Chapter 3 Economic and Institutional Factors The material in this chapter is designed to respond to the following tasks assigned to the Secretary of the Treasury by Section 6 of P. L. 93-479 (the numbers refer to subsections of Section 6): (2) survey the reasons for foreign portfolio investment in the United States; (3) identify the processes and mechanisms through which foreign portfolio investment is made in the United States, the financing methods used, and the effects of foreign portfolio investment on American financial markets; The chapter is divided into two parts. The first is in response to question (2) above and deals essentially with the economic and institutional factors influencing foreign portfolio investment in the United States. The second part considers the first two points raised in question (3), namely the "processes and mechanisms" and "financing methods" of such investment. (The last part of question (3)—the effects on U.S. financial markets-is discussed in Chapter 4.) Most of the analysis in this chapter is based on a report prepared by R. Shriver Associates (reproduced in Appendix D), which was in turn based on a field survey conducted in the latter part of 1975. It also incorporates material derived from the statistical data obtained in the Treasury survey itself, and from other data on international capital flows between the United States and the rest of the world. Why Foreigners Invest in U.S. Securities Foreign investors place funds outside their own countries primarily to reduce risk while achieving desired income and capital preservation or growth objectives by portfolio diversification. A domestic investment manager within the United States will pursue this objective by diversifying his holdings by industry, on the theory that not all industries are similarly affected by variations in the business cycle. Similarly, not all national economies, nor their respective capital markets, move up and down in perfect synchronization. This lack of synchronization provides opportunities for astute portfolio managers to improve risk-reward ratios. There are many other reasons, of course, why investors choose to place funds abroad. Fear of political unrest at home, lack of suitable investment vehicles at home (especially in relatively small countries and those in which large sections of the economy are closed to private ownership), and the threat of inflation and accompanying currency depreciation are among other forces frequently mentioned by respondents to the survey. Once having decided to place funds abroad, what are some of the major factors leading investors to choose the United States over other countries? The following discussion highlights those most frequently mentioned. A measure of the relative importance of these factors to the foreign respondents is given in Chart 1, which indicates that the main reasons foreigners place funds internationally are to preserve capital, to achieve long-term capital growth, and to be harbored in countries that are politically and economically stable. Expectations for Long-Term Capital Growth A large majority of foreign portfolio managers cited "long-term capital gains" as the major objective of investments in the United States. The term itself has undergone some changes in meaning over the past ten years. In the mid-sixties, for example, investing for longterm capital growth referred to the strategy of buying stock in companies whose earnings were expected to grow and holding on to those stocks until this growth was reflected in the value of the stocks. More recently, foreign portfolio investors-like those at home-have come to realize that long-term capital gain positions could be eroded by failure to recognize in time abrupt changes occurring in the fundamental characteristics of the investee company, its industry, or even its country. Consequently, it was reported, investment strategies have been altered to take short-term profits in particular securities when they occur, while nonetheless preserving the objective of long-term capital growth of investments. Note: Responses to question: "Do you agree that factor X is an important consideration affecting foreign portfolio investment in the United States?" The fact that many foreign governments do not tax capital gains undoubtedly encourages such strategies. Evidence in support of this view may be found in the fact that the turnover of foreign portfolios of U.S. stocks seems to be somewhat faster than the turnover of all stocks listed on the New York Stock Exchange. (See Chapter 4.) Relative Economic and Political Stability of the U.S. Unlike their U.S. counterparts, international portfolio managers must first decide the currency or country in which to invest. This decision requires an assessment of international economic and monetary developments, as well as of relative political stability. The United States is popular with foreign portfolio managers in large measure because of its relative political stability. Many European investors see the United States as more sympathetic to free enterprise and the profit motive than some other major countries, with less risk of nationalization of private enterprise. There was also frequent expression of the view that the U.S. economy was relatively less vulnerable to cyclical influences than some other countries. The question of exchange rate risk was frequently raised; while many respondents seemed to regard the present regime of greater exchange rate flexibility as adding a new hazard, there was no evidence that this was deterring portfolio investment in the U.S. to the benefit of such investment elsewhere. The Size and Liquidity of U.S. Capital Markets It has been estimated that securities traded in the United States constitute well over one-half the total world supply of marketable issues. Thus, a foreign portfolio manager seeking diversification is virtually forced to place at least some of his funds in U.S. securities. The relatively small size of many foreign economies in relation to their stock of accumulated savings, and the fact that in many countries business investment is financed extensively by bank credit, closely held stock issues, and government funds, combine to limit, domestic opportunities for portfolio investment. The lack of depth and liquidity associated with smaller capital markets abroad also makes it difficult to place large amounts of funds in a relatively short period of time. In short, there is a broad and seasoned secondary market for securities in the United States that frequently does not exist elsewhere. Organization and Regulation of U.S. Capital Markets Many foreign investors cited the regulation of the U.S. securities markets (mainly by the Securities and Exchange Commission) as a strong attraction to foreign in 'The U.S. accounted for roughly 3/4 of total world marketable securities in 1972, based on OECD data. The U.S. share has probably dropped somewhat in more recent years. The actual figure at any time will of course vary depending on differential movements in the stock market here and abroad and other factors. vestment. Other investors noted that the U.S. markets are better organized than many others; that is, the mechanisms for initiating and concluding a trade are more systematic-settlements occur promptly, specialists act to maintain orderly markets, etc. Greater Range of Investment Choices Many foreign portfolio managers invest in the United States to participate in industries that simply do not exist locally, or in other foreign countries. Most high technology industries, such as computers, communications, and aerospace, are concentrated in the United States. Foreign investors are also attracted to the natural resources of the United States such as