Tuesday, July 29, 2008

The Never Ending Foreign Sucker Express

One of the seemingly mysterious facts is that America can continue have a net surplus on international investment income flows. I mean, as protectionists always points out, haven't America had a constant trade- and current account deficit for more than 25 years, with the deficit being as large as 5 to 7% of GDP during the latest decade, meaning that America particularly during the latest decade has been a massive net borrower from abroad. And yet, despite being a massive net borrower, America continues to have a large net surplus in investment income from abroad. So in order words, foreigners are in effect paying America large amounts to borrow, and not the other way around (usually it is the borrower who is paying the lender).

How is that possible? The most blunt and honest answer is that the foreigners who invest in America are suckers who allow themselves to get screwed by the Americans.
To illustrate this point, let's look at their track record. First, their preferred choice of investment was U.S. government bonds. Government bonds have the advantage of at least not losing in value in nominal dollar terms, but because the U.S. dollar is constantly debased in the form of inflation and depreciation they are still losing in value in real terms. As I found when doing research for the paper I told you about a while ago, U.S. government bonds had the by far worst return of any government bonds in advanced countries during the latest 25-year period.

Then they started accumulating Mortgage backed securities in the hope of getting a higher return than from government securities. And well, I think we are all aware of how well that went. And now they are accumulating financial stocks, as we see in the case of Singapore's latest purchase of Merrill Lynch-stocks. Singapore had already bought a large stake in Merrill Lynch in December when the stock was worth more than twice their current value, meaning that the Singaporeans have lost more than half of what they invested then. Presumably, they hope things will turn out better this time.
But unless Merrill Lynch has gotten completely out of the housing market (I haven't studied their balance sheet in detail so correct me if I'm wrong, but I find that unlikely) then things are just going to get worse.

As I pointed out recently, house prices will fall a lot more before this is over. That in turn means that the value of any securities or loans backed by houses will also fall further, meaning that Merrill Lynch will continue to make big losses, losses that will have to be absorbed by the shareholders, including the Singaporeans.


Blogger Phastidio said...

Stefan, you are making a mistake about the Singaporean SWF Temasek Holdings. I agree with you they have significant loss on the stake they bought on Merrill on December, but in that agreement there was a safeguard clause. Actually, in the next capital increase, Merrill will have to pay Temasek 2,5 bln $ to offset losses on its earlier investment. I think Temasek is not exactly a sucker, at least in this case.

8:47 PM  
Blogger Reginald said...

These aren't individual private suckers. These are governmental suckers. Central banks and/or government run sovereign wealth funds keep buying US treasuries and mortgages. How long can it last? Well, communism lasted 70 years and it was a failure from the very beginning. Governments are going to keep making stupid investments as long as they can tax the people in their borders.

12:25 AM  
Blogger stefankarlsson said...

Phastidio: do you have any source about that safeguard clause?

Reginald: You're right that it is largely government entities in the form of central banks and sovereign wealth funds who are getting screwed.

However, many private entities are also losing big, including for example the Swiss bank UBS.

3:24 PM  
Anonymous Acrossthepond said...

I'd say that investing in the US was probably a pretty good investment 25 years ago, but began to turn spectacularly bad around 2000.

The real "conundrum" is as to why they persist today... One thing is that they mistake military might with economic strenght. This is especially true for the Saudis.

The other is that old creditor's trap: With so much at stake they simply cannot abandon the Usians, especially not at this point.

But for how long can this continue? That's an 64.000€ question indeed.

3:18 PM  

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