Capital Flow From Emerging Nations To U.S. Poses Some Risks

The U.S. has long depended on the kindness of strangers to finance its import bill. These days, those strangers are likely to be in China, Brazil, Mexico or some other emerging nation. The U.S. has to import, on net, almost $2 billion in capital a day to cover its enormous trade gap. Of the $920 billion that foreigners pumped into U.S. stocks, bonds and government securities last year, $361 billion -- a stunning 39% -- came from emerging-market nations, according to calculations by Bank of America, using Treasury Department data. China alone accounted for 21 percentage points of the total, with Brazil at 8.4 points, Russia at 2.8 points, and Mexico, Singapore, Malaysia, South Korea and others in the mix. That's probably just the tip of the iceberg. Capital from the oil-soaked Persian Gulf states often flows through London on its way to New York, so billions of dollars in investment flows that look British in the government reports are actually Arab. "Not only are we addicted to other people's money, but the money we're addicted to is from the poor countries," says Joseph Quinlan, chief market strategist at Bank of America. Of course, the Persian Gulf nations aren't exactly impoverished. But relative to the U.S., Brazil, Mexico and Russia are. In economic textbooks, capital is supposed to flow from slow-growing, rich countries that have a lot of it to fast-growing, poor countries that don't. Certainly that was the case before World War I, when Europeans exploited the natural wealth of their colonies. Now the textbooks are being turned upside down. "It's a historical anomaly that, in the last five or six years, even more money has been flowing from poor to rich than rich to poor," says Barry Eichengreen, an economist at the University of California at Berkeley. In part, the situation is the flip side of U.S. dependence on Chinese electronics, Russian oil and Mexican appliances. The more Americans spend, the more dollars the sellers accumulate. It would be one thing if they turned around and spent all of the money on Fords or Hollywood movies. But they don't. The Chinese, for instance, save almost half of their economic output. "They can't invest 48% of [gross national product] productively at home in a year, so they've got to take some of that money and park it abroad," Mr. Eichengreen says. But a lot of what's going on is that emerging-market nations are buying up dollars and looking for places to invest them. The trend has been building since the Asian crisis of the late 1990s. Back then, the Thais, Koreans and others got into trouble because they ran low on foreign-currency reserves and couldn't cover their foreign-currency debts. The Asians learned their lesson and began stockpiling foreign currencies to protect themselves from a run on the bank. The accumulation accelerated in 2002. As the U.S. dollar began to weaken, governments in South Korea, China, Taiwan and Japan decided to buy up dollars to keep their own currencies in line with the greenback. Last year, officials in Brazil, India, Malaysia and other emerging-market nations intervened in markets to avoid currency appreciation that they thought would hurt their companies and economies. This year, it's mostly China and the Persian Gulf oil powers that are awash in dollars and looking for places to invest them. In April alone, China's reserves grew by $75 billion. All told last year, central banks in emerging countries added about $1.2 trillion in Western currencies to their reserves, about $800 billion of it in dollars, according to Brad Setser, a fellow at the Council on Foreign Relations. Emerging-market sovereign-wealth funds added another $150 billion. Much of that ends up invested back in the U.S. The U.S. needs the money and shouldn't shun it, of course. But there are several reasons to be concerned about what's going on. President Bush's administration has long argued that foreigners park their money in the U.S. because of the attractive returns here. But new research by Massachusetts Institute of Technology economist Kristin Forbes, a former Bush adviser, finds that from 2002 to 2006, as the dollar slid, foreigners earned an average annual return of 4.3% on their U.S. investments, while Americans earned 11.2% on their investments overseas. Ms. Forbes concludes that it's not the profits that attract foreign money to the U.S., it's the sophistication of U.S. capital markets. Of course, the implication is that foreigners would run scared if they lost confidence in the transparency and fairness of Wall Street. And, these days, the Chinese could be forgiven if two words spring to mind when they think about U.S. financial markets: subprime mortgages. "They're probably questioning the efficiency of our financial markets," Ms. Forbes says. "Maybe they're thinking twice about continuing to invest such large sums in the U.S. in the future." They might lose even more faith if they see the U.S. succumb to protectionist sentiment and block the very exports that China and other nations sell. "You're not talking about goods anymore," says Bank of America's Mr. Quinlan. "You're talking about our financial lifeline." Furthermore, the U.S. finds itself not only dependent on money from the developing world, but in large part dependent on money from governments in the developing world -- and undemocratic ones. So far, those governments seem to have made the political decision that they're willing to hang onto their U.S. assets, despite the falling dollar. Private investors might have bailed out by now, in search of higher returns. "So far, it is stabilizing rather than destabilizing," Mr. Setser says. But there's no guarantee that the benevolence will last and, at some point, governments in places like Beijing may decide to exercise the leverage that their riches imply. "You're looking at an incredibly large flow of one country's money into the U.S. market," Mr. Setser says.