WhyFrgnrsInvestInTheUS Forbes 2010

Journal of International Economics 80 (2010) 321
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Journal of International Economics

j o u r n a l h o m e p a g e : w w w. e l s ev i e r. c o m / l o c a t e / j i e
Why do foreigners invest in the United States?

Kristin J. Forbes
MIT-Sloan School of Management, United States
NBER, United States
a r t i c l e
i n f o
Article history:
Received 30 June 2008
Received in revised form 2 September 2009
Accepted 3 September 2009
Keywords:
Home bias
Foreign investment
Portfolio ows
Capital ows
U.S. current account decit
Global imbalances
Financial development
Return chasing
a b s t r a c t
Why are foreigners willing to invest over $2 trillion per year in the United States? This paper tests various
hypotheses and nds that standard portfolio allocation models and diversication motives are poor
predictors of foreign holdings of U.S. liabilities. Instead, foreigners hold greater shares of their investment
portfolios in the United States if they have less developed nancial markets. The magnitude of this effect
decreases with income per capita. Countries that trade more with the United States also have greater
portfolio shares in U.S. equity and bond markets. These results support recent theoretical work on the role of
nancial development in sustaining global imbalances and have important implications for whether the
United States can continue to attract sufcient nancing from abroad without major changes in asset prices
and returns, especially in bond markets.
2009 Elsevier B.V. All rights reserved.
JEL classication:
F2
F3
F4
G1
1. Introduction
The causes and implications of global imbalances have recently
been a major focus of the academic literature in international trade
and nance. One of the most contentious aspects of this literature is
whether the current system of large global imbalances can continue.
Most traditional models suggest that this system will not persist
because the United States must stabilize its external debt ratios and
part of this adjustment will involve a large dollar depreciation
(Obstfeld and Rogoff, 2007; Blanchard et al., 2005). A more recent
series of papers argues that this system of imbalances could continue
for an extended period due to factors such as: differences in nancial
market development that make U.S. assets more attractive (Caballero
et al., 2008; Mendoza et al., 2006; Ju and Wei, 2006), a persistent
return differential between U.S. and foreign asset holdings (Gourinchas and Rey, 2007; Lane and Milesi-Ferretti, 2007a), or even dark
matter (Hausmann and Sturzenegger, 2006). A focus of several
papers is the key role of the U.S. nancial market in attracting foreign
capital especially its size, liquidity, efciency and range of
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URL: http://web.mit.edu/kjforbes/www.
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doi:10.1016/j.jinteco.2009.09.001
innovative instrumentscharacteristics that were perceived to be

strengths before 2008. Which side of this debate is correct has
important implications for the global nancial system, capital ows,
asset prices, and interest rates, as well as for how the corresponding
global imbalances adjust after the 2008 nancial turmoil.
Although discussions of global imbalances traditionally focused on
trade ows and savinginvestment imbalances, more recent attention
has focused on the corresponding capital ows. Gross capital ows
into the United States totaled $7.8 trillion over the 5 years from 2003
through 2007, increasing each year to just over $2 trillion in 2007.1
These capital inows balanced $1.3 trillion of U.S. capital outows and
the U.S. current account decit of $731 billion in 2007. Why are
foreigners willing to invest an average of well over $5 billion every
day in the United Statesespecially given relatively low returns
relative to comparable investments in other countries and an
expectation of dollar depreciation? Moreover, despite the increased
role of government institutions in U.S. capital inows, 81% of U.S.
external liabilities were held by the private sector at end-2007.
Understanding the motivation behind the millions of individual
Data from Bureau of Economic Analysis (2008).
K.J. Forbes / Journal of International Economics 80 (2010) 321
decisions that drive these capital inows is critically important to

understanding if this massive net transfer of capital into the United
States can last. The stability of these capital inows is generally
believed to be the greatest vulnerability to the current system of
global imbalances.
This paper attempts to explain why foreigners, and especially
private-sector investors, are willing to invest such large amounts of
money into the United States. It focuses solely on the drivers of foreign
capital ows into the United States and does not analyze the drivers of
U.S. capital outows or the corresponding net capital ow position
corresponding to the U.S. current account decit. The paper begins by
documenting who holds U.S. portfolio liabilities and shows that
foreigners have earned substantially lower returns on their U.S.
investments over the past 5 years than U.S. investors have earned
abroad, even after removing the effects of exchange rate movements
and ofcial sector investments. This return differential against
foreigners even exists within individual asset classes (equities, foreign
direct investment, and to a lesser extent, bonds) and after making
rough adjustments for risk. A simple analysis also shows that standard
portfolio allocation models do a poor job explaining patterns of
foreign investment in the United States.
There are, however, a number of reasons why foreigners in the private
sector would invest in the United Statesdespite earning relatively low
returnsthat are not incorporated in these simple portfolio allocation
models. For example, factors such as a country's nancial market
development, capital controls, corporate governance and institutions,
return correlation with the United States, distance and informational links,
and trade ows could affect its investment decisions. To test the validity of
these different theories, this paper builds on the literatures on home bias,
the allocation of investment across countries, and the macroeconomic
determinants of global imbalances. It uses annual information on foreign
holdings of U.S. equities and bonds and essentially runs a horse race to
evaluate the predictions from the various theoretical models and existing
empirical work.
This analysis is different from earlier work in this literature in
three ways. First, this paper is the only analysis that focuses on the
determinants of foreign investment into only the United States in
order to focus on its unique role in attracting foreign capital ows.
Most other work focuses on the global determinants of international
asset positions (such as Lane and Milesi-Ferretti, 2008; Bertaut and
Kole, 2004) and/or net capital ows for each country (which also
implicitly incorporates determinants of U.S. investment abroad, e.g.,
Gruber and Kamin, 2008). Second, this paper focuses on all types of
portfolio investment, as compared to most of the empirical work
which only focuses on equity owsdespite the greater importance of
debt ows.2 It also includes information on all types of investors
(including mutual funds, hedge funds, pension funds, life insurance
companies, and government agencies), as compared to some work
which only focuses on specic investors (usually mutual funds).
Finally, this paper focuses on what drives foreign individuals and
companies to invest in the United States, as well as on the
macroeconomic determinants of capital ows, combining what have
been different literatures.
The empirical results suggest that a primary factor affecting both
equity and bond investment in the United States is a country's level of
nancial development. Countries with less developed nancial
markets tend to hold a greater share of their portfolios in the United
States, and the strength of this relationship is inversely related to a
country's income level. Simulations suggest that the magnitude of this
effect on foreign exposure to U.S. markets is moderate in equity
markets and more substantial in bond markets. This primary role for
nancial development supports a recent focus of the theoretical
2
From 2003 to 2007, 47% of U.S. gross capital inows was in the form of bonds,
while only 7% was in equities. Some exceptions to this focus on equity markets are
Burger and Warnock (2003) and Lane (2006), which only focus on bond markets.
literature on global imbalances. There is also strong evidence that

countries that trade more with the United States invest relatively
more of their portfolios in U.S. equity and debt markets, and countries
with fewer capital controls invest relatively more in U.S. equity markets.
Foreigners do not invest more in U.S. markets if returns in their own
markets are less correlated with the United States, providing little
support for a diversication motive for foreign investment.
This key result that the size, liquidity, and overall attractiveness of
U.S. nancial markets have been signicant factors determining
patterns of foreign investment in the United States has important
implications for how the global economy adjusts to the crisis of 2008
and the evolution of global imbalances. Even though the crisis has
showed serious weaknesses in U.S. nancial markets, U.S. Treasuries
(and especially short-term U.S. T-Bills) were perceived by many
investors to be the safest and most liquid investment during this
tumultuous period. During the peak of the crisis in the second half of
2008, foreign demand for U.S. Treasuries remained strong, even
though the demand for other assets (including other U.S. assets)
plummeted. As the crisis abates, however, will U.S. nancial markets
continue to be perceived as the most attractive? Back-of-the-envelope
estimates suggest that if low- and middle-income countries develop
their nancial markets, this could lead to moderate sales of U.S.
equities and more substantial sales of U.S. debt. Finally, how will
changes in U.S. nancial regulations affect the relative attractiveness
of investing in the United States? If the crisis and policy responses
undermine the perceived advantages of U.S. nancial markets, this
could signicantly reduce foreign investment in the United States and
have important implications for the dollar, interest rates, asset
markets, and global imbalances.
The remainder of this paper is as follows. Section 2 discusses the
data on foreign investment in the United States, documents the return
differentials between these investments and U.S. investments abroad
and describes the variation in countries' exposure to U.S. markets.
Section 3 develops a model to structure the empirical analysis, links
this model to the existing literature, and discusses why foreigners
might invest in the United States. Section 4 mentions several
econometric issues and then presents empirical results on the
determinants of foreign exposure to U.S. equities. Section 5 presents
corresponding results for U.S. debt, including an analysis of the
differences between private and ofcial-sector investments. Section 6
describes simulations of what these results imply for foreign
investment in the United States and Section 7 concludes.
2. Background and data: foreign investment in the United States
This section discusses the paper's main data set and provides
background on foreign investment in the United States. It answers
three questions: Who invests in the United States? What returns have
foreigners earned from this investment? And have foreigners over-
or under- invested in the United States relative to the predictions of
standard portfolio models?
2.1. The data: who invests in the United States?
In order to measure foreign investments in U.S. equity and debt
markets, this paper primarily uses data from the Report on Foreign
Portfolio Holdings of U.S. Securities, compiled by the U.S. Department of
the Treasury, the Federal Reserve Bank of New York, and the Board of
Governors of the Federal Reserve System (hereafter referred to as
USG). It also performs sensitivity tests and augments the analysis
using a data set compiled by the International Monetary Fund, The
Coordinated Portfolio Investment Survey (hereafter referred to as IMF).3
3
See Forbes (2008), Appendix A and Griever et al. (2001) for details on the two data
sets.
Fig. 1. Largest holdings of U.S. portfolio liabilities in 2007. Notes: based on USG data released on 4/30/2008. Includes ofcial and non-ofcial sector holdings. * Bahrain, Iran, Iraq,
Kuwait, Oman, Qatar, Saudi Arabia and United Arab Emirates.
Both the USG and IMF data report foreign holdings of U.S. portfolio
liabilities broken down by country and security type on an annual
basis from 2000/2001 until 2007 and offer important advantages over
previous data sets. This is the rst time that an annual time series,
albeit still short, is available for international liability positions. Earlier
papers requiring annual information were forced to calculate
international holdings using accumulated ow data combined with
estimated valuation adjustments, which could lead to biased
estimates due to challenges such as tracking ows to their originating
country.4 Another advantage of these two data sets is that they
encompass holdings of U.S. liabilities by all types of private foreign
investors. In contrast, many other papers have focused only on mutual
fund investmentsthereby ignoring important investor groups such
as hedge funds, banks, pension funds, and insurance companies. One
shortcoming of both data sets, however, is that they do not include
foreign direct investment.5
The USG data provides information on the stock of foreign holdings
of U.S. equities and short- and long-term debt securities, including
reserves held by foreign ofcial institutions. Signicant penalties can
be imposed for non-reporting, so compliance and data quality are
believed to be very good. One concern with the data (as well as with
all data on international portfolio liabilities) is that it can over-report
the holdings of major nancial centers that are intermediaries for
transactions from other countries. This includes investment in mutual
funds, which then invest in foreign companies. 6 This misreporting
through third parties is less of a problem than in data on capital ows
and other data on international asset positions, but is still a concern
and is addressed in the sensitivity tests.
The USG sample includes information on $9.6 trillion of U.S. portfolio
liabilities in 2007, held by just over 200 countries/entities. Of these
liabilities, $3.1 trillion are equities and $6.4 trillion are debt securities.
Fig. 1 graphs the 25 largest reported holdings in 2007. The three largest
reported holdings of U.S. portfolio liabilities are Japan (with
$1,196 billion), China (with $922 billion) and the United Kingdom
(with $921 billion). The share of holdings between equity and debt also
varies signicantly across countries. For example, Japan holds 18%
equities and 82% debt, while Canada holds 73% equities and 27% debt.
The IMF data has several important differences from the USG data.
One major disadvantage is that it has more limited coveragewith 71
countries/entities and $8.0 trillion of U.S. portfolio liabilities in 2007
(versus over 200 countries/entities and $9.6 trillion in the USG data).
Several countries excluded from the IMF (but included in the USG)
data have large holdings of U.S. liabilities, such as China and the
Middle East oil exporters. Another disadvantage of the IMF data is that
it is collected by governments using different reporting standards and
therefore is not consistently measured across countries. Despite these
disadvantages, however, the IMF data is useful for sensitivity tests and
because it only includes private-sector investment (versus the USG
data which also includes the ofcial sector).7 Fig. 2 shows that foreign
ofcial entities held about 19% of U.S. foreign liabilities in 2007 and
were particularly important for bond markets.
2.2. What returns have foreigners earned from investing in the United
States?
A recent subject of heated debate in the academic literature has
been whether foreigners have earned high returns from investing in
the United States (Gourinchas and Rey, 2007; Cline, 2005; Lane and
Milesi-Ferretti, 2007a,b; Curcuru et al., 2008). Table 1 estimates
returns for all ofcial and private sector investors for a more recent
period than in these papersfrom 2002 through 2006ending
before the sub-prime crisis began in the United States.8 Although
See Griever et al. (2001).

