Commentary: The U.S. Is Awash in Foreign Money. That's a Problem

During the boom, the U.S. was a magnet for foreign investors. Lured by a soaring stock market, strong growth, and the promise of big returns from new technology, foreigners poured $3.7 trillion into U.S. financial assets from 1996 to 2000, nearly triple the rate of the previous five years. That money helped finance the Information Revolution.

Now the tech boom has collapsed--but the U.S.'s near-monopoly of global savings continues. In the first quarter, foreign investment in the U.S. ran at a rate of $950 billion annually, just below the record 2000 level. Although foreign acquisition of U.S. companies has fallen sharply since 1999 as merger mania has cooled, healthy portfolio investment in U.S. stocks and bonds has filled the gap.

What's happening is that foreign investors are staying relatively optimistic about U.S. economic prospects, even as growth forecasts for Europe, Japan, and East Asia are trimmed. Sure, the U.S. economy and markets are troubled, but many foreign investors expect that the U.S. "will pick up faster than Europe," says Johannes Reich, head of strategy at Metzler Bank, a Frankfurt private bank. In addition, the U.S. economy is seen as more flexible and better able to make use of information technology than rivals, which means bigger long-run productivity gains.

The flow of foreign money into the U.S. also has a certain self-fulfilling quality. By providing financing for home mortgages and corporate borrowing, it has supported U.S. housing and business construction. That helps explain why U.S. business and residential investment combined rose at a 2.3% rate in the first quarter.

But this dependence on foreign funds brings up two problems. First, if the U.S. continues to absorb most of the world's savings, that could choke off investment elsewhere. Business and residential investment in Europe and Japan fell sharply in the first quarter. If that continues, the U.S. would limp along as the world's safe haven, but global recovery would be slowed.

Alternatively, if the U.S. recovery is delayed longer than expected, or if productivity falls off, the U.S. may begin to look less attractive compared with other countries. Foreign investors will become less willing to fund U.S. borrowing, which would push up interest rates and squeeze growth. Moreover, the recent shift to easily liquidated portfolio investments makes the U.S. more vulnerable to a sudden change in sentiment. A slowdown in the flow of money into the country would pull down the dollar, making foreign investors less willing to hold U.S. financial assets.

So far, the influx of foreign money has been a net plus for the U.S. Foreign investors have been buying large quantities of the securities issued by housing lenders Fannie Mae and Freddie Mac. These foreign funds accounted for about 40% of home lending in the first quarter, making mortgages cheaper and easier to get.

EUROPE'S GLOOM. Foreign money has also helped insulate U.S. companies from the effects of the weak market. In the first quarter, foreign investors bought stocks and corporate bonds at a $440 billion annual rate. And foreign lenders such as the German bank HypoVereinsbank are funding U.S. commercial construction.

Meanwhile, money is streaming out of the rest of the world. In the first quarter, Japan ran a current account surplus of roughly $100 billion annually, although the number shrank sharply in May (page 50). The flow of money out of the euro zone has been steadily rising, too. In the first four months of 2001, net outflows of portfolio and direct investment from the euro zone totaled $360 billion, at annual rates. That's more than double a year earlier, as investors become gloomier about Europe's prospects. "This is the price that Europe will pay for not having done restructuring in time," says Jacob A. Frenkel, president of Merrill Lynch International in London.

That money is mostly flowing into the U.S. But the consensus about whose economic future is brighter has shifted repeatedly in recent years. Not too long ago, the prevailing view in Europe was optimism about the Continent's prospects and skepticism about the sustainability of U.S. productivity gains. Now, faith in the American economic revival rules. But if that faith diminishes, so will the influx of foreign capital.

By Michael J. Mandel

With David Fairlamb in Frankfurt

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