This Selected Issues paper on the United States examines the effect of the structure of the mortgage market on real housing activity and housing prices. The market-based financial structure has reduced the volatility of mortgage lending. Changes in the structure of the mortgage market have coincided with lower volatility of real housing activity. Regional income growth and unemployment rates have statistically significant and correct signed effects on housing prices. Tests of the relative importance of mortgage market structure and macroeconomic variables suggest an important effect from the financial structure.

Abstract

This Selected Issues paper on the United States examines the effect of the structure of the mortgage market on real housing activity and housing prices. The market-based financial structure has reduced the volatility of mortgage lending. Changes in the structure of the mortgage market have coincided with lower volatility of real housing activity. Regional income growth and unemployment rates have statistically significant and correct signed effects on housing prices. Tests of the relative importance of mortgage market structure and macroeconomic variables suggest an important effect from the financial structure.

IV. A Global View of the U.S. Investment Position28

1. The rapid increase in the United States’ net foreign liabilities has raised questions about foreign investors’ willingness to continue to hold or acquire U.S. assets. Federal Reserve Board officials, among others, have noted that the decline in the U.S. net international investment position (NIIP) is not sustainable over a longer time period (Ferguson, 2005, and Greenspan, 2005). This view is partly related to concerns that global investment portfolios may by now contain excessive holdings of U.S. assets, and that the financing of the current account deficit has recently shifted from equity to debt instruments. Both trends are seen as potential triggers of a disorderly exchange rate adjustment that could have harmful effects on financial markets and real activity (Cline, 2005, and Obstfeld and Rogoff, 2004).

2. The paper analyzes various indicators of the U.S. NIIP from a portfolio perspective. It examines whether investment portfolios have become more or less internationally diversified over time, and whether the increase in foreign claims on the United States can be explained by the growth of U.S. financial markets or a decline in home bias. The share of foreign portfolio exposure to U.S. assets is compared to the benchmark share of U.S. assets in the world portfolio. The U.S. NIIP is also compared with that of other countries, including a breakdown by investment category and analysis of recent changes.

A. Measurement of Global Portfolio Shares

3. When measuring the degree of home bias in large countries, the size of domestic financial markets needs to be taken into account. The analysis starts from the assumption that, in order to maximize international risk sharing, the share of an investor’s portfolio dedicated to claims on a particular country will equal the country’s weight in the outstanding global financial stock.29 However, it is a well-documented fact that investors favor their domestic markets—this is termed “home bias”30. A standard measure of home bias that accounts for the size of the domestic financial market relative to the rest of the world is:

HomeBias=A*D/W-DW(1)

where A* represents domestic holdings of foreign assets, D is the size of the domestic market, and W is the size of the world financial market. The numerator measures the actual share of foreign assets in the portfolio, while the denominator measures what this ratio would be in a fully diversified world. A value of zero indicates no holdings of foreign assets, while a value of one indicates that the country’s portfolio is perfectly diversified from a geographic perspective. For small countries, the denominator in the above equation is close to one, and the results of the formula are close to those obtained by taking foreign assets as a share of investors’ portfolios. For large countries, however, the denominator is lower, and the difference between the simple share of foreign assets in investors’ portfolios and the above formula is larger. This implies that investors in countries with large financial markets—especially the United States—would be expected to hold a lower share of foreign assets and a higher share of domestic assets, reflecting the country’s greater weight in the global financial universe.

4. The paper analyzes the implications of home bias for NIIPs. Replacing A* in (1) with L*, for foreign holdings of domestic assets, gives a measure of the degree of home bias displayed by foreign investors toward a particular country:

ForeignInvestorsBias=L*D/W-DW(2)

This formula describes foreign investors’ bias from the perspective of the country issuing the liabilities in question. Combining (1) and (2), the overall internationalization of a country’s financial market, including both assets and liabilities, can be measured as:

Internationalization=12(A*+L*)D/W-DW* 100(3)

Similarly, the difference between (1) and (2) provides a measure of a country’s indebtedness scaled by the size of the domestic market:

Indebtedness=A*L*D/W-DW* 100(4)

5. Scaling the NIIP by the size of the domestic market facilitates an examination of indebtedness based on portfolio shares. The NIIP is typically stated as a ratio to GDP, combining a stock concept and a flow concept and focusing on a country’s ability to service its debt. Determining whether a negative NIIP is large relative to the domestic market reveals whether the already high exposure of foreign investors to domestic assets might constrain a further rise in indebtedness.

