Putting too many eggs in one basket?

• Pages: 337

Page 337

The widening U.S. current account deficit and the associated large positions that foreigners are amassing in U.S. bonds and equities-roughly $5 billion-have garnered much attention from academics, policymakers, practitioners, and the financial press. There are many structural reasons for this accumulation. For portfolio equity investors, few countries protect the rights of outside investors more vigorously. For fixed-income investors, U.S. bond markets offer unparalleled depth and liquidity. But these large positions also leave foreigners exposed to fluctuations in U.S. asset prices. In an IMF Working Paper, Francis E. Warnock addresses this aspect of foreigners' U.S. positions by assessing how a rapid decline in U.S. financial market prices could impact foreigners across a wide range of countries.

He traces out the composition of exposure to U.S. securities markets and investigates its potential implications by studying the effect on wealth (in dollar terms and as a share of investor-country GDP) of an unexpected 10 percent decrease in U.S. bond and equity prices as well as in the value of the dollar against other currencies.

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Potential losses

Taking into account the currency composition of foreigners' U.S. holdings, Warnock finds that for every 10 percent drop in U.S. bond markets and in the exchange value of the dollar, foreigners' wealth losses would amount to 2.5 percentage points of foreign GDP. If, in addition, U.S. equity markets also declined by 10 percent, foreigners would incur another 1.5 percentage points of GDP in wealth losses. Thus, for every 10 percent decline in the dollar, U.S. equity markets, and U.S. bond markets, foreign wealth losses would amount to 4 percentage points of foreign GDP. Foreigners are also exposed through their positions in dollar-denominated bonds issued by foreign countries; bringing these holdings into the analysis puts the total wealth loss at nearly 5 percentage points of GDP-or roughly $1.2 trillion in foreign currency terms of financial wealth.

Narrow focus

Warnock used two datasets for the study. The first measures foreign...