Dollar bulls bet on weak appeal of US rivals By Philip Coggan
Financial Times May 20, 2002
To borrow a phrase from Ross Perot, investors can hear "a giant sucking sound" in international capital markets. It is the noise of the US economy sucking in more than $1bn (E600m) a day to fund its current account deficit.
Not everyone sees this as a problem. Paul O'Neill, US Treasury secretary, believes the inflow of capital reflects investor demand for US assets. International investors are buying US assets because they believe the prospects for the US economy are better than those of the rest of the world; in his view, the current account deficit is a result of an investment surplus, not the other way round.
But the foreign exchange markets are starting to have their doubts. The fear is that more and more of the US current account deficit is being financed by "hot money" - short-term flows that can easily flow out again. The US dollar has suffered a modest period of weakness against the euro and the yen.
The long-term trend has been for US capital inflows to come in the form of securities purchases, rather than bank deposits. According to the US Federal Reserve, foreign holdings of US securities rose from 49 per cent of all portfolio liabilities in 1989 to 65 per cent in 2000; over the same period, the proportion of liabilities accounted for by US banks declined from 36 to 19 per cent.
The result has been that foreign investors have become steadily more important in the US securities markets. As of November 2001, overseas investors accounted for 42.8 per cent of all private holdings of US Treasury securities, up from 39.2 per cent at the end of 1999. According to Goldman Sachs, they also own 11.2 per cent of all US equities and 21.4 per cent of US corporate bonds.
The sheer size of these holdings means that it is very difficult for investors to liquidate their positions. However, just because overseas investors are already heavily committed to the US financial markets does not mean they are required to throw new money into US assets. Enthusiasm for US securities may have dimmed in the wake of the bursting of the dotcom bubble and the doubts about US accounting standards arising from the collapse of Enron, the energy trading giant.
According to David Bowers, chief global investment strategist at Merrill Lynch, "'Anything but America' seems to be the theme song of institutional investors right now". Merrill's survey of global fund managers found that 63 per cent saw the US as the most expensive global equity market, while a net 58 per cent saw the US dollar as overvalued.
Those views are being reflected in transactions. According to Peter Dixon, an economist at Commerzbank, net purchases of US equities by non-residents in the three months to February averaged just over $5bn versus $15bn in the three months to February 2001. Similarly, purchases of US bonds dropped from $23bn to $13bn over the same period.
Bond flows are the key to the US financing issue. The improved fiscal position of the US government means that fewer Treasury bonds are being issued; net foreign purchases of Treasuries in 2001 were just $15.8bn. But foreigners bought a massive $371bn worth of other US bonds from corporations and from government agencies such as Fannie Mae and Freddie Mac. Net international bond issues by US borrowers in 2001 were a record $112bn.
One reason why foreigners are not purchasing so many US corporate bonds this year may be that the pace of issuance has slowed; according to Citibank, the four-week moving average of issuance has almost halved in recent weeks.
But if overseas investors are not buying bonds or shares in sufficient quantities, how is the US current account deficit being financed? Not, on the face of it, via direct investment; Peter Dixon of Commerzbank says the rate of foreign direct investment into the US slowed towards the end of last year.
The most likely explanation is that the remainder of the current account deficit is being financed by short-term deposits. But how long will foreign investors be happy to hold those deposits when US short-term interest rates, at 1.75 per cent, are well below those in Europe?
The question is where else they can put their money. In Japan, where the economy appears mired in deflation, government finances are out of control and interest rates are zero? Or Europe, where progress on economic reform is sluggish and political systems appear to be in turmoil?
Dollar bulls believe the lack of alternatives will support the US currency. But the next few months will put their confidence to the test.