Martin Feldstein: Capital Inflows Primarily from Foreign Governments, not Private Investors

Martin Feldstein says the optimistic view that capital inflows to the U.S. are the result of the attractiveness of investment is wrong and arises from a misinterpretation of the data. A proper interpretation of the data reveals that the source of capital inflows is primarily foreign governments, not foreign private investors. Furthermore, Feldstein says, "If they decide to buy fewer dollar bonds, the US current account deficit could not continue to be financed at current exchange rates and interest rates." He believes a 30% decline in the dollar is necessary to get the current account down from 6% of GDP to a more sustainable level of 3% and that much larger changes are possible.  Finally, he says the only thing holding up the dollar currently is the belief that interest differentials that make U.S. financial investment attractive will persist. He adds, "That sanguine belief may, however, reflect a serious misunderstanding of the magnitude and nature of the capital flow to the US.":

Uncle Sam’s bonanza might not be all that it seems, by Martin Feldstein, Commentary, Financial times: A major reason for the dollar’s current overvaluation is the widespread misunderstanding of the nature of capital flows to the US. The business press and many financial analysts provide the reassuring message that the flow of capital to the US substantially exceeds the amount needed to finance the US current account deficit, and that that inflow is coming primarily from private investors who are attracted by the strength of the American economy.

This optimistic analysis of the capital inflow is wrong. It results from a misinterpretation of the data provided by the US Treasury... It is easy to see why analysts reach this wrong conclusion. Recent ... press releases stated that the capital inflow was $278bn in the third quarter of last year, or $82bn more than the current account deficit for that quarter. The Treasury also reported that $257bn of this capital inflow came from private buyers.

In reality, there is no excess capital inflow and private investors are almost certainly not the primary source of the funds coming to the US. The figures..., while technically correct, are misleading for two reasons. First, the .. release refers only to transactions in long-term securities... It excludes bank deposits and bank lending, and flows of foreign direct investment into the US and by American investors to the rest of the world. A comprehensive measure of the capital inflow and outflow would show that the total net inflow is almost exactly equal to the amount needed to finance the current account deficit. ... If the total net inflow were larger than the current account deficit, the US would be accumulating large reserves of foreign exchange. In fact, reserves are virtually unchanged from year to year and are actually lower than they were two years ago. So it is wrong to conclude that the net capital flow to the US substantially exceeds the current account deficit. ...

A second source of confusion in the ... report is an easily misunderstood classification of whether the funds coming to the US are from governments or private sources. The ... measure of inflows from “private” sources overstates the actual private investment because it does not distinguish between a purchase by a private buyer for its own account and a purchase executed by a private institution on behalf of a foreign government. For example, if the Chinese government purchases US bonds through JPMorgan or another private bank, these funds will be recorded in the ... data as a private purchase. ...

My own belief, based on widespread conversations with officials and with private bankers, is that the inflow of capital that now finances the US current account deficit is coming primarily, perhaps overwhelmingly, from governments and from institutions acting on behalf of those governments. ...

The very large current account deficits are now being financed by bonds and shorter term fixed-income funds. Some of this has recently come from OPEC governments and other oil producers that are temporarily placing revenue in dollar bonds and bank deposits until they can spend those funds on investment or consumption. Much of the inflow in recent years has come from Asian governments that wanted to accumulate foreign ex-change to eliminate the risk of speculative attacks of the sort that hurt those countries in the late 1990s. A large amount is coming from China and other Asian governments to stop a falling dollar reducing their net exports. If they decide to buy fewer dollar bonds, the US current account deficit could not continue to be financed at current exchange rates and interest rates.

The US current account deficit increased ... in the first three quarters of last year and is widely predicted to move much higher in 2006. This unprecedented level is equal to 6.4 per cent of US gross domestic product. Experts estimate that the real trade-weighted value of the dollar must fall by at least 30 per cent just to shrink the trade deficit to a more sustainable level of 3 per cent of GDP. Much larger dollar declines are also possible. ...

