As elegantly put by the Bank of International Settlements in its recent annual report, the soft landing for the global economy suddenly seems more elusive.
The American retreat from the center of the international economy and the surge in policy uncertainty this year have jolted financial markets and resulted in a sustained depreciation of the American dollar.
Foreign investment in U.S. financial securities and direct investment in its corporations are outstripping U.S. holdings of foreign assets by $26 trillion as the end of last year.
This volatility is likely to continue as Washington’s de facto weak dollar policies prompt international investors to diversify away from the dollar and dollar-denominated assets.
Foreign investment in U.S. financial securities and direct investment in its corporations are outstripping U.S. holdings of foreign assets by $26 trillion as the end of last year.
It’s a stunning figure, one that has grown in recent years. But even though it is a sign of foreign investors’ confidence in the American economy, there are indications that it is starting to level off, and the pressure is likely to continue.
The estimated $3 trillion to $4 trillion increase in public debt over the next decade, for example—recently approved by Congress—will raise debt financing costs and add to concerns around the U.S. as the ultimate global safe haven.
To be sure, this leveling off in the net investment position has happened before, but those periods have occurred during times of economic strain, like the pandemic, or trade tensions, like the 2018 trade war.
Now, with a weak-dollar policy and increasing protectionism coming on top of rising public debt, foreign investors are poised to find other places to put their money than the U.S.
No longer so safe
This deterioration in the U.S. global position comes after a period of historic strength for the American economy.
For years, American innovation and productivity have attracted foreign investment in its securities and corporations. At the same time, global investors have no viable alternative to the depth of the U.S. Treasury and corporate bond market, even amid the recent shift.
This enduring strength of U.S. markets is why we think that what is occurring is a rational response to the U.S. attempt to rebalance the global economy.
In the end, it’s a diversification rather than de-dollarization.
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While the net international investment position of the U.S. is likely to deteriorate further, there is an effective limit to how far that can go.
We see the surge in investment in the U.S. as a natural progression of an economy that has continued to move beyond basic manufacturing and natural resource extraction.
In addition, the U.S. offers investors the reliability of centuries-long adherence to contract law.
So although shocks have rattled the global economy in recent years, foreigners have increased their purchases of U.S. assets at an accelerating rate.
In just the past five years, as measured its net international investment position, U.S. liabilities (U.S. assets owned by foreigners) grew at an 8.9% average annual rate, while U.S. assets (foreign assets owned by U.S. investors) grew at a 4.5% rate.
Foreign liabilities have accelerated at twice the speed of U.S. international assets, which goes hand in hand with the rising U.S. trade deficit, the dollar’s strength, the depth of the Treasury and corporate bond markets, and strength of the American equity market.
For American trading partners, the dollar’s strength served as a hedge until this year. Foreign exporters were able to invest their receipts in U.S. securities, gaining the return advantage of higher-yielding dollar-denominated securities while avoiding the cost of exchanging dollars for their foreign currencies.
But as the Bank of International Settlements report shows, the receipts from trade with Asia, while important, have not been the only way that the U.S. fiscal and trade deficits have been financed.
The predominant source of international investment into the U.S. economy has come from the advanced economies, with the Europe leading the way.
This should not come as a complete surprise. Just as the wealth of the U.S. economy can support both foreign and domestic investment, the financial centers of Europe and Japan are advanced enough to support investment in U.S. government debt and corporations.
There has been another bright spot for the U.S. On a cash flow basis, the U.S. had until this year maintained a net positive position on investment income, which is the income earned on U.S. investment in foreign assets and vice versa.
This net positive position was because the return on foreign assets owned by the U.S. exceeded the rate of return on U.S. assets held by foreigners.
But that’s changing. The cash flow has reversed course in four of the past five quarters. with the income stream now moving in favor of the United States’ foreign creditors. That shift can be attributed to the dollar’s loss of value over the past year, with returns on foreign assets now translated into fewer dollars.
A changing financial landscape
Investors over the last 20 years have become accustomed to what has been termed American exceptionalism, which has resulted in an abundance of cheap goods, big cars and the willingness of foreigners to invest in U.S. innovation and productivity.
