Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Going Global: The Changing Pattern of U.S. Investment Abroad

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Going Global: The Changing Pattern of U.S. Investment Abroad

Article excerpt

(ProQuest Information and Learning: ... denotes formulae omitted.)

Investors typically allocate only a small share of their portfolios to foreign assets. This pattern of investment behavior, known as "home bias," is puzzling because it causes investors to miss opportunities to diversify risks. During downturns in the U.S. economy, many domestic assets perform poorly, precisely when asset returns are most valuable. By purchasing foreign assets that are only partly affected by the U.S. business cycle, however, investors are able to hedge against adverse fluctuations in domestic income.

Recent evidence suggests that home bias might actually be declining. Over the past decade, U.S. holdings of foreign financial assets-stocks and bonds-have grown remarkably. At the same time, foreign physical assets, such as foreign direct investment in production plants, have also become far more common. Overall, the share of U.S. investments allocated to foreign assets swelled from 40 percent of GDP in 1990 to 89 percent in 2005.

This article investigates the recent behavior of U.S. foreign investment and the factors driving the change in its fastest growing category-namely, international equity investment. Home bias in U.S. equity investment has indeed declined during the last decade. However, the propensity to invest abroad has varied significantly across assets from different foreign economies. Specifically, U.S. investors tend to prefer investing in other industrial countries rather than in emerging markets. This pattern has likely developed because the assets of industrial countries provide a better hedge during downturns in the U.S. business cycle.

The first section of the article provides an overview of the recent trends in U.S. investment abroad. The second section discusses a theoretical framework that sheds light on why diversifying a portfolio with foreign assets can simultaneously increase the average return on investment and reduce the volatility of returns. The third section analyzes trends in the geographic allocation of cross-border investment. It also shows that U.S. investors have become more likely to favor investing in other industrial countries. The fourth section investigates the factors that could be driving this behavior.

I. RECENT CHANGES IN U.S. FOREIGN INVESTMENT

Since the early 1990s, the U.S. foreign investment position has changed dramatically, suggesting that home bias may be weakening. These changes can be summarized along three dimensions: the magnitude of the stock of foreign assets held in U.S. portfolios, the composition of investments abroad, and finally the geographic allocation of foreign investment.

The first dimension, the magnitude of investment abroad, began to evolve significantly more than a decade ago. In the early 1990s, the end-of-the-year market value of all types of foreign investments turned upward (Chart 1). By 2005, these investments, which range from foreign direct investment, to stocks and bonds, to government and private sector investments, had soared to 89 percent of U.S. GDP.

Of course, the change in investment behavior is due partly to a growing pool of funds available to fund foreign investment. But the change also depends on other factors. Specifically, the market value of the stock of these assets depends on new flows of investment, on capital gains (an increase in the price of foreign assets), and on exchange rate movements. For example, the rising value of the euro has increased the dollar value of assets whose price is denominated in euros. The yearover-year change in the stock of foreign assets partly reflects these "valuation adjustments," which are implicit in their dollar market price. The decline in the foreign asset position of U.S. investments from 1999 to 2002 was due in large part to the fall in the price of foreign assets, especially stocks, during that period (Chart 1).

How much of the growth in the stock of foreign assets can be attributed to new flows of investment abroad rather than to asset price and exchange rate changes? …

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