Foreign direct investment is dened as a holding of at least 10% of the value of the
rm. Foreign direct investment was 14% of total U.S. liabilities in 2007, while equity
and debt liabilities were 52%.
6
McKinsey Global Institute estimates that mutual funds comprised about 19% of
global assets under management in 2006.
5
7
Both datasets include investment by government-sponsored investment funds
that do not constitute ofcial reserve holdings, such as sovereign wealth and pension
funds.
8
These calculations address the measurement issues raised in Curcuru et al. (2008).
Fig. 2. Based on data from Bureau of Economic Analysis (2008), Part A from U.S. International Transactions Table and Part B from International Investment Position table. Direct
investment at current cost.
the more recent data therefore allows a more precise test for the
impact of return chasing, (i.e., if foreigners tend to invest more in
the United States after markets in their own countries have
performed worse relative to U.S. markets), as well as a more
long-term return differentials are important in studying the

dynamics of the U.S. current account decit, investors are more
likely to base current asset allocation decisions on returns over
shorter periodssuch as the last 3 or even 1 year(s). Focusing on
Table 1
Returns on U.S. and foreign investments: 20022006 (in percent).
Source: Based on original data from the Bureau of Economic Analysis. See Forbes (2008) Appendix B for calculation details.
2002
2003
2004
2005
2006
Average returns
2002 6
Exclude ERc
Sharpe ratiod
Ofcial and private

sector investment
Private sector investment

Direct investmenta
Equities
U.S. assets
abroad
U.S. foreign
liabilities
U.S. assets
abroad
U.S. foreign
liabilities
U.S. assets
abroad
U.S. foreign
liabilities
U.S. assets
abroad
U.S. foreign
liabilities
U.S. assets
abroad
U.S. foreign
liabilities
4.9
21.2
12.6
9.9
17.4
5.5
10.5
5.8
2.6
8.0
10.6
33.8
19.8
14.6
24.0
18.8
21.9
8.8
3.5
12.5
16.0
40.7
19.4
17.0
25.8
21.8
28.0
11.5
4.9
15.6
14.6
9.6
4.8
0.4
5.0
9.3
6.0
5.6
0.7
5.1
8.9
32.7
15.1
12.1
20.7
4.2
13.7
8.0
2.4
9.5
11.2
8.6
0.68
4.3
4.0
0.02
16.3
12.9
0.72
5.6
5.6
0.08
17.4
12.0
0.62
Bondsb
7.6
7.6
0.18
6.7
4.9
0.41
All securities
(equities and bondsb)
5.3
4.6
0.31
14.3
9.9
0.65
5.9
5.4
0.21
Notes: Returns incorporate income receipts plus valuation changes (which include price changes and exchange rate movements). Private sector refers to non-ofcial positions for
foreign-owned assets in the United States.
a
Direct investment at market value.
b
Bonds include corporate, government and agency bonds.
c
Average returns exclude the impact of exchange rate movements.
d
The Sharpe ratio is a risk-adjusted performance measure, calculated as: (Ri Rf)/i with Ri the mean return for asset i; i the standard deviation of returns for asset i; and Rf the
risk-free interest rate (which is measured as the average interest rate on the 10-year U.S. Treasury bond over this period).
accurate calculation of returns for specic asset classes (for which

the requisite is not available in earlier years).9
Table 1 shows that foreigners earned an average annual return of
only 4.3% on their U.S. investments over the last 5 years, substantially
less than the 11.2% return that U.S. investors earned on their foreign
investments. The bottom of the table reports the Sharpe ratio for U.S.
and foreign investment and shows that these return differentials
continue to exist even after making this rough adjustment for risk. It
also shows that after removing the impact of the 19% depreciation of
the dollar over this period, foreigners investing in the United States
still earned less than half of what U.S. investors earned abroad from
2002 through 2006.10
One potential explanation for this lower rate of return for
foreigners is that a larger portion of foreign investment in the United
States reects ofcial investmentwhich may put a lower priority on
expected returns.11 A related explanation is that foreigners prefer
assets with lower volatility, despite lower expected returns, than U.S.
investors (Lane and Milesi-Ferretti, 2007a; Gourinchas and Rey,
2007). The right side of Table 1 adjusts for both of these effects
by reporting average annual returns on U.S. and foreign privatesector investments in FDI, bonds and equities from 2002 through
2006.12 The table shows that even within specic asset classes, private
investors from outside the United States earned signicantly lower
returns on their U.S. holdings than U.S. investors earned abroad. For
example, foreigners earned only 7.6% on their U.S. equity holdings
and 5.3% on their U.S. bonds, while U.S. investors earned 17.4%
and 6.7% abroad, respectively. For all portfolio securities, foreign
investors earned less than half of what U.S. investors earned abroad.
These return differentials continue to exist, especially for equity and
FDI, after making rough adjustments for risk and exchange rate
movements.
These return differentials should not be interpreted as evidence
that foreigners have made poor investments or that U.S. investors
are somehow better than foreign investors. Foreigners may choose
to invest in the United States for a range of reasons (discussed in
more detail in Section 3) other than to earn high returns. Moreover,
these recent return differentials largely reect the recent performance
of U.S. versus foreign equity and bond market indices, driven partially
by the depreciation of the dollar. The results do suggest, however, that
return chasing was probably not an important factor supporting
foreign investment into the United States.
2.3. Do foreigners over- or under-invest in the United States?
Using the data discussed in Section 2.1, it is possible to calculate a
measure of exposure by individual countries to U.S. equity and debt
securities. The USExposurei,j of country i to U.S. security j is:
USExposurei;j =
USInvestmentsi;j
;
TotalPortfolioi;j
where USInvestmentsi,j is total holdings of U.S. portfolio liabilities by

country i of security j from the USG or IMF data. TotalPortfolioi,j is the
For details on the calculations behind these returns, see Forbes (2008), Appendix B.
As shown in Forbes (2008), Appendix B, the main reason why this result differs
from Curcuru et al. (2008), which nds no signicant return differential, is the longer
time period in their paper.
11
Dooley et al. (2003) argue that foreign governments purchase U.S. assets to
maintain undervalued exchange rates and/or to accumulate highly liquid, low-risk
reserve assets.
12
The statistics include U.S. ofcial reserve assets, but these are only 1.6% of total U.
S.-owned assets abroad at year-end 2007 and should not signicantly affect return
calculations. Moreover, since U.S. ofcial holdings of foreign assets are very
conservative investments, this would generate a downward bias in these estimates
of U.S. returns on foreign investments.
Table 2
Foreign exposure to U.S. equity and debt markets in 2006.
Source: See Section 2 for details on calculation and data.
Equity USG data
Debt USG data
Paraguay
Costa Rica
Singapore
Venezuela
Netherlands
Botswana
Switzerland
Canada
New Zealand
Norway
Uganda
Denmark
Armenia
United Kingdom
Sweden
Mexico
Swaziland
Australia
Austria
Ecuador
Israel
Japan
France
Bolivia
Germany
27.8%
27.8%
26.4%
25.0%
22.4%
18.0%
15.2%
15.2%
12.1%
11.7%
10.3%
9.7%
8.9%
8.0%
7.6%
7.1%
6.8%
6.3%
5.7%
5.4%
4.9%
4.9%
4.4%
3.8%
3.7%
Mean
Median
Std. deviation
Minimum
Maximum
Observations
4.3%
1.3%
6.8%
0.0%
27.8%
82
El Salvador
Costa Rica
Jordan
China
Kazakhstan
Belgium
Latvia
Singapore
Mexico
Hong Kong
Macedonia
Colombia
Switzerland
Indonesia
Chile
Slovenia
Thailand
Poland
Ireland
Philippines
South Korea
Turkey
Malaysia
Canada
United Kingdom
Debt IMF data

67.1%
66.6%
60.0%
49.2%
48.4%
39.3%
38.3%
33.9%
29.4%
26.7%
26.3%
25.0%
18.7%
18.5%
17.6%
13.8%
13.6%
12.7%
12.6%
12.6%
11.5%
11.4%
10.1%
9.8%
9.4%
14.8%
9.1%
17.2%
0.1%
67.1%
54
Israel
Kazakhstan
Kuwait
Costa Rica
Bulgaria
Bahrain
Ireland
Chile
Uruguay
Hong Kong
Norway
United Kingdom
Colombia
Russian Federation
Singapore
Switzerland
Estonia
Canada
Sweden
Argentina
Australia
Japan
Netherlands
Venezuela
Philippines
80.8%
50.1%
34.8%
30.9%
29.8%
28.1%
19.3%
18.8%
15.8%
15.3%
13.0%
12.6%
9.8%
8.7%
8.6%
8.4%
8.2%
6.8%
6.7%
6.0%
5.9%
5.7%
5.5%
4.9%
4.6%
9.5%
4.3%
14.6%
0.0%
80.8%
51
entire portfolio holdings by country i of security j and is calculated as

total domestic market capitalization for country i of security j plus
total foreign assets held by country i of security j less all foreign
holdings of country i's liabilities of security j. Securities j can be either
equity or debt securities. Data on domestic market capitalization for
equities is taken from Standard and Poor's (2007) and for debt
securities is taken from the Bank of International Settlements.13 Data
on total foreign assets held by country i and foreign holdings of
country i's liabilities is taken from the IMF data for the corresponding
calculations. This data is not available in the USG data, so I use
estimates of foreign equity assets and liabilities provided by Lane and
Milesi-Ferretti (2007a) and foreign debt assets and liabilities reported
by the International Monetary Fund (2008).
I calculate USExposurei,j using the USG and IMF data for each type
of security and then drop extreme outliers (dened as values less than
0 or greater than 100%), the SEIFiCs, and Luxembourg.14 Table 2 lists
summary statistics for the 25 countries with the greatest foreign
exposure to U.S. equity and debt markets in 2006 based on the
preferred USG data. It also reports debt holdings based on the IMF data
to show how private-sector holdings differ from the USG data which
also includes ofcial reserve holdings. The table shows that there is
substantial variation in different countries' exposure to U.S. equity
and debt. Foreign exposure to U.S. debt markets also tends to be
10
13
BIS Quarterly Review, Tables 11, 16A and 16B (September 2007). Available at
http://www.bis.org/publ/qtrpdf/r_qt0709.htm.
14
The SEIFiCs are: Aruba, Bahamas, Barbados, Bermuda, British Virgin Islands,
Cayman Islands, Cyprus, Gibraltar, Guernsey, Isle of Man, Jersey, Lebanon, Macao,
Malta, Mauritius, Netherlands Antilles, Panama, Turks and Caicos, and Vanuatu.
Extreme outliers are mainly nancial centers and countries that would be dropped
from the empirical analysis anyway due to data availability for other variables.
greater than that for equitiesespecially for the USG data which
includes ofcial-sector reserves.
Table 2 also shows that foreign exposure to U.S. markets is quite
low and, in most cases, substantially less than predicted by standard
portfolio allocation models. Standard portfolio theory (discussed in
more detail in Section 3.1.) predicts that under basic assumptions,
investors should hold the global market portfolio. Most countries,
however, have substantially less exposure to the United States than
the U.S. share of the global portfolioa well-documented pattern
referred to as home bias. More specically, in 2006 U.S. equity and
debt markets were 36% and 38%, respectively of global equity and debt
markets.15 Mean foreign holdings of U.S. equities and debt, however,
were only 4.3% and 14.8% of countries' portfolios, respectively. Median
holdings were even lower.16
These results raise several important questions. If countries are not
investing in the United States according to the predictions of standard
portfolio models, what determines their optimal U.S. exposure? Will
foreigners continue to invest in the United States in the presence of
consistently lower returns than if they kept their money at home?
What factors explain the substantial variation in different countries'
exposure to U.S. equity and debt markets?
Europe. Instead of focusing on a cross-section of countries, Leuz et al.

