CEP Discussion Paper No 662 December Financial Globalization and Exchange Rates Philip R. Lane and Gian Maria Milesi-Ferretti

Transcription

1 CEP Discussion Paper No 662 December 2004 Financial Globalizaion and Exchange Raes Philip R. Lane and Gian Maria Milesi-Ferrei

2 Absrac The founders of he Breon Woods Sysem sixy years ago were primarily concerned wih orderly exchange rae adjusmen in a world economy ha was characerized by widespread resricions on inernaional capial mobiliy. In conras, he rapid pace of financial globalizaion during recen years poses new challenges for he inernaional moneary sysem. In paricular, large gross cross-holdings of foreign asses and liabiliies means ha he valuaion channel of exchange rae adjusmen has grown in imporance, relaive o he radiional rade balance channel. Accordingly, his paper empirically explores some of he iner-connecions beween financial globalizaion and exchange rae adjusmen and discusses he policy implicaions. JEL Classificaion Numbers: F31, F32 Keywords: Financial inegraion, capial flows, exernal asses and liabiliies This paper was produced as par of he Cenre s Globalisaion Programme. The Cenre for Economic Performance is financed by he Economic and Social Research Council. Acknowledgemens Revised version of a paper prepared for he Dollars, Deb, and Deficis 60 Years Afer Breon Woods Conference co-organized by he Banco de España and he IMF, Madrid, June The auhors hank heir discussan Daniel Cohen, conference paricipans in Madrid and Budapes, and paricipans a he Kiel Insiue for World Economics seminar and he Glasgow-Srahclyde join seminar for useful commens, and Abdel Senhadji and Cédric Tille for daa on Ausralia and he Unied Saes. Marco Arena, Charles Larkin, and Vahagn Galsyan provided excellen research assisance. Lane is graeful for he hospialiy of he Cenre for Economic Performance a he LSE. Par of his paper was wrien while Lane was a visiing scholar a he Inernaional Moneary Fund. Lane also graefully acknowledges he financial suppor of he Irish Research Council on Humaniies and Social Sciences (IRCHSS) and he HEA-PRTLI gran o he IIIS. This paper is also par of a research nework on The Analysis of Inernaional Capial Markes: Undersanding Europe s Role in he Global Economy, funded by he European Commission under he Research Training Nework Programme (Conrac No. HPRN CT ). Philip Lane is Professor of Inernaional Macroeconomics a Triniy College Dublin and Direcor of he Insiue for Inernaional Inegraion Sudies (IIIS). He is also a Research Fellow a CEPR and was a Visiing Fellow a he Cenre for Economic Performance, London School of Economics. Gian Maria Milesi-Ferrei is a member of he Inernaional Moneary Fund and CEPR. Auhors addresses: plane@cd.ie; gmilesiferrei@imf.org Published by Cenre for Economic Performance London School of Economics and Poliical Science Houghon Sree London WC2A 2AE All righs reserved. No par of his publicaion may be reproduced, sored in a rerieval sysem or ransmied in any form or by any means wihou he prior permission in wriing of he publisher nor be issued o he public or circulaed in any form oher han ha in which i is published. Requess for permission o reproduce any aricle or par of he Working Paper should be sen o he edior a he above address. P. R. Lane and G. M. Milesi-Ferrei, submied 2004 ISBN X