The current small interest rate differences in favour of US bonds are not nearly enough to compensate investors for the fall in the dollar that is likely over the next few years. ... The dollar must fall faster than these small interest differentials in order to prevent the current account deficit from increasing more rapidly than GDP. ... At some point, that will trigger a shift away from the dollar. Private investors and the governments ... will inevitably shift at some time from dollars to euros or yen ... That that has not happened already reflects investors’ belief that it is still possible to benefit from the interest differentials before the dollar depreciates. That sanguine belief may, however, reflect a serious misunderstanding of the magnitude and nature of the capital flow to the US.

[Update:  PGL at Angry Bear has more.]

Comments

[pgl]

Wonder when Brad Setser will comment on this. But think about the fact that we as a nation have net debt to the rest of the world = 25% of national income so one would think that our net income from abroad would be around negative 1% of national income. Think about that and the usual Unpleasant Monetarist Arithmetic (aka basic finance) of Sargent&Wallace (e.g., their 1981 paper). So how can we run a permanent trade deficit? Isn't a permanent surplus needed to avoid rising debt/GNP ratios? More on this tomorrow at the Angrybear (hopefully) as I was just reading a real cool CBO research paper.

[Dave Schuler]

That's an interesting finding from a number of standpoints. Governments have the ability (and inclination) to make their buy and sell decisions at odds with the market to a greater extent than individuals.

The real question, I guess, is do this make us more or less vulnerable to a change in the wind?

[anne]

http://www.nytimes.com/2006/01/05/business/worldbusiness/05yuan.html?ex=1294117200&en=907a4afb14d88062&ei=5090&partner=rssuserland&emc=rss

January 5, 2006

Speculators Turn Away From China, Making Revaluation Less Pressing
By KEITH BRADSHER

HONG KONG - After several years of pouring huge amounts of money into China, speculators have abruptly stopped doing so, reducing somewhat the pressure for the Chinese to revalue their currency and helping to bring inflation down surprisingly sharply.

The weakening of attention toward China by international real estate investors and especially by currency traders, economists said, is making it harder for the Bush administration to push the authorities in Beijing to allow their currency, the yuan, to rise against the dollar.

Hundreds of billions of dollars have flowed into China in recent years, driving the country's total reserves beyond Japan's, to $860 billion. But this fall, only half as much money flowed into China as a year earlier.

Investors in the once red-hot Shanghai property market are walking away, and currency speculators who had bet that China would sharply strengthen the yuan have pulled back as it became clear that the authorities favor a slow approach to currency appreciation.

The flow of money has diminished even with the rise in the Chinese trade surplus, which has tripled in the last year to the irritation of politicians and business executives from Washington to Brussels to Tokyo. They want Chinese officials to let the yuan rise faster to make the country's exports more expensive in foreign markets.

In July, authorities revalued the yuan only slightly after trading partners complained that its link to the dollar kept exports cheaper than they would otherwise be. That, combined with very low interest rates, damped investment enthusiasm.

The slowing of speculative investments "takes the pressure off" Chinese authorities to allow appreciation, said William Belchere, chief Asia economist at Macquarie Securities here.

The reduced speculation has brought measurable advantages as well: inflation has almost disappeared, even as the economy grew at a 9.8 percent rate last year. Economists attribute this in part to dwindling amounts of speculative money sloshing around the economy.

China has also enjoyed excellent harvests, and there has been so much investment in new factories that a recent government report estimated that three-quarters of all categories of manufactured goods suffered from oversupply.

"There's no pricing capacity for anything," said Jing Ulrich, a J. P. Morgan economist here. "Food prices are falling," she said, and those for manufactured goods "are seeing stagnation at best." ...

[anne]

Speculators are not however buying the American dollar, they are buying the Australian dollar, Japanese Yen, Swiss Franc, British Pound and Euro. The Chinese Yuan is of course steady against the American dollar.

