Brad Setser and Tony Jackson both comment today on the seemingly inexorable rise of foreigner investors in the US, particularly to shore up foundering financial institutions.
Setser’s piece is much broader and also synthesizes and comments on recent hand-wringing in the media, so it gets pride of place. However, Jackson’s observation about the maybe-not-so-hot prospects for these buys is revealing.
The last time we has this much collective anxiety about foreign investment in the US was in the later 1980s, when Japan appeared ascendant and was snapping up choice US assets. However, many of these deals not only turned out to be disappointments, but a large portion were quietly sold later, often at lower prices, as Japanese financial institutions, trading companies, and construction firms needed more capital to cope with demands at home.
Now as Setser argues, the reasons for Japanese (and present day Canadian and European) investment weren’t as troubling as Chinese and Saudi investment, since the huge trade surpluses of the latter are at least in part due to maintaining pegs against the dollar even as it falls against other currencies. But that comparison lets the Japanese off the hook. A big reason that foreign investment was so enticing wasn’t the appreciation of the yen (I know the doctor will find it hard to believe, but I represented Japanese buyers in those days, and they scarcely gave current or prospective FX rates a thought). Japanese real estate, both residential and commercial, was grossly, absurdly overvalued. Anything anywhere else in the world looked dirt cheap. The yen could have been half were it was trading and US real estate still would have seemed a bargain. The domestic bubble, and the resulting easy access to credit (banks would lend 100% against commercial real estate) were the primary factors in the overseas investment boom. He similarly attributes Japanese “transplant” auto plants to the strong yen. Again, not exactly true. It was clear the further Japanese auto imports would not be tolerated. Rather than be subject to quotas or tariffs, the Japanese chose to build plants here (the Japanese were then shifting production to Malaysia in those industries where the then-high yen was impeding price competitiveness, and that likely would have been their choice in the absence of US political concerns. Today, many of our Chinese imports are similarly those of Japanese manufacturers.)
Japan is a special case, and its peculiarities do not undermine the validity of the rest of Setser’s thesis.
Jackson simply observes that investors in investment banks are likely to be buying into a model that may be in for a long period of decline. After the great bull market of the 1960s, the securities industry was hit with the double whammy of deregulation of commissions and stagflation, and didn’t return to robust times until the mid 1980s.
From Setser’s “The Unites States, on sale“:
The front page of the Sunday New York Times had a long article by Peter S. Goodman and Louise Story. But Maureen Dowd is a better barometer of the cultural zeitgeist that news page: today’s column skewers the Gulf’s purchases of US banks…
The irony of government funds bailing out Wall Street titans formerly noted for their privatizing zeal is hard to miss…
The other great irony, of course, its that “W”’s America has found that the investment funds of non-democratic governments offer easiest solution to the problems created by an under-capitalized American financial system. Selling the street to the Gulf (and Singapore) is a lot easier than bailing out the Street with taxpayer money….
The collapse of demand for US asset backed securities (at least those without a n implicit government guarantee) has forced the US to finance its deficit by selling off its companies to foreign investors. The Thompson financial data that Goodman and Story highlight suggests that foreign acquisitions of US assets will double in 2007, rising from around $200b to $400b. For the first time since 2000, foreign acquisitions will top US acquisitions abroad, generating around $100b in net inflows. That is not enough to finance a $750b deficit, but every little bit helps.
Goodman and Story also make another important point: a lot of the 2007 inflows came from Europe and Canada, not Asia or the Gulf.
That is important, and not just because European and Canadian flows come from private investors. There is an enormous difference between foreign investment that is result of a process of economic adjustment, and foreign investment that results from a systematic effort to impede adjustment. The European and Canadian flows reflect the adjustment process; flows from Asia and the Gulf reflect government policy decisions to impede adjustment.
What precisely do I mean?
The dollar has fallen substantially against the euro, the pound and the Canadian dollar. That has made US goods cheaper relative to European and Canadian goods. It also has made US financial assets cheap, comparatively speaking. The result: financial inflows into the US and a falling US deficit with Europe and Canada. The cheap dollar is pulling in money, but it is also setting in motion a process that will lead to the elimination of the US balance of payments deficit with at least Europe…
This was also a characteristic of the inflows from Japan in the 1980s. Japanese purchases of trophy US assets – most famously Rockefeller Center — came after the yen had appreciated substantially against the dollar, making US assets seem cheap. It was part of the same process that led Japanese automobile firms to invest in US “transplants” – a process that actually led to a fall in the US deficit with Japan up until the Japanese bubble burst.
The story has a set of interrelated parts, but it starts with a change in the exchange rate. That makes the US an attractive location for private investment. It also tends to increase US exports relative to imports. And the adjustment in the trade accounts eventually reduces the US need to import funds from abroad. Large foreign purchases finance the transition to a smaller, more sustainable external deficit….
Inflows from China, the rest of reserve-accumulating Asia, Russia and the Gulf have a different character. They are the result of government policies that impede adjustment – whether policies that impede the appreciation of their currencies against the dollar or policies that avoid distributing the oil windfall to a country’s citizens.