But that won’t last forever.
Consider England after the Second World War. Two world wars and an outdated social structure took its toll on the British economy, with the pound ceding its status as the reserve currency to the American dollar.
Today, a wealthy U.S. finds itself with a growing U.S. resistance to the global economy and to the perceived stricture of international institutions that allowed for the development of that wealth.
To that point, the BIS notes the growing connectedness of global financial markets, the increased transmission of financial conditions in the global economy and the increasing role of nonbank financial institutions that have financed the development of the advanced economies.
Instead of a laissez-faire approach to finance that nearly crushed the global economy in 2008, this connectivity will require that regulatory standards keep pace with the evolving structure of global financial markets.
The BIS finds that since the financial crisis, the focus has shifted from the activities of global banks engaged in cross-border lending to the activities of international portfolio investors in global bond markets.
This “second phase of global liquidity” had several key drivers, according to the BIS report.
On the borrowing side, it was driven by expansive fiscal policies in major jurisdictions and the surge in the supply of sovereign bonds. On the lending side, the growth of nonbank financial institutions and their need for diversification induced them to hold portfolios in a variety of currencies.
The nonbank accumulation of Treasury securities has considerably outpaced that of foreign official holders to the point that they currently account for more than half of all foreign holdings of Treasuries.
The largest increase in U.S. bond holdings of around $1.3 trillion is accounted for by European investors. The second-largest increase (of $575 billion) came from investors from other advanced economies.
The BIS report also notes that changes in bilateral portfolio positions are only loosely related to current account imbalances. Indeed, many of the largest increases in cross-border bond holdings since 2015 were reported by private investors from economies that did not run large current account surpluses.
This is not surprising considering that the largest nonbank financial institutions are based in advanced economies and tend to direct their investments toward the large bond markets of other advanced economies.
The focus on net measures like current account imbalances misses the point. It is the role of large gross portfolio positions between advanced economies that are key to the international transmission of financial conditions.
The foreign exchange swap market
The development of the foreign exchange swaps market has been a crucial factor fostering the globalization of sovereign bond markets, according to the BIS.
Given the centrality of the U.S. fixed income market, FX swaps have facilitated greater access to U.S. dollar-denominated bonds.as well as making the universe of bonds more accessible on a hedged basis.
The FX swap market is large, reaching $111 trillion at end of last year, with FX swaps and forwards accounting for roughly two thirds of that amount.
Roughly 90% of FX swaps have the dollar on one side, underlining the dollar’s linchpin role in the global financial system. More than three quarters of all outstanding FX swap contracts have a maturity of less than one year.
The BIS analysis finds that cross-border investment flows shed light on the growing connectedness among advanced economy markets.
These flows form the channel through which financial conditions in advanced economies including the U.S. can be affected by nonbank portfolio choices.
The recent episode of South Korean insurance companies’ exposure to long-term U.S. Treasury securities highlights the importance of hedging.
Interconnected financial conditions
Can another financial crisis happen again? Only if it is allowed to occur.
When monetary policy is tightened, risk premiums would be expected to rise.
Market participants are hedging their investments by requiring higher rates of return in anticipation of an economic slowdown and a greater risk of default. As anxiety over tariffs has grown, long-dated Treasuries have sold off.
At the same time, the appetite for risk remains elevated, as the quick recovery in the equity market demonstrates.
Still, the BIS warns that when risk appetite is high and cross-border positions of global investors build up quickly, that can unravel suddenly, leading to fire sales and sharp drops in asset prices in different markets.
What would it take for the world to lose confidence in U.S. institutions and dollar-denominated investments?
The takeaway
The U.S. negative net international position has been a result of the attractiveness of U.S. assets to international investment. The dollar’s sudden reversal and the selloff at the long end of the Treasury curve are reminders of how quickly the investment atmosphere can change.
While the cash flow derived from foreign investments has been a net positive gain for the U.S., the dollar’s decline has overturned that advantage.
For international investors, the dollar’s decline is a reminder of the need to hedge currency exposure.