6. Data on international investment holdings and domestic financial market size are used to obtain measures for portfolio internationalization and net investment positions based on Equations (3) and (4).31 The size of domestic financial markets—taken to be equal to the stock of financial instruments outstanding—is estimated for 45 countries. However, data limitations restrict the analysis of foreign holdings of domestic financial instruments to 22 advanced economies.

7. Reflecting diverse and complex data sources, the results of the following analysis are necessarily subject to a number of caveats. Although the data are obtained from cross-country sources with standardized definitions, some important country-specific features may not have been captured and other problems remain:

  • The definition of domestic equity outstanding may not include the market value of issuance abroad by domestic corporations; data on financial stocks are not adjusted for derivatives or other complex instruments; and country surveys on international holdings cannot always ascertain the final ownership of a financial instrument, reflecting limits on data for custodial holdings.32

  • Data on international holdings tend to understate assets compared to liabilities, often resulting in an upward bias for net international indebtedness (Bertaut and Griever, 2004). This dataset confirms the bias toward net indebtedness.

  • Because the rate of return the United States earns on foreign claims exceeds the rate it pays on claims held by foreigners, the indebtedness concept overstates the economic burden of the United States’ negative NIIP (Cline, 2005).

  • Valuation changes pose a further complication in analyzing external imbalances and NIIPs, as they weaken the link between a country’s current account balance and the change in its NIIP (see Box 1).

B. Trends in Portfolio Internationalization

8. Possibilities for increased holdings of international assets have multiplied due to rapid financial deepening in the 1990s(Figure 1). In industrial countries, financial markets have deepened at a remarkable pace, with stocks of debt, equity, and loans expanding from around 300 percent of aggregate GDP in 1990 to around 450 percent in 2003, interrupted only temporarily by the bursting of the global equity market bubble. Despite the similarity in overall market size, the United States relies more heavily on debt and equity financing, and less on bank financing, reflecting the larger role of U.S. securities markets in financial intermediation.

Figure 1.
Figure 1.

Industrial Countries: Financial Deepening, 1990–2003

(In percent of GDP in U.S. dollars)

Citation: IMF Staff Country Reports 2005, 258; 10.5089/9781451839647.002.A004

Source: Fund staff calculations.

9. When adjusting for the size of the domestic financial market, the bias exhibited by foreign investors against U.S. assets and U.S. investors against foreign assets is slightly larger than for other countries. As shown in Figure 2, this is true for all investment types, with the overall gap widening recently. Countries with highly internationalized portfolios include centers of global finance (the United Kingdom and Switzerland), countries that receive large foreign investments (Ireland), and Norway, whose international holdings grew rapidly as a result of its accumulating oil wealth.

Figure 2.
Figure 2.

Internationalization of Assets and Liabilities, 1990–2003

Citation: IMF Staff Country Reports 2005, 258; 10.5089/9781451839647.002.A004

Source: Fund staff calculations.

Valuation Changes and the International Investment Position

This box examines the effects of valuation changes on the U.S. NIIP. The change in a country’s NIIP as a ratio to GDP can be calculated as:

Δniiptfat+vctNIIPt1 *gt

where fat is the financial account balance as a share of GDP (which is approximately the inverse of the current account balance), vct is the sum of valuation changes as a share of GDP, and gt is the growth rate of nominal GDP. BEA (2005) further decomposes valuation changes since 1990 into changes in the price of assets, exchange rate changes, and other valuation changes.

A04bx1ufig01

United States: Change in the Net International Investment Position, 1990 - 2003

Citation: IMF Staff Country Reports 2005, 258; 10.5089/9781451839647.002.A004

Since 1990, net valuation changes have eased the impact of financial flows on the NIIP(Figure). This is more than accounted for by large positive gains in 2002 and 2003. Valuation changes in those two years improved the NIIP by 7.2 percent of GDP, offsetting a large proportion of the 10.4 percent of GDP deficit in financial flows in 2002 and 2003. This is consistent with the findings of Gourinchas and Rey (2005), that valuation changes on the U.S. NIIP have tended to have a stabilizing effect on external imbalances.

The gains in 2002 and 2003 reversed small earlier losses, as the cumulative effect on the NIIP of valuation changes from 1990–2001 was a loss of about 1 percent of GDP (net valuation changes were also negative in the 1980s). Additionally, year-to-year persistence in valuation changes is low, with essentially no correlation between the change in one year and the next, implying that valuation changes have not been systematic.