(2009), Aggarwal et al. (2005), and Burger and Warnock (2003) focus
on the determinants of U.S. investment abroad. Cai and Warnock
(2006) is the only paper to consider the oppositethe determinants
of foreign investment in the United Statesby focusing on securitylevel, U.S. equity investments in a sample of U.S. and foreign institutional
investors.18 An additional series of papers focuses on how specic
factors can affect the allocation of capital across countries, such as the
impact of corporate governance, accounting standards, institutions,
distance or other cross-country linkages. No papers in this literature,
however, have yet focused on the determinants of country-level
holdings of U.S. portfolio investment, or on the determinants of foreign
holdings of both U.S. equities and bonds.
A nal and relatively new literature is on the macroeconomic
determinants of the capital ows corresponding to global imbalances.
These papers model how macroeconomic variables such as nancial
market development, growth, productivity, and the demand for
savings can affect global capital ows. Several of the most recent and
noteworthy papers are discussed in more detail in Section 3.3. and
focus on the role of nancial development.
3.2. The model
3. The model and data: why do foreigners invest in the

United States?
3.1. Background
Three different literatures provide frameworks to analyze the
determinants of foreign investment in the United States: the literature
on home bias, on the allocation of investment across countries, and on
the macroeconomic determinants of global imbalances.
First, standard portfolio theory shows that if investors care only
about the mean and variance of the real return of their invested
wealth, if markets are efcient, and cross-border barriers to investment are small, then investors should hold the world market portfolio
of stocks. An extensive literature on home bias, however, shows that
investors deviate substantially from this prediction and tend to hold a
larger share of domestic assets in their portfolios.17 The literature on
home bias explores several possible reasons: explicit barriers and
costs to international investment, informational asymmetries leading
to different valuations of foreign and domestic assets, investors' desire
to hold a larger share of domestic equities to hedge against ination or
other risks, tax and legal systems that generate different expected
returns for citizens of different countries, behavioral biases (such as
investors exaggerating the risks of investing abroad or being overly
optimistic about the returns of domestic companies), and ownership
of domestic multinational companies that have substantial international exposure.
A second (and related) literature examines how investors allocate
their investment across different countries. For example, Lane and
Milesi-Ferretti (2008), Bertaut and Kole (2004), and Faruqee et al.
(2004) estimate the determinants of international equity holdings for
a cross-section of countries in either 1997 or 2001. Lane (2006)
estimates the bilateral composition of international bond portfolios in
This paper uses a modeling framework with substantial exibility

in order to incorporate the insights from each of these literatures on
international capital ows and investment patterns. The model
closely follows Cooper and Kaplanis (1986) and its adaptation in
Chan et al. (2005). Begin with a standard assumption that a
representative investor in country i maximizes the expected return
of his investments for a given level of variance:
Maxwi R wi ci ;
subject to:
wiVwi = v
and
wi I = 1;
where wij is the proportion of individual i's total wealth invested in

securities of country j, wi is the corresponding (J 1) vector of these
portfolio weights, R is a (J 1) vector of pre-tax expected returns, cij is
the cost to investor i of investing in country j, ci is the corresponding
(J 1) vector, V is the (J J) variance/covariance matrix of gross
returns, v is the given constant variance and I is a unity column vector.
Next, form a Lagrangean of the maximization problem in Eqs. (2)
through (4), with and i as the Lagrangean multipliers on Eqs. (3)
and (4), respectively. Set the derivative of the Lagrangean with
respect to wi equal to zero and solve for the optimal portfolio for
investor i:

.
1
R ci i I
wi = V
with
15
This includes international and domestic debt securities, as well as government,

corporate and nancial debt. Based on data from the BIS Quarterly Review, September
2007, available at http://www.bis.org/publ/qtrpdf/r_qt0709.htm.
16
Table 4 of Forbes (2008) shows that countries exhibit home bias towards most
other large countries, especially in equity markets, although on average they
underweight the United States more than other major nancial markets. For a more
detailed analysis of cross-border investment patterns, see Bertaut and Kole (2004),
which also nds that foreigners exhibit home bias toward most countries and tend to
underweight U.S. equities more than they underweight foreign equities.
17
See Chan et al. (2005), Ahearne et al. (2004), Tesar and Werner (1995) and French
and Poterba (1991). For a recent summary of work on home bias, see Kho et al. (2009).
i = IV
1
R IV
1
ci = IV
1
I:
18
Cai and Warnock (2006) is fundamentally different than the analysis in this paper
as it focuses on how the characteristics of specic securities (such as size, dividend
yield and other nancial ratios) instead of the characteristics of the foreign investor
affect U.S. investment. They also only focus on institutional investment in equities,
rather than this paper's broader focus on all types of investment in equities and debt.
Aggregate the individual portfolio holdings to obtain the market

clearing condition for the world equilibrium:
6
Pi wi = w*;
with Pi as the proportion of world wealth owned by country i, wi* is

the proportion of the world market capitalization in country i's
market, and w* is the corresponding column vector of wi* 's. Then,
dene z as the global minimum variance portfolio:
z = V
1
I = I V
1
I;
and combine Eqs. (5) through (7) to obtain:
Vwi w* = Pi ci ci z Pi ci ci I:
Eq. (8) shows the standard result that if there is no cost for
investor i to access both domestic and foreign markets (i.e., that
cij = 0 for all i and j) then every investor holds the world market
portfolio. If the costs to investing in different countries are not equal
to zero, however, then the portfolio holdings of each investor (i.e.,
country) differs from the world market portfolio.
Finally, to derive the central equation for estimation, it is useful to
make the standard, simplifying assumption that the covariance matrix
(V) is diagonal with all variances equal to s2. Then each country will
invest in country j (with i j) an amount that deviates from the world
market portfolio according to:
2
s wij wj* = z ci cij z Pi ci Pk ckj :
The rst term on the right of Eq. (9) is the weighted average
marginal cost for investor i to invest anywhere in the world. The
second term is the cost for investor i to invest in country j. The third
term is the world-weighted average marginal cost of investing, and
the last term is the weighted average marginal cost for all countries to
invest in country j.
Since this analysis will only focus on investment in one countrythe
United Statesthen j =US, and Eq. (9) can be further simplied to:19
wi;US wUS
* = ci;US z ci + ;
10
With and as constants, = 1/s2 and = z'Pici Pkck,US.

Eq. (10) shows the intuitive result that holding everything else
equal, countries with a higher cost of investing in the United States
relative to investing elsewhere will tend to have lower shares of their
*
portfolio invested in the United States (i.e., wi,US wUS
b 0). The
equation also shows that foreign investment in the United States is
determined by two sets of variables: the cost of investing specically in
the United States (ci,US) and the cost of investing abroad in general (ci).
3.3. The variables: theory and data
the theoretical and empirical motivation, data sources, and construction of each of the seven variables used in the main analysis: each
country's controls on capital ows, nancial market development,
corporate governance and institutions, return differential with the
United States, correlation in returns with the United States, distance
and informational links with the United States, and bilateral trade
with the United States.20 The appendix reports additional details on
the variables.
3.3.1. Capital controls
One factor determining a country's cost of investing abroad is its
capital controls, especially restrictions on private sector capital ows
(Ahearne et al., 2004; Burger and Warnock, 2003). Measuring a
country's capital controls, however, is not straightforward (Forbes,
2007a,b). Moreover, most measures of capital controls are extremely
broad and do not focus on portfolio investment, which is the key
component for this analysis. Therefore, I construct a new measure of
capital controls that focuses on controls on capital account transactions by the private sector for the purchases of equity and debt
securities. The index ranges from 0 to 3 and is based on detailed
country information from the (International Monetary Fund's Annual
Report on Exchange Rate Arrangements and Exchange Restrictions.
3.3.2. Financial market development
A focus of recent models on global imbalances is the incentive for
countries with less developed nancial markets and limited domestic
investment opportunities to invest abroad (especially in the United
States) to gain the benets of a larger, more liquid and efcient
nancial sector. Caballero et al. (2008) developed a model in which
high-growth economies (such as emerging markets and oil-exporters) generate a demand for saving instruments, and given the limited
instruments available in their own economies, they purchase U.S.
instruments. Mendoza et al. (2006) model a world in which countries
with less developed nancial systems accumulate foreign assets in
countries with more advanced nancial markets, so that countries
with negative net foreign asset positions can receive positive factor
payments. Ju and Wei (2006) develop a model in which poor
countries have less efcient nancial sectors but high returns to
investment, generating large outows of nancial capital from the
developing countries but inows of foreign direct investment.
Although not a focus of these models, some of these papers also
suggest that the negative relationship between a country's level of
nancial development and its investment in the United States could
decrease with the country's income per capita.21 For example, in
Caballero et al. (2008) if there is a positive correlation between a
country's income per capita and the nancial instruments available or
a negative correlation between a country's income per capita and its
economic growth (as found in the cross-country growth literature),
then higher income levels could decrease the demand for investments
in the United States. Similarly, in Ju and Wei (2006), if there is a
negative correlation between a country's income per capita and its
domestic returns to investment, then as a country's income increases,
both inows of foreign direct investment and the corresponding large
capital outows to the United States would decline.
Several other papers, however, argue that the relationship between
nancial market development and foreign portfolio investment may be
This theoretical framework can incorporate the range of factors

