What Goes With the Flow

Will foreigners stop investing in America?

From geopolitical strategy to apples, the world just doesn’t seem to buy what we’re selling these days. Yesterday’s figures on the trade deficit show that the American love affair with foreign goods and services is sadly unrequited. In 2002, the trade gap rose 20 percent from 2001, to $435 billion; exports fell 2.5 percent.

The yawning trade deficit is one among many factors that have contributed to a yearlong slide in the U.S. dollar. Last year, the greenback lost about 10 percent against the new currency of Old Europe—the once-feeble euro.

It’s convenient, although not always accurate, to view a nation’s currency as its stock price and hence as a proxy for its relative standing in the world’s economic pecking order. By that measure, the United States is surely off its peak. And when you add data on capital flows into the mix, the numbers betoken a seeming paradox. At a time when the global military power of America’s government is unchallenged, the worldwide economic leadership of its mighty private sector seems to be in jeopardy.

In the 1990s, the United States occupied a sweet spot. Growth was constant and robust, inflation and risk were contained, capital was put to work free of excessive restraints, and investors were rewarded abundantly. To investors in the volatile developing markets of Latin America and Asia, the United States was a rock-solid safe haven. For investors trapped in highly developed snail economies like Japan and Europe, the United States offered the prospect of growth. And since capital was treated better here than in virtually any other country, it migrated here. Foreign investors provided a good chunk of the investment fuel that kept our economic motors humming during the record expansion.

In recent months, however, some strategists have expressed fears that foreign investors, burned by the bursting NASDAQ bubble, fed up with Wall Street scandals, fearful of terrorist attacks, and suspicious of the Bush administration’s predilection for unilateralism, would repatriate their assets en masse. That hasn’t happened. But something more subtle is going on. “What we’re seeing is an incremental, and I would emphasize incremental—not qualitative—decline in investor confidence in the U.S.,” said David Gilmore, an analyst with Foreign Exchange Analytics.

In the stocks and in the bonds, they’re still coming to America. They’re just not coming at the rate they were before. According to the Federal Reserve Board, through the first three quarters of 2002, net acquisitions by foreigners of U.S. financial assets were running at a $610 billion annual pace, down from $631 billion in 2001 and off sharply from the 2000 peak of $932 billion.

Not surprisingly, foreigners, who always seem to buy in at the top of U.S. investment bubbles (remember the Japanese purchase of Rockefeller Center in 1989?) last year more than halved their new investments in U.S. equities. Net purchases of U.S. stocks by foreigners were pretty tame through 1998—a mere $42 billion—but exploded to $193.5 billion in 2000. Such purchases fell to $121.4 billion in 2001 and through September 2002 were running at an annualized rate of just $55.6 billion. Net sales of corporate bonds to foreigners were down 15 percent in the first three quarters of 2002—at an annual rate of $172 billion.

Foreign direct investment in the United States—i.e., the purchase of assets like factories—has plummeted by a far greater proportion. FDI fell to $130.8 billion in 2001 from its 2000 peak of $307.7 billion. Through the first three quarters of 2002, it was running at an anemic annual rate of $42.6 billion.

As their faith in the U.S. private sector has eroded over the past two years, foreign investors have continued to express great faith in the U.S. government. Net foreign purchases of U.S. government securities rose to $110.3 billion in 2001 and, through September 2002, were running at a $210 billion annual clip. We may thumb our noses at international treaties and dismiss the views of allies as irrelevant. But the U.S. government doesn’tdefault on its debts or devalue its currency. And despite today’s low interest rates, T-bills offer far higher returns than, say, Japanese government bonds.

This is a good thing, given that the Treasury Department is going to be selling a lot more government bonds in the years ahead than it did in the late 1990s. But on a macroeconomic scale, the mix of investment and the flow of capitals are troubling. In 2000, the private sector—the part of the economy that is supposed to generate growth—garnered 93 percent of the foreign funds that came in via FDI, the purchase of corporate bonds and corporate stock. Last year, the private sector captured just 53 percent of that total.

The U.S.’s chronic trade deficit is tolerable in part because many of the dollars consumers and businesses ship abroad have a way of finding their way back to our shores as investments. Venezuelan cement magnates buy apartments in Miami; the Chinese Central Bank buys Treasury bills; British pension funds load up on American stocks. These constant inflows of capital provide a rich source of capital for American businesses and governments and free Americans to do what they do best: consume. If that flow slows to a trickle, and if the dollars we ship abroad remain abroad or get shuffled to other regions, then more U.S. resources will have to be channeled away from consumption and into investment. And with rising deficits, more of that cash will have to go into the government’s coffers.

David Gilmore notes that foreign investors go through three phases when they sour on a marketplace. First, they allocate less new capital to the market. In the second phase, they stop allocating any new capital to it. And in the third phase, they become net sellers of U.S. assets. We’re well into the first phase now, at least with regard to the private sector. The implications for the U.S. economy are progressively worse at each stage.

The first Gulf War would not have been possible without the direct financing of countries like Japan and Saudi Arabia, which supported our goal of liberating Kuwait. Our ability to fund a second Gulf War—and its messy aftermath—may depend almost as much on foreign investors who don’t support our strategic objectives.