3 - 1 - I. INTRODUCTION Financial globalizaion has been one of he mos imporan rends in he world economy in recen decades. This process has involved sharply rising foreign asse and liabiliy posiions, wheher scaled by GDP or by domesic financial variables (Lane and Milesi-Ferrei 2003, Obsfeld and Taylor 2004). In addiion o larger gross posiions, financial globalizaion has also allowed a greaer dispersion in ne foreign asse posiions, wih a significan number of counries emerging as eiher large ne crediors or ne debors (Lane and Milesi-Ferrei 2002a). In general, financial globalizaion is one of he key rends ha has reshaped he global economy relaive o he environmen envisaged by he designers of he Breon Woods sysem in 1944 and undersanding is macroeconomic implicaions is crucial in formulaing a view on he appropriae fuure direcion for he inernaional moneary sysem. One consequence of financial globalizaion is ha he inernaional spillovers from asse price and currency movemens have been enhanced. In addiion o affecing he direcion and magniude of ne capial flows, asse price dynamics also generae changes in he valuaion of exising invesmen posiions. For insance, he value of he ne liabiliy posiion of he Unied Saes is quie sensiive o he relaive movemens in he U.S. versus non-u.s. equiy markes and swings in he value of he dollar. Indeed, such valuaion effecs may be as imporan as curren accoun imbalances in driving he dynamics of ne foreign asse posiions (Lane and Milesi-Ferrei 2001a, 2002a, Gourinchas and Rey 2004). Of course, asse price and currency movemens canno be viewed as exogenous influences on he value of inernaional invesmen posiions, since shifing global demands for various asses and liabiliies are an imporan driver of financial reurns and exchange raes (e.g. hrough he deerminaion of counry and currency risk premia). Moreover, here is an obvious inerplay beween he financial and rade accouns ha provides anoher link beween ne foreign asse posiions and exchange raes: a long-erm debor may require real depreciaion in order o generae he rade surpluses ha are he counerpar of susained ne invesmen income ouflows (Lane and Milesi-Ferrei 2002b, 2004b). In his paper we explore he inerconnecions beween financial globalizaion and exchange raes. To esablish he sylized facs abou financial globalizaion, he firs par of he paper examines rends in gross and ne inernaional invesmen posiions and heir componens for a large se of advanced and emerging economies. In Lane and Milesi-Ferrei (2003) we documened for indusrial counries an acceleraion in he pace of financial globalizaion since he mid-1990s; in his paper we updae our esimaes of exernal asses and liabiliies for a sample of emerging markes as well. 1 As noed above, a cenral aspec of our analysis is he focus on he facors explaining he changes in exernal posiions: no only capial flows bu also valuaion effecs, such as hose caused by asse price and exchange rae flucuaions. In he second par of he paper we firs provide an analyical framework ha is useful in undersanding he dynamics of ne foreign asses, and hen explore he conribuion of 1 Lane and Milesi-Ferrei (2004c) explain he consrucion of he daa.

4 - 2 - currency movemens o he revaluaion componen of ne foreign asse dynamics. This relaionship depends on a number of facors. For insance, he impac of an exchange rae depreciaion will depend on gross foreign asse and liabiliy holdings (in addiion o he ne posiion); he currency composiion of boh sides of he inernaional balance shee; and he co-movemen beween exchange rae changes and oher financial reurns. 2 These facors will vary across counries, according o he level of developmen, counry size and oher characerisics. Along one dimension, a high proporion of he liabiliies of a major indusrial counry is likely o be denominaed in is own currency, whereas a ypical emerging marke economy exhibis significan liabiliy dollarizaion. Counries also differ as o he mix of shor- and long-erm deb and he levels of porfolio equiy and FDI holdings in he inernaional balance shee: he impac of currency movemens on he ne exernal posiion is undoubedly sensiive o he exernal capial srucure. 3 Our analysis suggess ha heoreical work on open economy macroeconomics should srive o incorporae elemens such as persisen non-zero ne foreign asse posiions, large gross asse cross-holdings and mixed porfolios of equiy and deb insrumens and illusrae why hese feaures can make a difference o model dynamics and welfare analysis. Finally, in he las par of he paper we draw ou he implicaions of our empirical work for policy analysis. In paricular, we highligh ha he valuaion channel is unlikely o be open o policy manipulaion on a susainable basis. II. TRENDS IN INTERNATIONAL FINANCIAL INTEGRATION In Lane and Milesi-Ferrei (2002a, 2003), we documened a number of sylized feaures of inernaional capial flows and exernal posiions in indusrial counries. Flows o and from such counries increased subsanially in recen years, boh in absolue erms and as shares of GDP and domesic wealh. In his conex, he increase in FDI and porfolio equiy invesmen is paricularly noeworhy. The increase in gross exernal asses and liabiliies means ha valuaion effecs have become more imporan. We highligh hese feaures again below, wih an updaed daase including boh indusrial counries and emerging markes. A. Ne flows and ne posiions, indusrial counries Figure 1 plos ne foreign asses (as a raio of GDP) agains GDP per capia, measured in curren U.S. dollars, for he year There is a wide dispersion in ne exernal posiions among indusrial counries, wih Swizerland being by far he larges credior, and New Zealand and Iceland he larges debors in relaion o GDP. The posiive relaion beween ne 2 Tille (2003) provides an ineresing analysis for he Unied Saes. 3 Lane and Milesi-Ferrei (2001b) analyze some of he deerminans of he composiion of he inernaional balance shee.

