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<font size="5">The U.S. International Investment Position At Year-End 2001</font>


At year-end 2001, the gap between U.S.-owned assets abroad and foreign-owned assets in the U.S. reached -$2.31 trillion, or 22.6 percent of U.S. gross domestic product (Table 1). The continued rise in America?s net liabilities to the rest of the world has draped an increasingly ominous cloud over domestic and global economic activity. And it has prompted increased concern among investors, market analysts and institutions such as the Bank for International Settlements
BIS) and the International Monetary Fund (IMF).
One reason for this concern is the recent slowdown in the U.S. economy. The growth of GDP and net inflows of foreign funds both declined between year-end 2000 and year-end 2001. But since the former dropped much more significantly than the latter, external debt as a share of GDP rose a staggering 6.6 percentage points (from 16.0 to 22.6 percent).
Over the course of 2001, net foreign financial inflows ($752.8 billion) amounted to more than twice the increase in GDP ($335.2 billion). And the gap between inflows and outflows ($381.9 billion) topped GDP growth too - a clear sign of the U.S. economy's diminishing capacity to service its rising external liabilities.
Another reason for concern centers on the high level of uncertainty and volatility in financial markets. Wide swings in asset prices and exchange rates resulted in unusually high valuation adjustments to the U.S. international position in 2001. And these adjustments underscore the increased vulnerability of output, employment, price and profit levels to shifts in market sentiment.
For example, dollar appreciation and the worldwide decline in stock prices substantially affected U.S.-owned assets abroad. Massive valuation adjustments (-$858.8 billion) dwarfed net new financial outflows for foreign investment ($370.9 billion) and reduced the market value of U.S. holdings abroad from $7.35 trillion at year-end 2000 to $6.86 trillion at year-end 2001.
By contrast, dollar appreciation offset U.S. stock price declines and moderated valuation adjustments for foreign-held U.S. assets (-$514.8 billion). Thanks largely to the strong dollar, the market value of foreign-owned assets in the U.S. rose by $238 billion to $9.17 trillion (Table 2).

<font size="4">Components of the Investment Position</font>
Governments and official institutions. Most of the U.S. government's holdings of foreign assets are classified as international reserves. They include gold, special drawing rights issued by the IMF, the U.S. reserve position in the Fund and foreign currencydenominated assets. Other government assets include loans to and military sales contracts with other countries. At year-end 2001, U.S. international reserves totaled $130.0 billion, providing America scant coverage (1.4 percent) of foreign-held assets in the U.S. (see Table 2).
By contrast, foreign governments and official institutions held $1.02 trillion of dollar reserves in the U.S. at year-end 2001 - an amount equal to 11 percent of total foreign-owned U.S. assets and almost eight times greater than U.S. international reserves. About 64 percent of these foreign official holdings ($650.7 billion) is invested in U.S. Treasury securities and another 14.5 percent ($148 billion) in issues of U.S. government-sponsored enterprises such as Fannie Mae and Freddie Mac. In 2001, the net inflow of foreign official reserves slowed markedly to $5.2 billion, as sales of other assets ($-5.6 billion) partially offset purchases of Treasurys ($10.7 billion).
Direct investment. In the midst of a global slowdown in foreign direct investment, net financial outflows for U.S. FDI ($127.8 billion) sank to their lowest level since 1997. At the same time, declining stock prices abroad eroded owners' equity and dollar appreciation reduced the value of foreign currency-denominated assets. These valuation adjustments represented the largest component of the $487.9 billion decline in total U.S.-owned assets abroad. And they sliced the market value of U.S. companies' foreign direct investments by -$384.3 billion to a total of $2.29 trillion.
The net financial inflow for foreign direct investment in the U.S. also dropped sharply to $130.8 billion (from $217.0 billion in 2000) - again, the smallest increase since 1997. And this increase was dwarfed by price changes of -$344.4 billion that lowered the value of foreign-held U.S. direct investments to $2.53 trillion.
Portfolio investment. In 2001, U.S. residents' net purchases of foreign equities rose to $106.8 billion even as stock prices fell in most foreign markets. However, the price declines and exchange-rate devaluation more than offset the value of net new purchases, lowering total U.S. stock holdings abroad by -$374.4 billion to $1.56 trillion.
On the other hand, valuation adjustments favored U.S. holdings of foreign bonds. But domestic investors sold -$12.1 billion of these instruments, reducing their total holdings to $545.8 billion. Altogether, U.S. portfolio investment abroad dipped by -$278.9 billion to $2.11 trillion. And combined declines in direct and portfolio investment shrank the dollar value of outstanding U.S.-owned assets abroad by $487.9 billion - nearly one-third more than the $370.9 billion in total net outflow for new investment in 2001.
Meanwhile, in a year that began with continued pay downs of U.S. government debt and ended with projected federal deficits, nonofficial foreign investors sold $7.7 billion (net) of U.S. Treasury securities. Combined with valuation adjustments of -$4.5 billion, these sales dropped nonofficial foreign investors' holdings of Treasurys to $388.8 billion.
By contrast, foreign investors increased their net purchases of U.S. corporate and agency bonds by $288.2 billion, attracted by the higher yields on these instruments relative to U.S. Treasurys and debt securities issued in other countries. Positive valuation adjustments added another $28.4 billion, raising the total value of their holdings in U.S. corporate and agency paper to $1.39 trillion.
Nonofficial foreign investors also stepped up their net purchases of stocks. However, the fall in U.S. equity prices translated into negative valuation adjustments of -$203.1 billion that swamped foreign investors' net inflow of $119.5 billion. All in all, the value of these investors' outstanding stock holdings diminished to $1.46 trillion.
Nonbank claims and liabilities. During 2001, U.S. nonbanking firms slowed the rate of their deposits in Western Europe and Caribbean banking centers. At the same time, these firms reported a $14.3 billion increase in claims on unaffiliated foreigners. Despite valuation adjustments of -$5.6 billion, the growth in claims lifted nonbanking concerns' holdings of foreign assets to $830.1 billion.
Meanwhile, increased borrowing from foreign banks and offshore U.S. finance affiliates raised the value of nonbanking concerns' outstanding liabilities to unaffiliated foreigners by $75.1 billion. Consequently, the total value of these liabilities ($804.4 billion) more closely paralleled nonbank claims ($830.1 billion) than they did in preceding years.
Claims and liabilities reported by U.S. banks. A widespread retreat from commercial paper markets in 2001 had the effect of spurring demand for bank loans by foreign as well as domestic business borrowers. As a result, outstanding claims on foreigners reported by U.S. banks rose by $164.7 billion to $1.42 trillion. In addition, U.S. banks borrowed heavily from their own foreign branches to fund the increased demand for loans, raising total U.S. liabilities to private foreigners and international financial institutions by $144.8 billion to $1.30 trillion.
Foreign holdings of U.S. currency. Growing foreign demand for U.S. currency in the 1990s pushed up foreign holdings from $67 billion in 1989 to $157 billion in 1994 and $250.7 billion in 1999. After the Y2K-related surge in 1999, annual currency shipments leveled off to only $1.1 billion in 2000. But economic problems, dollar appreciation and predicted devaluations of other currencies quickly raised demand for greenbacks again. In 2001, foreign holdings of U.S. currency jumped by $23.8 billion to $275.6 billion.
Revisions. In its annual release of U.S. international investment data, the Commerce Department revised figures for 2000 by incorporating information from the U.S. Treasury Department's Benchmark Survey of Foreign Holdings of U.S. Portfolio Assets. Conducted every five years, this survey of custodians and issuers gathers detailed (security by security) information about foreign holdings of assets with maturities exceeding one year.
After factoring in survey information, the total market value of foreign-owned assets in the U.S. at year-end 2000 was revised downward from $9.38 trillion to $8.93 trillion. At the same time, data on U.S. owned assets abroad were revised upward from $7.20 trillion to $7.35 trillion. As a result of these revisions, the net international investment position for 2000 fell from -$2.19 trillion to -$1.58 trillion? and from 22 percent of 2000 GDP to 16 percent (see Table 1).*

