Why Do Foreigners Invest in the US - Research Proposal Example

Why Do Foreigners Invest in the US? What is Foreign Investment? Any investment is made keeping two things in mind, profitability and growth. Investors want to know how much they can earn off the security now and how much they will gain when they sell the security. This classification of purpose reflects income gains and capital gains of securities. There are many types of securities and can range from simple T-Bills to complex derivatives. The type of security that best suits an investor is one where the benefits are equal or greater than the costs. (Froot, 1993 p1-10) Foreign direct investment is one such form of investment. It is when governments or private investors of one country, invest in the assets or corporations of another country. This can be in the form of stocks, buying the country’s currency or then to buy the country’s assets, to name a few ways of foreign direct investment. (Froot, 1993 p20-30) However given the global complexities of today, many countries now regulate which sectors foreign parties can invest in and how much they can invest. While the right to decide who invests where in a country should be available to all countries, this attitude of selective investment is more prevalent in developed countries. This is because of the market power of developed countries in the international arena. For reasons which we will study later on, developed countries assets and corporations are considered a safer and more profitable investment by many foreign investors, which is why demand for these securities is high. This is also why many developed nations can afford to be choosy in deciding which investors to allow a stake in their country and which to not. (Froot, 1993 p35-45) Factors Affecting Foreign Investment Foreign investment, like any form of investment is dependent on two factors or profiability and grwoth. So all the factor affecting these two factors affect foreign investment. On a natinoal level, foreign investment in a country is directly correlated to its macro economic indicators such as gross domestic product, inflation rate, interest rate, balance of payments deficit.surpus and employment rate. Note that this list is not exhuastive. It also includes law and order situation, political stability, government outlook and infrastructural developement. Once these general items are checked off the list, the country of investment is decided. Once an investor decides which country to invest in, they then decide where in the country to invest in. Should it be in the safe T-Bills? Or should the investor consider being a venture capitalist in a new up and coming company with an innovative product but very little market research? The decision on where to decide in the country depends on whether the investor is risk averse or risk favouring. A risk averse investor will invest in securities with low volatility. These securities also yield the lowest returns often. Then again if the investor is a risk taker, he or she might invest in the new firm who is working on a cure for AIDS. After the country and personal preferences of the investor are determined, next comes the art of deciding which company or asset ot invest in. it should be noted that investors base their decision on future and not current market conditions. Hence, if an investor feels that in the future the security is of some value, then he or she will go for it but if they feel that the security is of no value then they will either sell it if they already have it or not buy it at all. In reality, why an investor chooses one security over another is a game of speculation and is based on the expectations of the investor, which may or may not be accurate. (ONeil, 2000 p20-50) Introduction to the US Investor Arena FDI U.S. assets and companies has been a subject of controversy since the end of the WWI. Increased holdings of US assets by foreign investors, has worried US politicians and citizens alike, particularly since the events of September 11th, 2001. The US Congress enacted the Exon-Florio Amendment in 1988 under President Ronald Reagan, the president has the power to block any foreign acquisition of a US company if it is deemed that that transaction is a threat to, or will impair, US national security. (Jackson, 2007) \ US is the largest beneficiary and investor of FDI in the world, with roughly $2.2 trillion stock of FDI in US at the end of 2008 corresponding to approximately 16% of U.S. gross domestic product. (CIA World Fact Book, 2009) Foreign investors have earned considerably lower returns on their U.S. investments over the past few years than U.S. investors have earned abroad. Data shows foreigners investing in the US only earned an average annual return of 4.3% on their investments over the last five years, which is less than the 11.2% return that U.S. investors earned on their foreign investments. (Forbes, 2008) Why would foreigners continue to invest in the US? (Tables taken from the Appendix of Why Do Foreigners Invest in the US, by K. J. Forbes, 2008) Reserve Currency The USD is the most held reserve currency in the world, followed by the Euro. As of 2008, the USD made up for 64% of the total official foreign exchange reserves (Source; IMF) USD has been historically viewed as being the most stable currency. As a result, this attracts other nations to invest in the U.S. In 1975, members of OPEC, under pressure from the US, agreed to only sell their oil in. USDs. Now all countries in world needed USDs to buy oil. This led to them investing in US assets to earn profits in USDs rather than converting local currencies into USDs. As a result, this attracts other nations to invest in the U.S. as the likelihood of it being a stable investment with regular returns is much higher. And according to Forbes (2009) if a country has larger reserve holdings, it is more likely to accumulate the “safe-haven asset” of U.S. bonds. Foreign firms looking to diversify their investment portfolios generally feel that the United States is a safe bet because of this perceived stableness. Sub-Prime Mortgages and US’s Low Interest Rates For years, fixed income securities, such as U.S. t-bills, were a favourite investment of investors who made up the “Giant Pool of Money” (Blumberg and Davidson, 2009) as they were guaranteed to produce a fixed amount of return