[Mark Thoma]

Dave:

Here's what Brad Setser had to say:"...Dr. Feldstein thinks central banks -- and oil sheiks -- are behind a lot of private flows into the US. And he doesn't seem convinced that this is will result in a stable equilibrium..."If it were private investors responding to solid fundamentals that would imply an element of persistence (stability). But this, apparently, is a response by central governments (including well-oiled ones) to interest differentials and other conditions that are not expected to persist and hence a reversal could come suddenly.

[Robert]

I cannot help but think of the ill-treatment and derision that Hans Blix received from the Bush Administration and their friends for daring to suggest there was a lack of overt evidence of WMD in support of their calls for miitary action in Iraq. Even if critical observers acknowledged there was a possibility that such WMD might exist, all such observers knew (or felt strongly) the case was way-stretched.

Over the same past three years, we've had to listen to CEA Chair after CEA Chair, the Sec'y Snow, as well as Kudlow, Laffer and most other ideologically-driven economists trumpet similarly far-fetched and triumphal stretches about how the US was the best place to invest, and that investors were holding USDs and beating a path to the next auction because of their confidence in the US, or our workforce, rule of law, safety, blah blah blah, yet most critical observers KNEW it was balderdash, and that the facility with which we were financing our CA deficits were the direct result of Asian CBs pursuing less-than-honorable neo-mercantilist goals, complmented by more recent petrodollar recycling.

I am just relieved to hear Dr. Feldstein finally dispel the notion that it's the broad deep market economically giving the US the vote of confidence.

As for David Schuler's question re: which is worse, I think conventional wisdom would recommend being as actuarially diversified as possible, in as many different dimensions as possible. In this respect the Treasury hasn't helped matters by continuing to skew issuance towards the shorter-end of the curve.

[brad s]

I'll have a bit more up soon if you are interested; I play basketball on monday nights. and pgl, i am almost done with my investigation into dark matter, which touches on the reasons for the continued favorable income balance. two keys -- very low interest rates on actual debt claims on the US, and the fact that US (reported) returns on US FDI abroad is much larger than the reported return on foreign FDI in the uS. the gains on US FDI v. foreign FDI offset the (low) interest payments on US debt. but watch out -- net interest should be -70b or so by my calculations in 06.

[Winslow R.]

Whose interest would be served by a sudden reversal?

Besides Buffet.

[pgl]

Brad Setser has weighed in on Feldstein's oped. Definitely worth the read even if Brad is rather cryptic today. Hint, read his links etc.

says...

Brad - just saw your comment. As promised - I'm working up something I hope is worthy on Dark Matter v. Fuzzy Income Accounting (aka transfer pricing). Let's just say, I really enjoyed the Dark Matter paper even if I'm not entirely buying their story.

[anne]

"Whose interest would be served by a sudden reversal?"

American investors should have significant international holdings as a diversification, but investors with any patience might have been increasing international holdings for quite a while. Values of stocks have been relatively attractive abroad even beyond the attraction of likely periodic or long term currency gains.

[anne]

http://www.msci.com/equity/index2.html

National Index Returns [Dollars]
12/31/04 - 12/30/05

Australia 17.5
Canada 28.9
Denmark 25.3
France 10.6
Germany 10.5
Hong Kong 8.4
Japan 25.6
Netherlands 14.9
Norway 25.7
Sweden 11.3
Switzerland 17.1
UK 7.4

http://www.msci.com/equity/index2.html

National Index Returns [Domestic Currency]
12/31/04 - 12/30/05

Australia 25.6
Canada 25.6
Denmark 44.8
France 27.4
Germany 27.4
Hong Kong 8.1
Japan 44.7
Netherlands 32.5
Norway 40.5
Sweden 33.3
Switzerland 35.8
UK 20.1

