Morgan-Stanley: A new source of external financing for theUS

http://www.morganstanley.com/GEFdata/digests/20020306-wed.html

Global: A New Source of External Financing for the US

Joe Quinlan/Rebecca McCaughrin (New York)


Notwithstanding a collapse in the US tech sector, an economic 
slowdown, a terrorist attack and a corporate accounting debacle, the 
appetite of foreign investors for US assets was never stronger last 
year. Net portfolio inflows totaled a record $531 billion in 2001- a 
16% jump from the prior year. In the fourth quarter alone, net US 
inflows surged by nearly 65% from the corresponding period of 2000, 
to $175 billion. The sharp uptick in the final quarter was due to a 
number of factors, including America's safe haven status, increasing 
signs of a recovery in the US economy, and the relative 
attractiveness of US assets against a backdrop of back-sliding on 
reform in Japan and weakness in Euroland.

Following the events of September 11th, foreign investors dumped 
nearly $12 billion of US equities, the largest monthly sell-off since 
the Russian debt crisis and collapse of the Long-Term Capital 
Management group, dragging down total inflows to just $5 billion in 
September. In October, however, net foreign purchases soared to 
nearly $70 billion on strong demand for US government and corporate 
bonds. In November, net inflows were $58 billion, down from October's 
record high, but still well above the average ($44 billion) seen over 
the first eight months of the year. Similarly, net inflows of $ 47 
billion in December were down from the prior month, but above the 
monthly average seen for the year. Net purchases by asset class were 
evenly spread for the month, with foreign purchases of US equities 
showing a significant recovery relative to prior months in 2001.

The US dollar's year-to-date strength-up 2% on a trade-weighted 
basis-suggests that US portfolio inflows have been sustained at a 
relatively healthy level in early 2002. That's likely to remain the 
case in a world where the US leads and everyone else follows. It's a 
familiar script and one that favors US assets. Still, while we remain 
impressed with the resiliency of US portfolio inflows thus far, we 
nevertheless harbor concerns related to the shift towards less 
traditional sources of capital.

It is common knowledge that China is a low-cost provider of consumer 
goods to the US, with US imports from the mainland running the gamut 
of consumer staples. Less well known is that the mainland is not only 
a key supplier of goods to the US but also a growing source of 
capital. Increasingly, China is recycling its US trade surplus back 
into US dollar-denominated assets, offsetting weaker inflows from 
Europe and Japan.

Over the last two months of 2001, Asia ex-Japan, led by China, 
emerged as a key source of external funding for the US, offsetting 
weaker inflows from more traditional sources-Japan and Europe. Last 
year, net portfolio inflows from Europe fell 8%. After soaring to a 
record $295 billion in 2000, and accounting for roughly two-thirds of 
US inflows, US net inflows from Europe declined to just 51% of total 
US inflows. US net inflows from Japan rose 15% in 2001, although over 
half of last year's total inflows occurred in October, when Japanese 
inflows soared to a record $33 billion. In November and December, net 
inflows from Japan totaled just $3.3 billion and $3.6 billion, 
respectively.

Net US inflows from Asia ex-Japan totaled $17.3 billion in November 
and another $19.8 billion in December, the strongest two-month surge 
on record. In December alone, the region accounted for 42% of total 
US inflows, with China and Hong Kong the primary sources of capital. 
The late-year surge in inflows from Asia ex-Japan pushed the regional 
total to a record $111 billion for the year, more than double the 
level of the prior year. As a result, Asia ex-Japan's share of US 
inflows rose to 21% last year, up from 11% in 2000. Chinese 
investors, we believe, have been attracted to US assets on account of 
the underlying strength of the US economy and increased investor 
nervousness in China as the nation implements provisions under WTO. 
In addition, growing concerns over Japan's prospects have likely 
provoked investors in the rest of Asia to reallocate funds from Japan 
to the US.

China has proven to be a reliable, low-cost provider of consumer 
staples to US consumers. But just how reliable a source of external 
funding can the mainland be to the US, given China's own massive 
capital needs? As the world's largest debtor nation, the US has long 
borrowed capital from the wealthy populations of Europe and Japan. 
Investors in these regions have been all too willing to plow a 
sizeable proportion of their excess savings into the US.

China, in contrast, is an emerging economic power that needs capital 
to fuel its own future development. Like the US, it is a large 
capital importer. China's underdeveloped infrastructure requires 
massive amounts of capital. If present consumption trends continue, 
more of China's savings will be spent at home rather than invested 
overseas. Indeed, any shift towards more consumption-driven growth in 
Asia ex-Japan implies less savings and capital to be invested in the 
US. In the near term, improving economic fundamentals in the region 
and the continued recovery of regional equity markets could have the 
same effect. Against this backdrop, a key question pivots on the 
sustainability of large capital inflows from China and Asia ex-Japan 
as an offset to declining flows from Europe and Japan.