Thursday, April 21, 2016

Foreigners Buy US Debt, US Investors Buy Foreign Equity

When it comes to international flows of debt and equity, the US economy as a whole has developed an interesting pattern: those from other countries are net buyers of US debt, while US investors and firms are net buyers of foreign companies--in the form of stock market equity investments and foreign direct investment. Pierre-Olivier Gourinchas discusses this pattern in "The Structure of the International Monetary System," an overview of recent research in this area appearing in the NBER Reporter (2016, Number 2, pp. 13-17).  He explains the pattern this way:
As financial globalization proceeded, U.S. investors concentrated their foreign holdings in risky and/or illiquid securities such as portfolio equity or direct investment, while foreign investors concentrated their U.S. asset purchases in portfolio debt, especially Treasuries and bonds issued by government-affiliated agencies in areas such as housing finance, and cross-border loans.
Here's a figure illustrating the pattern, with net debts owed from the US economy to the rest of the world at the bottom, and net portfolio equity and foreign direct investment by US investors in the rest of the world on top.


Why does this matter? Here are a few of the consequences as Gourichas lays them out.

1) Essentially, the US economy has been able to borrow cheaply from the rest of the world, and then invest those funds in companies around the world. The average return on equity over sustained periods of time is higher than the return on debt. Gourinchas cites estimates that the gap has been between 2.0 and 3.8% per year since 1973.

2) "These large and growing U.S. excess returns have first-order implications for the sustainability of U.S. trade deficits and the interpretation of current account deficits. As an illustration of the orders of magnitude involved, suppose that the U.S. has a balanced net international investment position with gross assets and liabilities of 100 percent of GDP. An excess return of 2 percent per annum implies that, on average, the U.S. can run an annual trade deficit of 2 percent of GDP while leaving its net international investment position unchanged. More generally, since a large part of realized returns take the form of valuation gains due to changes in asset prices and exchange rates, the current account, which excludes non-produced income such as capital gains, will provide an increasingly distorted picture of the change in a country's external position."

3) "[A] deterioration of the U.S. trade balance or of its net international investment position is often followed by a predictable depreciation of the U.S. dollar against other currencies. This depreciation may subsequently improve the U.S. trade balance along the usual channels, but it also improves the return on U.S. financial assets held abroad, thereby making the U.S. relatively richer.Most other countries don't seem to enjoy a similar advantage."

4) Why has this pattern of "foreigners buy US debt, US investors buy foreign equity" emerged? Gourinchas argues that a main reason is that "it reflects a superior capacity of the U.S. to supply `safe' assets—assets that will deliver stable returns even in global downturns." As a result, the US economy can depend on an inflow of debt financing at low interest rates. On the other side, "[w]illingly or not, global suppliers of safe-haven assets must bear more exposure to global risks." When a global recession occurs as in 2008, US-based investors will tend to bear heavier losses because they are more exposed to equity risks everywhere in the world. "Lower funding costs come with a commensurate increase in the global exposure of their external balance sheet."

5) Finally, the US economy probably can't keep playing the role of providing such a disproportionately large share of safe assets for the entire global economy. Gourinchas argues: As the world economy grows faster than that of the U.S., so does the global demand for safe assets relative to their supply. This depresses global interest rates and could push the global economy into a persistent ZLB [zero lower bound] environment, a form of secular stagnation. ... Finally, a body of empirical evidence suggests that environments with low interest rates may fuel leverage boom and bust cycles. The vulnerability of emerging and advanced economies alike to these crises has been amply demonstrated in the past."

For a few decades now, "foreigners buy US debt, US investors buy foreign equity" has been a reasonable equilibrium in the global financial system and a benefit to the US economy But in years ahead, it may well become a cause of stress.