5 - 3 - foreign asses and GDP per capia, shown in he Figure o hold in he cross-secion, holds also along he ime-series dimension as a counry ges richer, relaive o rading parners, is ne foreign asse posiion ends o improve (Lane and Milesi-Ferrei, 2002a). Table 1 summarizes ne capial ouflows from indusrial counries over he period , ogeher wih changes in heir exernal posiion. In absolue erms, Japan has been he larges capial exporer, while Swizerland and Norway had he highes ne ouflows relaive o heir GDP. On he oher side, he Unied Saes had by far he larges ne inflows in absolue erms, and also as a raio of GDP. While here is clearly a posiive relaion beween ne ouflows and change in he ne exernal posiion, he Table highlighs he imporance of valuaion effecs: for example, he Unied Kingdom was a ne capial imporer during his period, bu is ne exernal posiion improved by 7.5 percen of GDP; Canada insead was a ne capial exporer, bu is ne posiion deerioraed. In absolue erms, he difference beween ne capial inflows and he change in he ne asse posiion is paricularly large for he Unied Saes ne inflows were over $600 billion higher han he ne accumulaion of liabiliies. The reasons for his discrepancy are furher discussed below. B. Gross flows and gross posiions, indusrial counries Figure 2 summarizes he evoluion of gross exernal asses and liabiliies in indusrial counries during he pas 20 years. The growh in inernaional financial inerdependence is sriking: during his period, aggregae asses and liabiliies ripled as a share of GDP, FDI asses and liabiliies increased four-fold, porfolio equiy asses and liabiliies six-fold, and deb asses and liabiliies 2 ½ imes. Focusing on he mos recen period, he char also shows he effecs of he global decline in sock marke valuaions beween end-1999 and end-2002, which is he main facor behind he reducion in he sock of porfolio equiy asses and liabiliies during his period, and he recovery in sock marke valuaion and flows in Table 2 summarizes gross capial flows o and from indusrial counries during he mos recen period ( ). The size of gross flows is remarkable, paricularly o and from financial ceners such as Swizerland and he Unied Kingdom, bu also o and from he euro area and, relaive o GDP, Scandinavian counries. While ne flows are also subsanial, he daa sugges ha porfolio diversificaion, raher han ineremporal borrowing and lending, is he dominan moive for inernaional asse ransacions among indusrial counries. The daa in Table 2 also confirm he imporance of valuaion effecs, in addiion o gross flows, in explaining he dynamics of exernal asses and liabiliies. For example, exernal 4 Only a few counries in our sample (including he Unied Saes) measure FDI a marke value: hence, sock marke flucuaions have a less dramaic impac on FDI socks compared o porfolio equiy holdings. Of course, he fall in foreign porfolio equiy asses and liabiliies relaive o GDP does no imply a decline relaive o oal domesic equiy holdings.