As a result, the foreign assets pile up in government hands. Henny Sender gets this exactly right – all the money coming out of China right now is government money. Only China’s government is willing to take the risk that the dollar might fall as much against the RMB as it has already fallen against the euro…
The net result:
Government funds are the only large buyers of US assets in the world’s main surplus countries;
The government in question will likely take large losses on their investments, as they are taking currency risk that the market doesn’t want;
These flows aren’t part of a process that will eventually result in a set of changes that will bring the US deficit down. Rather they are a byproduct of policy choices to impede adjustment.
European private firms are investing in the US, precisely because it is now cheaper to produce in the US than in China. Chinese state firms are not investing in US plant and equipment. It is still cheaper to produce in China. Indeed, it isn’t at all clear to me that China’s government would ever be able (politically speaking) to invest in US facilities that compete with Chinese facilities, even if such investment made commercial sense. China’s government care more about Chinese jobs than commercial returns.
Back in the 1990s, a common vision of globalization was that the outward flow of capital from the US and Europe to the rapidly growing emerging world would provide new markets for US exports. That vision collapsed in the Asian crisis of 1997.
The new vision of globalization that emerged in the first part of the 2000s was quite different: globalization offered the US cheap imports and cheap bond financing, a combination that proponents argued offered big benefits to the US, even if it hurt workers who had to compete with cheap imports.
That vision is now coming under question: Chinese goods aren’t quite as cheap as they used to be, imported oil certainly isn’t cheap and the emerging world no longer seems all that inclined to accept US bonds in exchange for its exports.
The new, emerging vision of globalization taking shape in parts of Washington and New York is that globalization allows American entrepreneurs to create companies that the Street can help sell to sovereign funds in Asia and the Middle East to finance the US external deficit, to the benefit of all.
That vision is at least consistent with a set of recent trends. But my guess is that it will prove to be a hard (political) sale.
Now to Tony Jackson of the Financial Times, on why at least some of those foreign investments may not prove to be so stellar:
It is possible, to put it no higher, that the tidal wave of investment into western banks from sovereign wealth funds (SWFs) could prove a serious mistake. Leave aside the immediate specifics of the debt crisis, since the SWFs insist they are in for the long term. But might the supercharged banking model have finally run out of road?
The supercharging is not in doubt. McKinsey estimates that in 2006, profits per employee in banking were a staggering 26 times higher than the average of all other industries worldwide. McKinsey takes this as a bull point. Others may differ.
However, this is not a topic with easy answers. So let us lay out the arguments, starting with the prosecution case.
One risk for the investment banks – the main recipients of SWF largesse – is that the tide may have turned against securitisation. The banks’ model of originating and distributing debt, certainly, is under close scrutiny, not least by regulators.
For an example of the harm this might cause, take complex derivatives. These represent a package of risks, which the banks insure individually in the markets. They are also opaque, so the banks can sell them to clients for much more than the insurance cost.
The head of Deutsche Bank called last week for the pricing of these instruments to be more transparent, presumably on the grounds that bruised investors will otherwise reject them. But with that, bang goes the profit.
When such instruments fall out of fashion, the effect can last. Leveraged loans for buy-outs peaked in 1990, just in time for the junk loan crisis. They did not regain that level in real terms for 14 years.
Another big chunk of profit under threat could be proprietary trading. Historically, this has been money for old rope, since the bulge-bracket firms know more of what is going on than the competition.
But these days the hedge funds, which account for maybe 40 per cent of the banks’ revenues, demand a share in that information. And some of the brightest traders now work for hedge funds, not the banks. It emerged last week that one fund, Paulson & Co, made about $15bn (£7.7bn) last year betting against the mortgage market. Most of that will have come out of the banks. That was not supposed to happen. They were supposed to have the edge.
Finally, there is the vexed question of bankers’ pay. I will not add to the chorus on this, merely point out that the more shareholders – as opposed to employees – end up paying for blunders, the less they will pay for the shares.
An extreme example is Citigroup, where total shareholder return over the past five years has been slightly less than zero. Its wage bill, meanwhile, has risen 84 per cent.
Some will say this is being addressed by slashing jobs. But here too the model works against the shareholder.
After each crisis has passed, the banks have to re-hire in a hurry. The new hires – most of whom have been here before – duly extract gold-plated guarantees, which pay off handsomely next time they are sacked.
Then again, not all of this is new. So let us call a witness for the defence – Philip Augar, a former senior investment banker whose view of his former trade may be gauged from the title of his illuminating book, The Greed Merchants.
He argues that the latest crisis is merely the worst in a series. Investment banks, he says, are like children on grandma’s knee.
Whatever you do, she tells them, don’t touch the electric fence at the bottom of the garden. So they start creeping towards it. They touch it, there are howls and they rush back to grandma. Then, after a while, they start creeping back again . . .
But, Mr Augar argues, there is a learning process going on. The 1987 crash taught the banks how to manage equity risk. The bond crash of 1994 led to valuation-at-risk techniques. The LTCM crisis of 1998 taught them about market liquidity. Each time, they came back stronger.
Meanwhile, one could argue, the trauma of this downturn will once again draw attention away from the stellar profits the banks make in the good years. It will also allow them to plead to legislators that they are fragile and should be treated gently.
Maybe so. As I said, this is not a simple issue. But I lean to the prosecution case, for a simple reason.
If the investment banks survive this latest storm without damage – and with help from the SWFs – that represents a market failure. In a functioning market, after all, excess profits are competed away. Failing that, governments must ultimately intervene. How that will play out, there is no telling. But in the very long run, it is all too good to last.