International Capital Flows Following the September 11 Attacks

CRS Report for Congress
Received through the CRS Web
International Capital Flows Following the
September 11 Attacks
James K. Jackson
Specialist in International Trade and Finance
Foreign Affairs, Defense, and Trade Division
A major concern following the terrorist attacks on New York and Washington was
that foreigners would curtail their purchases of U.S. financial assets and reduce the total
inflow of capital into the U.S. economy, thereby weakening the value of the dollar. The
Federal Reserve moved aggressively on its own and in tandem with other central banks
at an unprecedented level to avert a potential crisis in the markets. These efforts were
largely successful: by year-end U.S. equity markets slowly recovered their pre-attack
values; and the exchange rate value of the dollar returned to its pre-attack rate after
fluctuating within a fairly narrow range. Data also indicate that capital outflows were
higher than normal for the month of September, but panic selling of U.S. assets did not
occur. This report will be updated as warranted.
The September 11 attacks on New York and Washington struck at the heart of the
U.S. financial center, disabling some stock and equity markets for a short time. These
attacks raised concerns about the ability of the markets to absorb the shock and about the
prospects that foreign investors would curtail their purchases of U.S. financial assets and
reduce the inflow of capital into the U.S. economy, thereby weakening the value of the
dollar. Although a decline in the value of the dollar would have benefitted export-sensitive
and import-competing industries in the economy, it likely also would have pushed up
interest rates and had a negative impact on such interest-sensitive industries as autos and
housing. International flows of capital around the world have grown dramatically over the
last decade. These flows exercise a primary influence on exchange rates and global flows
of goods and services. They also allow the United States to finance its trade deficit
because foreigners are willing to lend to the United States in the form of exchanging the
sale of goods, represented by U.S. imports, for such U.S. assets as stocks, bonds, and U.S.
Treasury securities.
The dollar is heavily traded in financial markets around the globe, at times playing the
role of a global currency. Disruptions in this role have important implications for the

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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. Recent data indicate that the daily trading of foreign
currencies totals more than $1.2 trillion, or more than the annual amount of U.S. exports
of goods and services. The data also indicate that 90% of the global foreign exchange1
turnover is in U.S. dollars.
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 market2 averages $254 billion; similar transactions in the U.S.34
foreign exchange derivative markets averages $135 billion. Foreigners also buy and sell
U.S. corporate bonds and stocks and U.S. Treasury securities. Foreigners now own 20%5
of the total amount of outstanding U.S. Treasury securities held by the public. In 2000
(the latest year for which complete data are available), the foreign direct investment inflow
into U.S. businesses reached nearly $300 million, or over 16 percent of total gross private
investment of $1.7 billion. In addition, foreign investors acquired an additional $500
million in U.S. corporate bonds and stocks.
A comprehensive set of data on capital flows, represented by purchases and sales of
U.S. government securities and U.S. and foreign corporate stocks, bonds, into and out of6
the United States is collected by the Treasury Department on a monthly basis. These data
indicate that in September 2001, capital flows out of U.S. capital markets were slightly7
higher than normal. These capital flows were in the form of a statistically significant
decline in foreigners’ net purchases of U.S. government and corporate bonds and an
increase in Americans’ net purchases of foreign stocks and bonds. While the attacks on

1 Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2001;
Preliminary Global Data. Bank for International Settlement, October 2001. p. 2-4. A copy of
the report is available at: []
2 Defined as foreign exchange transactions in the spot and forward exchange markets and foreign
exchange swaps.
3 Defined as transactions in foreign reserve accounts, interest rate swaps, cross currency interest
rate swaps, and foreign exchange and interest rate options.
4 The Foreign Exchange and Interest Rate Derivatives Markets Survey: Turnover in the United
States. The Federal Reserve Bank of New York, April, 2001. p. 1. A copy of the report is
available at: []
5 Treasury Bulletin, December 2001. Table OFS-2. p. 56.
6 These data are available through the World Wide Web at Treasury Department’s Treasury
International Capital (TIC) reporting site: []
7 These results were derived at the 95% confidence level for monthly data from January 2000 to
September 2001.

