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HISTORICAL:

Foreigners Seem To Be Souring On U.S. Assets
At a time when U.S. trade deficits are growing to historic proportions, foreign interest in U.S. stocks and bonds may be fading. If this continues, there could be consequences for U.S. interest rates and the dollar.

Foreign purchases of securities in the U.S. in May came to $56.4 billion. While that was large enough to finance the current-account deficit, it was down 26% from April and represented the lowest monthly total in seven months. It also marked the fourth consecutive monthly decline of such purchases by foreigners.

The report on foreign purchases included bad news for U.S. stocks, revealing that May was the third consecutive month foreigners have been net sellers. That hadn't happened in nearly a decade.

Potentially more troubling was the slowdown in Asian purchases of U.S. debt -- especially in Japan, which holds 16% of all U.S. Treasurys. That country's nascent economic recovery has eased the government's concerns about maintaining a weak currency to boost exports, in turn reducing the Bank of Japan's need to intervene and buy dollars.

The result: Japan bought $14.6 billion in U.S. Treasurys in May and $5.5 billion in April, according to the U.S. Treasury Department. That is a significant drop from a monthly average of $25 billion for the seven-month period ending in March. If the Japanese economy continues to rebound, Tokyo's Treasury purchases are unlikely to return to those lofty levels. That has some economists concerned.

"Japan is to the U.S. financial markets what Saudi Arabia is to the world oil markets -- the primary provider of capital," Joseph Quinlan, chief market strategist for Banc of America Capital Management, wrote in a recent report. "Self-sustained growth in Japan could ultimately obviate the need for the Bank of Japan to purchase U.S. securities, leaving a buying void in the U.S. Treasury market, helping to drive yields higher." Bond prices and yields move in opposite directions.

Indeed, in the two months that Japanese buying of Treasurys slipped, the yield on the 10-year note jumped to 4.65% at the end of May from 3.88% on April 1, though it has since fallen to 4.43%.

The Bank of Japan and other Asian central banks have become an increasingly important pillar of support for the Treasury market, because their currency interventions and large trade surpluses with the U.S. have resulted in excess dollars to invest. Since these central banks are concerned less about a high rate of return than a stable and easily tradable investment, U.S. Treasury debt has been a major beneficiary.

Yet if recent trends toward lower U.S. investment persist, the U.S. eventually could have a tougher time funding its current-account deficit, which reached a record $144.9 billion in the first quarter. Any trouble financing that deficit would lead to higher borrowing costs through rising U.S. interest rates. It also could cause the dollar, which hit a three-week high against the euro on Friday, to resume its decline.

Indeed, problems with the current account could end up making the dollar "possibly quite a bit weaker," said John Llwellyn, chief global economist for Lehman Brothers.

For now, however, funding the current account shouldn't be a concern, said Rebecca McCaughrin, an economist for Morgan Stanley. She noted that in 2004 the U.S. needs to attract a monthly average of $50 billion to fund that deficit. After averaging $82 billion for the first four months of the year, the U.S. need attract only about $35 billion a month for the rest of the year. "Europeans alone could do it," Ms. McCaughrin said.

Still, foreigners now control 40% of U.S. Treasury debt, and their purchases are unlikely to return to peak levels seen at the start of the year, she said. "So U.S. interest rates could still go higher, even if the current account is funded," Ms. McCaughrin said.

Other foreign investors' appetites for U.S. securities also have been waning, in part because rising oil prices have forced some countries to spend more of their dollar reserves on energy. That leaves fewer dollars to invest in the U.S. markets.

Mr. Quinlan said that is the case for China, Asia's second-biggest buyer of U.S. securities, which bought $13 billion in U.S. assets through May, compared with $33.1 billion a year earlier.

The pullback in Beijing's interest in U.S. Treasurys was larger still: China was a net purchaser of $1.7 billion of U.S. Treasurys in the first five months of the year -- down 91% from the $18.4 billion in net purchases a year earlier.

Even the United Kingdom, long a reliable buyer of U.S. securities, turned negative in May, with net sales of $4 billion. That was its first monthly net sale since October 1998 during the near collapse of giant U.S. hedge fund Long-Term Capital Management and the aftermath of the Russia financial crisis. Clear hints from the U.S. Federal Reserve that it would be raising interest rates likely caused U.K. investors to trim positions in U.S. Treasurys, Mr. Quinlan said. Anticipation of the Fed's first rate increase in four years also may have contributed to the three consecutive months that foreigners sold U.S. stocks.

By many accounts, however, Japan remains the critical buyer. Mr. Quinlan argued that Japan has become "America's de facto banker, helping to keep U.S. interest rates low over the past year." Currency traders say the Bank of Japan hasn't intervened in the currency market since March, and the pace of Japanese Treasury buying of the recent past looks unsustainable: Japan bought $175 billion in U.S. Treasury debt from September to March, a figure that exceeds Japanese purchases of Treasurys in the previous seven years combined.

Ms. McCaughrin said there has been anecdotal evidence that private Japanese investors, including banks and pension funds, also have been scaling back purchases of U.S. assets and have been investing more locally, to take advantage of a rebounding Japanese economy, or in other overseas markets, to capitalize on the global economic expansion. - by Craig Karmin     WALL ST JOURNAL    26 July 2004