If China's bond market were as well developed as the cross-country average - about the level of development in South Korea -- then China's predicted holdings of U.S. bonds would be about $200 billion below their current level.
One of today's most contentious economic debates is whether the current system of large global imbalances can continue. Some researchers suggest that this system will not persist because the United States must stabilize its external debt ratios, and part of that adjustment will involve a large depreciation of the dollar (even more than has occurred so far). Others argue that global imbalances could continue for an extended period because of factors that make U.S. assets more attractive and the persistent return differential between U.S. and foreign asset holdings. Most researchers agree that the greatest short-term vulnerability to the current system is the willingness of foreigners to continue to invest almost $2 trillion per year into the United States at existing exchange rates and interest rates.
Over the five years from 2002 through 2006, gross capital flows into the United States totaled $6.2 trillion. Foreigners invested an average of over $5 billion in the United States every day, despite relatively low returns compared to investments in other countries and the widespread expectation of continued dollar depreciation. Moreover, over two-thirds of U.S. external liabilities were held by the private sector by the end of 2006. What motivates the individual decisions that drive these capital inflows, and can this massive net transfer of capital into the United States last?
In Why Do Foreigners Invest in the United States? (NBER Working Paper No. 13908), Kristin Forbes notes that foreigners have earned substantially lower returns on their U.S. investments over the past five years than U.S. investors have earned abroad, even after removing the effects of exchange rate movements and government investments. This return differential exists even within individual asset classes (equities, foreign direct investment, and to a lesser extent, bonds) and after making rough adjustments for risk.
Still, foreign investors might choose to continue investing in the United States and financing the large U.S. current account deficit for several reasons. Indeed, they may choose to purchase U.S. portfolio investments in order to benefit from the highly developed, liquid, and efficient U.S. financial markets, and from the strong corporate governance and institutions in the United States -- although both of these perceived strengths of the United States have shown some vulnerabilities during the recent financial market turmoil. Foreigners also may invest in the United States in order to diversify risk, especially if returns in U.S. financial markets have little correlation with returns in their own country's domestic financial markets. Or, investors outside the United States may put their money here because of their strong linkages with the United States, through trade flows or such measures of "closeness" as distance, inexpensive communications, or sharing a common language.
Forbes asks which of these factors are actually significant in determining foreign investment in the United States. She finds that a country's financial development is consistently an important factor that affects its investment in both U.S. equity and debt markets. Specifically, countries with less developed financial markets invest a larger share of their portfolios in the United States and the magnitude of this effect decreases with income per capita. Her estimates suggest that if China's bond market were as well developed as the cross-country average - about the level of development in South Korea ---then China's predicted holdings of U.S. bonds would be about $200 billion below their current level.
Countries with fewer controls on capital flows and larger trade flows with the United States also invest more in U.S. equity and debt markets. And, return differentials are important in predicting U.S. equity (but not bond) investments, because foreigners invest more in U.S. equities if they have had relatively lower returns in their own equity markets. Finally, despite strong theoretical support, it appears that diversification motives have little impact on patterns of foreign investment in the United States.
Forbes notes that these results -- and especially the primary role of a country's financial market development in determining its investment in the United States -- have three important implications. First, the results support the theoretical literature on global imbalances that emphasizes the role of U.S. financial markets. Although the exact mechanism varies across models, one key theme in recent research is that lower levels of financial market development in other countries will continue to support capital flows into the United States, thereby supporting the U.S. current account deficit and large global imbalances without major changes in asset prices. A second, related, implication is that as countries around the world continue to develop and strengthen their own financial markets, this will gradually reduce this important driver of capital flows into United States. These adjustments would likely occur slowly, though, because the development of financial markets, especially in low-income countries, is a long process. Finally, and potentially more worrisome, because the liquid and efficient financial markets of the United States are a major impetus behind U.S. capital inflows, anything that undermines the perceived advantages of U.S. equity and bond markets could present a serious risk to the sustainability of U.S. capital inflows. The U.S. sub-prime crisis and continued turmoil in U.S. financial markets already may have undermined this perceived "gold standard" of financial markets, and the risk of a sudden increase in poorly thought-out regulation may aggravate these concerns. If countries with less developed financial markets begin to question the relative advantages of U.S. financial markets, this could lead to a more rapid adjustment in U.S. capital inflows, global imbalances, and asset prices.
-- Les Picker