September 11 likely were a factor in the shift of some of these capital flows,8 it is
impossible from the data alone to separate out the effects of the attacks from other events
that might have caused investors to pare back their accumulation of some dollar-
denominated securities. The attacks of September 11 added to existing concerns about
the course of the economy over the next year. Following the attacks:
!Currency traders quickly forged a voluntary “gentleman’s agreement” not
to profit from the event, which helped stabilize the value of the dollar,
measured against a broad range of currencies. By September 14,
however, the agreement had faltered as currency speculators began
driving down the value of the dollar.9
!The Federal Reserve, concerned about the prospects of a panic in
international financial markets, coordinated actions among central bankers
and financial ministers around the globe to ensure the smooth operation
of the international financial markets. These actions included an infusion
of liquidity by the Federal Reserve of about $40 billion10 and a roughly
equivalent amount by the European Central Bank and coordinated
intervention in the foreign exchange markets on at least two occasions by
the Federal Reserve, the European Central Bank, and the Bank of Japan
to support the value of the dollar.11 Federal Reserve officials also
signaled to U.S. banks that they would suspend temporarily some U.S.
bank regulations in order to provide U.S. credit markets with needed
liquidity, adding to other efforts to stem market uncertainty concerning
liquidity and settlement problems associated with the Bank of New
York.12 Two weeks after the attacks, the dollar had declined 3% against
the euro and 3.6% against the yen as foreigners’ demands both for dollars
and for some U.S. financial assets waned.
!The Bank of Japan intervened in foreign currency markets on five
instances between September 11 and September 27 by buying dollars to
stop the rise in the value of the yen. These efforts were undermined

8 Phillips, Michael M., Michael R. Sesit, and Silvia Ascarelli, Foreign Investors, Jittery Over
Holdings, Begin Pulling Some Funds From the U.S. The Wall Street Journal, September 26,

2001. p. B 14.

9 Downey, Jennifer, and Grainne McCarthy, Dollar Movement is Limited on Decision by Traders
Not to Overact to Attacks. The Wall Street Journal, September 13, 2001. p. C 2.
10 U.S. Financial Data, Federal Reserve Bank of St. Louis, October 4, 2001. p. 2-4.
11 Ip, Gregg, G. Thomas Sims, and Paul Beckett, Fed Pumps Cash to Bank System to Help Meet
Spiking Demand. The Wall Street Journal, September 13, 2001. p. C-1.; Ip, Gregg, and Paul
Beckett, Fed Acts to Bolster Banks at Home and in Europe. The Wall Street Journal, September
14, 2001. p. A 2.; Hardy, John, Dollar Rises on More Central Bank Intervention. The Wall Street
Journal, September 28, 2001. p. C 13; Ip, Greg, and Jim VandeHei, Economic Front: How Policy
Makers Regrouped to Defend the Financial System. The Wall Street Journal, September 18, 2001.
p. A 1; Cool Heads at the Central Banks. Financial Times, October 1, 2001. p. 2.
12 Raghavan, Anita, Susan Pulliam, and Jeff Opdgke, Team Effort: Banaks and Regulators Dew
Together to Calm Markets After Attack. The Wall Street Journal, October 18, 2001. p. A 1.

