Foreign Ownership of U.S. Financial Assets: Implications of a Withdrawal

Foreign Ownership of U.S. Financial Assets:
Implications of a Withdrawal
Updated July 14, 2008
James K. Jackson
Specialist in International Trade and Finance
Foreign Affairs, Defense, and Trade Division

Foreign Ownership of U.S. Financial Assets:
Implications of a Withdrawal
Summary
This report provides an overview of the role foreign investment plays in the U.S.
economy and an assessment of possible actions a foreign investor or a group of
foreign investors might choose to take to liquidate their investments in the United
States. Concerns over the potential impact of disinvestment have grown as national
governments have become more active investors and as uncertainty over the risks
associated with securities backed by sub-prime mortgages has increased volatility in
financial markets. Actions taken by foreign investors to liquidate their holdings
could affect the U.S. economy in a number of ways due to the role foreign investment
plays in the United States and due to the current mix of economic policies the United
States has chosen. The impact of any such action on the economy would also depend
on the overall condition and performance of the economy and the financial markets.
If the economy were experiencing a strong rate of economic growth, the impact of
a foreign withdrawal likely would be minimal, especially given the dynamic nature
of credit markets. If a withdrawal occurred when the economy were not experiencing
robust rate of growth or if credit financial markets were under duress, the withdrawal
could have a stronger effect on the economy.
The particular course of action foreign investors might choose to take and the
overall strength and performance of the economy at the time of their actions could
affect the economy in different ways. Congress likely would become involved as a
result of its direct role in making economic policy and its oversight role over the
Federal Reserve. In addition, the actions of foreign investors could complicate
domestic economic policymaking. Foreign investors who decide to liquidate their
holdings of one particular type of investment would normally need to look for other
types of assets to acquire. While there are a multitude of possible strategies foreign
investors could pursue, this analysis assesses the impact of four of the most likely
strategies a single large foreign investor or a group of foreign investors could choose
to employ to reduce or withdraw entirely their holdings of U.S. financial assets:
^!A rapid liquidation of U.S. Treasury securities.
^!A shift in the make-up of foreign investors’ portfolios among
various dollar-denominated assets.
^!A rapid shift from dollar-denominated assets to assets denominated
in other currencies.
^!A slow shift in the make-up of future accumulations of assets away
from dollar-denominated assets to assets denominated in currencies
other than the dollar.
This report will be updated as events warrant.

Contents
Overview ....................................................1
Foreign Investment in the U.S. Economy...........................3
Flow of Funds in the U.S. Economy...........................4
Foreign and Domestic Sources of Funds........................7
Foreign Capital and the Value of the Dollar.....................8
Withdrawal of Foreign Investment...............................10
Sudden Withdrawal from U.S. Treasury Securities...............10
Diversify Portfolios Among Dollar-Denominated Assets..........12
Shift Away from Dollar-Denominated Assets...................13
Slow Shift Away from Dollar-Denominated Assets..............14
Conclusions .................................................14
List of Figures
Figure 1. Foreign Private and Official Capital Inflows Into the United States,
1996-2007 ...................................................3
Figure 2. Flows of Funds in the U.S. Economy, 1996-2007.................5
List of Tables
Table 1. Capital Inflows to the United States, 1996-2007..................4
Table 2. Flow of Funds of the U.S. Economy, 1996-2007..................6
Table 3. Selected Indicators of the Size of the Global Capital Markets, 2006...8

Foreign Ownership of U.S. Financial Assets:
Implications of a Withdrawal
Overview
Foreign capital inflows are playing an important role in the economy. Such
inflows bridge the gap between U.S. supplies and demands for credit, thereby
allowing consumers and businesses to finance purchases at interest rates that are
lower than they would be without overseas capital inflows. Similarly, capital inflows
allow federal, state, and local governments to finance their budget deficits at rates
that are lower then they would be otherwise. These foreign capital inflows allow the
Nation to support expenditures exceeding its current output level and finance its trade
deficit. A sharp reduction in those inflows likely would complicate domestic efforts
at making and conducting economic policies.
To date, the world economy has benefitted from the stimulus provided by the
nation’s combination of fiscal and monetary policies and trade deficit. Foreign
investors now hold slightly less than 50% of the publicly held and publicly traded
U.S. Treasury securities, 25% of corporate bonds, and about 12% of U.S. corporate¹
stocks. The large foreign accumulation of U.S. securities has spurred some
observers to argue that this foreign presence in U.S. financial markets increases the
risk of a financial crisis, whether as a result of the uncoordinated actions of market
participants or by a coordinated withdrawal from U.S. financial markets by foreign
investors for economic or political reasons. Concerns are also growing that over the
long run U.S. economic policies and the accompanying large deficit in its
international trade accounts could have a negative impact on global economic
developments, especially for the economically less developed countries.
Some observers are concerned that a foreign investor with significant holdings
in the United States or a group of foreign investors could engage in an abrupt and
large-scale liquidation of dollar-denominated securities, particularly a sell-off of U.S.
Treasury securities. These observers argue that the vast sums of dollars held and
managed by some foreign governments, termed sovereign wealth funds, raise the
prospects of such a coordinated withdrawal, because the funds potentially increase
the ability of foreign governments to instigate a rapid withdrawal. It is uncertain,
though, what types of events could provoke a coordinated withdrawal from U.S.
securities markets. Although unlikely, a coordinated withdrawal from U.S. financial
markets potentially could be staged by foreign investors for economic or political
reasons or it could arise from a sharp drop in U.S. equity prices as a result of an
uncoordinated correction in market prices. Also, concerns over the ability of the
federal government to service its foreign debt and a loss of confidence in the ability

