Friday, January 13, 2006

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Why are Americans better at FDI?

Matthew Higgins, Thomas Klitgaard, and Cédric Tille have an article in the Federal Reserve Bank of New York's December 2005 edition of Current Issues in Economics and Finance on net flows in international investment income. Given the fact that foreigners currently have a net claim on $2.5 trillion in U.S. assets, onme would expect the U.S. to be paying out a lot more in interest, dividends, and profits to foreigners than Americans would receive from their investments.

The weird thing is that, so far, this hasn't been true. Last year the U.S. earned $36 billion more on their foreign investments than foreigners earned in the United States. The question is, why?

Higgins et al have a simple answer and a more complex answer. The simple answer is that foreigners are investing heavily in fixed-income, interest-bearing assets, while Americans concentrate their outflows in riskier but more rewarding areas -- foreign direct investment and foreign portfolio investment. This result is actually consistent with a point I was trying to make before about the comparative advantage Americans hold in risk attitudes.

What really intrigues me, however, is this fact -- even if one limits the discussion to FDI, Americans do better abroad than foreigners do here:

[T]he rate of return on U.S.FDI assets has consistently been higher than that on FDI liabilities (Chart 4). Since 1982, the rate of return on FDI assets has, on average, exceeded that on FDI liabilities by 5.6 percentage points, and not once during this period has the differential dropped below 3.2 percentage points. Surprisingly, perhaps, there is no consensus about the reason for this large and persistent difference in rates of return....

Since 2000, the U.S. rate of return on FDI has risen from 5.4 percent to 8.6 percent, an increase of 3.2 percentage points; the foreign rate of return on FDI in the United States has risen from 2.0 percent to 4.3 percent, an increase of 2.3 percentage points.Had rates of return on FDI remained at their 2000 values, U.S. net income receipts would have been $33 billion lower in 2004....

Seeking to shed light on the puzzle, we examine FDI returns by industry and country. Unfortunately, our analysis deepens the puzzle rather than solves it: with few exceptions, the U.S. rate of return advantage holds across industries and countries. of U.S. firms at about the advanced-economy average.

This puzzle is pretty damn important. The gap in returns is significant enough so that Harvard economists Ricardo Hausmann and Federico Sturzenegger talking about this as "dark matter", explaining why the U.S. has been able to run a persistent current account deficit without any decline in the U.S. surplus on investment income.

Higgins et al proffer some possible explanations -- tax differentials, less experienced foreign investors, U.S. firms are better governed and more efficient, or the U.S. market is just more competitive and so profits will be lower here. Only the last argument persuades me much.

Higgins et al also don't think this situation will persist. Haussman and Sturzenegger, on the other hand, push the argument that US has a comparative advantage in FDI very hard:

Imagine the construction of EuroDisney at the cost of 100 million (the numbers are imaginary). Imagine also, for the sake of the argument that these resources were borrowed abroad at, say, a 5% rate of return. Once EuroDisney is in operation it yields 20 cents on the dollar. The investment generates a net income flow of 15 cents on the dollar but the BEA [Bureau of Economic Analysis] would say that the net foreign assets position would be equal to zero. We would say that EuroDisney in reality is not worth 100 million (what BEA would value it) but four times that (the capitalized value at our 5% rate of the 20 million per year that it earns). BEA is missing this and therefore grossly understates net assets. Why can EuroDisney earn such a return? Because the investment comes with a substantial amount of know-how, brand recognition, expertise, research and development and also with our good friends Mickey and Donald. This know-how is a source of dark matter. It explains why the US can earn more on its assets than it pays on its liabilities and why foreigners cannot do the same. We would say that the US exported 300 million in dark matter and is making a 5 percent return on it. The point is that in the accounting of FDI, the know-how than makes investments particularly productive is poorly accounted for....

In a nut shell our story is very simple. The income generated by a country’s financial position is a good measure of the true value of its assets. Once assets are valued accordingly, the US appears to be a net creditor, not a net
debtor and its net foreign asset position appears to have been fairly stable over the last 20 years. The bulk of the difference with the official story comes from the unaccounted export of knowhow carried out by US corporations through their investments abroad, explaining why the US appears to be a consistently smarter investor, making more money on its assets than it pays on its liabilities and why the rest of the world cannot wise up. In addition, the value of this dark matter seems to be rather stable, indicating that they are likely to continue to compensate for the measured trade deficit.

Globalization has made the flows of dark matter a very significant part of the story and the traditional measures of current account balances paint a very distorted picture of reality. In particular, it points towards imbalances that are not really there, making analysts predict crises that, for good reason, remain elusive.