identied in the literature on home bias, international investment
patterns, and global imbalances to predict investment by other
countries in the United States. The remainder of this section discusses
19
Since the U.S. share of the global market portfolio changes across time, it is
in the left-hand side variable instead of absorbing it into
necessary to include the wUS
the constant for the panel estimation.
20
A number of statistics could have been used to measure several of these variables.
The selected statistics were chosen to balance existing theory and evidence with data
availability for a broad cross-section of countries. The sensitivity analysis also explores
the effect of using different variable denitions.
21
The literature on nancial development, capital account openness, and growth
also suggests that these relationships may be nonlinear and depend on a country's
income level. See Klein (2003).
10
positive instead of negative. For example, Martin and Rey (2004) focus
on transactional frictions in asset markets and predict that larger
countries will have deeper domestic equity markets and hold more
foreign assets. Lane and Milesi-Ferretti (2008) nd evidence that
countries with more developed stock markets tend to have larger
foreign equity holdings and argue that barriers to international
investments may fall as countries develop more nancial market
sophistication in their domestic markets. Gruber and Kamin (2008) look
at the broader issue of the determinants of current account balances and
nd that nancial development does not explain international patterns
of current account balances.
Therefore, the impact of a country's nancial market development
on its investment in the United States remains an empirical question,
and the analysis below uses several different measures of nancial
market development to test its role. To measure nancial market
development for the regressions analyzing foreign investments in U.S.
equity markets, I begin by using the ratio of stock market capitalization to GDP. For regressions analyzing investments in U.S. bond
markets, I begin by using the ratio of private bond market capitalization to GDP. I focus on these measures as they most closely follow
the theoretical work on nancial market development, but sensitivity
tests also use a variety of other measures of nancial development.
3.3.3. Corporate governance and institutions
Foreigners may also choose to invest in the United States in order
to benet from its strong corporate governance, accounting standards
and institutionsall of which would raise their expected returns from
investment. Several papers nd evidence that corporate governance
affects capital ows, and especially that countries with stronger
corporate governance receive more investment.22 Kim et al. (2008),
however, argue that there should be a positive (instead of negative)
correlation between a country's corporate governance and its
investment in countries with strong governance. They study foreign
investment in Korea and nd that countries with stronger corporate
governance are more likely to avoid investment in companies with
weaker corporate governance, while countries with weaker corporate
governance do not discriminate between high- and low-governance
rms.
Since a number of different variables are needed to capture the
various aspects of a country's corporate governance, accounting
standards and overall institutional environment affecting investment,
I created an index to measure a country's relevant aspects of corporate
governance. The index is the rst standardized principal component
of: control of corruption, rule of law, regulatory quality, and property
rights. The index takes on higher values for countries with a better
environment for investment and is constructed to have a mean of
zero.23
3.3.4. Returns
Several papers document that investors tend to chase returns by
increasing investment in stocks, countries or funds that have
outperformed and/or decreasing investment after underperformance
(see Froot et al., 1992; Bohn and Tesar, 1996; Sirri and Tufano, 1998).
More recent work, however, challenges this evidence for international
investments (see Thomas et al., 2007; Hau and Rey, 2008).
In order to test for any effect of return chasing on foreign portfolio
investment in the United States, I include a variable in the empirical
analysis measuring the return differential between each country and
the United States over the past year. This measure captures whether
22
For example, see Giannetti and Koskinen (forthcoming), Leuz et al. (2009), Daude
and Fratzscher (2006), and Aggarwal et al. (2005).
23
The sensitivity analysis also considers a number of alternate measures of corporate
governance.
the domestic equity or bond market has recently out- or underperformed the U.S. market. For regressions estimating foreign
investment in U.S. equities, I control for the percent difference in
equity market returns using the broadest equity index available. For
regressions estimating investment in U.S. bonds, I control for the
percent difference in bond returns using an index that includes
corporate, government and agency bonds for each country. In each
case I focus on U.S. dollar returns.
3.3.5. Correlation/diversication benets
Standard nance theory assumes that when investors construct
their portfolios, they seek to maximize their expected returns
subject to a minimum variance. Demand for an asset will depend on
the correlation between that asset's returns and the returns of other
assets in the portfolio. Since investors tend to hold large shares of
their portfolios at home (home bias), then if returns in the United
States are less correlated with returns in the home country,
investors should hold a greater share of U.S. assets to receive the
benets of diversication. This prediction has received mixed
support in the empirical literature on international investment
patterns (Burger and Warnock, 2003; Chan et al., 2005; Lane and
Milesi-Ferretti, 2008).
In order to test if diversication benets are an important
determinant of foreign investment in the United States, I measure
the correlation in stock and bond returns between each country's
market and the U.S. market. More specically, for regressions
estimating foreign investment in U.S. equities, I control for the
correlation in monthly dollar stock returns between each country's
broadest equity index and a broad U.S. equity index over the last
3 years. For regressions estimating investment in U.S. bonds, I control
for the correlation in monthly dollar bond returns between each
country's broad bond market index (including corporate, government
and agency bonds) and a broad U.S. bond market index over the last
3 years.
3.3.6. Closeness/distance
Several papers provide empirical evidence that investors prefer to
invest in countries that are closerwith closeness measured not
only by geographic distance, but also by familiarity and connectivity
through measures such as telephone trafc (see Portes et al., 2001;
Bertaut and Kole, 2004; Daude and Fratzscher, 2006; Coval and
Moskowitz, 1999). Others, however, nd no signicant role for
closeness when predicting cross-border asset holdings and suggest
that informational frictions may matter more for turnover and capital
ows than asset positions (see Lane and Milesi-Ferretti, 2008).
In order to test if any of these aspects of closeness affect foreign
investment in the United States, I constructed an index to incorporate
the various aspects of distance, familiarity and connectivity between
each country and the United States. More specically, the index is the
rst standardized principal component of six variables: the log of
distance between the country and the United States, the cost of a
phone call to the United States, and dummy variables for whether the
country shares a common language (English), shares a border, was a
former colony of the United States, and has a currency union with the
United States. The index takes on higher values for closer countries
and is constructed to have a mean of zero.
3.3.7. Bilateral trade ows
Several theoretical papers predict a relationship between bilateral
trade ows and international asset positions or capital ows, although
the empirical evidence on any relationship is less inconclusive (see
Obstfeld and Rogoff, 2001; Ahearne et al., 2004; Antrs and Caballero,
2009; Aviat and Coeurdacier, 2007; Lane and Milesi-Ferretti, 2008). In
order to capture any potential relationship between trade ows and
foreign investment in the United States, I include a variable in the
empirical analysis controlling for total trade (exports plus imports)
11
Table 3
Summary statistics.
Variable
# Observations
Mean
Median
Standard deviation
Minimum
Maximum
DevUS, equitiesa
DevUS, bondsa
Capital Controls
Financial Development, equities
Financial Development, bonds
Corporate Governance
Returns, equities
Returns, bonds
Correlation, equities
Correlation, bonds
Closeness
Trade
410
260
520
478
476
503
483
224
380
285
515
520
2.966
1.684
1.737
0.532
0.567
0.027
0.516
0.285
0.472
0.168
0.001
0.099
2.871
1.621
2.000
0.280
0.390
0.446
0.291
0.215
0.727
0.295
0.043
0.049
1.574
1.269
1.019
0.993
0.446
1.929
0.641
0.319
0.543
0.577
1.270
0.114
6.804
5.306
0.000
0.000
0.038
4.173
0.001
0.001
0.939
0.867
3.118
0.003
0.874
0.804
3.000
16.017
2.024
3.477
5.281
2.652
0.992
1.000
6.588
0.681
Based on USG data.
between each country and the United States divided by the country's
GDP.
3.4. Summary statistics
The previous section discussed seven variables that are included in
the base estimates of the determinants of foreign portfolio investment
in the United States. Table 3 reports summary statistics when these
seven variables are combined with the USG data on foreign portfolio
holdings of U.S. liabilities (discussed in Section 2).24
4. Estimation and equity market results
4.1. Estimation
Combining the model resulting in Eq. (10) with the variables and
data discussed in Sections 2 and 3 and country and year dummies
yields the following model for estimation:
DevUSi;t = i + 1 CapitalControlsi;t + 2 FinancialDevelopmenti;t
+ 3 CorporateGovernancei;t + 4 Returnsi;t
+ 5 Correlationi;t + 6 Closenessi;t
11
+ 7 Tradei;t + t + it ;
where DevUSi,t is the log deviation of each country i's holdings of U.S.
portfolio liabilities from the U.S. share in the global market portfolio in
year t25; i are country-specic effects; CapitalControlsi,t, Financial
Development i,t , CorporateGovernance i,t , Returns i,t , Correlation i,t ,
Closenessi,t, and Tradei,t are variables measuring capital controls,
nancial development, corporate governance, market returns, market
correlations, closeness, and trade (as dened in the appendix) for
each country i over year t or at the end of year t; t are the year
dummy variables and it is the error term. Eq. (11) is estimated
separately for each asset (equities or debt).
One potential issue with Eq. (11) is endogeneity with the
measures of nancial development. More specically, stock market
and private bond market capitalization (the measures of nancial
market development for the initial equity and debt regressions,
respectively) are components of the calculation of foreign exposure to
24
To create the nal data set, I drop observations with no information on: (1)
holdings of U.S. equities or debt in either data set; (2) GDP; or (3) either equity market
capitalization or total debt securities.
25
I focus on results using the logarithmic deviation, ln(wi,t,US/w*t,US), for the
dependent variable instead of the difference for two reasons. First, the logarithmic
form more closely approximates a normal distribution and is a better t for the data.
Second, this form is more commonly used in other work on the cross-country
determinants of portfolio investment based on similar models, such as in Chan et al.
(2005). The sensitivity analysis also reports results using the difference.
U.S. equities and debt. To address this problem in the equity

regressions, I made an instrument for stock market capitalization
using stock market value traded to GDP.26 In the debt regressions, I
made an instrument for private bond market capitalization using the
share of private bond market capitalization in total bond market
capitalization and the ratio of private credit by deposit money banks
and other nancial institutions to GDP.27 Following Stock and Yogo
(2005), the F-statistics show that the instruments for both sets of
regressions are not weak. The sensitivity analysis also shows that the
key results are robust to different instruments and measures of
nancial development.
In addition to endogeneity, there are several other econometric
issues with Eq. (11): the limited time-series variation in several of the
explanatory variables, the correlation between the country-xed
effects and other explanatory variables, and the structure of the error
term. Most of the variance in several of the explanatory variables is
across countries and not across time. To take an extreme example, the
closeness between each country and the United States (as measured
by distance, cost of a phone call, and dummy variables if the country
has a common language, shared land border, former colonial
relationship or is in a currency union with the United States) is
constant or close to constant for most countries across years.
Therefore, using estimators that only focus on the within-country
variation across time (such as xed effects) are not desirable. Another
issue is that the error term has a complex structure, not only because
investment in the United States tends to be highly correlated from
year to year for each country, but also because the error terms have
different variances across countries. Therefore, it is necessary to
utilize an estimator that has sufcient exibility to incorporate this
error structure.
In order to address each of these issues, I use a cross-sectional,
time-series FGLS estimator that allows for the error terms to be
heteroscedastic and autocorrelated within each panel (i.e., country),
but uncorrelated across countries. The autocorrelation term is
assumed to be AR1 and allowed to vary across countries. In other
words, the error term follows the structure:
Eit = i i; t1 + it ;
Eit = 0;
Varit = i2 ; and
Covit is = 0; if ts and ij:
12
26
The correlation between stock market value traded and stock market capitalization (both relative to GDP) is 74%. The correlation between stock market value traded
and the dependent variable is 23%.
27
The correlation between private bond market capitalization to GDP and the share
of private in total bond market capitalization is 73%. The corresponding correlation
with the private credit variable is 60%. The correlations of the two variables with the
dependent variable are 18% and 16%, respectively.
12
Table 4
Regression results: foreign investment in U.S. equities.
Capital Controls
Financial Development
Corporate Governance
Returns
Correlation
Closeness
Trade
Full
sample
Full
sample
IMF
data
Full
sample
Middle and
low incomea
High
incomea
Largest
holdingsb
GDP
weighted
Foreign
bias
US bias
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(10)
0.217**
(0.049)
0.354**
(0.085)
0.363**
(0.041)
0.022**
(0.007)
0.098*
(0.053)
0.053
(0.059)
3.261**
(0.699)
0.195**
(0.048)
0.291**
(0.086)
0.514**
(0.073)
0.022**
(0.007)
0.105**
(0.052)
0.037
(0.068)
2.548**
(0.813)
0.458**
(0.143)
0.208**
(0.044)
0.407**
(0.090)
0.242**
(0.054)
0.039**
(0.009)
0.165**
(0.076)
0.031
(0.058)
2.151**
(0.473)
2.519**
(0.154)
0.283**
(0.037)
1.177**
(0.179)
0.071
(0.057)
0.010
(0.007)
0.190**
(0.068)
0.043
(0.057)
3.190**
(0.775)
0.102**
(0.033)
0.172**
(0.073)
0.791**
(0.055)
0.032*
(0.019)
0.106
(0.088)
0.011
(0.050)
1.477**
(0.677)
0.024
(0.044)
0.155*
(0.091)
0.673**
(0.097)
0.071**
(0.030)
0.435**
(0.165)
0.199**
(0.039)
2.835**
(0.561)
3.070**
(0.865)
0.200**
(0.045)
0.169**
(0.067)
0.067
(0.044)
0.020**
(0.008)
0.065
(0.047)
0.040
(0.039)
4.180**
(0.483)
0.905**
(0.111)
65
319
463.7
46
221
1161.3
41
199
437.0
24
120
542.4
8
36
1606.1
0.115**
(0.030)
14.720**
(1.517)
0.542**
(0.051)
0.030**
(0.008)
0.053
(0.053)
0.018
(0.045)
1.140**
(0.539)
0.545**
(0.129)
1.441**
(0.149)
65
319
1615.0
0.038*
(0.020)
0.159**
(0.031)
0.435**
(0.022)
0.020**
(0.006)
0.078*
(0.043)
0.124**
(0.024)
0.037
(0.286)
0.578**
(0.039)
65
319
479.1
0.143**
(0.042)
11.292**
(1.363)
0.350**
(0.070)
0.008
(0.006)
0.135**
(0.049)
0.107
(0.071)
4.477**
(0.816)
0.424**
(0.141)
1.112**
(0.137)
65
319
576.2
62
340
2223.4
62
298
713.0
GDP per Capita

Financial Development * GDP per capita
Countries
Observations
Wald 2
Notes: Explanatory variable is the log of the deviation in each country's holdings of U.S. equity liabilities from the world market portfolio based on USG data except in columns 9 and
10. In these columns the dependent variable is the Foreign Bias and Home Bias as dened in Section 4.3. * and ** are signicant at the 10% and 5% levels, respectively. Standard errors
in parentheses. See Appendix A for variable denitions. Estimates are FGLS and are adjusted for heteroscedasticity and autocorrelation within each country. Regressions include
period dummy variables.
a
Based on World Bank denitions.
b
Only includes observations for which country holds over $50 billion in U.S. equities.
4.2. Central results: equity markets

