How do Foreign Investments affect the US Economy?

United States is a Superpower, and everyone wants to be a part of this wealth creating machine. In order to fully utilize this machine, it is important to know the impact that foreign countries have on the US Economy. At the end of the day, there are only 5 places in the US Economy where foreign investors/countries can invest their money:

Equities/Stocks

In order to get exposure to the top companies in the world and get a good return on their investment, foreign countries would consider investing in the US stock market. Usually, foreign countries prefer investing in the US bonds since it is one of the safest investments. However, when the government runs on a budget surplus (which was the case back during Clinton administration from late 90s to early 2000s – picture below), there are not many government bonds issued. Now, if there are only limited number of bonds available, foreign countries have to invest in other asset classes such as the US stock market. This is one of the reasons what led to the dotcom tech bubble. Foreign investments played a major role in inflating the stock prices of various securities.

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Bonds issued by Fannie Mae and Freddie Mac/Government Sponsored Enterprise (GSE)

After the tech bubble burst in 2000, foreign investors moved away from the US Stock market. The US government was still running at budget surplus (picture above), which meant that there were only limited number of US government bonds being issued. Looking for other investment options in the US Economy, the foreign investors chose to go with GSE. Foreign investors liked this investment because these enterprises had an implicit guarantee from the US government that they will not be allowed to fail. So, the excess liquidity from foreign countries went here. Foreign investors pushed the property price higher and is one of the reasons that caused the housing bubble.

Government Bonds

After the housing bubble burst in 2007, US had the great recession. In order to come out of the recession, the government had to ramp up their spending by A LOT. This meant running large budget deficit (look at years 2008-14 in the picture above) and issuing a lot of government bonds.

Let me break this down for you. Let us say you run a company and want to hire 500 people, but don’t have a single penny in your bank account. What would you do? You would probably go to the bank for a loan. Now instead of you, picture the US government running the country. If the government wants to build new roads, highways, bridges, and wants to employ 500,000 people, but does not have enough tax revenue to cover all those costs. What would it do? Easy! Issue government bonds. Instead of going to the banks, they are getting loans from average Joe, foreign countries, small and large businesses, etc. In short, they’ll take money from anyone and in return, guarantee a payment with interest after a specified time.

Let’s go back to government issuing more bonds during the great recession. Since there were lots of government bonds issued, foreign investors could potentially put all their money into the safest investment out there. Is that what they did? Did the foreign investors inject all their excess cash into the US government bond market? What do you think? The US government has been running large budget deficit since 2008. The picture below shows the major holders of US debt. China and Japan hold almost half of the total securities held by foreign investors. With US debt exceeding $21 trillion in 2018, do you think there could be a bubble in the government bond market? What if the government isn’t able to pay back that money? Can the US government go bankrupt?

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I personally don’t think US government would go bankrupt. One of the best players on the US government’s team is inflation, which I’ll talk about in a future blog post. Another player that’s on the team is the department of treasury, who can print money out of thin air (not a wise choice), but I digress. Let’s talk about the last 2 foreign investment opportunities in the United States.

Asset Backed Securities (ABS)/Corporate Debt

These investment options are similar to the bonds issued by Fannie Mae and Freddie Mac, however ABS are not guaranteed by the US government. This means that the investor could lose all his/her money if the securities fail. ABS are usually of one of these classes: home equity loans, auto loans, credit card receivables, and student loans. Student loans have been getting a lot of attention lately. The $1.38 trillion worth of student loans is said to be in a bubble right now. According to the Federal Reserve, outstanding student loan debt is currently exceeds credit card debt ($977 billion), and auto loan debt ($1.1 trillion). So, do you think student loans are in a bubble?

What do I mean when I ask you if you think student loans are in a bubble? Let me explain. A bubble is formed anytime the price of an asset trades above its intrinsic value. Let’s think about student loans for a second. You want to purse a degree in social sciences from a private college like Columbia University, whose yearly tuition is $57,208. Assuming you finish your degree in 4 years and received no scholarship, you’ll be in more than $200,000 in debt. Debt which was financed through a financial institution like JP Morgan Chase or Wells Fargo, who probably bundled these loans into an ABS, which was most likely sold to a foreign investor. So, you can picture the financial institution like the middle man. Now, do you think a social sciences bachelor’s degree is worth more than $200,000? Let’s say you do think that it’s worth it and finish the program in 4 years. What if you can’t land a job after 4 years? How are you going to pay back that $200,000? Let’s be optimistic and say that you landed a job. Assuming you had a 30 year loan, just paying off the principal alone would make your monthly payment $555.55. Imagine you lose your job in the next 30 years. How would you pay your debt? We are in a bull market right now, so it is easier for people to find jobs after graduation. But, if we were in a downturn, people graduating won’t find jobs and those who had student loans might start defaulting. Some of you might be wondering how do I find the intrinsic value of a social science degree? Well if you can get that same knowledge and degree from a state college at $10,000/year, then that is the true value of the asset. If you paid $200,000 for your social science degree, then you overpaid by $160,000. There could be thousands, if not millions, like you who overpaid by $160,000 – and that is how bubbles are created. So, could the student loans be in a bubble? If this $1.38 trillion worth of outstanding students loans were in a bubble, and if it were to burst (define burst: lots of people defaulting on student loans), it has the potential to create a havoc in all other asset classes in the US Economy. I digress too far. Let’s quickly talk about corporate debt.

An example of corporate debt could be something like this: if Apple needs $500M to built 5 new factories, it can issue corporate bonds. Foreign investors can buy these corporate bonds if they like. Since corporate debt is riskier than US government debt, the interest rates paid on these corporate bonds is usually higher than that paid on the US government bonds. As always, the riskier the companies/assets, the higher return on investment.

Foreign Direct Investment (FDI)

Finally onto our 5th and last investment opportunity for foreign investors. Like the name suggests, Foreign Direct Investment is an investment made by someone outside of the United States into a business interest located in the United States.  An example of FDI would be when Tata Motors, an Indian company, acquired Land Rover and Jaguar from Ford in 2008. This was a direct foreign investment made by a firm outside of the United States.

Equities/Stocks, Bonds issued by Fannie Mae and Freddie Mac, Government Bonds, Asset Backed Securities (ABS), and Foreign Direct Investment (FDI) are the 5 ways how foreign money can be injected in the US Economy. As you can see, foreign investments definitely have an impact on the United States. The question I would like to leave you with is to think about where the next bubble might be? Where have the foreign investors/countries put majority of their cash? Which asset class is inflated? Is it the stock market? Bonds? Or everything? If you can spot it, you can be the next Michael Burry (he saw the housing bubble) from The Big Short movie.

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