over a given period of time. FDI declined quite considerably after 2000 when a record US$300 bn had been invested in U.S. businesses and real estate. This was 19% of the total amount of investment in the U.S. (Jackson, 2005) This fell from US$167 bn in 2001 to US$63.8 bn in 2003, the lowest in a decade. (U.S. Bureau of Economic Analysis, 2009) The global FDI dropped by 41% in 2001 and 21% in 2002. (Jackson, 2005) According to the United Nations World Investment Report, this global drop in FDI was due to “slow economic growth in most of the parts of the world, falling stock market valuations, lower corporate profitability, a slowdown in corporate restructuring, and a slowdown in privatization efforts in some areas.” (p.1, 2005) In 2004 interest rates were slashed to a historic low of 1%. This was great for those who wanted to borrow money, but the fixed income securities that were making so many people money, suddenly weren’t a very attractive investment anymore. Investors then turned to the US housing market. The average price of real estate in US on a national level had always risen. Due to this flawed premise, securitised mortgages became extremely popular for both U.S. and foreign investors. As shown in the graph the returns on these mortgages backed securities were phenomenal, and FDI began to rise again. Investors made a lot of money buying and selling these types of securities. Consumer Friendly Market The US spends the most and saves the least. The U.S. household saving rate had fallen to less than 1% for the years 2005, 2006, and 2007 after declining every year for the previous 20. (Feldstein, 2009) The rising stock market and increasing values of homes encouraged working individuals to save less and to spend more of their disposable income. However, in 2008 the U.S. household saving rate began to rise again. Due to the massive drop in household wealth as a result of the financial crisis and near collapse of the housing market, the savings rate had reached 6.9% by May, 2009. (Feldstein, 2009) This savings rate is expected to rise and to stay high for the foreseeable future. This increase in the savings rate will have a largely negative effect on FDI in the US. With US spending less, demand will decline generating lower returns in a country dependent on consumer spending for economic activity. (Barr, 2008) Also, with more people saving, the need for foreign investors falls as liquidity rises. Why Do Foreigners Continue To Invest In The US? One of the primary reasons for the historical success of the US financial sector has been the it’s well structured mechanism. While it may be true that in the current arena of economic crisis it might seem that this system was after all not fool proof, what needs to be remembered is that this system did for many years make a lot of people a lot of money. This is one of the primary reasons why investors still find the US economy to be one of the safer economies to invest in. Another reason is that while the US economy may be in turmoil at the moment, there are countries whose economies are in much worse shape. Hence they would rather invest in the US than in their own economy. Kristin Forbes (2009, p. 32) notes in her paper that even though investors earned lower returns on their investment, they continued to invest in the US. This was because they wanted to benefit from the well structured and liquid financial markets and also because they wanted to spread their risks and reduce the risk of volatility. However as previously mentioned, investment is based on speculation which is subjective. Investors might invest in the US because of strong trade ties which might or might not have anything to do with the investment. On the other hand they might choose to invest in the US in the hopes of strengthening trade ties with the US. With a country as big and well connected as the US, there really is no one answers to the question why do foreigners invest in the US? Conclusion US investment abroad yield higher returns because US investors are risk takers. Foreigners investing in the U.S. on the other hand will tend to seek less volatiles assets like official sector purchases even though lower returns are expected. (Forbes, 2009) As the graph shows, FDI has slowed in recent years. The GFC has shown how fickle the financial system in the US really was. We found out that the fundamentals were not sound in US’s economy, and this made investors very wary about investing in the US in the future. The need for foreign countries to hold massive amounts of U.S. USDs is decreasing every year as well. More oil is being sold in Euros around the world, which in turn redirects foreign capital inflows to Europe instead of the US. Bibliography Barr, C. 2008. CNN Money. The Bright Spot in a Dark Economy. [Online] http://money.cnn.com/2008/10/15/news/rainy.day.fortune/index.htm?postversion=2008101614 (Accessed on 31st March, 2010) Blumberg, A. and Davidson, A. 2008. This US Life: Giant Pool of Money. [Radio Broadcast] Chicago Public Radio. May 9th 2009. Burgess, L. 2009. Gold World. The Role of the U.S. USD as Reserve Currency: Is the USD in Danger? [Online] http://www.goldworld.com/articles/us+USD-reserve-currency/359 (Accessed 24th March, 2010) Conrad B. and Galland, D. 2009. Safe Haven. FDI the U.S. – Going Down, Down, Down. [Online] http://www.safehaven.com/article-14044.htm (Accessed on 24th March, 2010) Feenstra, R. C. and Taylor, A. M. 2008. International Economics. Worth. Feldstein, M. 2009. Project Syndicate. US’s Savings Rate and the USD’s Future. [Online] http://www.project-syndicate.org/commentary/feldstein12/English (Accessed on 31st March, 2010) Forbes, K.J., 2008. Why Do Foreigners Invest in the US? NBER Working Paper No. 13908. Cambridge. Meinrath, S. 2008. The US Personal Savings Rate Freaks Me Out. [Online] http://www.saschameinrath.com/2008/sep/08/united_states_personal_savings_rate_freaks_me_out (Accessed on 30th March, 2010) Peterson Institute for International Economics. 2009. FDI the US. [Online] http://www.iie.com/research/topics/hottopic.cfm?HotTopicID=10 (Accessed 24th March, 2010) Ott, M. 2002. The Concise Encyclopedia of Economics. FDI the US. [Online] http://www.econlib.org/library/Enc1/ForeignInvestmentintheUnitedStates.html (Accessed 22nd March, 2010) Solnik, B. and Dennis McLeavey. 2009. Global Investments .6th Edition. Pearson. Read More