FRBSF Economic Letter
2004-25; September 10, 2004
Exchange Rate Movements and the U.S. International Balance
Sheet
The U.S. current
account deficit has been growing for several years, as the country
has been importing increasingly more than it has
been exporting. In 1992, the current account deficit was 0.8% of
GDP, and by the end of 2003, it had soared to an unprecedented
4.8% of GDP.
To finance this widening deficit, the U.S. has had
to borrow massively from foreigners, resulting in large net financial
inflows. Many
have pointed to these inflows as the main reason for the rising
net U.S. indebtedness to foreigners; in 1992, U.S. net indebtedness
was 7% of GDP, and at the end of 2003 it was over 24% of GDP.
Net
foreign indebtedness is measured by the "net international
investment position," or NIIP, which is calculated annually
by the U.S. Bureau of Economic Analysis. The NIIP is negative when
the value of U.S. investments abroad is less than the value of
foreign investments in the U.S., and it is positive in the reverse
case. The size of the negative NIIP has raised concerns in some
quarters about whether current account deficits of this magnitude
are sustainable. For example, if foreign investors, both private
and official, had accumulated a disproportionate share of U.S.-issued
securities in their portfolios, then they might want to pull their
money out of the U.S. and diversify into non-U.S. assets. Doing
so would shrink the pool of resources available for the U.S. to
finance its foreign borrowing and, according to many, that could
lead to higher interest rates. Higher interest rates, in turn,
could put a damper on aggregate demand and lead to slower economic
growth.
Recent research has examined the evolution of the NIIP and
has found that current account deficits and the associated net
financial
inflows are not the only factors influencing it; rather, research
finds that changes in asset prices and especially in exchange
rates have played an important role recently because of their effect
on the values of the stocks of assets and liabilities that make
up the NIIP.
In this Economic Letter, I review this literature,
discuss these determinants of the NIIP, and provide some evidence
on their
relative quantitative importance. In particular, the evidence
suggests that
since the late 1990s, exchange rate movements have had a more
significant effect on the value of U.S. assets abroad and,
therefore, have
played a larger role in shaping the evolution of the NIIP.
What
is the NIIP, and what are its determinants?
The U. S. NIIP reflects the U.S. international balance sheet.
On one side of the ledger is the value of the accumulated
stock of
U.S. claims on foreigners; this would include, for example,
the shares or bonds of, say, German firms held by U.S. residents.
On the other side is the value of the accumulated stock of
foreign
claims on U.S. residents; this would include, for example,
shares or bonds of U.S. firms held by German residents. The
difference
between the two is the NIIP, and when claims of foreigners
on the
U.S. are greater than U.S. claims on foreigners, it represents
the net foreign indebtedness of the U.S. economy.
The types
of assets and liabilities included in this measure go well beyond
corporate securities like shares and bonds.
For example,
U.S. claims on foreigners include other private assets,
such as the value of U.S. direct investment abroad (U.S. subsidiaries
and
branches in foreign countries) and U.S. bank loans and
trade
credits. They also include official reserve assets (such
as gold and foreign
currency reserves) and government assets (such as foreign
treasury bills).
Among the most important determinants of
the NIIP—and the most commonly referred to until recently—are
net financial
inflows.
For example, consider today's current account deficit
in the U.S. In order to pay for the excess of imports over
exports,
the U.S.
must borrow funds from foreigners, and, by the same token,
foreigners must purchase liabilities issued by the U.S.
Hence, a current
account deficit generates net borrowing from abroad.
These financial transactions
are recorded as net financial inflows and imply an increase
in the stock of net U.S. liabilities to foreigners and
a deterioration
in the NIIP.
But another determinant of the NIIP to consider
is valuation adjustment. This occurs through changes in the
value of the stock of foreign
assets owned by U.S. residents and in the value of
the stock of U.S. liabilities held by foreigners. Changes
in the values
of these
U.S. assets and liabilities reflect fluctuations both
in asset prices and in exchange rates.
Valuation adjustments
arising from asset price fluctuations occur when the prices of
existing equity shares change.
