2007 September 25 Tuesday
Foreign Investment In US Declines With Dollar Decline

The rise in oil prices, accumulating debt burdens, the bursting of the housing bubble, and the large US trade deficit have pushed down the US dollar. The long expected adjustment of currencies is taking place. Also, foreign buying of US securities has declined as the dollar has weakened.

Even before the recent market turmoil began, foreign buying of U.S. financial assets had slowed. A Treasury Department report showed foreign holdings of long-term securities such as equities, notes and bonds increased by a net $19.2 billion in July, the slowest pace in seven months and well below the $97.3 billion tallied in June.

Worries about foreigners wanting to diversify out of dollars rose last week after Saudi Arabia decided for the first time not to cut interest rates in lock step with the U.S. Fed, leading to some speculation that it would soon end its currency's peg to the dollar.

A decline in the dollar combined with a decline in foreign investments creates inflationary pressures in a few ways. First off, imports cost more. Second, the drop in the dollar also increases foreign demand for US goods and therefore enables US manufacturers to raise prices. Third, the decline in foreign purchases of bonds raises interest rates. All these forces are inflationary. If strong inflation shows up then the US Federal Reserve will have to raise interest rates and push the US economy into a recession.

The Middle Eastern nations no longer use their oil revenue to buy goods from the United States.

What happened? Oil nations are more willing to diversify out of the dollar than they used to be, said Mansoor Mohi-uddin, the head of foreign exchange strategy at UBS, in Zurich.

Stephen Jen, the global head of current research for Morgan Stanley in London, agreed. "Oil exporters' propensity to import from the U.S. has declined in recent years, while their tendency to import from Europe and Asia has risen steadily," he said, adding that OPEC nations currently buy more than three times as much from the European Union as from the United States.

The recent decision of the Saudi central bank to not follow the US Federal Reserve in lowering interest rates indicates the Saudis may be headed toward breaking their dollar peg. The Saudis import most of their goods from the European Union and the rise of the Euro against the dollar has caused a high rate of inflation in Saudi Arabia. By letting their currency rise against the dollar they will reduce their cost of imported goods from Europe and lower internal prices.

Foreign cash flows into US securities has even reversed.

The tally for all of the third quarter isn't yet in, but last week we learned what happened to some of these investment flows in July. Net foreign purchases of U.S. stocks dropped to $21 billion, from $29 billion in June. Net foreign purchases of U.S. corporate bonds slumped to $4 billion from $26 billion the prior month as the incipient credit crunch throttled global demand for junk. All that spare cash flowed into short-term debt, which saw an inflow of $67 billion after an outflow of $28 billion in June. Meanwhile, counting stock swaps and the repaid principal on bonds, foreigners actually took $3 billion more out of long-term U.S. securities than they put in.

Americans have been living beyond their means, importing more goods than they exported. American living standards may stagnate or fall during the readjustment that will bring imports and exports back into balance. That readjustment will be a contributing cause of the next recession.

Even East Asian bondholders are becoming reluctant to buy US financial paper.

The dollar's slump to a 15-year low against six of its most actively traded peers is turning the gains into losses for international bondholders, prompting China, Japan and Taiwan to sell. Overseas investors own more than half of the $4.4 trillion in marketable U.S. government debt outstanding, up from a third in 2001, according to data compiled by the Treasury Department.

``The support that Asia has shown in buying U.S. Treasuries has been a major supporter of keeping long-term interest rates lower than where they probably would be,'' said Gary Pollack, who oversees $12 billion as head of fixed-income trading in New York at the private wealth management unit of Deutsche Bank AG, Germany's biggest bank. ``This could put some upward pressure on yields in the United States.''

Higher long term interest rates will raise mortgage payments and further dampen demand for housing and therefore cause more of a housing price decline. This produces winners and losers. It is good news for people who want to buy a house a few years from now.

Early on China's big effect was as lower priced maker of goods but now China's demand for raw materials is exerting a larger influence on financial markets and prices.

China's emergence in the early 1990s as the low-cost workshop of the world furnished global markets with an endless supply of cheap goods, creating stiff competition that kept down prices everywhere. For a time, that effect more than offset costs for raw materials, notably oil, which also began to rise as China, India and other emerging economies began to develop.

Now, however, these populations can increasingly afford to live a little better, driving a new spiral of demand for building materials to accommodate expanding infrastructure; foodstuffs to feed cattle as more meat is put on the table; and oil to fuel new cars and more manufacturing.

Over the past five years alone, oil prices have risen 158 percent, to around $80, while the price of wheat has soared 126 percent. Costs for nickel, used to build Alno's sinks, have shot up 415 percent.

The price of food has been rising like the price of oil and for similar reasons.

"Food is going to be like oil," a product that gets more expensive as China and India get richer, said Chris Williamson, chief economist at NTC Economics in London.