They might be right -- but they don't have any evidence that this is true beyond the persistence in the gap between U.S. and foreign rates of return in FDI.

This is a really, really interesting puzzle, however -- and I'm very surprised some B-school professor hasn't written something so definitive on the topic that the book is a must-read. Maybe I'm out of it, but I haven't seen any book like this.

In lieu of a tome, commenters are free to figure out and post on this puzzle for themselves.

posted by Dan on 01.13.06 at 12:16 PM


Am I oversimplifying things by using the concept of risk / return tradeoff to explain this? Investment in the US is typically considered to have lower systematic risk associated with it (and therefore lower returns) while investing in non-US markets (which includes a lot of riskier emerging markets) has a higher risk / return profile.

The problem it seems with this sort of theory is the consistency of outperformance by US investment overseas. Higher risk portfolios may average higher returns over time but over a long period, underperformance by the riskier portfolio in a given year is to be expected.

Maybe "we" are just smarter?

posted by: Jay on 01.13.06 at 12:16 PM [permalink]

The long answer is several books long but the short answer is Bretton Woods II and petrodollars. As long as the dollar is the world's reserve currency, expect all sorts of weirdness to happen.

posted by: Dan K on 01.13.06 at 12:16 PM [permalink]

Im sure George Soros has the answer. And it involves the doom of the US somehow.

posted by: Mark Buehner on 01.13.06 at 12:16 PM [permalink]

Brad Setser makes the claim that a large portion of this is because of tax arbitrage, that its profitable for multinationals to declare profits abroad than in the US.

It might be useful to separate foriegn corporate investments from central bank investments too -- the latter are likely to be very conservative, and the dollars' status guarantees those will continue. Huge liquidity for treasuries is another factor.

Political stability is certainly a factor for Middle East countries and some Third World countries investing in the US -- they're willing to take lower yields for safety.

Finally, as a wealthier country, the US may just be more willing to spend on riskier instruments.To illustrate -- a poor American may put what savings they have into safe but lower yielding FDIC accounts, wealthier Americans will go for the stock market, the wealthiest for real exotic investments.

posted by: erg on 01.13.06 at 12:16 PM [permalink]

Dan -- As erg noted, I argue that the anecdotal evidence points to corporate tax arbitrage as a key explanation. But if you come across the definative b-school explanation, do let me know. So ask Bill Gates, or the big pharma CEOs with big profits in Ireland for the answer, not old George Soros.

I'll set aside my argument that investing in US dollar denominated assets is actually very risky for a foreign investors looking to maintain their real wealth in local currencies terms. The big current account deficit and all. Not everyone agrees with it.

But I don't think the US just is good at borrowing at low cost to buy high yielding assets argument works that well. For a couple of reasons. First, US returns abroad really aren't that good. The shocking thing is that reported foreign returns on their FDI are really bad -- less than they would have gotten holding long-term Treasuries generally. It isn't US skill, at least not skill at anything other than taking foreign direct investors for a ride that shows up in the data (now if FDI in the US doesn't want to show profits in the US for tax reasons, the story changes ... ). Second, most US FDI is just not in risky markets, nor are most US debt securities claims on risky places. Most US FDI is in the UK. lots more is in Switzerland. Throw in Japan, Canada and the Eurozone and you have a decent mental image of US assets abroad. Read the CBO report on this topic. Or look at the data the IMF has assembled on the sources of FDI in China (hint -- it ain't mostly coming from the US). US investors also own foreign bonds -- but they are mostly the securities issued in well developed markets that are almost as liquid as our own. UK, Japan, Canada, eurozone and the like.

We have lent tons of money to the Caymans too; I bet the Caymans also invests a lot in the US .... hhmmm? Maybe some b-school prof can help us out there. Or tax attorney.

posted by: brad setser on 01.13.06 at 12:16 PM [permalink]

This is a shot in the dark, but is it possible that the ROR is dependent on both the production in the host country and factors in the home country? Thus if US firms are making large profits at home (say Intel) and they invest in a production facility abroad shouldn't we expect that they have a higher ROR? They reason they investment is because they have some firm specific asset that gives them a comparative advantage over local firms.

Thus the same reasons why the U.S. economy has grown more quickly than the economies of the other FDI source countries could be the same reason why US investment abroad earn higher returns than foreign firms investing in the US.

This is just a late night shot in the dark, but I do think we want to consider the determinants of FDI to solve this mystery.

