXJ) investors. Over the last quarter in particular, flows from Japan have accelerated, with investors plowing record amounts of funds into US securities. Much of the surge has come from larger-than-usual Japanese Government Pension Investment Fund (GPIF) allocations to foreign bonds and a search for higher yields abroad. However, as the GPIF funds are depleted and life insurance firms pare their foreign investment, the pace is likely to slow, particularly as we near the end of Japan’s fiscal year in March. This, in turn, shifts the full burden of support to AXJ investors — a rather unstable source of investment, with flows somewhat erratic month to month.
Globalization Unraveling?
Contrary to expectations at the start of the year for a flight of US capital abroad, US residents have remained reluctant to load up on foreign-denominated financial assets. US investors are on track to repatriate foreign-held securities this year, which would mark only the second time since 1980 that US investors have actually retrenched from global financial markets. As major world stock markets continued to come under pressure, US residents sold $17 billion of foreign equities in the third quarter. US residents have also been reluctant to take advantage of higher yields abroad, selling off $6.9 billion of foreign bonds during Q3. While the US is hardly a picture of economic health (our US economists expect GDP growth to weaken significantly in Q4 2002), neither are Europe and Japan, both of which are expected to lag the US economy in 2002 and again in 2003. The silver lining we see is that US repatriation has bolstered the US’s shallow savings pool and has likely taken some pressure off the USD.
Bottom Line
The US appears to be in a far more precarious position than two years ago, when foreign investment was buoyed by robust FDI, supplemented by strong equity and bond inflows, and broad geographical support. Today, the support is much more lopsided, with the US now a net source for FDI, and foreigners targeting primarily government securities. With Japanese investment likely to taper off in the next few months and European investors retrenching, the origin of investment has also shifted to a less traditional and potentially less stable source — Asia Ex-Japan. Granted, the US does have the benefit of the global low-interest rate environment, which historically tends to push capital toward capital-scarce economies, in addition to a fairly gloomy global backdrop that is unlikely to drive competition for foreign capital. But there’s no denying that the US is now more susceptible to a pullback in inflows, given the narrower underpinning for its hefty capital needs.
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