¹ For more information, see CRS Report RL32964, The United States as a Net Debtor
Nation: Overview of the International Investment Position, by James K. Jackson.

of national U.S. policy makers to conduct economic policies that are perceived
abroad as prudent and stabilizing could spur some foreign investors to reassess their
estimates of the risks involved in holding dollar-denominated assets. In other cases,
international linkages that connect national capital markets could be the conduit
through which events in one market are quickly spread to other markets and ignite
an abrupt, seemingly uncoordinated, withdrawal of capital. Such concerns have
increased as financial markets have attempted to re-price the perceived risks and
uncertainty associated with securities backed by sub-prime mortgages.
A liquidation of capital could be limited to one segment of the credit markets
as one foreign investor or a group of foreign investors attempted to adjust the
composition of their portfolios. A withdrawal also could mark a major shift in
investment strategies by foreign investors as they shifted away from dollar-
denominated securities. Short of a financial crisis, events that cause some foreign
investors to adjust their portfolios likely would have short-run negative effects on
U.S. interest rates and on the international exchange value of the dollar. However,
should a large group of foreign investors make a permanent shift in their strategies
to limit or to reduce their purchases of U.S. securities, such actions likely would
complicate efforts to finance budget deficits. Given the current mix of economic
policies, the loss of capital inflows would affect U.S. interest rates, domestic
investment, and the long-term rate of growth of the economy. Such a loss of capital
inflows would be especially troublesome if it occurred during a time when concerns
over the rate of growth in the economy were increasing. During periods when the
rate of economic growth is slowing, the Federal Reserve generally resorts to reducing
interest rates to stimulate the economy. However, the loss of capital inflows would
tend to push the Federal Reserve to raise interest rates to attract more capital inflows.
Congress likely would find itself embroiled in any such economic or financial crisis
through its direct role in conducting fiscal policy and in its indirect role in the
conduct of monetary policy through its supervisory responsibility over the Federal
Reserve.
Some observers are also concerned that recent developments in the financial
system have increased the possibility of a financial crisis. They contend that such a
crisis could damage the international financial system in the short run and could
potentially affect the performance of individual economies. The rapid expansion of
market activity through the consolidation of equity exchanges and the development
of complex financial instruments and hybrid securities that are traded across national
borders has spurred some analysts to question whether the market and financial
innovations have outpaced the efforts of regulators. For instance, concerns about the
risks of sub-prime mortgage-backed securities has eroded some investors’ confidence
in the underlying stability of some segments of the global financial system. As a
result, some observers argue that improvements in the financial system that arise
from greater market efficiencies by spreading risk across national borders may be
blunted, because the underlying risks of certain widely traded financial instruments
have become more difficult to assess. Consequently, some commentators maintain
that the risks of a domestic financial crisis spreading across national borders have
become more pervasive because of the rapid internationalization of financial services.
Others note that by expanding into financial activities that were not part of the
original core business of financial services, providers may be exposed to new and
additional types of risk for which they are not well prepared. According to the IMF,

“there is little empirical evidence to date to determine whether cross-border
diversification of financial institutions reduces or increases firm-specific or systemic
vulnerabilities.”²
Foreign Investment in the U.S. Economy
Capital flows are highly liquid, can respond abruptly to changes in economic
and financial conditions, and exercise a primary influence on exchange rates and
through those rates onto global flows of goods and services. As indicated in Figure
1, these capital inflows are composed of official inflows, primarily foreign
governments’ purchases of U.S. Treasury securities, and private inflows composed
of portfolio investment, which includes foreigners’ purchases of U.S. Treasury and
corporate securities, financial liabilities, and direct investment in U.S. businesses and
real estate. In 1996, total foreign capital inflows to the United States reached over
$551 billion, but by 2000 foreign capital inflows totaled more than $1 trillion, as
indicated in Table 1. Such inflows were reduced in 2001 and 2002 as the growth
rate of the U.S. economy slowed, but grew to over $1.8 trillion in 2007 as the rate of
economic growth improved. Private capital inflows comprise more than three-
fourths of the total capital inflows, with foreign purchases of corporate securities,
stocks and bonds being the main components of these inflows. In 2007, official
inflows attributed to foreign governments accounted for 22% of total foreign capital
inflows, down slightly from the share recorded in 2006.
Figure 1. Foreign Private and Official Capital Inflows Into the United
States, 1996-2007

Billions of dollars
$1600
$1400
Private
$1200
$1000
$800
$600
$400
Official
$200
$0
-$200
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Source: Department of Commerce
² Op. cit., Global Financial Stability Report, p. 107.

