Subprime fallout may sour foreigners on U.S. debt

Subprime fallout may sour foreigners on U.S. debt

http://www.reuters.com/article/reutersEdge/idUSN2343968420070823

Thu Aug 23, 2007 4:36PM EDT
By Emily Kaiser - Analysis

WASHINGTON (Reuters) - Burned by fallout from the troubled U.S. mortgage market, foreign investors may be less willing to cheaply finance towering American debt, forcing up borrowing costs and threatening U.S. economic growth.

European investors in particular have been feasting on U.S. corporate debt issues, and the strong demand has helped to keep the cost of credit low. Some analysts worry that investors, suddenly risk-averse after the subprime mortgage mess shone a spotlight on lax lending practices, will demand fatter returns.

"We have to wonder whether foreigners will retrench from U.S. corporate debt, which has been financing more than half of the U.S. trade deficit," strategists from Societe Generale wrote in a note to clients.

The U.S. trade deficit for the first half of 2007 stood at $391.3 billion, after a record $818.1 billion last year.

To cover the deficit, the U.S. economy needs to attract more than $2 billion a day in investment, which has not been a problem to date as countries with big trade surpluses, such as the oil exporters and China, stock up on U.S. securities.

That has enabled U.S. consumers to keep spending freely, but concerns are growing that the gravy train may soon slow.

Fred Bergsten, director of the Peterson Institute for International Economics in Washington, said that even before the subprime mortgage problems, there were signs that global appetite for U.S. investment was waning as growth accelerated in other regions such as Europe, and key creditors diversified their holdings away from the U.S. dollar.

"The real issue is, What is the impact of all this ... on U.S. monetary policy and the U.S. economy?" he said.

Bergsten sees the potential for a "self-reinforcing risky cycle" where the U.S. Federal Reserve lowers the benchmark interest rate to shore up financial markets, and the U.S. economy slows because of the slumping housing sector, deflecting foreign investors and driving down the dollar.

The weak dollar in turn pushes up inflation, pressuring the central bank to raise interest rates rather than cut them.

HOLDING THE BAG

The credit concerns that have rocked global financial markets in recent weeks have already soured investors on commercial paper, a form of debt that companies use for short-term financing.

Commercial paper outstanding dropped by $90.2 billion in the week ended August 22, following a record $91.1 billion decline the week before, according to Federal Reserve data.

U.S. companies had enjoyed years of cheap, open access to capital, much of it provided by foreign lenders, and that has helped to fuel U.S. expansion and corporate profits.

According to Societe Generale research, European investors bought about $335 billion in U.S. corporate debt in the past 12 months. Some of those purchases included debt linked to troubled subprime mortgages.

Several European banks have disclosed that they held subprime-related debt, and investors remain on edge, waiting for the next confession.

'FIRE DRILL'

Despite the credit turmoil, the United States boasts the world's deepest capital markets and will still attract foreign money, albeit at a price, said Kenneth Rogoff, an economics professor at Harvard University and former chief economist at the International Monetary Fund.

"There are not that many places to go if you want to buy credit, but it will certainly have an impact on how much we're going to pay to borrow," he said.

Economists have long warned that a soaring current account imbalance threatened to tank the U.S. dollar and gobble up a growing portion of cash if debt servicing costs rose.

Some see an inherent risk in the fact that the key buyers of U.S. assets include oil exporters and China -- countries that have had strained relationships with the United States at times. If those countries dumped their dollar-based holdings, it could wreak havoc on the U.S. financial system.

The silver lining is that the U.S. trade gap has narrowed recently as the U.S. economy slows while the rest of the world picks up, but Rogoff said it was still too early to determine how the credit problems would affect the balance.

He called the latest bout of market unrest a "fire drill and not a full-blown crisis," but added that it should serve as a warning about how vulnerable the debt-laden U.S. economy is to a global downturn.