Debtor Nation (part 1)
Debtor Nation
http://www.realtor.org/rmomag.NSF/pages/feature3nov06?OpenDocument
What do the chairman of the Federal Reserve, the exchange rate of the euro, and a rich investor from Shanghai have in common? All have some influence over the interest rate your buyers get on their mortgage.
The intricate interplay of foreign capital and interest rates has been the subject of discussion — and some concern — among economists in recent years. Foreigners love investing in the United States. U.S. Treasuries and other instruments, including mortgage-backed securities, provide foreign investors with a safe, stable place to rest their funds. That’s been good news for the housing industry, which has seen a steady flow of cheap mortgage money. It’s been more than four years since rates topped 7 percent. Without foreign capital, by one rough estimate, rates would be somewhere in the 12 percent range.
But whether the United States can sustain the current level of foreign investment and whether, in the long run, it’s good for the nation’s economy are questions without easy answers.
Give us your huddled masses yearning to earn
What’s certain is that foreign investment has been steadily growing. From 2001 to 2005, foreign purchases of U.S. Treasury bonds and other debt instruments, including mortgage-backed securities, rose from $785 billion to $1.3 trillion, according to U.S. Bureau of Economic Analysis data. As of last year, foreign investors held about half of all outstanding Treasuries, according to a report in
The New York Times.
The prosperity of the global economy, the stability of U.S. markets, and the volume of U.S. imports of foreign goods are all factors in explaining this bonanza.
“The United States has the most well-developed capital instruments in the world. Its economy is growing, it’s politically stable, and much of foreign investors’ savings is already denominated in dollars,” in part because of the influx of dollars they get from U.S. consumers buying their goods and services, says Greg McBride, senior financial analyst for Bankrate.com.
For those benefits, foreigners have been willing to keep investing at relatively low rates of return.
To be sure, foreign investment hasn’t been the only contributor to low-interest rates. Another has been the highly accommodative monetary policy of the Fed in the wake of the terrorist attacks and tech bust in 2001. The Fed pushed down its target rate for the overnight loans bank charge one another to a record low 1 percent in an effort to ward off a feared recession.
These days the Fed seems more concerned about inflation than recession and had raised the federal funds rate to just over 5 percent as of mid-2006 to head off what it fears is a potentially overheated economy. Long-term interest rates hovered just below 6.5 percent in August, and it’s unlikely that rates will drop significantly any time soon. “We expect the 30-year fixed mortgage rate to trend upward to 7 percent by the second quarter of 2007 and hover just below that for the remainder of the year,” says NATIONAL ASSOCIATION OF REALTORS® Chief Economist David Lereah.
The result, of course, has been a chill in the housing market. “Buyers are seeing mortgage rates in relation to where they were in 2003, when they were under 6 percent,” says Beverly Rasmussen CRS®, PMN, a 25-year real estate veteran with Exit Tri-County Realty in Upper Marlboro, Md. Rasmussen says half of her prospective customers are young households waiting for rates or prices or both to come down.
“Higher rates have an impact on sales and prices, no doubt,” says David Wyss, chief economist for Standard & Poor’s, the global credit rating agency. “We’ve seen the beginning of that downward trend over the past year. We’ll be looking at more of the same if foreign investors start going away.”
Could — or should — foreign investment be curbed?
Most experts don’t anticipate a major pullout of foreign funds. At the same time, several factors make at least a partial withdrawal possible.
For example, as the population ages in capital-exporting countries like Germany and Japan, those countries will face shrinking tax bases and growing transfer payments, so those countries will have less to invest. Some foreign investors may also steer clear of U.S. investments fearing a political backlash, as happened when a Chinese energy company tried to buy the oil company Unocal Corp. (The Chinese bid was withdrawn.)
There are other, “what if” factors. For example, China could revalue its currency, which would result in fewer dollars flowing into Chinese exports and, thus, fewer dollars flowing back into U.S. Treasuries. Foreign central bankers and investors could decide to diversify their holdings in search of better returns. Changes in U.S. laws could make foreign ownership more risky or less attractive.
Some economists believe a reduction of foreign capital will be better for the U.S. economy in the long run because the huge share of U.S. liquidity controlled by foreigners heightens the economy’s vulnerability. A Sept. 25 Wall Street Journal article said the nation’s net debt stood at 20 percent of GDP at the end of 2005, compared with 15 percent on average for the 12 euro countries.
Of greatest concern is the ballooning U.S. current-account deficit. As of mid-2006, it stood at a record annual rate of more than $800 billion, or almost 7 percent of the U.S. gross domestic product. That deficit is the difference between what the United States invests overseas and spends for goods and services from other countries and what other countries pump into the United States. The current-account deficit is broader than the more familiar trade deficit — which has also been extremely high, running between $600 billion and $700 billion from 2004 to 2005 — ince the current-account deficit incorporates all investment and payments, including dividends and other remittances, flowing to and from countries.
Economists differ on the peril a rising current-account deficit poses for the United States. Some say it represents foreigners “buying up” the country. Others say it ultimately benefits both Americans and foreign investors because of the way it keeps interest rates down, allowing U.S. consumers to buy cheap foreign goods and services while helping to grow foreign economies.
Economists generally agree, though, that it’s in the interests of the United States and even the global economy for the current-account deficit to recede to about 2 percent to 3 percent of GDP from the current 7 percent. Otherwise future U.S. economic growth could be curtailed as U.S. resources increasingly go to paying off creditors rather than investing in the technology, infrastructure, and education that leads to future U.S. productivity growth.
“If you’re running a deficit in the government account, you’re crowding out private borrowing, and we’re financing that difference with foreign capital. Since that capital has to be paid back with interest, you’re also putting the squeeze on the current budget,” says Karl Case, an economics professor at Wellesley College.
The path to righting these imbalances starts with foreign investors diversifying into other countries — a painful remedy for those whose livelihood depends on low interest rates. Only when foreign investment stops flooding the United States and interest rates go higher will U.S. borrowing ebb.
Higher rates would help restrain core inflation (goods and services exclusive of volatile energy and food), which in mid-2006 was growing at a rate of about 4.2 percent. The U.S. savings rate might also improve since higher rates would attract household deposits while discouraging investment in assets such as cars and houses. Right now the U.S. savings rate is about 15 percent of the GDP, down from a little bit more than 16 percent in 1995. However, all of that is from corporate savings. The personal savings rate, which has been dropping steadily for years, is negative, and has been since early 2005.
“For the first time since the Great Depression, household spending is now exceeding earnings,” says Wyss.
Internationally, higher rates would also weaken the value of the dollar, making U.S. services and goods more competitive abroad and curtailing the attraction of foreign goods and services here. Although a strong dollar suggests a strong economy, it leads to increased imports, decreased exports, and a widening of the current-account deficit.
Realistically, however, the dollar probably wouldn’t drop as far as is necessary to give U.S. exports a major boost, economists say. Before it went too low, central bankers in other countries would likely try to shore it up to preserve the competitive strength of their exports.
“Particularly in places like Japan,” which is export-driven, says Wyss, “the dollar needs to get into the $1.50–$1.60 range against the euro to get to equilibrium.” At $1.60, U.S. exports would improve, U.S. imports would decline, and the current-account deficit would shrink. But central bankers probably won’t let it reach more than $1.29, about where it was in late August.
“In the long run,” says Wyss, “everyone [in international economics] agrees the dollar needs to get to a sustainable level, but in the short run, it’s very convenient for everyone if the dollar stays stronger.”