Economists generally attribute the rise in foreign investment in the United States
to comparatively favorable returns on investments relative to risk, a surplus of saving
in other areas of the world, the well-developed U.S. financial system, and the overall
stability of the U.S. economy. These net capital inflows (inflows net of outflows)
bridge the gap in the United States between the amount of credit demanded and the
domestic supply of funds, likely keeping U.S. interest rates below the level they
would have reached without the foreign capital. These capital inflows also allow the
United States to support expenditures exceeding its current output level and finance
its trade deficit, because foreigners are willing to “lend” to the United States in the
form of exchanging goods, represented by U.S. imports, for such U.S. assets as
stocks, bonds, and U.S. Treasury securities. Such inflows, however, put upward
pressure on the dollar, which tends to push up the price of U.S. exports relative to its
imports and to reduce the overall level of exports. Furthermore, foreign investment
in the U.S. economy drains off some of the income earned on the foreign-owned
assets that otherwise would accrue to the U.S. economy as foreign investors repatriate
their earnings back home.
Table 1. Capital Inflows to the United States, 1996-2007
(in billions of dollars)
^Pri^{vate as}^s^e^ts
^Offi^ci^al^Direct^T^reas^u^ry^C^o^rp^orate^U.S.
^Yea^r^T^o^ta^l^a^sse^t^s^To^t^a^l^inv^e^st^m^e^nt^s^ecurities^s^ecurities^currency^Other
¹⁹⁹⁶^$551.1^$126.7^$424.4^$86.5^$147.0^$103.3^$17.4^$70.2
¹⁹⁹⁷^706.8^19.0^687.8^105.6^130.4^161.4^24.8^265.5
¹⁹⁹⁸^423.6^-^19.9^443.5^179.0^28.6^156.3^16.6^62.9
¹⁹⁹⁹^740.2^43.5^696.7^289.4^-^44.5^298.8^22.4^130.5
²⁰⁰⁰^1,046.9^42.8¹^,004.1^321.3^-^70.0^459.9⁵^.3^287.6
²⁰⁰¹^782.9^28.1^754.8^167.0^-^14.4^393.9^23.8^184.5
²⁰⁰²^768.2^114.0^654.3^72.4^100.4^285.5^21.5^174.4
²⁰⁰³^829.2^248.6^580.6^39.9^113.4^251.0^16.6^159.7
²⁰⁰⁴^1,440.1^394.7¹^,045.4^106.⁸^107.0^369.8^14.8^477.0
²⁰⁰⁵^1,204.2^259.3^995.0^109.⁰^132.3^450.4^19.0^234.3
²⁰⁰⁶^1,859.6^440.3¹^,419.3^180.⁶^-^35.9^592.0^12.6^670.2
²⁰⁰⁷^1,863.7^412.7¹^,451.0^204.⁴^166.3^391.9^10.9^677.3
^Source:^Bach^,^C^h^ri^s^t^oph^er^L^{., U}^.^S^.^In^t^e^rn^atⁱ^oⁿ^a^l^T^r^an^s^actⁱ^oⁿ^sⁱⁿ^2007,^Sur^{vey of C}^u^r^r^e^{nt Bus}ⁱ^nes^s^,
^A^p^ri^l^{2008, p. 48.}
Flow of Funds in the U.S. Economy. Figure 2 shows the net flow of
funds in the U.S. economy. The flow of funds accounts measure financial flows
across sectors of the economy, tracking funds as they move from those sectors that
supply the capital through intermediaries to sectors that use the capital to acquire

physical and financial assets.³ The net flows show the overall financial position by
sector, whether that sector is a net supplier or a net user of financial capital in the
economy. Because the demand for funds in the economy as a whole must equal the
supply of funds, a deficit in one sector must be offset by a surplus in another sector.
Figure 2. Flows of Funds in the U.S. Economy, 1996-2007

Billions of dollars
$1000
$800
Rest of the World
$600
$400
Businesses
$200
$0
-$200
Households
-$400
-$600Government
-$800
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Source: Federal Reserve
Generally, the household sector, or individuals, provides funds to the economy,
because individuals save part of their income, while the business sector uses those
funds to invest in plant and equipment that, in turn, serve as the building blocks for
the production of additional goods and services. The government sector (the
combination of federal, state, and local governments) can be either a net supplier of
funds or a net user, depending on whether the sector is running a surplus or a deficit,
respectively. The interplay within the economy between saving and investment, or
the supply and uses of funds, tends to affect domestic interest rates, which move to
equate the demand and supply of funds. Shifts in the interest rate also tend to attract
capital from abroad, denoted by the rest of the world (ROW) in Table 2.
As Table 2 indicates, from 1996 through 1998, the household sector ran a net
surplus, or provided net savings to the economy. The business sector also provided
net surplus funds in 1996, or businesses earned more in profits than they invested.
The government sector, primarily the federal government, experienced net deficits,
which decreased until 1998, when the federal government and state and local
governments experienced financial surpluses. Capital inflows from the rest of the
world rose and fell during this period, depending on the combination of household
³ Teplin, Albert M., the U.S. Flows of Funds Accounts and Their Uses, Federal Reserve
Bulletin, July 2001, pp. 431-441.

