Foreign Investors and the US Taper

The news that in December foreign investors sold a net US$45.88bn of US securities capped a year in which, unprecedentedly, the world repatriated capital from the US.  Although it may not seem immediately obvious, there are circumstances in which this might matter a lot to the US in 2014 and beyond.

The capital outflow came to US$133bn during 2013, and it contrasts with the US$613bn net capital inflow into the US in 2012 – so it's a turnaround in financial behaviour of approximately US$746bn in a single year. What's more, the fact that the US saw a net capital repatriation by its foreign investors is something that has happened only once before in post-Cold War financial history, as the chart shows. Even at the depth of the financial crisis of 2008/09 capital still flowed into the US. Not now.

This seems like a genuinely historic change in behaviour. Changes in financial behaviour tend to be extremely rare – a once in a generation reconsideration of tactics and strategies. If it proves so, it will influence the underlying flows of capital and trade for years and possibly decades to come.

All of which makes it remarkable that it has had no noticeable impact on the US: money supply, bond yields, dollar value, net foreign liability position of the US banking system – none seem to have been challenged by this abrupt reversal of international capital flows. If it is a historic change, it is one which has arrived seemingly without consequence.

The reason, of course, is the link between the Fed's buying (and guidance) and net foreign investment. On the one hand, the Fed has simply been prepared to buy all the bonds foreign investors wanted to sell.  Whilst foreign investors sold US$133bn of securities in 2013, the Fed bought no fewer than US$1.08tr. The chart below shows the way in which Fed buying has tended to offset net foreign buying over the last few years. 

But of course the relationship between the Fed and foreign investors has another strand: like other investors, foreign investors spent much of 2013 anticipating the onset of the Fed’s tapering. Net selling started in February, but then peaked in the 3m to June with US$115bn of net selling, as markets absorbed April’s FOMC news that tapering was probably on its way.  So the Fed’s forward guidance might be said to have both encouraged foreign capital out of US treasury markets at the same time as buying the securities they wanted to sell. 

Even so, such net foreign selling should be expected to erode the positive monetary stimulus of the Fed’s treasuries buying.  And indeed it has: the Fed initiated QE3 in September 2012, and the Fed’s balance sheet shows its holdings of securities rising $51.1bn only in 2012, but $1.0844tr in 2013.  But once you adjust this for the reversal of foreign capital flows, the net buying changes only from US$664bn in 2012 to US$951.2bn in 2013.  As the chart shows, the net effect has been . . . . moderate. 

What matters for now is whether the foreign net outflow of 2013 was purely a trading response to the realization that the taper was on its way, or whether it represents a fundamental shift in global financial behaviour.

If the former, then we can conclude that the exit of foreign capital essentially initiated a de facto tapering some nine months earlier than officially executed. More, it raises the possibility that the visible negative impact of the Fed’s actual tapering this year may itself now be positively offset by a return of foreign capital inflows, or at least a cessation of the outflow.   

Since December, the Fed has announced a cut in its monthly bond buying from the original US$85bn per month to US$65bn. This tightening of US$20bn a month would be halved simply by a cessation of net capital outflows (which averaged US$11bn a month in 2013).

If, by contrast, the willingness to repatriate capital from US securities markets represents a once-in-a-generation re-ordering of financial risks and rewards, then the Fed’s taper could be a gamble which turns out to be unexpectedly painful.

In short, the monthly net long-term capital flows announcements from the US now demand watching closely.

Finally, we need to look at the other side of the transaction:  US$133bn is a sizeable amount of capital repatriation. It would be enough to form a powerful offset to the view that news of Fed tapering has stripped easy capital from emerging markets and helped precipitate a range of currency crises. But alas, the main selling has come not from Asia, but from Europe.  In December, for example, when total net selling came to US$45.9bn, European investors sold US$48.8bn, whilst Asian investors bought a net US$7.1bn, with China’s net US$5.36bn selling offset by net buying from Japan of US$6.73bn.