Table 4 reports the main regression results predicting foreign
investment in U.S. equities from Eq. (11) using the FGLS estimation
technique discussed in Section 4.1. Columns 1 and 2 report the central
results based on the USG data, with and without a control for lagged GDP
per capita. Since this variable is usually signicant and is highly correlated
with some of the explanatory variables, I include it in the reported
regressions (although it generally has no effect on the key results).28
Column 3 reports results using the IMF instead of the USG data.29
Many of the coefcient estimates in the rst 3 columns of Table 4
have the expected sign and are highly signicant, while others have
uctuating signicance and a varying sign. More specically, the
coefcients on Financial Development, Capital Controls, and Returns
are all consistently negative and signicant, indicating that countries
with higher levels of nancial development, greater controls on
private-sector capital ows, and higher equity returns (relative to the
United States) hold lower shares of their portfolios in U.S. equities.
The coefcient on Trade is positive and signicant, while the
coefcient on Closeness is usually not signicant unless Trade is
dropped from the regression. This is not surprising given the high
multicollinearity between these two variables and the nding in Aviat
and Coeurdacier (2007) that the impact of distance on bilateral asset
holdings is signicantly reduced when controlling for bilateral trade.
This suggests that countries that are closer and trade more with the
United States also tend to invest more in U.S. equity markets
although it is difcult to disentangle these two effects.30 The positive
coefcient on Corporate Governance suggests that countries with
28
The correlation of GDP per capita with Corporate Governance is 0.91, with Capital
Controls is 0.53, and with Financial Development is 0.33.
29
I repeat all of the tests discussed in this section using the IMF data. The key results
and conclusions are unchanged, so I only report results using the preferred USG data.
30
If Closeness is replaced with the individual components of the index, the
coefcients on the components generally have the expected sign, but signicance
varies based on which control variables are included.
better corporate governance tend to invest more in U.S. equity

markets, supporting the analysis by Kim et al. (2008). The coefcient
on Correlation is usually positive, although its sign and signicance is
not robust to the following series of sensitivity tests, providing no
support for the diversication argument that countries whose stock
market returns are less correlated with U.S. stock returns invest more
in U.S. equity markets.
The coefcient estimates in Table 4 also suggest that the
magnitude of the effects of these signicant variables on foreign
exposure to U.S. equity markets is generally moderate. For example,
Fig. 3a graphs the exposures of several large emerging markets in the
sample to U.S. equity markets. The left bar for each country shows the
country's actual exposure to U.S. equities in 2005. The middle bar is
the country's estimated exposure based on the coefcient estimates in
column 2 of Table 4. The right bar shows the country's estimated
exposure to U.S. equities if the country increased its nancial
development to U.S. levels and held everything else constant.
Fig. 3a shows that for most countries, the estimated exposure to U.
S. equities is fairly close to the actual values (except for India where
the actual exposure is substantially less than the tted value, and for
Mexico where the actual exposure is substantially more than the
tted value). The graph also shows the moderate reduction in
exposure to U.S. equities predicted for each country if it increased
nancial development to U.S. levels.31 For example, China would
reduce its exposure to U.S. equities from 0.50% to 0.37%. These effects
are fairly small because most of the large emerging markets are
substantially underweight U.S. equitiesdespite the role of nancial
development in increasing their incentive to invest abroad.
Shifting to the other coefcient estimates in column 2 of Table 4, the
coefcient on Capital Controls suggests that if China removed its capital
controls (reducing its index measure from 2 to 0) and held everything else
31
Section 6 discusses how these reductions in exposure translate into U.S.
investment inows.
13
Fig. 3. a. Foreign exposure to U.S. equity markets in 2005. Notes: Actual is the country's actual exposure to U.S. equities, calculated as the country's investment in U.S. equities
divided by its total equity portfolio as dened in Eq. (1). Estimated is the estimated exposure based on regression results in Column 2 of Table 4 that predict foreign investment in U.
S. equities. Estimated with U.S. Financial Development is the estimated exposure using the same regression results but assuming that the country increases its nancial
development to the U.S. level. Financial development is measured as stock market capitalization to GDP. b. Foreign exposure to U.S. debt markets in 2005. Notes: Actual is the
country's actual exposure to U.S. debt, calculated as the country's investment in U.S. debt (including corporate, agency and government bonds) divided by its total debt portfolio as
dened in Eq. (1). Estimated is the estimated exposure based on regression results in Column 1 of Table 6 that predict foreign investment in U.S. debt. Estimated with U.S. Financial
Development is the estimated exposure using the same regression results but assuming that the country increases its nancial development to the U.S. level. Financial development
is measured as private bond market capitalization to GDP.
constant, China would increase its exposure to U.S. equities from 0.50% to
0.73%. Similarly, if China's equity market returns increased by 10% per year
(relative to U.S. returns), then the coefcient on Returns suggests that
China would reduce its exposure to U.S. equities to 0.40%. If trade between
China and the United States (as a share of GDP) decreased by 50%, then
China would decrease its exposure to U.S. equities from 0.50% to 0.44%.
Although these changes appear to be small, they translate into moderate
amounts of U.S. investments. For example, holding everything else
constant, if China decreased its exposure to U.S. equity markets from 0.50%
to 0.40% in 2006, this would translate into Chinese sales of about $1 billion
of U.S. equities.32
Next, to further explore this relationship between nancial development and foreign investment in U.S. equities, I test if this relationship
32
To put this number in context, the USG data reports that China held $3.8 billion of
U.S. equities in June 2006. Total U.S. equity market capitalization was $19.4 trillion at
year-end 2006.
varies with a country's income level. To begin, column 4 of Table 4

includes an interaction term between Financial Development and GDP
per capita. The coefcient on Financial Development continues to be
negative and highly signicant, and the coefcient on the interaction
term between Financial Development and GDP per capita is positive and
highly signicant. This suggests that the negative impact of nancial
development on foreign investment in U.S. equities tends to diminish as
income levels increase.33 Then I reestimate the base model for two subsamples: high-income countries and low/middle income countries.34
33
Including a squared interaction term to capture any non-linearities in this relationship
does not improve the t of the regression and the coefcient on the squared term is
insignicant.
34
Income divisions for this analysis are based on World Bank classications. There is not a
consistently signicant difference between middle and low income countries, and the
sample size of low income countries is so small that it is impossible to draw any meaningful
conclusions for this sample.
14
Columns 5 and 6 show the results. The estimated coefcient on Financial

Development is signicantly larger (more negative) in the low/middle
income group. This further suggests that the negative impact of nancial
development on investment in U.S. equities is greater for lower income
countries.
Even if a country's level of nancial development is a key factor
affecting its decision to invest in U.S. equities, it still may not be an
important determinant of overall foreign investment and capital ows
into the United States if it is not an important factor for large countries
and countries responsible for the majority of investment into the
United States. More specically, as shown in Fig. 1, a small number of
countries are responsible for a large share of investment into the
United States. To control for this and focus on the key determinants of
overall investment in the United States, I perform two additional tests.
Column 7 of Table 4 repeats the main regression analysis, but only
includes observations for which countries hold at least $50 billion of
U.S. equity liabilities.35 Column 8 repeats the main analysis, but
weights observations by GDP.36 In each case, the coefcient on Financial Development remains negative and signicant, suggesting that
nancial development is an important factor determining overall
investment levels in the United States and not just the investment
patterns of small countries. This issue is also explored in more detail in
Section 6.
4.3. Foreign bias versus U.S. bias: equity markets
The model estimated above tests for the determinants of each
country's exposure to U.S. markets. Each country's exposure to U.S.
markets, however, can be further decomposed into two components:
a country's foreign bias and U.S. bias. Foreign bias is the extent to
which a country invests more abroad relative to the share of the
foreign market in the global market (an inverse of home bias). U.S.
bias is the extent to which the country has a greater share of its
foreign portfolio in the United States relative to the U.S. share in the
foreign market. More specically, dropping the subscript t for
simplicity, the deviation of each country i's holdings of U.S. portfolio
liabilities from the world market portfolio as specied in Eq. (11) can
be decomposed as:

USInvestmentsi =TotalPortfolioi
DevUSi;t = ln
MarketCapUS =MarketCapGlobal
13
B
C
B
C
ForeignInvestmentsi =TotalPortfolioi
B
C
.
= lnB
C
B MarketCap
C
MarketCap
*USInvestments
=ForeignInvestments
@
i;Foreign
Global
i
iA

MarketCapUS MarketCapi;Foreign
14
= ln ForeignBiasi + ln USBiasi
15
where USInvestmentsi and ForeignInvestmentsi are country i's holdings

of U.S. portfolio liabilities and foreign portfolio liabilities, respectively;
TotalPortfolioi is country i's total market capitalization plus its holdings
of foreign liabilities less foreign holdings of country i's domestic
liabilities; MarketCapUS and MarketCapGlobal are U.S. and global market
capitalization; and MarketCapi,Foreign is global market capitalization
35
This is close to the mean plus one standard deviation.

Weighting observations by the country's U.S. equity holdings does not change the
key results.
36
less country i's market capitalization. Each variable can be calculated

for equities or debt.
Using this decomposition, it is possible to evaluate whether each
country i's holdings of U.S. equities is driven by the country's
foreign bias and/or its preference for U.S. investments in its foreign
portfolio. Column 9 of Table 4 repeats the base estimates from
column 2 of Table 4, except replaces DevUS i with ForeignBiasi as the
dependent variable. The negative and signicant coefcient on Financial Development indicates that countries with lower levels of
nancial development hold a greater share of their equity investment abroad (i.e., less home bias).
In order to test if countries with less developed nancial markets
also tend to have a greater preference for U.S. investment (as
compared to foreign investment in general), column 10 of Table 4
repeats this regression with USBiasi as the dependent variable. The
coefcient on Financial Development continues to be negative and
signicant, suggesting that not only do lower levels of nancial
development tend to increase a country's share of investment abroad,
but also increase a country's share of investment in the United States
relatively more than in other countries. The sum of the coefcients on
Financial Development in the regressions predicting ForeignBias and USBias in columns 9 and 10 also add to 0.328, which is close to the coefcient
on Financial Development in column 2 (0.291) as predicted in Eq. (15).
This series of results supports the theoretical predictions that if a country
has lower levels of nancial development, it will not only invest more
abroad in total, but also invest relatively more of its foreign portfolio in the
United States.
4.4. Concerns and sensitivity tests: equity markets
The key results reported above are subject to a number of potential
concerns, such as the measure of nancial development, estimation
technique, and role of outliers. This section attempts to address each
of these concerns and then performs additional sensitivity tests. These
tests are also repeated using the IMF data, which has no impact on the
key results.
Since the impact of nancial market development on foreign
investment in the United States is a key focus of this paper, columns 1
through 4 of Table 5 begin by taking a closer look at alternative measures
of nancial market development: stock value traded to GDP, the stock
turnover ratio, an index of nancial market development in equity
markets (constructed as the rst standardized principle component of:
stock market capitalization to GDP, stock market turnover, and private
credit by deposit money banks and other nancial institutions to GDP),
and using the initial measure of nancial development but with a broader
set of instruments (stock value traded to GDP, stock market turnover, and
private credit by deposit money banks and other nancial institutions to
GDP).37 The negative and signicant coefcients on each of these
different measures of nancial development support the result that less
nancially developed economies (no matter how nancial development
is measured) hold a greater share of their portfolios in U.S. equities.
Next, columns 5 through 9 of Table 5 use several different estimation
techniques. Column 5 ignores the time-series variation in the data and
estimates Eq. (11) using a cross-section, with each variable averaged
across all available years. Column 6 returns to using panel data, but
estimates the model using pooled OLS with errors adjusted for
clustering by country and heteroscedasticity. Column 7 uses a tobit
37
The table reports results that include the controls for GDP per capita and its
interaction with Financial Development because both variables are consistently
signicant. Key results are unchanged if one or both of these controls are excluded.
Variables used to construct the different measures of nancial market development
are from Beck et al. (2000), using the revised version of the data through 2005 and
available at: http://econ.worldbank.org.
15
Table 5
Sensitivity tests: foreign investment in U.S. equities.
Different measures of nancial development
St. value
traded
Capital Controls
Financial
Development
Corporate
Governance
Returns
Correlation
Closeness
Trade
GDP per Capita
Fin. Dev. * GDP cap
Countries
Observations
Wald 2
Stock turnover
Indexa
Adds instrumentsb
Different estimation techniques