saving, business sector saving and investment, and the extent of the deficit or surplus
in the government sector.
Starting in 1999, the household sector began dissaving, as individuals spent
more than they earned. Part of this dissaving was offset by the government sector,
which experienced a surplus from 1998 to 2001. As a result of the large household
dissaving, however, the economy as a whole experienced a gap between domestic
saving and investment that was filled with large capital inflows. Those inflows were
particularly large in nominal terms from 2000 to 2006, as household dissaving
continued and as government sector surpluses turned to historically large deficits in
nominal terms. Such inflows have kept interest rates below the level they would
have reached without the inflows, but have put added pressure on the international
exchange value of the dollar.
Table 2. Flow of Funds of the U.S. Economy, 1996-2007
(in billions of dollars)
^G^overnm^e^nt
^Hou^s^eh^ol^S^t^{ate an}^d
^Yea^r^ds^B^u^sine^sse^s^ROW^To^t^a^l^L^o^cal^F^ederal
¹⁹⁹⁶^175.2^19.8^-^196.8^-^1.2^-^195.6^137.9
¹⁹⁹⁷^47.4^-^18.3^-^116.6^-^47.5^-^69.1^219.6
¹⁹⁹⁸^128.0^-^45.7^64.8^48.8^16.0^75.0
¹⁹⁹⁹^-^132.7^-^62.6^115.3⁹^.9^105.4^231.7
²⁰⁰⁰^-^371.0^-^82.9^252.5^54.5^198.0^476.3
²⁰⁰¹^-^494.4^-^82.9^233.4^35.4^198.0^485.4
²⁰⁰²^-^343.4⁸^.7^-^382.6^-^95.6^-^287.0^501.7
²⁰⁰³^-^101.8^30.3^-^546.3^-^70.4^-^475.9^535.4
²⁰⁰⁴^-^230.6^136.8^-^468.6^-^32.9^-^435.7^554.4
²⁰⁰⁵^-^741.0^-^26.1^-^413.1^-^16.1^-^397.9^773.3
²⁰⁰⁶^-^656.9^-^170.5^-^338.8^-^50.3^-^283.0^829.3
²⁰⁰⁷^-^188.0^-^45.4^-^353.3^-^90.7^-^284.0^677.4
^{I 2007}^6.4^-^57.9^-^486.5^-^95.7^-^387.8^728.1
^{II 2007}^-¹^,199.6^10.8^-^130.2^-^64.3^-^65.9^621.4
^{III 2007}^618.5^-^86.9^-^435.9^-^84.8^-^351.1^441.9
^IV²⁰⁰⁷^-^177.8^-^47.6^-^449.5^-^118.2^-^331.3^918.2
^{I 2008}^219.2^-^90.9^-^636.8^-^162.7^-^474.1^592.1
^Source:^{Board of}^G^o^v^e^rn^ors^of^t^h^e^F^e^deral^R^e^s^e^rv^e^S^y^s^t^em^,^Fl^ow^of^Funds^Account^s^of^t^h^e^Uⁿⁱ^t^e^d
^St^at^es^{, Fl}^ow^s^{and O}^u^t^s^t^andi^ngs^Fi^r^s^t^Q^uar^t^e^r²⁰⁰⁸^{, Ju}ⁿ^e^{5, 2008.}
In 2007, capital inflows fell by about $150 billion from the amount recorded in
2006. This drop in capital inflows reflected a sharp drop in household dissaving, a
decrease in business sector dissaving and an increase in the deficits experienced by
State and Local governments. In the first quarter of 2008, the flow of funds show a

large drop in capital inflows from the rest of the world, from $918 billion in the
fourth quarter of 2007 through the first quarter of 2008. In addition, households
turned from a dissaving of $178 billion in the fourth quarter of 2007 to a net saving
of $219 billion in the first quarter of 2008, reflecting the growing concern among
households over the state of the economy. The Federal Reserve has reported⁴ that in
the first quarter of 2008, households experienced a drop in their net worth of $1.7
trillion.
As the flow of funds data indicate, foreign capital inflows augment domestic
U.S. sources of capital, which in turn keep U.S. interest rates lower than they would
be without the foreign capital. Indeed, economists generally argue that it is this
interplay between the demand for and the supply of credit in the economy that drives
the broad inflows and outflows of capital. As U.S. demands for capital outstrip
domestic sources of funds, domestic interest rates rise relative to those abroad, which
tends to draw capital away from other countries to the United States.
Foreign and Domestic Sources of Funds. The United States also has
benefitted from a surplus of saving over investment in many areas of the world that
has provided a supply of funds and accommodated the overall shortfall of saving in
the country. This surplus of saving has been available to the United States because
foreigners have remained willing to loan that saving to the United States in the form
of acquiring U.S. assets, which have accommodated the growing current account
deficits. Over the past decade, the United States experienced a decline in its rate of
saving and an increase in the rate of domestic investment. The large increase in the
nation’s current account deficit would not have been possible without the
accommodating inflows of foreign capital.
Foreign capital inflows, while important, do not fully replace or compensate for
a lack of domestic sources of capital. Capital mobility has increased sharply over the
last 20 years, but economic analysis shows that a nation’s rate of capital formation,
or domestic investment, seems to be linked primarily to its domestic rate of saving.
This phenomenon was first presented in a paper published in 1980 by Martin⁵
Feldstein and Charles Horioka. The Feldstein-Horioka paper maintained that despite
the dramatic growth in capital flows between nations, international capital mobility
remains somewhat limited so that a nation’s rate of domestic investment is linked to
its domestic rate of saving.⁶

⁴ Board of Governors of the Federal Reserve System, Flow of Funds Accounts of the United
States, Flows and Outstandings, First Quarter 2008, June 5, 2008.
⁵ Feldstein, Martin, and Charles Horioka, Domestic Saving and International Capital Flows,
The Economic Journal, June, 1980, pp. 314-329; Feldstein, Martin, Aspects of Global
Economic Integration: Outlook for the Future. NBER Working Paper 7899, September

2000, pp. 9-12.

⁶ Developments in capital markets have improved capital mobility since the Feldstein-
Horioka paper was published and have led some economists to question Feldstein and
Horioka’s conclusion concerning the lack of perfect capital mobility. (Ghosh, Atish R.,
International Capital Mobility Amongst the Major Industrialized Countries: Too Little or
Too Much?, The Economic Journal, January 1995, pp. 107-128.) Indeed, some authors
(continued...)