For example,
when the price of the shares of a U.S. firm owned by
a German investor increases, so does the value of his
asset
holdings
of that firm.
Therefore, it leads to a deterioration of the U.S.
NIIP. In the same way, when the share prices of a U.S. firm
fall, so
does
the value of the foreign investor's asset holdings,
leading to an improvement
in the U.S. NIIP. Conversely, when the price of foreign
assets held by U.S. investors increases, the U.S. NIIP
improves,
while a drop in those prices leads to a decrease in
the value of
the gross asset position and to a deterioration of
the U.S. NIIP.
When assets or liabilities are denominated
in foreign currencies, exchange rate movements may also create
valuation
adjustments
affecting the dollar equivalent of the value of gross
U.S. assets and liabilities.
As a substantial fraction of U.S. claims on foreigners
is denominated in foreign currencies (39% according
to Tille
2004), exchange
rate movements generate corresponding gains or losses
on these assets.
For example, an appreciation of the dollar drives down
the dollar value of assets held by U.S. investors that
are denominated
in
foreign currencies. In contrast, most U.S. liabilities
to foreigners are denominated in dollars; so their
value is
basically not
affected by exchange rate movements. Therefore, holding
other things equal,
a dollar appreciation results in a deterioration of
the NIIP; and, correspondingly, when the dollar depreciates,
the dollar
value
of foreign-currency denominated assets held by U.S.
investors increases, resulting in an improvement in the U.S. NIIP.
Why
do valuation adjustments matter now? Before the late 1990s valuation
adjustments had only a small impact on the NIIP—in other words,
net financial
inflows
arising from
the current account deficit and changes in the NIIP
traced each other closely for the most part.
 In the late 1990s,
however, the two began to diverge significantly. Figure 1 plots
net financial inflows and
annual changes
in the U.S. NIIP from 1997 to 2003, the last year of
available data.
As the figure shows, in 1999, for example, net financial
inflows amounted
to about 2.5% of GDP, but the change in the NIIP was
actually positive at 1% of GDP; on a cumulative basis,
from 1998
to
2003 the net
financial inflows required to fund the ongoing current
account deficits amounted to 21.9% of GDP, while the
U.S. NIIP deteriorated
by only 11.8%. The difference between these numbers
suggests how important valuation adjustments have been in shaping
the recent
behavior of the U.S. NIIP. Specifically, valuation
adjustments
have added a significant counterbalance to the increase
in the U.S. NIIP arising from the current account deficit.
A
key reason for the growing importance of valuation adjustments
for the U.S. NIIP is the country's increased
financial
integration with the rest of the world over the last
two decades. The
volumes of both gross assets and gross liabilities
increased sharply
in the U.S., and, as a result, asset price and exchange
rate fluctuations
generated larger capital gains and losses.
Similar results
have been found for other countries. Lane and Milesi-Ferretti
(2001) reported that for industrialized
countries,
such as Australia,
Austria, Finland, the Netherlands, New Zealand, Sweden,
Switzerland, the U.K, as well as the U.S., the correlation
between the
current account and changes in the NIIP is low or even
negative, suggesting
the increased importance of valuation adjustments for
short-run
movements in the NIIP. Like the U.S., these countries
have developed a significant degree of financial integration
with the rest of
the world and built up substantial gross international
investment positions (see also Obstfeld and Rogoff
2001 and Lane and
Milesi-Ferretti 2003). In a subsequent study, Lane
and Milesi-Ferretti (2004)
found similar patterns for some emerging economies,
such as Hungary, Indonesia, Mexico, and Thailand.
Which matters
more—asset price changes or exchange rate movements? Tille (2003) explores the relative importance of asset
price changes and exchange rate changes for valuation
adjustments. He finds that
between 1999 and 2001 valuation adjustments were responsible
for 37% of the worsening of the U.S NIIP, and, of that,
30%
can be
imputed to exchange rate changes; specifically, the appreciation
of the dollar during that period had a substantial impact
on the value of assets held by U.S. residents that were
denominated in
foreign currencies, while asset price declines played
a quantitatively limited role. Tille (2004) also reports
that during the late
1990s and up to 2002 it was common for valuation adjustments
caused by
exchange rate movements to influence the NIIP substantially—on
the order of 2% of GDP.
