Fading of the Home Bias: The Unappreciated Story

Investors have traditionally shown a preference for their own markets. This is perfectly understandable. Invest in what you know best, is often the advice of professionals. However, liberalization of capital markets and the pursuit of better returns have seen the home-bias fade. This is especially noteworthy in Japan, one of the world’s largest creditor nations, as well as the United States, the world’s largest debtor.

The conventional view is that the U.S. needs to import sufficient capital to fund its massive current account deficit. While this is a fine starting point, the real situation is much more complicated. One of the complications that have tended to be under-appreciated is the demand on the part of U.S. investors for foreign securities. In essence, this means that the US capital requirement is the current account deficit and these other capital outflows.

U.S. investors purchases of foreign securities seem to have accelerated in late 2006. According to the Treasury Dept’s TIC data, U.S. investors bought $47.4 billion worth of foreign securities in Dec after purchasing $37.3 billion in November. Both these numbers represented record monthly purchases. The previous record was set in September 2004 at just below $30 billion. This time series indicates that Americans bought about the same amount of foreign securities in the last four months of the year as they did in the first eight months of the year (roughly $123 billion).

Private sector data tell a similar story, even though the figures are not reconcilable with the Treasury’s TIC report. The Investment Company Institute which tracks flows into mutual funds reported recently that roughly 92.5% of U.S. flows into equity funds went into international and global funds last year.

This translates into $148.5 billion into international and global funds compared with a little more than $12 billion into domestic funds. Moreover, the Institute’s data indicated that in seven of the last eight months of 2006, retail investors actually were net sellers of domestic funds.

The last time U.S. investors were so enamored with foreign assets may have been in 1995, when the Investment Company Institute reckons that a little more than 77% of U.S. flows into equity funds were earmarked for international and global funds. This contrasts with the experience during the peak of the dotcom bubble, when US investors put more than $310 billion into domestic funds while liquidating about $4.5 bln from international and global funds.

The Financial Research Corporation also tracks flows into stock and bond funds. Their figures indicate that international and global funds took in about $193 billion in 2006, almost 20% more than 2005. That means that US investors have about $1.6 trillion pf investment in international and global funds, up from $600 billion in 2003. Of course this represents substantial asset appreciation as well as new purchases.

It has received little attention, but a significant diversification of U.S. portfolios has taken place. The Investment Company Institute estimates that 22% of the American’s equity holdings are now in foreign markets, up from 15% in 2004. The Financial Research Corporation figures put the diversification at closer to 26%, up from 13% in 2003. Despite the nuance differences, the general conclusion is the same. American investors as a whole are more diversified than they have ever been and current levels are near what financial advisers often suggest.

There is little sign that the U.S. investor appetite for foreign securities has been satiated. To the extent that investors are chasing returns the fact that foreign equity markets are generally off to a better start than U.S. indices this year may underpin the demand for foreign shares. This may be especially true for the BRIC funds, which may have accounted for more than half the amount that went into international and global funds last year. Russia is the exception. In addition, the negative view many have for the U.S. dollar and a sense that the U.S. growth advantage over Europe may narrow and Japan may also encourage the continued diversification of U.S. portfolios.

Japanese investors have also diversified their portfolios. Contrary to what it may appear by reading the newspapers, speculators are not the only ones who have been selling the yen and buying higher yielding assets. Japanese investors have been doing it too. Not only is their size bigger than the speculators at the IMM, but their holdings seem to be more stable.

During the current fiscal year that began last April, Japanese investors bought more than $76 billion worth of foreign bonds and stocks. To put this figure in perspective, consider that the last time there was a significant squeeze of short yen positions in the futures market from late October 2006 through early December 2006, non-commercials (speculators) reduced their net short yen positions by a little more than 110,000 contracts or roughly $12 billion.

It is also noteworthy that the unwinding of short yen positions in the futures market did not create much stress in the financial system. The euro, sterling, the Australian dollar and many other currencies continued to strengthen against the yen during that bout of yen short covering. Emerging markets also continued to perform well in general.

Instead of besmirching the carry-trade, G7 officials should have embraced it. The purchase of foreign assets by Japanese investors is a sign of the health and robustness of the system. The private sector is re-cycling a larger part of Japan’s current account surplus. In the past, when the private sector has failed to do so, officials via intervention have often stepped into the breach.

Japan’s appetite for foreign securities is having important knock-on effects on the country’s current account surplus. Specifically, Japan’s average monthly trade surplus in 2006 was JPY788. 3 billion (about $6.7 billion), but the country earned an average of JPY1.145 trillion (about $9.8 billion) a month from its overseas investments. It is the investment income balance that is increasingly driving Japan’s current account surplus. The dividend and interest income have distinct seasonal patterns. There is a big drop off in June and in November and December. The slippage in the investment income balance at the end of 2006 will likely be more than recouped in Q1 2007.

Taken as a whole these developments, the diversification of U.S. and Japanese investment portfolios and the reliance on the private sector to re-cycle Japan’s current account surplus are salutary developments. They speak to the health of the global financial system. U.S. investor purchases of foreign assets helps reduce their vulnerability to a weaker dollar. U.S. investors’ holdings of foreign securities also help blunt the impact of the U.S. current account deficit on the country’s net international investment position.

Japan’s appetite for foreign assets offers a more stable component to the carry-trades that apparently have caused some official angst. It reflects the health of the private sector and its ability to re-cycle the current account surplus and avoid the need for official action. The BOJ has not intervened in the foreign exchange market since March 2004 and with the private sector doing much of the heavy lifting they can remain on the sidelines.