partially by Japanese firms that were repatriating some U.S. holdings to
shore up their cash balances to meet financial reporting deadlines on
September 30.13
!The Federal Reserve lowered key interest rates by one half a percentage
point on September 17 and on October 2: the one-point drop in rates left
the federal funds rate at 2.5 percent and the bank discount rate at 2.0%,
the lowest those rates had been since 1962. The drop in rates on
September 17 was followed by other central banks, including the
European Central Bank, the Bank of Canada, and the Swedish central
bank.14 The Swiss central bank lowered its interest rates to stop the Swiss
franc, which had been targeted by some investors fleeing from dollars,
from appreciating further. The following day, the Bank of England cut
interest rates by one-quarter of a percentage point. At the European
Central Bank’s bi-monthly meeting on September 27, the Bank decided
to keep its interest rates unchanged at 3.75%. A similar action by the
Bank on October 25 sparked a large sell-off of corporate stocks in
Europe and strengthened foreign demand for dollar-denominated assets.15
Panic selling of dollar-denominated assets did not occur, as some had feared,
following the September 11 attacks. In many respects currency and financial markets
remained more steady than many had expected and regained their pre-attack levels within
weeks. By mid-October, investors had discounted the effects of the attacks and had
turned firmly toward the dollar, which recovered its pre-September 11 rates against the
yen and the euro.16 While some foreigners reduced their dollar asset holdings immediately
following the attacks due to concerns about the safety and profitability of such
investments,17 other investors showed continued interest in dollar-denominated assets.
Issues of high quality, investment grade corporate bonds and auctions for Treasury
securities after September 11 went smoothly with strong sales pushing up prices of
benchmark 10-year Treasury securities.18 Initially, this demand stemmed from expectations
that the Federal Reserve would lower key benchmark interest rates by another one-half
percentage point on October 2. The price of a bond is inversely related to the interest rate,
so lowering interest rates raises the price, making the bond more valuable. On October

4, the Treasury Department took the unprecedented move of holding an unscheduled

13 Zaun, Todd, Japan Steps in Again to Damp Yen, Ease Lot of its Exporters. The Wall Street
Journal, September 26, 2001. p. A 10; Hardy, John, Dollar Rises on More Central Bank
Intervention. The Wall Street Journal, September 28, 2001. p. C 13.
14 Sesit, Michael, and Michael Williams, Europe, Canada Reduce Rates After Fed’s Cut; Japan
Sells Yen. The Wall Street Journal, September 18, 2001. p. A 14.
15 Karmin, Craig, Frustrated Investors Trigger Massive Stock Sale As Europe’s Central Bank
Leaves Rates Unchanged. The Wall Street Journal, October 26, 2001. p. C 11.
16 McCarthy, Grainne, Dollar Climbs Against Euro and the Yen. The Wall Street Journal, October

12, 2001. p. C 13.

17 McGee, Suzanne, and Kara Scannell, Trying Hard, A Few Companies Raise Cash. The Wall
Street Journal, September 28, 2001. p. C 1;
18 Parry, John, New Signs of Economic Weakness and Abatement of Price Pressures Set Stage for
Treasury Rally. The Wall Street Journal, September 28, 2001. p. C 15.

auction of 10-year Treasury bonds to avert a breakdown in one part of the financial
markets that had been disrupted by the terrorist attacks from spilling over to other
markets. 19
The lack of action by the European Central Bank in lowering key interest rates and
poor economic performance of other economies further strengthened foreign demand for
dollar-denominated assets. In addition, the events of September 11th demonstrated that
in times of crisis, investors still seem to prefer the U.S. dollar-denominated bond market
to its euro counterpart. During the three weeks following the attacks, not a single
corporation sold a bond in euros, while issues of corporate bonds in the U.S. market fell
by only a third below its average. A recent report by the European Commission states that
the shift toward dollar-denominated assets in times of crisis reflects “the relative strength
and resilience of the U.S. dollar as a financing currency in volatile market conditions.”20
Policy Analysis
Foreign investors appear to have shaken off their concerns about the effects of the
September 11th attacks on the U.S. economy and are focusing instead on other factors that
will affect the course of the U.S. economy during the next year. Over the long run, the
underlying economic prospects for the U.S. and other nations will continue to determine
the overall international flow of capital. Foreigners are continuing to invest heavily in U.S.
corporate bonds and a rally in U.S. stock markets could draw foreign investors back into
buying these securities. Foreigners’ direct investments to acquire U.S. businesses and real
estate also held up well in the first half of 2001, although such investment activity is not
expected to match the record-setting performance of the previous year. Of more
immediate concern, however, is the impact a U.S. economic downturn, aggravated by the
events of September 11, will have on the global economy. The United Nations released
a forecast on October 10, 2001 for the world economy in the year ahead that was more
pessimistic than previous reports. According to the report, this added pessimism stems
from a slowdown in foreign investment in and capital flows to developing economies.
Investments in U.S. Treasury securities declined markedly over the past year due to
the large federal government budget surpluses, which were used, in part, to retire Treasury
securities. As the surpluses shrink and new Treasury securities are issued, they are
expected to be desired. Such securities continue to be perceived by most investors as
among the most secure in the world. Moreover, the overall monetary, fiscal, and
regulatory framework of the U.S. economy is perceived by most investors as being the
best combination for providing the most attractive overall investment climate in the world,
despite the current weakness in the economy. Currency analysts expect the dollar to trade
lower both in the near term and over the next year. One additional complication will be
the effects of the introduction of the euro, which took place on January 1, 2002. Although
the euro strengthened against the dollar over the summer, concerns are growing over the
disruptions that could arise from the move to full implementation of the euro.

