June 17, 2002

Foreigners "Saturated" With U.S. Dollar Assets?: Either Way, They Need to Buy More or the Dollar Is Coming Down

Morgan Stanley seems to think that slow purchases of U.S. dollar assets by foreigners reflects not their "abandonment" of but their "saturation" by U.S. dollar assets.

I don't see the difference. With a required capital inflow of $300 billion a year at current exchange rates, the current value of the dollar cannot be sustained either if foreigners abandon or if foreigners are saturated with dollar assets,


Morgan Stanley

Global: Foreign Holdings of US Securities Near Saturation

Joe Quinlan/Rebecca McCaughrin (New York)

The plunge in US portfolio inflows -- down by over 40% in the first quarter of this year (according to US Treasury data) from the same period a year ago -- has sparked fears of foreign investors abandoning the US financial markets, leaving the debt-stretched US economy devoid of capital and the US dollar in a free fall. We do not subscribe to such a dire scenario and believe the recent pullback in US inflows requires some perspective. In particular, we think the diminished appetite for US assets among foreign investors is less about abandonment and more about saturation.

Foreign holdings of US assets are currently at or near record highs, and given present circumstances (a weak US profits environment, corporate accounting irregularities, the US-led war on terrorism), there are few compelling reasons for foreign investors to increase their dollar-based investments. At the end of the first quarter, for instance, foreign holdings of US Treasuries totaled just over $1.25 trillion, not far from the $1.3 trillion annual peak of 1998. At current levels, foreign investors own 36.7% of outstanding marketable Treasury securities, off slightly from the record 37.2% share of 2001.

Foreign holdings of US agency securities, or the debt of government-sponsored enterprises like Fannie Mae and Freddie Mac, also stood at record levels in the first quarter of this year. Then, foreign investors held $745.6 billion of agency issues, up from $593 billion in same period a year ago, and more than double the outstanding levels of 1999 ($395 billion). Given the increased popularity of government agencies among investors, foreigners were holding 14.5% of outstanding agency securities in the first quarter. That was basically unchanged from last year, but up from 12.7% in 2000 and 10.1% in 1999.

Corporate bonds have been another favorite asset of foreign investors over the past few years, with foreign holdings nearly doubling between 1998 ($660 billion) and 2001 ($1.2 trillion). Foreign holdings edged higher to $1.3 trillion in the first quarter of this year, an amount equal to roughly 24% of outstanding US corporate bonds.

Similar trends are evident in US equities. Foreign holdings of US stocks increased in the first quarter of this year, rising from just under $1.7 trillion at the end of 2001 to a near record high of $1.75 trillion in the first quarter. For the period, foreign investors held nearly 13% of the value of outstanding corporate stocks, up from 12.4% in 2001 and 11.1% in 2000.

All of the above underscores just how much influence foreign investors exert in the US credit markets. As holders of over one-third of US Treasuries, foreign investors are obviously a critical force in the US treasury market, a key point to remember as the US federal budget swings from a surplus to a deficit. As large investors in government agencies, foreign capital has been a significant source of funds for US mortgage markets. Meanwhile, soaring foreign purchases of corporate bonds helped fuel the US investment boom of the late 1990s, while foreign purchases of US equities added more liquidity to US equity markets. All totaled, foreign holdings of US credit market instruments (which excludes equities) accounted for 11.7% of total US credit market debt in the first quarter, a record high.

No Place but Down?

After aggressively accumulating US assets over the past few years, many global investors find their portfolios saturated with US assets. For US portfolio inflows in 2002 to match last yearís record surge would require a truly outstanding performance of the US economy and corporate America relative to the rest of the world. The markets hardly see it that way, hence reduced inflows in the first quarter of this year. At this juncture, there is more downside risk than upside potential for portfolio inflows. But that said, we are not in the camp of an en masse abandonment of the US credit market. Rather, itís about saturation and the gradual process whereby foreign investors lighten up their US-dollar holdings.

Posted by DeLong at June 17, 2002 11:20 AM

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