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Global: The Resiliency of US Portfolio Inflows
Joe Quinlan and Rebecca McCaughrin (New York)
Various clouds loom over the US economy. Among the darkest is the US current account deficit, expected to reach 4.8% of total US output this year, expanding further to 5.5% in 2003. Bankrolling this external imbalance means the US must import over $1 billion a day. A dip in capital inflows would force the world’s largest debtor nation to confront its day of financial reckoning.
In the face of America’s widening current account deficit, investors have become increasingly alarmed about America’s ability to secure foreign capital. The most frequently asked questions are: At what point does the current account deficit become too large? How long will foreign investors continue to finance the US savings shortfall? How will the imbalance be narrowed — will it be gradual or disorderly? Will the prospects of diminished capital inflows lead to rising interest rates and a falling US dollar?
There are no easy answers to these questions, and adding even more uncertainty to the debate is the increased complexity of global capital flows. Cross-border capital flows are more dynamic than ever before, making it difficult to interpret month-to-month fluctuations in US portfolio inflows. More certain is that the US has been remarkably adept in attracting foreign capital to finance its deficit over the past year. In June, the most recent data available, gross US portfolio inflows totaled $50 billion, the second highest monthly total of the year.
Defying the Odds — a Brief Look Back
If the last twelve months have taught investors anything, it is that US portfolio inflows are extremely robust. Indeed, on numerous occasions over the past year, it looked as if the world was finally ready to sell the US short and reallocate its capital elsewhere. However, like the proverbial cat with nine lives, US capital inflows have also exhibited resiliency over the past year.
Back in 2000 the US rode a massive wave of foreign capital, with private net FDI and portfolio inflows totaling a staggering $385 billion, according to Bureau of Economic Analysis estimates. In 2001, however, financing the US current account deficit became more of a concern as double-barreled financing reverted to single-barreled financing. As the M&A boom fizzled, net US M&A inflows fell to just $68 billion in 2001 versus $175 billion the prior year. Given that M&A is a large component of total FDI flows, the decline in inward FDI mirrored the M&A bust. European investors led the retreat, ending one of the greatest transatlantic M&A booms in history. The burden of financing the deficit thus fell to portfolio inflows, considered more fickle than FDI.
Strong portfolio flows to the US, however, postponed a current account crisis in 2001. Yet it was not all smooth sailing. As evidence mounted that one of the longest US economic expansions in history had run its course, foreign investors grew more nervous about buying US assets. A weak US economy, juxtaposed against a widening current account deficit, loomed large at mid-year 2001 and was reflected in the deceleration in portfolio inflows last summer. After averaging $50 billion per month in the first five months of 2001, US portfolio inflows dipped to $39 billion in June, and plunged further to just $27 billion in July, according to US Treasury figures. At the same time, US investor sentiment soured, and investors began to seek other opportunities abroad, tilting towards Europe in particular. The euro recovered from the low reached in May and enjoyed a brief rally during the rest of the summer.
By September 2001, investors were growing increasingly concerned about the current account deficit. September 11th triggered a massive sell-off of US financial assets. Jolted by the attack, foreign investors dumped nearly $10 billion in US equities, the largest monthly sell-off since the LTCM/Russian crisis. Total US portfolio inflows amounted to just $5.3 billion in September versus a monthly average of $44 billion over the first eight months of 2001. Entering the final quarter of the year, the mood was grim. Prevailing wisdom held that the US economy was headed for recession and that the war against terrorism would be long and expensive.
Yet, rather than bail out of US assets, as many feared, foreign investors bailed in, with portfolio inflows soaring to nearly $70 billion in October alone. A number of events underpinned confidence in the US and sustained portfolio inflows, including aggressive Fed easing following September 11th, a rebound in US financial markets, the safe haven status of US securities, and the growing expectation that the US economy would be the first to emerge from the global recession. The confluence of these factors helped to boost long-term portfolio inflows to $173 billion in the final quarter of last year, the largest quarterly surge ever registered.
Multiple crosscurrents affect the monthly ebb and flow of US portfolio inflows, and this year has been no different. Early in 2002, it appeared that foreign investors were finally ready to capitulate and shift out of US assets, with net portfolio inflows totaling just $26.7 billion in the first two months of this year, a fraction of the level of the first two months of 2001. Net inflows would have been even smaller during this period had investors in Asia ex Japan not offset weak inflows from Japan and Euroland. More recently, Japanese investment in US securities has also picked up the slack of declining Euroland flows. In May, Japanese investors initially appeared to be shifting their portfolios into Euroland securities. But the reallocation proved to be short-lived. By June, Japanese investors had already gravitated back toward US assets. In July, we suspect that the bulk of the nearly $30 billion in outflows (according to MoF figures) also targeted US assets. If so, that amount should help compensate for declining investment from Europe. Large Japanese outflows have continued through August, which bodes well for fulfilling US capital needs.
The United States — Still One of the Best Bets in Town
In the late 1990s, the US was largely the only game in town for global investors — hence, the massive capital inflows. Today, given the corporate accounting scandals in the US, questions regarding the Fed’s handling of the economy, and the recent downshift in economic activity, the US is no longer viewed in as favorable a light. However, it is still a strong bet. If nothing else, investors should keep one key point in mind when it comes to America’s ability to fund the deficit: global capital flows reflect the relative (not absolute) attractiveness of global assets, and US dollar denominated assets currently remain among the most attractive on a relative global basis. Europe has fumbled its chance to lead the global economy, while Japan remains mired in recession. Ongoing financial problems in South America have only raised the level of risk aversion among investors and made US assets that much more attractive. By this metric, the US does not look all that bad, a factor supportive of near-term capital inflows. |