19 Ip, Greg, Treasury Sale Averts a Crisis in ‘Repo’ Market. The Wall Street Journal, October

5, 2001. p. C 1.

20 Sims, G. Thomas, In Crisis, Bond Investors, Issuers Seem to Prefer to Deal in Dollars. The Wall
Street Journal, October 23, 2001. p. C 16.

Options and Implications for U.S. Policy
The September 11 attacks dealt a major challenge to the U.S. economy and to
policymakers around the world. Financial and foreign exchange market activities were
slightly out of the norm the first few weeks following the attacks, but actions by the
Federal Reserve and by other central banks helped head off a financial panic and a loss of
confidence by ensuring that the financial system was supplied with liquidity through
coordinated actions. Central bank coordination in times of crises is not uncommon, but
the speed with which the coordination was reached and the aggressiveness of the banks
to stem any loss of confidence in the financial system are unusual. The high level of
coordination among central banks likely demonstrates the lessons they learned and the
techniques they developed by addressing other financial crises over the last two decades.
It likely also demonstrates the recognition that national economies have become highly
interconnected and that a shock to one creates spillover effects onto other economies and
The highly developed and broad-based nature of the U.S. financial system proved that
it could weather one of the worst blows in decades. Not even the aggressive actions by
the Federal Reserve, however, could anticipate or forestall all of the potential
repercussions. The Federal Reserve, for instance, performs a number of functions that,
although transparent to most market participants, are essential to the smooth operating of
the system by providing for the timely settlement of market transactions and for sufficient
financial resources, or liquidity. Disruptions to this process can create additional, and
potentially serious, problems in other financial markets that may not seem apparent at first
glance. The crisis also demonstrates that the financial markets are highly efficient at
processing information, a phenomenon which aids in spreading both good and bad news
quickly. As a result, the markets absorbed the impact of the September 11 events quickly
and likely moved on in a short time to assess the economic effects of other economic
events and other economic news. This means that the overall course of the U.S. economy,
rather than the events of September 11 likely determined the flows of capital into and out
of the United States through the remainder of 2001.
The fiscal stimulus provided to the economy by additional federal government
spending, combined with the measures taken by the Federal Reserve to lower interest
rates, are the most important U.S. policy factors affecting the flows of capital into and out
of the United States. The Federal Reserve moved aggressively following the terrorist
attacks to reassure investors and to demonstrate the strength of the U.S. economic system.
Congressional actions to reinforce that approach appear to have had a similar reassuring
impact on foreign investors, currency traders, and the domestic economy. Such actions
included the $40 billion Emergency Supplemental Appropriations for reconstruction and
defense (P.L. 107-38, September 18, 2001), and $15 billion to aid the airline industry.