<font size="4">Assessing the Outlook</font>
During the boom years of the late 1990s, critical questions about the burgeoning U.S. current account deficit were dismissed out of hand. The official U.S. government position was and is that foreign inflows represent a vote of confidence in the strength of the U.S. economy and in American financial markets.
To be sure, many observers conceded the deleterious effect of current account deficits on some aspects of U.S. competitiveness. As countries dependent on sales to the U.S. reinvested their export earnings in American financial assets, they helped maintain the dollar's strength and pushed up prices for U.S.-produced goods at home and abroad. As a consequence, American manufacturers suffered, highpaying manufacturing jobs dwindled and employment growth shifted to lower paying service jobs.
But America's external imbalances gave rise to another, equally damaging, dynamic, too. Ample inflows of foreign savings boosted the price of financial instruments and encouraged U.S. businesses and households to increase their borrowing and forgo saving. As the expansion of net external debt ramped up domestic borrowing, economic growth increasingly came to depend on the continued influx of funds to support historically high levels of indebtedness.
By year-end 2001, foreign investment in U.S. government and private debt securities totaled $2.4 trillion with another $1.5 trillion invested in U.S. corporate stocks - a combined amount equal to 38 percent of U.S. GDP. If foreign inflows slow or funds are withdrawn, the resulting dollar depreciation, falling asset prices and rising interest rates will dampen investment and spending. It is this prospect that now poses the largest threat to economic stability and growth in the U.S. and globally.
Most prescriptions for defusing this threat focus restoring market confidence. But the reforms proposed to date do not go far enough. For example, they do not provide assurances that the majority of S. household savings - invested now in pension funds rather than insured bank deposits - can be protected from devastating losses. Shifting federal financial guaranty programs from institutions to individuals (using current institutional reporting of the market value of assets) would help restore confidence, safeguard a growing share of household savings and modernize a patchwork safety net that too often functions as a corporate subsidy.
It is also time to reassess how the current international financial and monetary architecture influences trade and capital flows - and how trade and capital-flow imbalances now foster boom-bust cycles in both strong- and weak-currency countries. The U.S. and world economies have entered a period of heightened risk and instability.
Policymakers must bring all sources of vulnerability the table for review. Superficial solutions and those cut wholly from ideological cloth have become an unaffordable luxury.

- Jane D'Arista

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