Great post on an important and unanswered question.

posted by: Nate on 01.13.06 at 12:16 PM [permalink]

Try removing the Japanese from the equation and then run the numbers again. They seem to have a genius for direct investing in the US at the very peak of the market (cf Rockefeller Center bought ca 1989, sold at a loss to Goldman just as the manhattan RE mkt was emerging from the bottom a few years later...). Probably true for the French (cf Vivendi) and the Germans (Bertelsmann, Daimler etc) as well.

It would be interesting to break out the data for M&A activity between giant firms, which tends to produce poor returns, vs minority stakes taken by giant investors or investment funds in small local firms. The latter seem more characteristic of US investment abroad, esp since far more of the US investment comes from very savvy private equity investors whereas most of the European and Japanese FDI in the US is done by less-nimble mega-firms buying up or "merging" with large US firms (Daimler and Chrysler, Vivendi and Universal).

Perhaps another problem here for non-Americans is that FDI requires not just operating expertise but also a culture of management and financial performance measurement that is easily exportable. The US companies that focus heavily on FDI (P&G, GE, Citigroup) tend to be extremely disciplined, ruthlessly focused on pleasing customers and winning market share-- winning attributes in any market-- while the European and Japanese companies tend to invest in the US partly for political/market access reasons (Japanese auto manufacturers) or internal reasons that have more to do with the personality of the chairman (Jean-Marie Messier at Vivendi) or a sudden wish by the board (perhaps after listening to some McKinsey consultants) to get global, fast. A tough change for family-owned, read-aim-aim again European firms especially. Far more difficult for them to come in with their management style and culture and turn around or grow a US company than v-v.

posted by: thibaud on 01.13.06 at 12:16 PM [permalink]

the answer lies with international finance economists. And there's a book out that covers it in very good detail:

posted by: No von Mises on 01.13.06 at 12:16 PM [permalink]

From a lawyer, not an economist, my observation is that the US Treasury bond market is the largest, most liquid, fairest market in the world. The expansion of our National Debt has produced good beyond even Hamilton's wildest dreams. Think about it: a company in Shanghai that has invested in textile mills in China knows that if they decide to sell their assets in China or take some profits out, for whatever reason, they have (1) a safe place to park funds; (2) as or more importantly, a market determined "safe rate" of return to measure other opportunities against. Thsu, they can make a decision about their investment in China without having an immediate decision to make about where to put the money longer term.

This is more than the dollar being a reserve currency. The Treasury bond market is so huge and so liquid, there has never been another market comparable to it in the world. It is the world's liquidity. Of course foreigners over invest in it, but what choice do they have?

posted by: Dan(not Drezner) on 01.13.06 at 12:16 PM [permalink]

"Of course foreigners over invest in it, but what choice do they have?"

That's precisely it. There is little to no choice. So long as the enormous capital inflow keeps coming (and it will), Americans "will be better at FDI" (whatever that means). If you have more capital than anyone else for use and exchange value, you will be the best at getting a return in industry and the forex market. Not to mention, you also hold enough power to unilaterally devalue the dollar (which 60-70% of the worlds asset are denominated in).

The corporate culture argument is worthless. Look at the flows! And the size of financial flows!

posted by: No von Mises on 01.13.06 at 12:16 PM [permalink]

How about the other side of this...what kind of returns do non-US-based companies see on their FDI in the U.S.? I would bet that the ROI of a BMW Toyota assembly plant is pretty high.

Although it's important to emphasize that ROI of any entity below the level of the total corporation is highly dependent on cost allocation / transfer pricing.

posted by: David Foster on 01.13.06 at 12:16 PM [permalink]

There is nothing to worry about. When the time comes when foreigners want all their money back (although I think it is unlikely to happen), we print more dollars to pay them. Certainly the consequence is sharp devaluation and no one will be willing to lend us anymore after that. But don’t worry, America will not become a poor country overnight. Suppose this happens in 2050, at that time GDP per capita is 100,000 USD, and American economy crash (because pull-out of foreign investment from America) and let’s say the economy lose 90% of production capacity, eh, we are still not a poor country and we won’t be starving anyway!

posted by: R-Squared on 01.13.06 at 12:16 PM [permalink]

It could also in part be explained black market money flows.

posted by: M. Simon on 01.13.06 at 12:16 PM [permalink]

BTW it might be noted that black market money is not interested so much in ROI as in money laundering.

Thus explaining the lower return on American investments.

posted by: M. Simon on 01.13.06 at 12:16 PM [permalink]

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