Why foreigners invest in the US?

One of the most important contributors to the robust economic health of the US economy for most of the past two decades, despite the rising trade and current account deficits, has been the continuing willingness of emerging market Central Banks to invest a large part of their burgeoning foreign exchange surpluses in the low yielding US Treasury securities. Over $2 trillion dollars has been flowing into the US every year, sustaining a spectacular consumption boom that has been the engine of US economic growth.

Over the five years from 2002 through 2006, gross capital flows into the United States totaled $6.2 trillion. Foreigners invested an average of over $5 billion in the United States every day, despite relatively low returns compared to investments in other countries and the widespread expectation of continued dollar depreciation. Why have these investors foregone large returns and invested in the low yielding US government securities?

This is the subject of an NBER working paper by Kristin Forbes, which argues that the absence of adequate depth and maturity in the domestic financial markets is the major reason for this capital flows. Countries with less developed financial markets invest a larger share of their portfolios in the United States and the magnitude of this effect decreases with income per capita. The inference from this finding is that lower levels of financial market development in other countries will continue to support capital flows into the United States, thereby supporting the US current account deficit and large global imbalances without major changes in asset prices.

Forbes writes, "Indeed, they (foreginers) may choose to purchase U.S. portfolio investments in order to benefit from the highly developed, liquid, and efficient US financial markets, and from the strong corporate governance and institutions in the United States - although both of these perceived strengths of the United States have shown some vulnerabilities during the recent financial market turmoil. Foreigners also may invest in the United States in order to diversify risk, especially if returns in US financial markets have little correlation with returns in their own country's domestic financial markets. Or, investors outside the United States may put their money here because of their strong linkages with the United States, through trade flows or such measures of "closeness" as distance, inexpensive communications, or sharing a common language."