Foreign Capital and the Value of the Dollar. Liberalized capital flows
and floating exchange rates have greatly expanded the amount of capital flows
between countries. These capital transactions are undertaken in response to
commercial incentives or political considerations that are independent of the overall
balance of payments or of particular accounts. As a result of these transactions,
national economies have become more closely linked, the process some refer to as
“globalization.” The data in Table 3 provide selected indicators of the relative sizes
of the various capital markets in various countries and regions and the relative
importance of international foreign exchange markets. In 2006, these markets
amounted to $500 trillion, or more than 30 times the size of the U.S. economy.
Worldwide, foreign exchange and interest rate derivatives, which are the most widely
used hedges against movements in currencies, were valued at $347 trillion in 2006,
78% larger than the combined total of all public and private bonds, equities, and bank
assets. For the United States, such derivatives total nearly three times as much as all
U.S. bonds, equities, and bank assets.
Table 3. Selected Indicators of the Size of the Global Capital
Markets, 2006
(in billions of U.S. dollars)
^B^o^nds^{, E}^quities^{, and B}^a^nk^As^s^e^ts^E^x^{change M}^a^rk^{et Derivatives}
^Gr^o^s^s^OT^C^OT^C
^Do^m^e^stic^To^t^a^l^Foreign^Iⁿ^teres^t
^P^r^o^duct^Offi^ci^al^Stock^M^a^rk^et^Debt^Ban^k^E^x^ch^an^ge^Ra^te
^(G^DP)^Res^erves^To^t^a^l^Ca^pit^a^liza^t^ioⁿ^Securities^Asse^t^s^To^t^a^l^Derivatives^Derivatives
^Worl^d^48,434.4⁵^,091.5^194,462.7^50,826.6^68,200.9^74,465.2^395,557.⁰^48,620.0^346,937.0
^Eu^ropean
^Uⁿⁱ^oⁿ^13,658.0^252.7^73,983.7^13,068.⁸^23,192.3^37,736.3^N^.A^.^N^.A^.^N^.A^.
^Eu^{ro A}^r^ea^10,586.1^157.5^54,822.0⁸^,419.1^18,761.1^26,719.2^145,903.⁰^18,280.0^127,623.0
^Un^ited
^S^t^at^es^13,194.7^54.9^56,822.0^19,569.0^27,^050.1^10,202.9^154,799.0^40,488.0^114,311.0
^Japan⁴^,377.1^879.7^20,109.5⁴^,795.8⁸^,^723.7⁶^,590.0^58,329.0^10,579.0^47,750.0
^Source:^G^l^obal^Fⁱ^nancⁱ^a^l^S^t^a^b^{ility Rep}^o^r^t^{, In}^t^e^rn^atⁱ^oⁿ^a^l^Mon^e^t^a^ry^F^uⁿ^d^{, A}^p^ri^l^{2008, S}^t^atⁱ^s^tⁱ^cal
^A^ppen^dⁱ^x^{, T}^a^bl^{e 3.}
^No^te:^T^o^{tal d}^e^rⁱ^v^a^tiv^{es d}^o^e^{s n}^o^{t in}^clu^d^{e eq}^u^ity^an^d^co^m^m^o^d^ity^-^lin^k^e^d^d^e^rⁱ^v^a^tiv^es.
Another aspect of capital mobility and capital inflows is the impact such capital
flows have on the international exchange value of the dollar. Demand for U.S.
assets, such as financial securities, translates into demand for the dollar, because U.S.
securities are denominated in dollars. As demand for the dollar rises or falls
according to overall demand for dollar-denominated assets, the value of the dollar
changes. These exchange rate changes, in turn, have secondary effects on the prices
of U.S. and foreign goods, which tend to alter the U.S. trade balance. At times,

⁶ (...continued)
argue that short-term capital flows among the major developed economies are highly liquid,
perhaps too liquid, and seem to be driven as much by short-term economic events and
speculation as they are by longer term economic trends.

foreign governments have moved aggressively in international capital markets to
acquire the dollar directly or to acquire Treasury securities in order to strengthen the
value of the dollar against particular currencies.
Also, the dollar is heavily traded in financial markets around the globe and, at
times, plays the role of a global currency. Disruptions in this role have important
implications for the United States and for the smooth functioning of the international
financial system. This prominent role means that the exchange value of the dollar
often acts as a mechanism for transmitting economic and political news and events
across national borders. While such a role helps facilitate a broad range of
international economic and financial activities, it also means that the dollar’s
exchange value can vary greatly on a daily or weekly basis as it is buffeted by
international events.⁷
A triennial survey of the world’s leading central banks conducted by the Bank
for International Settlements in April 2007 indicates that the daily trading of foreign
currencies through traditional foreign exchange markets⁸ totals more than $3.2
trillion, up sharply from the $1.9 trillion reported in the previous survey conducted
in 2004. In addition to the traditional foreign exchange market, the over-the-counter
(OTC)⁹ foreign exchange derivatives market reported that daily turnover of interest
rate and non-traditional foreign exchange derivatives contracts reached $2.1 trillion
in April 2007. The combined amount of $5.3 trillion for daily foreign exchange
trading in the traditional and OTC markets is more than three times the annual
amount of U.S. exports of goods and services. The data also indicate that 86.3% of
the global foreign exchange turnover is in U.S. dollars, slightly lower than the 88.7%
share reported in a similar survey conducted in 2004.¹⁰
In the U.S. foreign exchange market, the value of the dollar is followed closely
by multinational firms, international banks, and investors who are attempting to
offset some of the inherent risks involved with foreign exchange trading. On a daily
basis, turnover in the U.S. foreign exchange market¹¹ averages $664 billion; similar

⁷ Samuelson, Robert J., “Dangers in a Dollar on the Edge,” The Washington Post, December

8, 2006, p. A39.

⁸ Traditional foreign exchange markets are organized exchanges which trade primarily in
foreign exchange futures and options contracts where the terms and condition of the
contracts are standardized.
⁹ The over-the-counter foreign exchange derivatives market is an informal market consisting
of dealers who custom-tailor agreements to meet the specific needs regarding maturity,
payments intervals, or other terms that allow the contracts to meet specific requirements for
risk.
¹⁰ Triennial Central Bank Survey: Foreign Exchange and Derivatives Market Activity in
2007. Bank for International Settlement, September 2007, pp. 1-2. A copy of the report
is available at [http://www.bis.org/publ/rpfx07.pdf].
¹¹ Defined as foreign exchange transactions in the spot and forward exchange markets and
foreign exchange swaps. A spot transaction is defined as a single transaction involving the
exchange of two currencies at a rate agreed upon on the date of the contract; a foreign
exchange swap is a multi-part transaction that involves the exchange of two currencies on
(continued...)

