Wednesday, September 5, 2007

Does Rising Foreign Ownership of U.S. Assets Pose a Geopolitical Problem?

The August 2007 sell off in U.S. financial markets, which was triggered by the crisis in sub-prime mortgage lending and borrowing, is one illustration of a potentially larger problem. The U.S. government and the American people have been borrowing vast sums to finance spending and consumption. The federal government borrows several hundred billion dollars every year to pay its bills. The Congress periodically raises the federal debt ceiling for the government to remain in business. As of mid-August 2007, total federal debt stood at $8.97 trillion. Of this, the outstanding marketable debt of the federal government in the hands of the public, which excludes non-marketable securities held in the Social Security and Medicare Trust Funds, was $5.34 trillion, up from $346 billion at the end of 1973. Foreign ownership of marketable debt has almost tripled, from 15 percent in 1986 to about 42 percent in mid-2007, of which Asian central banks hold the lion’s share. The large share of foreign ownership of U.S. debt gives other nations, not all of whom are always friendly, the potential to influence U.S. monetary policy, interest rates, economic growth, and, perhaps more worrisome, U.S. foreign policy and national security.

Foreign ownership of federal debt is only part of the picture. A broader indicator is net foreign claims on U.S. assets. It changes with net acquisitions by foreign residents in the U.S. less net acquisitions abroad by U.S. residents. The change is largely driven by the current account deficit, the difference in U.S. purchases of goods and services over sales to foreigners, a deficit which is financed with foreign capital inflows. Largely in surplus during 1946-1981, the current account has since been in deficit since 1981. The deficit passed $100 billion in 1985, reached $214 billion in 1998, $415 billion in 2000, to about $800 billion in 2006. During the ten years 1998-2007 (which includes an estimated $800 billion in 2007), the cumulative deficit comes to about $5.4 trillion.

Economists and demographers project future trends to estimate the need for revenue to support a growing elderly population, the viability of Social Security and Medicare, and other topics. Assume that the U.S. continues to accrue a current account deficit at the present rate, or higher, for years to come. That would transfer $800 billion or more a year in U.S. assets to foreigners, disproportionately to China and oil exporting nations, especially in the volatile Middle East, home to radical Islam. Ten years would add $8 trillion, or more, to foreign claims; twenty $16 trillion, and so on. Saudi Arabia enjoys a $100 billion annual current account surplus, China, $250 billion, Russia, $80 billion, and so on.

The growth in foreign ownership of U.S. assets can be compared with the net wealth of U.S. households. Excluding real estate, the value of all U.S. household net wealth in 2006 was around $29 trillion, of which equities constituted about $16 trillion (household, pension, and insurance company holdings of corporate equities and mutual funds). Within a generation, foreign ownership of U.S. federal debt and equities will skyrocket.

A part of this ownership takes the form of an increasingly important phenomenon, sovereign wealth funds (SWF), which have captured the attention of economists and investment analysts. SWF are directly or indirectly controlled government investment vehicles funded by foreign currency assets which are managed separately from the official reserves of central banks. SWF are currently estimated at $2.2-2.5 trillion dollars, close to half of the $5.1 trillion in official foreign exchange reserves. Morgan Stanley has estimated that SWF will increase to $5 trillion by 2010 and $12 trillion by 2015. About two-thirds have derived from commodity exports (oil, gas) and one third from transfers from official foreign exchange reserves. Examples include Abu Dhabi’s Investment Authority ($875 million), Singapore’s Government Investment Corporation ($330 billion), Norway’s Petroleum Fund ($300 billion), and Russia’s stabilization Fund ($100 billion). The investments of private Saudi residents and Arab sheiks are akin to SWF. Some SWF have been and are seeking to acquire strategic foreign enterprises (banks, energy, airlines, ports, and publishing companies). Examples include the Dubai Ports Authority, CNOOC (a Chinese oil company), and Russia’s Gazprom, to name a few.

China has announced plans to create a SWF of $200 billion out of its foreign reserves of more than $1.3 trillion, which are increasing by $250 billion a year. During 1995-2006, China’s foreign reserves rose at an average annual rate of 20 percent. It is likely that China will inject additional billions into its SWF as its reserves continue to grow. In contrast with regulated private investment funds, SWF are not required to disclose governance or their portfolios.

Most economists argue that capital inflows are good for the U.S. economy, supporting investment that creates jobs and growth. Indeed, some claim that the portion of the trillions of dollars of SWF that will be invested on U.S. equity markets will help to prop up the market. The question is whether the increasing foreign ownership of U.S. assets poses economic and political risks.

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