A04bx1ufig02

United States: Impact of Valuation Changes and Growth Effects on NIIP, 1990–2003

Citation: IMF Staff Country Reports 2005, 258; 10.5089/9781451839647.002.A004

The importance of valuation changes in determining the NIIP has been increasing as gross positions rise(Figure). Without valuation changes, the expected correlation between a country’s current account balance and the change in its NIIP is 1, but in this dataset the correlation is only 0.1 (the correlation for the United States is also 0.1). Differences in the performance of domestic and foreign equity markets and movements in the exchange rate affect gross foreign assets in a different way than gross foreign liabilities, driving overall net valuation changes. For example, because U.S. foreign assets are mostly denominated in foreign currency and U.S. foreign liabilities in domestic currency, a depreciation of the dollar will boost the dollar value of U.S. asset holdings without changing the dollar value of U.S.liabilities, leading to an improvement in the NIIP. Tille (2003), for instance, shows that, even when the NIIP is balanced, a given change in the exchange rate will result in a larger change in the U.S. NIIP when gross positions are larger.

1 Although cumulative valuation changes resulting from asset prices and exchange rates were negative, other valuation changes were consistently positive throughout the period.

10. However, after adjusting for the size of the economy or of outstanding financial instruments, the internationalization of U.S. portfolio holdings is close to what would be predicted. The benefits of geographic portfolio diversification are lower for investors in an economy with more diverse activities and a greater variety of investment opportunities.33 Figure 3 shows that—using the size of the economy or depth of financial markets as proxies for economic diversity in simple linear regressions—these factors explain the lower degree of internationalization of the U.S. financial market.34

Figure 3.
Figure 3.

Internationalization and Country Size, 2003

Citation: IMF Staff Country Reports 2005, 258; 10.5089/9781451839647.002.A004

Source: Fund staff calculations.

11. Notwithstanding a rise in portfolio internationalization, rapid growth in global financial markets has been a larger contributor to the increase in foreign asset holdings.

Figure 4 (on the previous page) shows that holdings of foreign assets more than doubled as a share of GDP since the early 1990s. Portfolio internationalization also increased, but reached only one-and-a-half time the level it had in 1990, implying that growing domestic markets were responsible for a larger share of the growth in foreign holdings than the decline in home bias. The fastest-growing markets, in debt securities and equity, were also the markets becoming more internationalized during the period, perhaps adding to the perception that investors shifted a large proportion of their portfolios abroad.

Figure 4.
Figure 4.

Industrial Countries: Internationalization of Assets and Liabilities, 1990–2003

(1990 = 100)

Citation: IMF Staff Country Reports 2005, 258; 10.5089/9781451839647.002.A004

Source: Fund staff calculations.

12. However, the United States appears to have particularly benefited from a worldwide decline in the home bias to finance rising liabilities. Figure 5 decomposes the changes in U.S. holdings of foreign assets and foreign holdings of U.S. assets. On the liabilities side, growth in U.S. markets would have caused foreign holdings to increase from 42 percent of GDP to 64 percent of GDP since 1990. The increased propensity of foreign investors to hold U.S. assets added another 31 percent of GDP to U.S. liabilities, with about half the increase in debt securities. By contrast, the internationalization of U.S. asset portfolios has increased less strongly. Growth in foreign markets would have caused U.S. holdings to increase from 37 percent of GDP to 56 percent of GDP, with a fall in the home bias of U.S. investors contributing an additional 13 percent of GDP, mainly in equity and FDI.

Figure 5.
Figure 5.

United States: Foreign Liabilities and Assets, 1990–2003

(In percent of GDP)

Citation: IMF Staff Country Reports 2005, 258; 10.5089/9781451839647.002.A004

Sources: Bureau of Economic Analysis; and Fund staff calculations.

C. The U.S. International Investment Position

13. Global asset portfolios appear not to be significantly overweight in U.S. assets, relative to the United States’ benchmark share in an internationally diversified portfolio. The benchmark share is constructed taking into account the assets that investors in each country would maintain in domestic financial instruments. All other financial instruments are considered to be “diversifiable”, in that they would be owned by foreign investors in a world of complete geographic diversification. Given the degree of home bias shown in Figure 2, actual foreign portfolios are much smaller in size than “diversifiable” assets. Figure 6 examines whether, given this home bias, claims on the U.S. occupy a larger share of foreign portfolios than the benchmark the U.S. share of diversifiable assets is outstanding. By this metric, non-U.S. portfolios are underweight in U.S. equity/FDI and loans, and marketweight in U.S. debt securities. U.S. equity and FDI as a share of foreign portfolios peaked during the stock market boom in the late 1990s but has since fallen from slightly overweight to well underweight, while the portfolio share of U.S. loans increased steadily until falling back in the last two years. The share of foreign portfolios dedicated to U.S. debt securities peaked in 1997 and 2001 before declining more recently. These numbers give little indication that foreign absorption capacity of claims on the U.S. would be constrained in the near future.35

Figure 6.
Figure 6.