X-section averages
X-sectionc
Tobit
Quantilec
Differencesd
Excludes:
nancial
centerse
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(10)
0.143**
(0.042)
11.056**
(1.334)
0.350**
(0.070)
0.008
(0.006)
0.135**
(0.049)
0.107
(0.071)
4.477**
(0.816)
0.197
(0.138)
1.088**
(0.134)
65
319
576.2
0.084*
(0.047)
4.590**
(0.841)
0.480**
(0.072)
0.017**
(0.006)
0.123**
(0.049)
0.123*
(0.066)
2.095**
(0.770)
0.611**
(0.144)
0.449**
(0.090)
65
319
585.1
0.126**
(0.039)
6.936**
(0.408)
0.452**
(0.056)
0.005
(0.006)
0.055
(0.042)
0.123**
(0.054)
4.006**
(0.549)
0.173
(0.109)
0.702**
(0.043)
62
303
3061.4
0.211**
(0.030)
15.319**
(1.116)
0.566**
(0.060)
0.014**
(0.006)
0.217**
(0.043)
0.093
(0.061)
3.288**
(0.659)
0.871**
(0.115)
1.515**
(0.110)
62
303
1470.1
0.513**
(0.172)
18.572**
(4.701)
0.311
(0.224)
0.098
(0.134)
1.045**
(0.489)
0.007
(0.117)
3.191*
(1.605)
0.795**
(0.293)
1.815**
(0.472)
65
65
0.338**
(0.148)
14.943**
(3.657)
0.408*
(0.206)
0.039
(0.028)
0.330
(0.226)
0.038
(0.107)
3.533**
(1.584)
0.753**
(0.291)
1.477**
(0.364)
65
319
0.335**
(0.161)
14.951**
(5.243)
0.407*
(0.221)
0.040
(0.028)
0.334
(0.240)
0.038
(0.160)
3.552*
(1.904)
0.752**
(0.315)
1.478**
(0.519)
65
319
0.310
(0.211)
19.042**
(5.907)
0.382
(0.256)
0.035
(0.037)
0.280
(0.266)
0.055
(0.202)
3.221
(2.406)
0.615*
(0.368)
1.876**
(0.589)
65
319
0.008**
(0.003)
0.150**
(0.062)
0.008**
(0.003)
0.001
(0.000)
0.000
(0.003)
0.005**
(0.003)
0.163**
(0.032)
0.010
(0.007)
0.014**
(0.006)
65
319
891.3
0.127**
(0.045)
10.077**
(1.557)
0.357**
(0.074)
0.008
(0.007)
0.088*
(0.053)
0.054
(0.076)
4.464**
(0.859)
0.499**
(0.151)
0.988**
(0.162)
60
294
431.1
Notes: See notes to Table 4. All regressions except column 5 include period dummies.
a
Index is the rst standardized principle component of: stock market capitalization/GDP, stock market turnover, and private credit by deposit money banks and other nancial
institutions to GDP.
b
Includes additional instruments for nancial market development: stock market turnover and private credit by deposit money banks and other nancial institutions to GDP.
c
Standard errors are clustered by country.
d
Dependent variable is measured as differences instead of log deviation.
e
Excludes major nancial centers: Hong Kong, Ireland, Japan, Singapore, Switzerland, and the United Kingdom.
model to adjust for the restriction that no country can hold less than 0%
or more than 100% of their equity exposure in the United States. Column
8 uses a quantile model to estimate the median (instead of the mean) of
the dependent variable and therefore to reduce the impact of outliers
and skewness in the dependent variable. The tobit and quantile
regressions include bootstrapped standard errors adjusted for heteroscedasticity and clustering by country. Finally, column 9 calculates the
dependent variable as the difference between each country i's holdings
of U.S. portfolio liabilities and the world market portfolio in year t
(instead of using the logarithmic form). Although the signicance of
most of the coefcient estimates uctuates across these different
estimation techniques, the coefcients on Financial Development and its
interaction with GDP per capita remain negative and signicant in each
column.
Due to data concerns as discussed in Section 2, I next perform
several tests for the impact of outliers and sample selection. Column
10 of Table 5 drops major nancial centers because reported
investment in the United States by nancial centers may be overstated
because of their role as nancial intermediaries. 38 In another test I
also include a dummy variable for nancial centers. The dummy is
usually positive and signicant, but has no impact on the other key
results. I also drop the 10 largest outliers and then drop one country at
a time. These results are not reported due to space constraints, but the
coefcients on Financial Development and its interaction term are each
always signicant at the 1% level.
Finally, I perform sensitivity tests that use different denitions for
key variables or include additional control variables. This series of
tests is discussed in more detail in Forbes (2008) and results are not
38
Major nancial centers are dened as: Hong Kong, Ireland, Japan, Singapore,
Switzerland, and the United Kingdom. The SEIFiCs were already dropped from the
sample.
reported here as the main ndings do not change. These tests include:
measuring Returns and Correlation over different time horizons;
measuring Correlation as the correlation in growth rates with the
United States; dropping the period dummies; and using several
different indices of corporate governance.39 I also add controls for:
regional dummy variables; if the country has its currency pegged to
the U.S. dollar40; GDP per capita squared and/or cubed; the percent
change in the dollar exchange rate over the past year; or the annual
rate of CPI ination.41
Several patterns become apparent in this series of sensitivity tests.
The coefcient that is consistently signicant (usually at the 5% and
always at the 10% level) in all specications is the negative coefcient
on Financial Developmenteven when nancial development is
measured using very different denitions that focus on liquidity and
turnover rather than overall size. Countries with less developed
nancial markets have a greater share of their equity investments in
the United Stateseven after controlling for a variety of other factors
that inuence investment. Furthermore, this relationship appears to
be stronger as income levels fall.
Several other variables predicting foreign investment in U.S. equities
are usually (but not always) signicant across these sensitivity tests. The
39
In most cases the coefcient on the indices of corporate governance is positive and
signicant, but when the measures of corporate governance are included individually
instead of aggregated into an index, their sign and signicance uctuates based on the
specication. This suggests that countries with better corporate governance may
invest more in U.S. equities, but it is impossible to disentangle exactly which
components of corporate governance are most important.
40
This includes countries that have adopted the U.S. dollar and available at: http://
www.dartmouth.edu/~jshambau/. This dummy variable is usually negative (instead of
positive) and often signicant.
41
The exchange rate and ination data are from the IMF's International Financial
Statistics, CD-ROM. The sign and signicance of the coefcients on these variables
uctuate based on the specication.
16
Table 6
Regression results: foreign investment in U.S. bonds.
Base
Basea
Base
Middle and
low incomeb
High
incomeb
Largest
holdingsc
GDPweighted
Financial development
measured by:
Credita
Capital Controls
Financial
Development
Corporate
Governance
Returns
Correlation
Closeness
Trade
GDP per Capita
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(10)
0.014
(0.042)
0.714*
(0.375)
0.198**
(0.077)
0.002
(0.003)
0.045
(0.057)
0.102**
(0.049)
2.470**
(0.575)
0.473**
(0.223)
0.200**
(0.045)
0.493**
(0.150)
0.106**
(0.038)
0.304**
(0.065)
4.833**
(0.630)
0.593**
(0.109)
0.026
(0.080)
1.704**
(0.641)
0.004
(0.087)
0.002
(0.006)
0.014
(0.183)
0.034
(0.031)
3.719**
(0.701)
0.039
(0.041)
0.912**
(0.445)
0.384**
(0.118)
0.003
(0.009)
0.091
(0.114)
0.479**
(0.071)
6.208**
(0.984)
32
152
175.1
53
248
288.2
0.055
(0.042)
21.379**
(5.611)
0.075
(0.087)
0.003
(0.003)
0.054
(0.057)
0.245**
(0.067)
4.334**
(0.651)
0.708**
(0.273)
2.138**
(0.563)
32
152
217.3
12
55
93.8
19
93
132.2
0.089
(0.057)
203.476**
(22.981)
0.125
(0.167)
0.009
(0.011)
0.465**
(0.143)
0.058
(0.066)
0.473
(1.197)
1.468**
(0.481)
19.624**
(2.196)
10
38
1828.9
0.108**
(0.041)
31.172**
(3.435)
0.263**
(0.082)
0.006*
(0.004)
0.055
(0.076)
0.342**
(0.038)
5.313**
(0.378)
1.111**
(0.247)
2.965**
(0.362)
32
152
492.9
0.083**
(0.034)
15.570**
(1.958)
0.286**
(0.053)
0.004
(0.003)
0.017
(0.059)
0.322**
(0.044)
4.654**
(0.387)
1.577**
(0.226)
1.517**
(0.199)
40
184
382.2
0.050
(0.042)
5.252**
(0.773)
0.094
(0.072)
0.000
(0.003)
0.025
(0.056)
0.313**
(0.040)
5.230**
(0.389)
0.560**
(0.228)
0.505**
(0.081)
32
152
696.2
0.052
(0.044)
18.398**
(5.750)
0.130
(0.101)
0.000
(0.004)
0.135*
(0.072)
0.070
(0.067)
1.981**
(0.743)
1.140**
(0.315)
1.887**
(0.589)
27
129
107.8
Fin. Dev. * GDP cap

Countries
Observations
Wald 2
Indexd
Excludes
nancial
centerse
Notes: Explanatory variable is the log deviation in each country's holdings of U.S. debt liabilities from the world market portfolio based on USG data. * and ** are signicant at the 10%
and 5% level, respectively. Standard errors in parentheses. See Appendix A for variable denitions. Estimates are FGLS and are adjusted for heteroscedasticity and autocorrelation
within each country. Period dummies included.
a
Financial development is measured by private credit by deposit money banks and other nancial institutions to GDP.
b
Based on World Bank denitions.
c
Only includes observations for which country holds over $50 billion in U.S. bonds.
d
Financial development index constructed as rst standardized principle component of: private bond market capitalization to GDP, public bond market capitalization to GDP and
private credit by deposit money banks and other nancial institutions to GDP.
e
Excludes major nancial centers: Hong Kong, Ireland, Japan, Singapore, Switzerland, and the United Kingdom.
coefcient on Capital Controls is usually negative and signicant and the

coefcient on Trade is usually positive and signicant. These results
indicate that countries with fewer controls on private sector capital
ows and that trade more with the United States tend to invest greater
shares of their portfolios in the United States. The coefcient on Correlation is usually positivealthough it is often insignicant and its sign
uctuates. Therefore, in contrast to theoretical predictions, countries
whose market returns are less correlated with the United States do not
invest more of their portfolios in U.S. equity markets.
5. Bond market results
5.1. Central results: bond markets
Moving from equity to debt markets, Table 6 reports results
predicting foreign investment in U.S. debt markets (including corporate,
government and agency bonds) as specied in Eq. (11). The rst column
reports the base results. The sample size is close to half that for the equity
regressions because the market information necessary to construct the
variables for Financial Development, Returns and Correlation is not as
widely available for bond as equity markets. A disproportionate share of
the dropped countries is low- and middle-income economies. Therefore,
column 2 modies the specication to increase sample size by measuring
Financial Development using private credit by deposit money banks and
other nancial institutions to GDP and dropping the controls for Returns
and Correlation (which are usually not signicant in the bond market
regressions). These changes increase the sample size from 32 to 53
countries and the number of low- and middle-income countries from 13
to 34. Column 3 includes a control for Financial Development interacted
with GDP per capita. Columns 4 and 5 report estimates for middle/low
and high income countries, respectively. These three columns suggest
that the impact of nancial development on investment in U.S. bond