Why did exchange rate movements become so important?
The main reason is the surge in U.S. holdings of assets
denominated
in foreign
currencies—these amounted to 15% of GDP in 1992 and
to 24% at end of 2002 (Tille 2004). More recently,
the relative
importance
of exchange rates appears to continue to hold. During
2002 and
2003, as the dollar depreciated substantially, valuation
adjustments arising from exchange rate changes cushioned
the deterioration
of the U.S. NIIP. As the figure illustrates, net financial
inflows amounted to about 5.4% of GDP in 2002 and 5%
in 2003,
while the
ration of the NIIP to GDP actually improved by 0.26%
between those two years. The improvement is accounted
for by valuation
adjustments,
and the bulk of it by exchange rate movements. Conclusions
The increase in the degree of financial integration
of the U.S. with the rest of the world has widened the
channel by
which valuation
adjustments, and particularly exchange rate movements,
can affect the NIIP. For example, a depreciation
of the dollar
can improve
the NIIP, as gross assets are exposed to valuation
adjustments due to exchange rate movements, while gross liabilities
are not; this valuation effect of exchange rate movements
is
equivalent to a transfer of wealth from foreign countries
to the U.S.
Likewise,
an increase in the value of the dollar worsens the
NIIP
and it is equivalent to a wealth transfer from the
U.S. to the
foreign
countries it borrows from.
The consequences of exchange
rate movements for a country that borrows in dollars, as many
emerging market economies
do, however,
are quite different. A depreciation of its own
currency increases the burden of its foreign borrowing and
worsens its NIIP.
All this is not to say, however,
that we need not pay attention to the relation between the NIIP
and the
current account
deficit. Rather, as Gourinchas and Rey (2004)
have pointed out, the
valuation adjustment through exchange rates is
particularly helpful in
explaining short-term and medium-term changes
in the NIIP—that is, over at
most a couple of years. Longer-term developments
in the NIIP, however, are more deeply rooted
in trade and the
associated
condition of
current accounts.
Michele Cavallo
Economist References
[URLs accessed August 2004.]
Gourinchas, Pierre-Olivier, and Hélène Rey. 2004. "International
Financial Adjustment." Mimeo, University of California, Berkeley.
http://socrates.berkeley.edu/~pog/academic/IFA/ifamarch16.pdf
Lane, Philip R., and Gian Maria Milesi-Ferretti.
2001. "The
External Wealth of Nations: Measures of Foreign Assets and Liabilities
for Industrial and Developing Countries." Journal
of International Economics 55 (December), pp. 263-294.
Lane, Philip R., and Gian
Maria Milesi-Ferretti. 2003. "International
Financial Integration." IMF Staff Papers 50 (September), pp.
82-113.
http://www.imf.org/External/Pubs/FT/staffp/2002/00-00/pdf/lane.pdf
Lane,
Philip R., and Gian Maria Milesi-Ferretti. 2004. "Financial
Globalization and Exchange Rates." Mimeo. IMF.
http://www.imf.org/external/np/res/seminars/2004/60/pdf/ferret.pdf
Obstfeld,
Maurice, and Kenneth Rogoff. 2001. "Perspectives
on OECD Economic Integration: Implications for U.S. Current Account
Adjustment." In Global Economic Integration: Opportunities
and Challenges, pp. 169-208. FRB Kansas City.
http://www.kc.frb.org/publicat/sympos/2000/s00rogo.pdf
Tille,
Cédric. 2003. "The
Impact of Exchange Rate Movements on U.S. Foreign Debt." Current
Issues in Economics and Finance 9 (January), pp.1-7.
FRB New York.
http://www.ny.frb.org/research/current_issues/ci9-1.html
Tille,
Cédric. 2004. "Financial Integration and the
Wealth Effect of Exchange Rate Fluctuations." Mimeo. FRB New York.
|