Share of U.S. Assets in Foreign Portfolios, 1990–2003

Citation: IMF Staff Country Reports 2005, 258; 10.5089/9781451839647.002.A004

Source: Fund staff calculations.

14. The U.S. NIIP is comparable to that of many other industrial countries, but appears unusually large given the tendency for larger countries to have lower absolute NIIPs(Figures 7 and 8). For small open economies, net foreign assets or liabilities can often be large relative to the size of their domestic financial markets. For example, Australia and New Zealand report high levels of net indebtedness, amounting to over 30 percent of the outstanding stock of domestic investments. However, larger countries such as the G-7 generally maintain NIIPs—either positive or negative—closer to balance, given that it is more difficult for countries with large financial markets to run up a large NIIP relative to market size. This negative relationship is depicted in the downward sloping line in Figure 8. The figure suggests that the absolute size of the U.S. NIIP is much larger than expected—although less so when accounting for foreign reserve holdings. This result holds even if the United States and Japan are excluded from the regressions.

Figure 7.
Figure 7.

Industrial Countries, Net International Position by Type of Investment, 2003

(In percent of diversifiable assets)

Citation: IMF Staff Country Reports 2005, 258; 10.5089/9781451839647.002.A004

Source: Fund staff calculations.
Figure 8.
Figure 8.

Absolute Net International Investment Position and Country Size, 2003

Citation: IMF Staff Country Reports 2005, 258; 10.5089/9781451839647.002.A004

Source: Fund staff calculations.

15. The U.S. NIIP has deteriorated since 1990. The NIIP has moved from a negative position of 3 percent of U.S. market value to 9 percent in 2003, and appears poised to fall further due to continued current account deficits. Most other industrial countries’ positions improved during this period, with only Germany, Greece, and the Netherlands also having a worsening NIIP.

16. In particular, the U.S. position in debt securities is weaker than in other investment classes, and is deteriorating(Figure 9). Both the net equity and FDI position, which is slightly positive, and the net loan position, which is slightly negative, are near the average for industrial countries (see Figure 7). However, the net debt securities position has fallen to 25 percent of the outstanding market from 13 percent in 1990. This is significantly larger than the industrial country average of 11 percent. The decline appears to have been driven mainly by an influx of foreign investors into U.S. debt securities, as the position would have been broadly stable if the degree of home bias had remained at 1990 levels (Figure 10).36

Figure 9.
Figure 9.

United States, International Asset and Liabilities Positions, 1990–2003

(In percent of diversifiable assets)

Citation: IMF Staff Country Reports 2005, 258; 10.5089/9781451839647.002.A004

Source: Fund staff calculations.
Figure 10.
Figure 10.

United States, Net International Positions, 1990–2003

(In percent of GDP)

Citation: IMF Staff Country Reports 2005, 258; 10.5089/9781451839647.002.A004

Sources: Bureau of Economic Analysis; and Fund staff calculations.

17. The U.S. dollar’s reserve currency status accounts for some of the negative U.S. debt securities position, but the recent deterioration has mainly been in non-reserve items. At end-2003, Treasuries held as international reserves accounted for over 20 percent of all Treasuries held by the public, and 8 percent of agency bonds were also held as reserves (up from 11 percent and 1 percent, respectively, in 1990). Excluding reserves, the U.S. had a net debt securities position of -6 percent of the outstanding market in 1990 and -16 percent in 2003. Debt securities excluding reserves thus accounted for 10 percentage points of the 12 point deterioration in the net debt securities position over the period, while reserves only accounted for 2 percentage points.

D. Conclusions

18. The U.S. has experienced the same trends toward financial deepening and internationalization of portfolios as other industrial countries. U.S. markets remain less internationalized than other countries, even adjusting for the U.S.’s large share of the global market. The difference can be explained by the United States’ greater variety of economic activities—it is not as necessary for U.S. investors to diversify their portfolios by investing abroad as it would be for investors in a country with a smaller assortment of economic activity.