markets decreases with income per capita.
Next I repeat the extensive series of sensitivity tests discussed in
Section 4.4, and since the coefcients on GDP per capita and its interaction
with Financial Development are both signicant, I continue to include them
in the regressions. The remainder of Table 6 reports a selection of these
sensitivity tests. Columns 6 and 7 focus on estimates for countries with the
largest holdings of U.S. debt by including only countries that hold over
$50 billion in U.S. bonds or using GDP-weights, respectively. Columns 8
and 9 use different measures of nancial development in bond markets:
private credit by deposit money banks and other nancial institutions
divided by GDP and an index of bond market development that is the rst
standardized principle component of private bond market capitalization,
public bond market capitalization, and private credit by deposit money
banks and other nancial institutions (all divided by GDP).42 Column 10
drops nancial centers.
These results estimating the determinants of foreign investment
in U.S. bond markets (and the full set of sensitivity tests that are not
reported due to space constraints), agree with some, but not all, of
the preceding results for foreign investment in U.S. equity markets.
Financial Development continues to be consistently negative and
highly signicant, indicating that countries with less developed
nancial markets tend to invest a larger share of their portfolios in
U.S. bonds. Moreover, the positive and signicant coefcient on the
interaction between Financial Development and GDP per capita
suggests that this effect continues to decrease with income per
capita, i.e., that the effect of nancial development on investment in
42
All variables are from Beck et al. (2000), available at: http://econ.worldbank.org.
17
Table 7
Private- and ofcial-sector investment in U.S. bonds.
IMF data for bonds
(Excludes ofcial sector reserves)
Capital Controls
Financial
Development
Corporate
Governance
Returns
Correlation
Closeness
Trade
GDP per Capita
Fin. Dev. * GDP per cap
Base
GDP-weighted
Base
Bonds
(1)
(2)
(3)
(4)
(5)
0.072**
(0.037)
41.547**
(3.220)
0.076
(0.053)
0.002
(0.002)
0.004
(0.054)
0.187**
(0.022)
2.705**
(0.460)
0.459**
(0.154)
4.228**
(0.323)
0.111**
(0.030)
42.149**
(4.430)
0.256**
(0.063)
0.004**
(0.002)
0.047
(0.050)
0.256**
(0.036)
3.284**
(0.480)
1.198**
(0.179)
4.167**
(0.437)
31
153
560.0
31
153
323.8
0.091**
(0.038)
41.751**
(3.225)
0.079
(0.053)
0.002
(0.002)
0.003
(0.054)
0.167**
(0.026)
2.232**
(0.557)
0.397**
(0.158)
4.245**
(0.325)
0.401
(0.343)
31
153
556.4
0.059
(0.043)
30.948**
(6.180)
0.014
(0.084)
0.000
(0.003)
0.074
(0.056)
0.077
(0.087)
2.900**
(0.909)
0.887**
(0.297)
3.139**
(0.613)
1.780**
(0.459)
32
152
188.1
0.192**
(0.040)
9.673**
(1.240)
0.418**
(0.046)
0.006
(0.006)
0.117**
(0.047)
0.182**
(0.066)
5.204**
(0.798)
0.427**
(0.121)
0.947**
(0.124)
1.272**
(0.323)
65
316
863.2
Reserves/GDP
Countries
Observations
Wald 2
USG data
Equities
Notes: Explanatory variable is the log of the deviation in each country's holdings of U.S. debt or equity liabilities from the world market portfolio. * and ** are signicant at the 10%
and 5% level, respectively. Standard errors in parentheses. See Appendix A for variable denitions. Estimates are FGLS and are adjusted for heteroscedasticity and autocorrelation
within each country. Period dummies included.
U.S. bonds is weaker for higher income countries. The coefcient on

Trade is usually positive and signicant, suggesting that trade with
the United States is an important predictor of investment in U.S.
bond markets. The coefcient on Correlation continues to rarely be
negative and signicant, indicating that the correlation between a
country's returns and the U.S. market is not important in predicting
foreign investment in U.S. bonds or equities.
Most of the other coefcient estimates in Table 6, however, differ from
the estimates predicting foreign investment in U.S. equity markets. The
coefcients on Corporate Governance and Returns are often insignicant.
The coefcient on Closeness is now never positive and signicant, and
instead is often negative and signicant. It no longer becomes positive and
signicant when Trade is excluded from the regression (as occurred in the
equity regressions). The coefcient on Capital Controls is usually negative,
but less often signicant than in the equity regressions, and appears to be
sensitive to the inclusion of a few countries with stringent capital controls
in the sample. The coefcient is usually negative and signicant, however,
when the number of low- and middle-income countries in the sample
increases, such as in column 2. All in all, the results from regressions
predicting foreign investment in U.S. bonds have a lower degree of
explanatory power and less consistent results across specications for
many variables than the regressions predicting foreign investment in U.S.
equities. The most consistent result, however, continues to be the negative
relationship between a country's level of nancial market development
and its investment in U.S. debt markets.
Moreover, the estimates suggest that the magnitude of these effects
can be largeand substantially larger than the effects on foreign investment in U.S. equitiesdue partly to countries' larger exposure to U.S.
bonds. Fig. 3b repeats the analysis in Fig. 3a, except for emerging market
exposure to U.S. debt markets. The left and middle bars for each country
show each country's actual and predicted exposure to U.S. debt markets
in 2005 (based on the coefcient estimates in column 1 of Table 6).
Emerging market exposure to U.S. bonds is substantially greater than to
U.S. equities. For some countries (such as Brazil and the Philippines), the
estimated exposure is similar to the actual exposure, while for other
countries (such as China, Indonesia and Mexico), the model underpredicts foreign exposure to U.S. debt. The right bar for each country
shows estimated exposure if the country increased its nancial
development to U.S. levels. For example, China would reduce its
estimated exposure to U.S. bonds from 6.9% to 3.4% and Brazil would
reduce its exposure from 5.4% to 2.6%. These effects are substantially
larger than the comparable reduction in exposure to U.S. equities from
increased nancial development in emerging equity markets. Section 6
discusses the impact on overall foreign investment in U.S. bonds.
5.2. Private- versus ofcial-sector investment: bond markets
One important difference between foreign investments in U.S. equity
versus debt markets is the role of the ofcial sector.43 Although ofcial
holdings of U.S. equities have been small, Fig. 2 shows that ofcial
holdings of U.S. debt, and especially U.S. government and agency bonds,
are substantial.44 Foreign ofcial investment in the United States may be
affected by different factors than foreign private investment.
To test for different factors driving private and ofcial investment in U.S. bonds, Table 7 repeats the main analysis using the IMF
data instead of the USG data. As discussed in Section 2.1, the IMF
data only includes private-sector investment, while the USG data
also includes ofcial-sector reserve holdings. Column 1 reports the
base estimates and column 2 reports estimates weighted by GDP.
These results (and a full series of sensitivity tests that are not
reported) show that the key results predicting foreign investment
in U.S. bond markets do not change when ofcial-sector investments are excluded. Financial market development continues to
43
Ofcial-sector investment is foreign ofcial reserve holdings and does not include
assets held or invested by quasi-government agencies.
44
As of June 2006, foreign ofcial holdings were 0.9% of U.S. equities, 36.5% of
marketable U.S. Treasuries, 8.3% of U.S. agencies and 0.9% of U.S. corporate bonds.
Based on UST data (June 2007).
18
have a negative and signicant effect on foreign investment in U.S.

bonds, and this effect continues to decrease as income per capita
increases. The one noteworthy change is that the coefcient
estimates for Financial Development and its interaction term tend
to be larger for the IMF data than the USG data, suggesting that the
impact of nancial market development on investment in U.S. debt
markets may be greater for the private than the ofcial sector.
As a nal test for differences between ofcial- and private-sector
investment in U.S. debt, I add a control variable for each country's
ofcial reserve holdings to GDP.45 If a country has larger reserves, it is
more likely to accumulate the safe-haven asset of U.S. bonds
(especially Treasuries). Column 3 of Table 7 reports results for privatesector investment in U.S. bonds (using the IMF data), and column 4
reports the same regression when ofcial-sector investment is
included (using the USG data). Column 5 reports results for foreign
investment in U.S. equity markets using the USG data (and are
basically the same as those using the IMF data for equities). The
coefcient on reserves is only positive and signicant in the
regression predicting foreign holdings of U.S. bonds when ofcialsector investment is included.46 These intuitive results suggest that
countries with larger reserves tend to hold greater shares of their
bond portfolios in U.S. debt markets when the bond portfolios include
ofcial- as well as private-sector investments. There is no evidence,
however, that countries with larger reserves hold a greater share of
their private-sector bond portfolios or equity portfolios in U.S.
investments.
6. Implications for foreign investment in the United States
This section takes the results from Sections 4 and 5 one step
further to provide rough estimates of how changes in foreign
nancial development could affect not only country exposure to U.S.
equity and debt, but also affect capital ows and investment into the
United States. To simplify these estimates it uses measures of
nancial development that remove concerns with endogeneity.47
More specically, these simulations measure nancial development
in equities using the stock market turnover ratio and in bonds using
private credit by deposit money banks and other nancial institutions to GDP (as reported in column 2 of Table 5 and column 8 of
Table 6, respectively). These estimates should be interpreted as
showing how changes in nancial market development through
improved liquidity and efciencybut not necessarily larger market
sizeaffect investment in the United States.
Next, assume that each of the low- and middle-income countries
in the sample increases its nancial development in equity or bond
markets to the sample mean for 2005, but everything else remains
constant. More specically, for the equity regressions, the mean for
the stock market turnover index is the level for Portugal (the lowestincome country in the high-income country group) and slightly more
than for Greece. For the bond regressions, the mean for the private
credit measure is about the value for Italy and slightly more than for
Greece and South Korea. Table 8 reports actual holdings of U.S. equity
and bonds in 2006 for each country in the sample and the predicted
change in U.S. holdings corresponding to the increase in nancial
45
The data on reserve holdings (less gold) is from the IMF's International Financial
Statistics CD-ROM.
46
In regressions predicting foreign holdings of U.S. bonds, a control variable for
whether a country's currency is pegged to the dollar usually has a positive coefcient,
but signicance varies across specications.
47
When nancial development is measured by stock or private bond market
capitalization (both scaled by GDP), then any analysis of the effect of changes in a
country's nancial development would simultaneously change the left-hand side
variable (which includes stock or bond market capitalization in the denominator),
thereby complicating any calculations.
Table 8
Estimated impact on foreign investment in U.S. markets in 2006 from nancial
development in low- and middle-income countries.
Argentina
Bangladesh
Botswana
Brazil
Bulgaria
Chile
China
Colombia
Croatia
Czech Republic
Cote d'Ivoire
Ecuador
Egypt
El Salvador
Estonia
Ghana
Hungary
India
Indonesia
Jamaica
Jordan
Kazakhstan
Kenya
Latvia
Lithuania
Macedonia
Malaysia
Mexico
Morocco
Namibia
Peru
Philippines
Poland
Romania
Russian Federation
Slovak Republic
South Africa
Sri Lanka
Thailand
Tunisia
Turkey
Venezuela
Zimbabwe
Sample statistics
Total
Mean
Median
U.S. equities ($mn)
U.S. bonds ($mn)
Actual
holdings
Predicted change
in holdings
Actual
holdings
12
1111
1369
9
6692
3818
948
20
270
7
210
281
3
232
133
1
1107
0
209
4
0
4
76
30
5981
17
9
129
552
274
125
99
0
4
0
0
5
47
0
50
20
9
24
4
1
37,934
3
9478
695,111
15,278
879
6715
1159
175
1700
17,570
11,663
8450
549
14,961
33
155
1606
740
244
9
237
22
1558
25
439
10
202
1418
9
71
2008
10
45
490
187
17
2
19
4
117
6
0
2
0
437
3
38,248
981
202
5302
136
5
Predicted change
in holdings
3904
24,574
2
2089
394,509
11,955
324
2326
859
53
546
11,229
10,364
4682
648
2
32
15,578
83,123
205
1
19
0
58,447
1272
7914
14,265
1070
6380
8039
2015
15,797
241
19,855
6660
0
98
15,036
5711
979,499
36,278
6715
562,424
20,831
2089
Notes: Estimates for equity markets based on regression in Table 5, column 2. Estimates for
bond markets based on regression in Table 6, column 8. Each regression includes controls
for income per capita and its interaction with nancial development. Financial
development in equity markets is measured by the stock turnover ratio and in bond
markets is measured by private credit to deposit money banks and other nancial
institutions to GDP. Estimates of the change in holdings in U.S. equity or bonds assume that
each country increases its nancial development in equity or bond markets to the sample
mean for each measure in 2005. Countries are classied as low- and middle-income based
on World Bank denitions.
development to the sample mean in each country. The bottom of the

table reports summary statistics.
The estimates in Table 8 should be interpreted very cautiously
as rough approximations given the coarseness of the model.
Nonetheless, the estimates indicate several noteworthy results.
First, the average reduction in each country's holdings of U.S.
equities from nancial development ($136 million) is substantially less than the average reduction in holdings of U.S. bonds
($20.8 billion). This is not surprising as most countries, and especially
19
lower income countries, tend to have signicantly less exposure to