transactions in the U.S. foreign exchange derivative markets¹² average $607 billion,
nearly double the amount reported in a similar survey conducted in 2004.¹³
Foreigners also buy and sell U.S. corporate bonds and stocks and U.S. Treasury
securities. Foreigners now own slightly less than 50% of the total amount of
outstanding U.S. Treasury securities that are publicly held and traded.¹⁴
Withdrawal of Foreign Investment
This section analyzes four possible strategies a single large foreign investor or
a group of foreign investors could employ to reduce or withdraw entirely their
holdings of financial assets in the United States. These strategies include
^!a rapid liquidation of U.S. Treasury securities,
^!a shift in the make-up of foreign investors’ portfolios among various
dollar-denominated assets,
^!a rapid shift from dollar-denominated assets to assets denominated
in other currencies, and
^!a slow shift in the make-up of future accumulations of assets away
from dollar-denominated assets to assets denominated in currencies
other than the dollar.
Sudden Withdrawal from U.S. Treasury Securities. The large holdings
of U.S. Treasury securities by foreign governments have led some observers to
consider the prospect of a withdrawal from the U.S. Treasury securities market by a
single foreign government. At the first hint that a foreign government was
attempting to liquidate all or even a large part of its holdings of U.S. Treasury
securities, the price of such Treasury securities likely would plummet in U.S.
securities markets and the market rate of interest would rise, perhaps appreciably, in
the first few hours or days. For instance, on November 7, 2007, a report, that was
later repudiated, asserted that Chinese officials were considering shifting some of
China’s foreign currency reserves, reportedly worth $1.4 trillion, in dollars and in

¹¹ (...continued)
a specified date at a rate agreed upon at the time of the conclusion of the contract and then
a reverse exchange of the same two currencies at a date further in the future at a rate
generally different from the rate applied to the first transaction.
¹² Defined as transactions in foreign reserve accounts, interest rate swaps, cross currency
interest rate swaps, and foreign exchange and interest rate options. A currency swap
commits two counterparties to exchange streams of interest payments in different currencies
for an agreed upon period of time and usually to exchange principal amounts in different
currencies as a pre-agreed exchange rate; a currency option conveys the right to buy or sell
a currency with another currency as a specified rate during a specified period.
¹³ The Foreign Exchange and Interest Rate Derivatives Markets: Turnover in the United
States April 2007. The Federal Reserve Bank of New York, April, 2004. pp. 1-2. A copy
of the report is available at [http://www.newyorkfed.org/markets/triennial/fx_survey.pdf].
¹⁴ Treasury Bulletin, March 2007, Table OFS-2, p. 48.

such dollar-denominated assets as Treasury securities, out of dollar-denominated
securities. Acting on the report, investors sold securities and the dollar. As a result,
the broad Dow Jones industrial average plunged 360 points in one day and the dollar
sank against other major currencies.¹⁵ In response to the fall in the exchange value
of the dollar, indexes of equities markets in Europe and Japan also fell.
Such cross-border spill-over effects are not new, but potentially have become
more pervasive as a result of the broad linkages that have been forged among the
once-disparate national financial systems. As an example, concerns in U.S. capital
markets in early June 2006 over prospects that a rise in consumer prices and in the
core inflation rate would push the Federal Reserve to raise key U.S. interest rates
sparked a drop in prices in U.S. capital and equity markets where inflation concerns
quickly spread to markets in Europe and Asia as equity prices fell in those markets
as well.¹⁶
If a foreign investor with large U.S. holdings or a group of foreign investors
attempted to launch a withdrawal from U.S. Treasury securities, investors and other
market participants would calculate quickly the expected effects of those intended
actions on market prices, interest rates, and the exchange value of the dollar and
would then act swiftly on those anticipated effects. As a result, the prices of Treasury
securities likely would drop sharply, while interest rates would rise, because the price
of such securities is inversely related to the interest rate. In addition, the dollar likely
would fall in value relative to other currencies, because the shift away from dollar-
denominated assets would increase demand for and the prices of other currencies
relative to the dollar. Consequently, the drop in the price of Treasury securities and
the drop in the exchange value of the dollar would significantly discount the value
of any Treasury securities that would be sold and sharply reduce the proceeds for any
investor participating in such a sell-off. As a result, the potentially large financial
losses that would attend an attempt to liquidate assets rapidly are likely to dissuade
most investors from employing such a strategy.
The drop in the prices of Treasury securities and the decline in the exchange
value of the dollar, however, probably would be short-lived. Foreign investors
selling Treasury Securities presumably would do so in order to acquire non-dollar-
denominated assets. Such a shift in demand from U.S. Treasury securities to other
foreign securities would drive up the prices of those securities and the exchange
value of foreign currencies. As a result, the lower prices for Treasury securities and
for the dollar would offer other investors arbitrage and investment opportunities to
acquire assets that investors likely would deem to be temporarily undervalued. As
a result, investors likely would move to acquire Treasury securities and the dollar,
which means that demand would increase for both the low-priced Treasury securities
and the lower-valued dollar, which would drive up the prices of both assets. Such
a response could significantly blunt, or even entirely reverse, the initial drop in prices

¹⁵ Grynbaum, Michael M., and Peter S. Goodman, Markets and Dollar Sink as Slowdown
Worry Increases. The New York Times, November 8, 2007.
¹⁶ Masters, Brooke A., Pondering the Bear Necessities, The Washington Post, June 7, 2006,
p. D1; Samuelson, Robert J., Global Capital On the Run, The Washington Post, June 14,

2006, p. A23.