oil, gas and timber. Finally, in some foreign countries, the choice of issues is limited because the local government is in charge of many sectors of economic activity; for instance, to invest in airlines, railroads or even utilities, it may be necessary to invest in the United States. The U.S. markets are also unique in offering a large variety of instruments such as warrants, options, rights, and convertible debentures. Sales Efforts of U.S. Securities Dealers The U.S. securities industry makes a strong effort to sell U.S. securities abroad. This has involved attemptssome ill-fated-to organize foreign mutual funds to purchase U.S. securities. However, most large broker/dealers provide the same kinds of advice and services to their foreign clients as to their domestic accounts, and have established branch offices in major foreign cities the better to serve foreign clients (as well as, of course, to engage in underwriting of issues, notably Euro-issues, abroad). Although many foreign investors reported having suffered losses in the late sixties and early seventies following the recommendations of salesmen for U.S. broker/dealers, they report that they still continue to purchase securities through firms in which they have confidence. In effect, the salesmen are the analysts, economists and investment managers who combine to produce reliable recommendations. In addition, U.S. corporate executives travel abroad regularly to address investor groups to keep them informed of developments in their respective companies. Foreign investors are also actively sold U.S. securities by their own local brokers, particularly those that may have participated in foreign underwriting of U.S. issues. The Greater Efficiency of U.S. Markets U.S. security markets are widely considered to be the most efficient in the world, in the sense that information is widely available and almost instantaneously reflected in the prices of stocks. This means that even inside information is no guarantee of consistent returns in excess of those earned by the market as a whole. Some investors view the efficiency of U.S. markets as a reason for not investing in the U.S.; most, however, consider efficiency to be a positive factor. The former say they can make good profits only on markets where manipulation is common. The latter say that the full disclosure of accounting information required in the U.S. provides a broader knowledge of the companies in which to invest. By contrast, non-U.S. companies that are listed only on foreign markets often provide very limited information. The information that is provided is often poorly presented, incomplete, and, sometimes, deliberately misleading. Additional Reasons In addition to those listed above, there are many other reasons why foreign portfolio managers invest in the United States. In some cases, investments are made in the United States because children of the beneficial owners are being educated and/or are otherwise living in the United States, or because the investors have other family ties here. The introduction of price controls in Canada was said to have led to increased foreign holdings, primarily in the United States, by many Canadian investors. Finally, at times of serious political crises abroad, large sums of money have typically flowed from the troubled area into Swiss (primarily) and U.S. banks and thence, in all probability, into U.S. securities to varying degrees. Factors Influencing the Level and Composition of Foreign Portfolio Investment in the United States In the preceding pages the principal general factors attracting foreign investors to U.S. securities have been briefly summarized. In this section specific factors affecting the volume of such investment at particular time periods and the choice of investment securities, will be described briefly. Obviously, the short-run cyclical outlook for major investee countries will be compared. On balance, however, the prevailing opinion among persons interviewed was that most foreign investors take a long view-they are not trying to profit from short-term market swings. Nevertheless, foreign investors seem to be avid consumers of U.S. economic projections. Actual and anticipated exchange rate changes may alter at least the timing of portfolio investment, and countries subject to frequent or violent rate changes may lose even their longer term attractiveness to foreign investors. Some respondents expressed the view that greater exchange rate flexibility may induce some investors to avoid exchange risk by investing locally. Relative interest rates among countries at any particular time and current interest rates in the United States compared to those prevailing in the past or expected to prevail in the future, will obviously affect the timing, and perhaps the absolute volume, of private foreign investment in U.S. debt issues. As discussed in the chapter on legal issues, some foreign investors are sensitive to U.S. disclosure rules. In particular it was frequently stated that potential investors were fearful of having their identity disclosed to their own governments, as is provided for in many of our reciprocal tax treaties. It was stated that even some residents of treaty countries, who could benefit from the lower withholding rate specified in the treaty, would elect to pay the full U.S. withholding rate to avoid having their U.S. holdings disclosed to their own govern ments. Expanding these disclosure provisions, it was reported, could discourage portfolio investment in the United States. And even if disclosure could be avoided by using a foreign bank or other institution as an investment channel, the result might be that a greater proportion of any given portfolio might be invested abroad. Changes in tax laws affecting returns on portfolio investments, particularly the prospective abolition of the U.S. withholding tax, were seen as having important potential effects. The pros and cons of this proposal have been extensively discussed in other forums; little if any, new information was developed in the Shriver interviews. Most respondents were agreed that abolition would cause a shift in the composition of investment toward bonds and high yield (as distinguished from "growth") stocks.2 Changes in foreign exchange controls abroad obviously have a considerable effect on foreign portfolio investment in the United States. Many, if not most, countries maintain de jure, if not always de facto, controls on outward capital movements; Canada, Switzerland, and Germany are, however, outstanding exceptions. Changes in the amount of real foreign capital available for outside investment, as indicated by balance of payments surpluses, will also affect portfolio investment in the United States. Variations among countries in the proportion of total foreign savings may also have an effect, since some countries (e.g. Canada) have a higher propensity than others for placing externally invested funds in the United States. Any foreign investor of a particular type (individual, investment company, pension fund, etc.) chooses the composition of his portfolio in much the same manner as his U.S. counterpart. Once having decided how much to invest in the United States, he allocates his funds among various investment vehicles (chiefly stocks and bonds, but also options, warrants, and other special purpose instruments). Second, within investment types, money is divided among industries, and among specific securities within each industry. Some factors which affect the vehicle decision include: The investment objectives and willingness to The perception of future monetary and fiscal 2See Chapter 5, "Legal Aspects of Foreign Portfolio Investment" for additional discussion of the impact of the withholding tax. |