U.S. equities than to U.S. bonds (as shown on Table 2) combined
with the smaller size of the U.S. equity market relative to U.S. debt
markets.
Second, and closely related, the estimated total reduction in
foreign holdings of U.S. equities by the low- and middle- income
countries in the sample is $5.3 billion (16% of actual holdings in the
sample in 2006), while the estimated reduction in foreign holdings of
U.S. debt is a more substantial $562 billion (57% of actual holdings in
the sample in 2006). These magnitudes, however, are moderate in
relation to the size of U.S. nancial markets and foreign investment in
these markets. More specically, U.S. equity market capitalization at
end-2006 was $19.4 trillion and foreign investment in U.S. equities
was $2.4 trillion. U.S. bond market capitalization (including Treasuries, agencies and corporate bonds) was $26.7 trillion and foreign
holdings of U.S. debt were $5.3 trillion.
Finally, a number of factors that are not fully incorporated in this
analysis could bias the estimates either upward or downward. For
example, as countries become more nancially developed they tend to
increase the size of their investment portfolios. Even if the share of
their portfolios invested in the United States declined as estimated in
Table 8, their increased portfolio size could simultaneously increase
their demand for U.S. investments. This effect could offset some of the
reduction in U.S. holdings implied by the model and generate an
upward bias in the estimates of the aggregate impact of nancial
development abroad on foreign investment in the United States.
On the other hand, since the coverage of low- and middle-income
countries in the sample is fairly limitedespecially for the bond
regressionsthese estimates likely understate the aggregate impact of
nancial development abroad. A number of countries with substantial
investment positions in the United States are not included in the sample.
For example, the oil-producing economies in the Middle East and Africa
held $136 billion of U.S. bonds at the end of 2006; Taiwan held
$128 billion and Russia held $111 billion. If each of these countries had a
comparable 57% decrease in their holdings of U.S. debt due to nancial
market development, this would generate an additional $215 billion of
U.S. bond sales in addition to the original estimate of $562 billion.
Moreover, none of these estimates include investment in the United
States by the SEIFICs (which held over $350 billion in U.S. equities and
over $550 billion in U.S. debt in 2006) as it is impossible to track the
country origination of these funds. If a large share of investment in the
United States from the SEIFICs originates in countries with low levels of
nancial development, then increases in nancial development in these
countries could lead to substantially greater sales of U.S. equities and
bonds. Therefore, although these estimates of the potential impact of
nancial development in low- and middle-income countries on
investment in U.S. equities and debt should be interpreted cautiously,
they indicate that the magnitude of the effect could be signicant,
especially for U.S. bond markets and especially if any such adjustments
occurred over a short period of time.
invest more in U.S. equity and debt markets, and countries with fewer
capital controls tend to invest more in U.S. equities. Finally, despite
strong theoretical support, diversication motives appear to have little
impact on patterns of foreign investment in the United States.
These results support a recent trend in the theoretical literature
on global imbalances that emphasizes the role of the large, liquid
and efcient U.S. nancial markets in attracting capital from
countries with less developed nancial markets. The literature
suggests that if the United States continues to be perceived as
having attractive nancial markets, U.S. capital inows will
continue to support the U.S. current account decit and corresponding system of large global imbalances without major changes
in asset prices. Over time as other countries develop their own
nancial markets, this impetus to invest in the United States could
diminish. Since building and developing nancial markets and their
corresponding rules, regulations and infrastructure is a slow
process, however, any such effect on investment into the United
States would likely occur gradually over many years.
The crisis of 20072008, however, showed glaring weaknesses in the
U.S. nancial and regulatory system and may lead investors to question
their previous belief that U.S. nancial markets are attractive. If so,
investors could have responded to the crisis by rapidly withdrawing
capital from the United States. Foreign investors did sell U.S. equities,
corporate and agency debt during the peak of the crisisfollowing the
general trend around the world of investors selling all types of foreign
investments during this period. In sharp contrast, however, foreign
demand for U.S. Treasury debt, and especially short-term T-bills,
increased sharply. During the peak of the crisis in the second half of
2008, foreigners purchased $381 billion of U.S. T-billsup sharply from
about $75 billion in both the 1st half of 2008 and 2nd half of 2009.48
These patterns suggest that although the crisis originated in the United
States, the status of U.S. Treasuries as a safe-haven investment remained
undiminished and investors were still attracted to the liquidity of U.S.
government debt during this period of extreme risk aversion
As the crisis recedes, nancial markets begin to normalize, risk
aversion falls, and credit becomes more available, will foreigners
still be attracted to U.S. nancial markets? As U.S. borrowing and
debt levels increase to record levels, will this diminish foreign
appetite for U.S. government debt? The United States will continue
to be the largest and most liquid nancial market in the world (at
least for several years), but will it continue to be seen as the most
attractive? Or has the crisis undermined these perceived advantages of investing in the United States? Will the new regulations
imposed on U.S. nancial markets make them more efcient? Or
will they undermine the benets of U.S. equity and bond markets
and thereby present a serious risk to the sustainability of U.S.
capital inows? If countries with less developed nancial markets
begin to question the relative advantages of U.S. nancial markets,
this could lead to a rapid adjustment in U.S. capital inows, global
imbalances and asset prices.
7. Conclusions
Acknowledgements
Although foreigners investing in U.S. markets earned lower returns

before the crisis of 20078 than U.S. investors earned abroad (and then
suffered major losses during the crisis), there are still several reasons
why they might continue investing in the United States and nancing
the large U.S. current account decit. This paper evaluates which of the
factors suggested in the theoretical and empirical literature have been
signicant determinants of foreign investment in the United States. The
strongest and most consistent result is that a country's nancial
development is an important factor affecting its share of investment
in both U.S. equity and debt markets. More specically, countries with
less developed nancial markets invest a larger share of their portfolios
in the United States and the magnitude of this effect decreases with
income per capita. Countries that trade more with the United States also
Thanks to Pierre Azoulay, Henning Bohn, Stephanie Curcuru,

Tomas Dvorak, Steve Kamin, Philip Lane, Gian Maria Milesi-Ferretti,
Vincenzo Quadrini, Brad Setser, Linda Tesar, Eric van Wincoop,
Frank Warnock, and seminar and conference participants at MIT,
Harvard, the NBER, the American Economic Association meetings,
the IMF-UK ESRC Conference on International Macro-Finance and
the Federal Reserve Bank of San Francisco's Pacic Basin Conference
for extremely helpful comments and discussions. Special thanks to
Philip Lane and Gian Maria Milesi-Ferretti for providing unreleased
data on international equity positions.
48
Data source: http://www.ustreas.gov/tic/.
20
Appendix A. Variable information
Variable
Denition
Source
Additional notes
Capital
controls
Index ranging from 0 to 3. Country receives

1 point for a capital control in each of these
categories: capital market securities, capital
transactions for personal capital movements,
and capital transactions for institutional investors.
Index constructed as the rst standardized
principal component of: distance to U.S., cost
of phone call to U.S., and dummy variables if
the country has a common language, shared
land border, former colonial relationship or
is in a currency union with the U.S.
Index constructed as the rst standardized
principal component of: control of corruption,
rule of law, regulatory quality, and property rights.
Calculated using data from the International

Monetary Fund's Annual Report on Exchange
Rate Arrangements and Exchange Restrictions
(AREAER), years 19972005.
If data is not available for a specic component

of the index then it is assumed to be 0.
Distance is the log of the great circle distance in

miles between the capital city of each country
and the United States. Cost of phone call is the
lowest cost available for a 5-minute international
phone call from the country to the United
States during business hours.
Corporate
Corruption measures extent to which public power
governance
is exercised for private gain, including petty and
grand forms of corruption and capture of state
by elites and private interests. Rule of law measures
extent to which agents have condence in and abide
by the rules of society, including contract enforcement
and likelihood of crime and violence. Regulatory
quality measures ability of government to formulate
and implement sound policies and regulations that
permit private sector development. Property rights is
assessment of the ability of individuals to accumulate
private property, secured by clear laws enforced by
the state.
Stock return indices based on Datastream's index
Constructed using data on stock and bond return
Correlation
Correlation in monthly returns over the last
if available. If Datastream does not calculate the
indices in U.S. dollars from Datastream. Bond
three years. Returns are stock returns for equity
regressions and bond returns for bond regressions. indices include corporate, agency and government index, then I use the S&P/IFC index, and if this is
not available, then I use the Dow Jones index
bonds.
(all of which are reported by Datastream). See
notes on Return for details on bond indices.
From Beck et al. (2000), revised version with data
Private bond market capitalization includes
Financial
Measured by stock market capitalization to GDP
through 2005 available at: http://econ.worldbank.org. private domestic debt securities issued by
development for equity regressions. Measured by private bond
nancial institutions and corporations. Financial
market capitalization to GDP for bond regressions.
development is instrumented for in both the equity
and bond regressions as described in Section 4.1.
Bond returns from Citigroup's WGBI, All Maturities
Returns
Percent difference in average monthly returns with Stock and bond return indices in U.S. dollars from
the U.S. over the last year. Returns are stock returns Datastream. Bond indices include corporate, agency Total Return Indices for developed countries and
JPMorgan's EMBI Global Diversied Bond Return
and government bonds.
for equity regressions and bond returns for bond
regressions.
Indices for developing countries. If neither source
is available, then I use Citigroup's ESBI index, then
Merrill Lynch's USD Emerging Sovereign Index. See
notes on Correlation for details on stock indices.
Imports are total merchandise imports including
Data on imports and exports from: International
Trade
Sum of total exports and imports between the
Monetary Fund, Direction of Trade Statistics. Data on cost, insurance and freight (c.i.f.).
United States and the country divided by the
GDP from World Bank, World Development
country's GDP.
Indicators CD-ROM (2006).
Closeness
Data on phone calls is from

http://www.phone-rate-calculator.com. Remainder
of data is from Rose and Spiegel (2002) and
Clark et al. (2004). Data is available at websites:
http://faculty.haas.berkeley.edu/arose/RecRes.htm
and www.nber.org/~wei.
Data on corruption, rule of law and regulatory
quality is from World Bank (2006). Data on
property rights is from Heritage Foundation,
Index of Economic Freedom, available at
http://www.heritage.org/index/.
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Contents lists available at ScienceDirect

Journal of International Economics

Why do foreigners invest in the United States?

innovative instrumentscharacteristics that were perceived to be

Data from Bureau of Economic Analysis (2008).

K.J. Forbes / Journal of International Economics 80 (2010) 321

decisions that drive these capital inows is critically important to

literature on global imbalances. There is also strong evidence that

K.J. Forbes / Journal of International Economics 80 (2010) 321

See Griever et al. (2001).

K.J. Forbes / Journal of International Economics 80 (2010) 321

long-term return differentials are important in studying the

Ofcial and private

Private sector investment

K.J. Forbes / Journal of International Economics 80 (2010) 321

accurate calculation of returns for specic asset classes (for which

where USInvestmentsi,j is total holdings of U.S. portfolio liabilities by

Debt USG data

Debt IMF data

entire portfolio holdings by country i of security j and is calculated as

K.J. Forbes / Journal of International Economics 80 (2010) 321

Europe. Instead of focusing on a cross-section of countries, Leuz et al.

3. The model and data: why do foreigners invest in the

This paper uses a modeling framework with substantial exibility

where wij is the proportion of individual i's total wealth invested in

This includes international and domestic debt securities, as well as government,

K.J. Forbes / Journal of International Economics 80 (2010) 321

Aggregate the individual portfolio holdings to obtain the market

with Pi as the proportion of world wealth owned by country i, wi* is

and combine Eqs. (5) through (7) to obtain:

s wij wj* = z ci cij z Pi ci Pk ckj :

With and as constants, = 1/s2 and = z'Pici Pkck,US.

This theoretical framework can incorporate the range of factors

K.J. Forbes / Journal of International Economics 80 (2010) 321

K.J. Forbes / Journal of International Economics 80 (2010) 321

Based on USG data.

U.S. equities and debt. To address this problem in the equity

K.J. Forbes / Journal of International Economics 80 (2010) 321

GDP per Capita

4.2. Central results: equity markets

better corporate governance tend to invest more in U.S. equity

K.J. Forbes / Journal of International Economics 80 (2010) 321

varies with a country's income level. To begin, column 4 of Table 4

K.J. Forbes / Journal of International Economics 80 (2010) 321

Columns 5 and 6 show the results. The estimated coefcient on Financial

where USInvestmentsi and ForeignInvestmentsi are country i's holdings

This is close to the mean plus one standard deviation.

less country i's market capitalization. Each variable can be calculated

K.J. Forbes / Journal of International Economics 80 (2010) 321

Different estimation techniques

K.J. Forbes / Journal of International Economics 80 (2010) 321

Fin. Dev. * GDP cap

coefcient on Capital Controls is usually negative and signicant and the

that the impact of nancial development on investment in U.S. bond

K.J. Forbes / Journal of International Economics 80 (2010) 321

U.S. bonds is weaker for higher income countries. The coefcient on

K.J. Forbes / Journal of International Economics 80 (2010) 321

have a negative and signicant effect on foreign investment in U.S.

U.S. equities ($mn)

U.S. bonds ($mn)

development to the sample mean in each country. The bottom of the

K.J. Forbes / Journal of International Economics 80 (2010) 321

lower income countries, tend to have signicantly less exposure to