Alan Greenspan fears higher long term inflation is coming.

The former chairman of the U.S. Federal Reserve, Alan Greenspan, is doubtful. In his new memoir, he writes that inflation could hit 4 percent to 5 percent in a decade, enough to halve the purchasing power of a dollar in about 15 years.

As salaries continue to rise in China and as Chinese demand pushes up costs of raw materials the Chinese manufacturers are beginning to raise prices and economists expect they will continue to do so. China will shift from being a deflationary force on prices to being an inflationary force.

The burst of the housing bubble has caused the Federal Reserve's to use lower interests rates to try to avoid a recession. But inflationary pressures might force the Fed to eventually shift gear on interest rates.

If the Fed gets it just right, the economy will slip through this crisis and keep expanding with only modest inflation, making investors happy. If the Fed's rate cuts are too little, too late, recession fears will return, sending another cold wind through credit markets and the stock market. If the Fed cuts rates too much, inflation could loom.

What was troubling some investors after the Fed rate cut last week, a reduction in short-term rates by half a percentage point, to 4.75%, was the latter risk -- the risk of inflation.

If rising inflation forces a rise in interest rates then the US economy could go into recession.

Some money managers already are warning that inflation may force the Fed to raise rates early next year, taking back last week's gift. Higher rates would hurt stocks because they stifle the economy and make it harder for investors to borrow.

Something similar happened in 1999, when the Fed had to raise rates after cutting them during the 1998 financial crisis. The economy ended up in recession in 2001.

The recession will be uneven. Some exporters will experience sales growth made possible by a weakening dollar.

Share |      By Randall Parker at 2007 September 25 08:58 PM  Economics Financial

Kenelm Digby said at September 26, 2007 2:53 AM:

The upshot to all this is that we must accept a world in which China is the dominant economic and financial player - and that world will be apparent to even the biggest sceptics much sooner than they think.

John S Bolton said at September 26, 2007 3:27 AM:

Dpending on whether inability to do hundreds of billions per year in dollar support as in the last year, forces them back, like Japan, to the 0-1% growth level for 15 or more years.
Higher interest rates are disinflationary, not inflationary.

Wolf-Dog said at September 27, 2007 7:38 AM:

What will happen when the United States becomes unable to sustain the same $700 billion annual trade deficit? For the record, the latter figure is more than 9 % of the money supply M2, and more than 5 % of the GDP. This $700 figure is so enormous that it is the main subsidy for the rest of the world. With this subsidy, China and Europe pay for raw materials and yet maintain a positive trade balance. Once the US becomes unable to sustain this trade deficit, there will be more pressure on other countries. At this rate, when the US dollar declines another 80 % within ten years, then suddenly the American goods and services will become very competitive, especially since quality is improving dramatically. Within 10 years, genetically engineered crops will combat inflation, unless there are unexpected environmental disasters like the greenhouse effect wiping out all agriculture.

christian said at October 5, 2007 8:58 AM:

there will be ASSET price deflation and cost of living inflation in the united states. food energy an cost of goods as well as long term intrest rates (mortgage payments increasing) will zap consumer spending and send the usa into a severe recession perhaps more. (depending on how fast the usa can grow there exports in the face of shrinking consumer's spending) maybe new technology can provide this boost (but it will be foreigner's buying it up)

the first round of bernanke's attempt to fight deflation in regards to CPI deflation (by cutting rates and devaluing dollar, thus repricing food, gas, and imports (walmart good) increase in the cost of living as well as will presure foreing country's 2 be country's de-pegging from the dollar, and probably not returning (even if the fed reverses intrest rate policy's in 2008 sometime) although they will may try to aggresively cut further cut short term rates, soon they will be in a conundrum in the face of foreingers driving up long term intrest rates . this will force the fed's hand to raise short term rates and they will be able to do so, without their fear of the cpi deflation "boogey man" because prices will be in need of trimming anyway. the increase in cost of goods will suffocate the consumer in the united states due to a cycle of unemployment and less spending that amplifys.

due to the pressure from over-leveraged assets and deregulation infecting foreign markets as well as the need for lowering intrest rate enviornements in the face of growing derivatives and attempts to delay the credit contraction further will lead other country's to eventually tap out their consumers and go the way the u.s is headed. (or face massive defaults and global depression) really , either way it appears the game is up, globally very soon.

we will be left with a fascist/communist one world gov't as well as alot of uselss "eaters" which may require historical and "hidden" yet aggresive measurees to ensure the continuation of the human species in a civil way thru the regulation of the population in accordance with the economy.

i.e they need to kill a lot of people 2 adress concerns of poverty driving down industrialized nations as well as find a solution to the decline in supply of oil. good thing the first people that may be effected by these "aggresive measures" may be those that account for 1/4 of the world's oil use

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