of the securities and of the dollar. Given the dynamic nature of finance and credit
markets and the instantaneous communication of information, such actions likely
would occur within a very short time frame.
For instance, fears spread rapidly after the terrorist attacks on New York and
Washington on September 11, 2001, that foreigners would curtail their purchases of
U.S. financial assets and reduce the total inflow of capital into the U.S. economy.
Following the attacks, foreign governments and private investors did reduce their
purchases of Treasury securities from pre-attack levels and the value of the dollar fell
relative to other major currencies. These effects were fully reversed within 30 days,
however, as currency traders forged a short-lived agreement not to profit from the
attacks and the Federal Reserve undertook actions on its own and in concert with
central bankers and financial ministers around the globe to ensure the smooth
operation of the international financial markets.¹⁷ Similarly, the Federal Reserve
likely would not be expected to sit by idly while foreign investors attempted a
coordinated withdrawal from U.S. equity markets, if those actions threatened to
undermine the stability of the markets.
The overall performance of the U.S. economy at the time of any attempted
withdrawal would also influence the economic effect of the withdrawal. For
instance, if the U.S. economy were experiencing a robust rate of economic growth,
the impact of a withdrawal by foreign investors likely would be minimal, both in the
short run and in the long run. However, if such a withdrawal were to occur at a time
when the U.S. economy were not experiencing a robust rate of economic growth, or
if the U.S. credit and financial markets were under duress, such a withdrawal may
well have a more pervasive effect by undermining investors’ confidence in the
stability and performance of the markets and could result in higher interest rates and
a lower exchange value of the dollar over the short run and prolong the adjustment
process. In addition, actions that change foreign investors’ assessment of the
underlying risks of the financial system or that undermine foreign investors’
confidence in the stability of the financial system could prod some foreign investors
to reassess the composition of their portfolios.
For instance, at the time of the rumored Chinese withdrawal from U.S.
securities, U.S. financial markets already were strained by concerns over the impact
of record oil prices and potentially large losses associated with sub-prime mortgaged-
backed securities. As a result, the Dow Jones industrial average of U.S. stocks
moved erratically through the end of November 2007. By the end of November
2007, the Dow was down nearly 290 points from where it had been following the loss
of 360 points on November 7, 2007.
Diversify Portfolios Among Dollar-Denominated Assets. Another
possible course of action some foreign investors could pursue would be to diversify
abruptly the composition of their portfolios by replacing a sizeable portion of their
holdings of U.S. Treasury securities with other dollar-denominated assets. As
foreign investors traded Treasury securities for other assets, the price of Treasury

¹⁷ For more information, see CRS Report RS21102, International Capital Flows Following
the September 11 Attacks, by James K. Jackson.

securities would decline and the prices of other assets would rise as demand shifted
away from Treasury securities and toward other dollar-denominated assets. Because
total demand for dollar-denominated assets would remain constant, there likely
would be little movement in the exchange value of the dollar, but the shift of demand
would alter the relative prices of various domestic assets. Such shifts in demand are
not a rare occurrence, but happen frequently as investors change their evaluations of
the relative value of corporate equities, corporate bonds, and Treasury securities and
in response to changes in economic policies and actions by the Federal Reserve.
If foreign investors attempt to alter abruptly the composition of their portfolios
away from Treasury securities, the prices of such securities would fall and the prices
of corporate bonds and equities would rise, reflecting the shift in demand. If
investors perceived this shift in demand and, therefore, the shift in prices, as a one-
time adjustment in the composition of foreign investors’ portfolios, some investors
likely would take advantage of the rise in prices in equities and bonds to sell their
holdings and take their profits at what likely would be perceived to be overvalued
prices and, conversely, buy Treasury securities at what they would view as
temporarily undervalued prices. After these adjustments, market prices likely would
settle at prices that would be close to or equal to those that had existed prior to the
original shift in demand by foreign investors.
Shift Away from Dollar-Denominated Assets. Another course of action
some foreign investors could pursue would be to pare down their holdings of dollar-
denominated assets through a relatively swift liquidation of part of their holdings of
dollar-denominated assets. In this case, a single foreign investor or a group of
foreign investors would sell off part of their holdings of such dollar-denominated
assets as corporate stocks and bonds or Treasury securities and possibly even direct
investments (investments in U.S. businesses and real estate), although selling direct
investments in this manner seems less likely given the generally long-run strategies
investors use in acquiring them. If some foreign investors attempted to accomplish
such a readjustment in their portfolios quickly by liquidating a portion of their
holdings of corporate stocks and bonds and of Treasury securities, the prices of those
assets would fall, given the current pervasive role foreign investors play in most U.S.
financial markets.
In addition, because the foreign investors would be liquidating their dollar-
denominated assets in order to acquire assets denominated in other currencies, the
exchange value of the dollar would fall relative to the price of foreign currencies.
The drop in the prices of dollar-denominated equities and bonds combined with the
lower exchange value of the dollar would erode the expected profits of any investor
selling such securities and likely would attract the interest of other foreign investors,
who presumably could liquidate their now higher-priced foreign securities and
leverage their now higher-valued foreign currency to acquire dollar-denominated
assets. Furthermore, U.S. multinational firms may well take advantage of the higher-
valued foreign currency to repatriate part of the profits of their foreign affiliates,
which would boost the balance sheet of their U.S. parent company, possibly even
using the repatriated profits to acquire their own stock. Such repatriated profits likely
would put upward pressure on the exchange value of the dollar, because foreign
earnings would have to be converted into dollars before they were repatriated.
Similarly, foreign firms operating in the United States likely would retain their profits