[anne]

http://www.msci.com/equity/index2.html

National Index Returns [Dollars]
12/30/95 - 12/30/05

Australia 11.5
Canada 14.5
Denmark 14.2
France 10.7
Germany 7.7
Hong Kong 5.4
Japan -0.0
Netherlands 8.0
Norway 11.9
Sweden 12.8
Switzerland 9.1
UK 8.5

http://www.msci.com/equity/index2.html

National Index Returns [Domestic Currency]
12/30/95 - 12/30/05

Australia 11.6
Canada 12.7
Denmark 15.7
France 12.2
Germany 9.3
Hong Kong 5.4
Japan 1.3
Netherlands 9.7
Norway 12.6
Sweden 14.8
Switzerland 10.6
UK 7.4

[Robert]

Looking in the rear-view mirror, many non-US equities were attractive several years ago (nadir=Mar03) providing some excellent absolute & relative investment opps whether in USDs or local currency. But "ratings" have inflated (prices rising in excess earnings) and they are less attractive today.

Looking forward, with real interest rates unlikely to return to the very negative post-9-11 levels (unless Bernanke arrives with helicopter), BuBa's Weber calling on the ECB to raise rates, higher oil prices biting, real estate (in many important world locales) no longer providing capital gains for wealth effects or equity extraction opps, a flat US yield curve, and valuations that are pedestrian at best for the avergae stock, the environment is not terribly supportive for further attractive equity returns.

I am not a perennial bear, but for equities (globally) to thrive in the immediate future, they will need continued strong growth from the US. And to me, it appears we've already borrowed a reasonable portion of this from the future. I WANT to be optimistic, respect your optimism, but am challenged to find it myself at the moment...

[Winslow R.]

"Whose interest would be served by a sudden reversal?"

Paraphrasing Anne:
Americans with international holdings.

Anne, wouldn't American asset prices increase as well as the flood of liquidity hit our markets?

What about the guys that could actually create a devaluation? Japan, China, and the U.S. Tsy? I don't think Europe or Soros (American investors) could do it. Would any of those that could benefit?

[anne]

Currency speculators can gain with a sudden relative value reversal. Were the dollar to lose significant value, those who hold dollars or American bonds would lose, but as was shown last year those who hold dollar assets in stock or real estate might not lose. European stocks rose markedly last year as the Euro lost value. American stocks rose markedly as the dollar lost value from 1985. British stocks rose after the Pound was allowed to float and suddenly lost value.

[Winslow R.]

Anne, wouldn't American asset prices increase as well as the flood of liquidity hit our markets?

Anne wrote:
"British stocks rose after the Pound was allowed to float and suddenly lost value."

I think we agree, American asset investors both here and abroad would not be hurt as asset prices would inflate either way. It is the currency spectulators that could be hurt if caught on the wrong side.

My Point: A U.S. Tsy lead competitive devaluation would have little political opposition here in America, even from tsy bondholders who have taken advantage of TIPS option. GM and Ford problems just make the case stronger for corporates as well. Some return is better than none.

China, Saudi Arabia et al. (they know the price point we shift to alternatives), Japan, etc. would lose markets in a sudden currency devaluation. They will not be the ones to start the inflation 'war'.

[anne]

David Swensen's conservative and I think effective Vanguard model portfolio would look like this:

30% American total stock market index
15% international developed market index
5% emerging market index
20% real estate investment trust index
30% total bond market index

[Robert]

If I am not mistaken, from what I've read, he also earmarks a reasonable allocation to non-traditional assets (private equity? timberland?), as well as some chunky opportunistic allocations to active value-tilted strategies that shave the so-called sharp edges off of those index allocations).

It's conservative from the point of view of minimizing hurt irrespective of whether the economy falls from it's current ridgeline towards inflation or deflation...

[anne]

What can be done with study and skill, a team, and billions to invest, is different than what may otherwise be done :) But, there are clever alternatives. Vanguard managed health care and energy funds have been superb in lieu of owning forest and wells. Though indexes work too. International indexes can well be international value indexes. The total bond market index should for many years have been Vanguard's managed long term investment-grade bond fund.