19. Global portfolio data gives mixed signals regarding foreigners’ exposure to U.S. assets, and the decline in the U.S. net debt position could be a cause for concern. On the positive side, an examination of foreign portfolios confirms that they contain about the expected proportion of U.S. assets, and measures for U.S. indebtedness rank near the middle of industrial countries in most asset classes. That said, the U.S. NIIP is weaker than would be expected given the size of the U.S. economy and financial markets, even if international reserves are included in the analysis, and its net debt securities position is particularly large. The overall NIIP and the net debt securities position are also deteriorating rapidly, and the large current account deficit implies that foreign claims on the United States will continue to mount.

APPENDIX: Data

  • Domestic equity market capitalization: for most countries, from the World Federation of Exchanges, which standardizes across countries and excludes the capitalization of foreign companies listed on an exchange; the value of mutual funds and similar shares; and options, futures, and derivatives. Additional data sources are: Datastream; the IMF’s Global Financial Stability Report; Meridian’s World Stock Exchange Fact Book; and Standard and Poor’s Emerging Stock Markets Fact Book.

  • Debt securities outstanding: from the Quarterly Review of the Bank of International Settlements, Tables 12A and 16A.

  • Domestic stock of loans outstanding: where available, from the OECD’s National Accounts Volume IIIB, spliced with data from the IMF’s International Financial Statistics(IFS) for missing observations in the former dataset. Data for non-OECD members were taken mainly from the IMF’s Money and Banking Database, which is based on raw data used in the IFS. Additional data were taken from IFS and, for Chile, China, the Czech Republic, Hong Kong SAR, Peru, and Taiwan Province of China, from published national sources. Data were converted to U.S. dollars using exchange rates from IFS.

  • Foreign holdings of financial instruments: Data on the international holdings of financial instruments were kindly provided by Philip Lane and Gian Maria Milesi-Ferretti (see Lane and Milesi-Ferretti, 2005a). These combine official data on international investment positions with estimates of external assets and liabilities based on balance of payments flows and various other sources, with appropriate valuation adjustments based on equity price fluctuations and exchange rate changes. For a description of the methodology see Lane and Milesi-Ferretti (2001).

Table 1.

List of Countries 1/

article image

Italics indicate countries for which international holdings data were analyzed. Non-italicized countries were only included in the totals for global financial stocks.

References

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28

Prepared by Andrew Swiston.

29

See Karolyi and Stulz (2002) for a model and survey of the literature.

30

Bertaut and Kole (2004) and Sorenson and others (2005) present recent data on home bias.

31

The data used for this paper are described in the appendix.

32

See Griever, Lee, and Warnock (2001) for an in-depth examination of U.S. data on international financial holdings.

33

Errunza and others (1999) show that the benefits of international diversification can be emulated by holding equity in domestically-based multinational corporations. To the extent that this type of firm is more prevalent on U.S. equity markets than those in other countries, this would further reduce U.S. investors’ need for geographic portfolio diversification relative to investors of other countries.

34

The results hold true even in regressions excluding the United States and Japan.

35

This measure may understate the share of U.S. equities that are truly “diversifiable”, as Bertaut and Kole (2004) and Dahlquist and others (2003) find that the share of U.S. equities in the global portfolio available to most investors is even higher when using float-adjusted market capitalization (equity not held by controlling shareholders).

36

The only variation in the lines labeled “At 1990 level of internationalization” is due to the changing weights of each asset class in U.S. and global financial stocks.

United States: Selected Issues
Author: International Monetary Fund
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    Industrial Countries: Financial Deepening, 1990–2003

    (In percent of GDP in U.S. dollars)

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    Internationalization of Assets and Liabilities, 1990–2003

  • View in gallery

    United States: Change in the Net International Investment Position, 1990 - 2003

  • View in gallery

    United States: Impact of Valuation Changes and Growth Effects on NIIP, 1990–2003

  • View in gallery

    Internationalization and Country Size, 2003

  • View in gallery

    Industrial Countries: Internationalization of Assets and Liabilities, 1990–2003

    (1990 = 100)

  • View in gallery

    United States: Foreign Liabilities and Assets, 1990–2003

    (In percent of GDP)

  • View in gallery

    Share of U.S. Assets in Foreign Portfolios, 1990–2003

  • View in gallery

    Industrial Countries, Net International Position by Type of Investment, 2003

    (In percent of diversifiable assets)

  • View in gallery

    Absolute Net International Investment Position and Country Size, 2003

  • View in gallery

    United States, International Asset and Liabilities Positions, 1990–2003

    (In percent of diversifiable assets)

  • View in gallery

    United States, Net International Positions, 1990–2003

    (In percent of GDP)