rather than suffering a loss in value by translating those profits into higher priced
foreign currencies in order to repatriate their profits back to their foreign parent
company. Presumably, such profits could be used to augment investments within the
United States.
Slow Shift Away from Dollar-Denominated Assets. Finally, some
foreign investors could decide to shift away from dollar-denominated assets by
engaging in a long-term shift in the rate at which they accumulate such assets. Such
a strategy would have the benefit of avoiding the large short-run shifts in the prices
of financial assets and in the exchange value of the dollar that would attend any
attempt by a group of foreign investors to make a rapid adjustment in the
composition of their portfolios. A decrease in the inflow of capital from abroad
would reduce the domestic availability of capital and place upward pressure on credit
and financial assets as interest rates would rise to equate the demand and supply of
credit. For the U.S. economy as a whole, a long-term shift away from dollar-
denominated assets by foreign investors could have a slightly negative impact on the
economy over the long run given the current mix of economic policies. A reduction
in the inflow of foreign investment would tend to push down the prices of stocks and
bonds and push up interest rates since those wanting credit would be competing for
a smaller pool of funds. The price of Treasury securities would fall as the Federal
government would be required to raise interest rates in order to attract domestic and
foreign investors to acquire Treasury securities, which would raise the cost of
financing the Federal government’s budget deficit.
In addition, the shift from dollar-denominated assets would tend to push up the
exchange value of foreign currencies relative to that of the dollar because an increase
in demand for foreign assets would also raise demand for foreign currencies. The
lower-valued dollar would raise the price of U.S. imports, particularly of raw
materials and manufactured goods, which would put upward pressure on consumer
and wholesale prices and tend to affect most negatively those sectors of the economy
that are especially sensitive to movements in interest rates: the housing and
automobile sectors. The decline in the international exchange value of the dollar also
would tend to favor those industries and sectors of the economy that export. As long
as the international exchange value of the dollar remained relatively low compared
with other currencies, the exported goods sectors of the economy likely would
expand by attracting more capital and labor and the imported goods sector of the
economy would decline, assuming that all other things in the economy remained
constant.
Conclusions
It is not uncommon for investors to adjust the composition of their portfolios as
economic and financial conditions change. Given the recent surge in foreign
investors’ accumulation of dollars and dollar-denominated assets, it is not
unreasonable to expect that from time to time they will also attempt to adjust the
composition of their portfolios between corporate stocks and bonds, U.S. Treasury
securities, and direct investments in U.S. businesses and real estate. A long-term
shift away from dollar-denominated assets, however, could have a negative effect on
the long-term rate of investment, productively, and the rate of growth in the U.S.
economy. Such a shift in the value of the dollar would tend over the long run to

benefit the exported goods sector of the economy, but it could also complicate efforts
to conduct domestic economic policies. Although there are numerous other
currencies that might attract investors, the dollar continues to be the most widely
traded currency around the globe, which means it likely will retain its desirability as
an investment asset and as a medium of exchange for some time to come. Also, the
vast and deep capital markets in the United States combined with the highly
developed banking and legal systems continue to make investments in U.S. financial
assets attractive to foreign investors, despite short-run changes in perceptions of risk
or economic performance.
Should a foreign investor with large financial holdings in the United States or
a group of investors attempt to liquidate abruptly their holdings of assets such as
Treasury securities, they would experience a severe loss in the value of those assets
first as they attempted to sell their large holds in the market and then as they
attempted to convert their dollar holdings into other currencies. As a result of these
losses, it seems unlikely that a foreign investor with large holdings or a group of
foreign investors would attempt to liquidate their securities quickly. A more likely
course of action would be for foreign investors to adjust the composition of their
portfolios slowly over time.
If only one or a few foreign investors engaged in a strategy to liquidate part of
their U.S. financial holdings, their actions alone are likely to have a limited impact
on the economy over the short run, because market forces would be expected to
adjust to attract other foreign investors to replace those who had withdrawn.
However, if a broad range of foreign investors, for whatever reason, decided to
reduce their holdings of dollar-denominated assets, interest rates in the United States
likely would rise in response to market forces that would place them above the level
where they would have been if the foreign capital inflows had remained at their
higher levels. A higher level of interest rates would lead some firms to reduce their
level of borrowing and investing and spur some households to curtail their
consumption, especially of such interest sensitive products as housing and
automobiles, which usually are financed over long periods of time. Over the long
run, the lower level of investment by firms could be expected to result in a lower rate
of growth in productivity and, therefore, in a lower rate of growth in the economy.
In addition, if foreign investors were to attempt an abrupt adjustment to the
composition of their portfolios that disrupted the financial markets or the broader
economy, the Federal Reserve would not be expected to stand idly by on the
sidelines. In such circumstances, the Federal Reserve has shown some agility in
intervening on its own to stabilize credit markets and to move in coordination with
other central banks. On December 11, 2007, for instance, the Federal Reserve
decreased the federal funds rate and the discount rate on loans between banks by a
quarter of a percentage point to ease credit conditions. Then, on December 12, 2007,
the Federal Reserve announced that it would make $40 billion and perhaps more
available to commercial banks in short-term loans to ease domestic liquidity issues
and another $24 billion available to European central banks that had become so
concerned about potential losses from U.S. mortgage-backed securities that they had
begun to hoard cash and were unwilling to make loans to each other except at

unusually high interest rate premiums.¹⁸ Such willingness on the part of the Federal
Reserve to intervene in the financial markets to ensure stability likely makes a
prolonged financial crisis arising from a liquidation of financial assets by one foreign
investor or a group of foreign investors unlikely, even if those investors are foreign
governments.

¹⁸ Federal Reserve Press Release, December 12, 2007; Irwin, Neal, “Fed to Team With
Central Banks on Credit,” The Washington Post, December 12, 2007; Norris, Floyd, and
Vikas Bajaj, “Fed Joins Other Banks to add Cash,” The New York Times, December 12,

2007.