Five Reasons Foreign Money Boosts the U.S. Economy

Overseas funding helps keep interests rates low and growth humming—and is often a better deal for us than for them.

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Here's one trend we may as well get used to: high-visibility foreign investments in U.S. companies, especially banks reeling from the mortgage meltdown. Investors from Singapore, China, and the Middle East have been pouring billions into financial giants like Citibank, Merrill Lynch, Morgan Stanley, and Bear Stearns—and with bank losses mounting rather than abating, more infusions seem to be on the way.

Are foreigners buying America? Hardly. High-profile foreign investments in brand-name U.S. companies may fuel anxiety about the rise of other economic powers and American workers displaced by globalization. And it certainly provides America-first politicians with fodder for scaremongering—much like the 1980s, when a Japanese buying binge fed fears that every real-estate icon in the country would end up in foreign hands.

But foreign investors actually own a relatively small portion of corporate America, and even big-sounding $5 billion investments won't change that very much. And in many ways, foreign investment is good for the U.S. economy and for Americans. Here's why:

It keeps companies humming. Banks need money, and if they had trouble raising capital, they'd have to offer investors a higher rate of return to get it. To cover the added costs, they'd have to raise the interest rates on loans, to both consumers and corporations. So cash infusions from any source, foreign or domestic, are a vital economic lubricant—especially with a possible recession looming. "It's helpful to U.S. firms because it keeps interest rates lower than they otherwise would be," says James Barth, an economist with the nonprofit Milken Institute in Los Angeles. "It keeps the banks in business, and they don't have to spend as much to earn a profit."

It supports the U.S. economy. If you have a product to sell, you need buyers willing to pay money for it, the more the better. When foreigners buy shares of U.S. companies, they're helping keep demand for those shares strong and prices up. If 2008 turns out to be a bear market for U.S. stocks, foreign demand could keep it from being worse. Foreign money coming into the United States also helps offset the negative consequences of a large federal deficit and a low savings rate—namely, depreciation in the dollar—since it represents demand for dollar-denominated assets.

Foreign investors could do better elsewhere. Believe it or not, America isn't that great an investment, but foreign money keeps flowing anyway. Foreigners invest about $2 trillion a year in the United States—and get a lower return than Americans investing overseas. New research by MIT economist Kristin Forbes shows that between 2002 and 2006, foreigners investing in U.S. assets earned an average annual return of 5.8 percent. Americans investing overseas earned more than twice as much—15.3 percent.

Now, foreign investors aren't foolish—and many are advised by the very Wall Street firms now seeking overseas funding—so the explanation probably lies in the stability, liquidity, and prestige that come from investing in America.

Recent deals illustrate the phenomenon. Last June the Chinese government invested $3 billion in the Blackstone Group, the big private equity firm, when it went public. The shares have steadily fallen, with the Chinese stake losing 30 percent of its value since then—a $900 million setback in a mere seven months. Even back in the '80s, the Japanese deals that generated headlines and hand-wringing didn't turn out so well. "Those were bad investments by the Japanese—but they were good for the U.S. sellers," says Forbes. And nobody's complaining now.

Foreign holdings in the United States are relatively low. It's true that foreigners invest more in American stocks and bonds than Americans invest in the securities of other countries. But that makes sense, since U.S. securities account for about 45 percent of all the stocks traded in the world and 38 percent of all the bonds. (Japan, No. 2 in both markets, accounts for just 9 percent of the world's stocks and 18 percent of bonds.) In a pure market, the portfolios of other nations would include U.S. stocks and bonds in the same proportion they're available in the market. But research by the Milken Institute and others shows that U.S. securities are underrepresented in virtually every foreign portfolio.

The phenomenon is known as "home bias"—a tendency in most countries to invest in homegrown assets even when more appealing foreign ones are available. But the Milken research shows that most countries show a stronger bias against American securities than against other foreign investments. There's not a single country, in fact, that meets the 45 percent benchmark for U.S. stocks in its own portfolio. As for U.S. bonds, China is a huge buyer, with 66 percent of its bond investments in American holdings, far above the 38 percent benchmark. But that share is declining, as China diversifies its investments—a trend which itself has caused concern that lower Chinese demand for treasury securities could raise the rates on mortgages and other long-term loans here in America.

There's plenty of room for more foreign investment. Congress, the Treasury Department, and the Federal Reserve all have units that monitor foreign stakes in U.S. firms and watch for nefarious behavior. Of course, government watchdogs have napped before, but the biggest concern among economists is that the flow of foreign funds into the United States will decline, rather than increase—which could lead to higher interest rates, tighter credit, and lower growth (or a deeper recession). The Milken Institute projects healthy growth through 2010 in the U.S. holdings of foreign countries like China and Singapore and of more traditional investors such as Japan and the United Kingdom. If foreigners suddenly decided to put their money elsewhere, there would still be scary-sounding headlines—about fresh shocks to the U.S. economy.