6 - 4 - liabiliies (and, o a lesser exen, asses) in he Unied Saes increased by subsanially less han he underlying flows. The primary reason was he decline in U.S. sock marke valuaions during his period, which reduced he value of boh foreign equiy and FDI holdings in he Unied Saes. The smaller decline in sock marke valuaions (measured in U.S. dollars) in oher counries during his period helps explain he smaller capial losses incurred by U.S. invesors on heir foreign equiy holdings. 5 C. Ne flows and ne posiions, emerging markes We focus on a sample of 21 emerging markes (lised in he Appendix). Figure 3 plos he evoluion of he average curren accoun balance as a raio of GDP in our emerging markes sample. The key cycles in capial flows o emerging markes sand ou clearly from his picure: he deerioraion of curren accoun imbalances in he lae 1970s unil he deb crisis, heir sharp reversal during he remainder of he 1980s, he increase in imbalances during he early 1990s, and he new reversal following he Mexican crisis and especially he Asian crisis. Indeed, boh he average and aggregae curren accoun posiion of he emerging counries in our sample urned posiive in 1998 and increased furher in recen years. The dynamics of he ne exernal posiion, expressed as a raio of GDP, are ploed in Figure 4. I shows he deerioraion caused by he deb crisis and is afermah, a subsequen sharp improvemen, he sabilizaion of he ne exernal posiion from 1990 o 1996, he deerioraion caused by he sharp declines in GDP and real exchange depreciaion characerizing he Asian crisis, and he subsequen improvemen associaed wih curren accoun surpluses and srenghening currencies in Asia. In he daa, here is no evidence of an increased dispersion in curren accoun balances across he counries in our sample (ha is, here is a significan common rend in he ne capial flows o his emerging marke group), while he dispersion of he underlying ne exernal posiions has increased. Figure 5 plos he ne foreign asse posiion, scaled by GDP, in relaion o GDP per capia in curren US dollars a end While here is sill a posiive relaion beween ne foreign asses and GDP per capia, his relaion is much weaker han for indusrial counries. Indeed, crediors include economies wih high GDP per capia, such as Taiwan province of China, bu also economies wih much lower GDP per capia, such as Russia and Venezuela. 6 5 The difference in sock marke performance beween he Unied Saes and world markes is enirely accouned for by he year 2003, during which he sharp depreciaion of he U.S. dollar raised foreign sock reurns measured in dollars. Beween end-1998 and end-2002 he decline in sock marke valuaions in he Unied Saes and world markes was similar. 6 In addiion o he sandard macroeconomic drivers of ne foreign asse posiions ha were emphasized by Lane and Milesi-Ferrei (2002a), poliical risk and naural resource endowmens are oher variables ha may be imporan, especially in reference o he counries lised here.

7 - 5 - Table 3 characerizes he size of ne capial flows among some counries in our sample, boh in absolue erms and as a raio of GDP, during he period The able shows a number of Lain American and Cenral European counries as he larges ne recipiens of ne capial flows, alhough Turkey and Argenina experienced ne ouflows if IMF and excepional financing are need ou. 7 As he daa on curren accoun dynamics sugges, a number of emerging markes paricularly Asian counries, ogeher wih Russia have been on average ne capial exporers, o a subsanial degree. For example, Thailand s cumulaive ne ouflows over he 5-year period oal over 30 percen of is 2003 GDP. D. Gross flows and gross posiions, emerging markes Figure 6 provides a longer-erm perspecive on he size of exernal asses and liabiliies in hese emerging markes. Boh asses and liabiliies have increased subsanially as a raio of GDP during he pas 20 years. However, here is virually no increase in average exernal liabiliies when scaled by expors, raher han GDP, while he rend increase in exernal asses is sill visible. This sands in conras wih he evidence for he advanced economies, where he increase, especially since he mid-1990s, is very srong even as a share of expors. As noed earlier, an ineresing quesion is wheher he composiion of exernal asses and liabiliies has changed over ime. Table 4 provides evidence ha highlighs he increased relaive imporance of direc invesmen and porfolio equiy liabiliies. The averages hide subsanial heerogeneiy counries such as Chile and he Cenral European economies in our sample (Czech Republic, Hungary, and Poland) have exernal equiy liabiliies above 50 percen of GDP, while he levels end o be lower in Asian economies. The able also documens he increase in foreign exchange reserves, expressed as a share of GDP, during he pas 20 years. I should be noed, however, ha his increase has gone hand in hand wih he increase in oher exernal asses, so ha a he end of 2002 reserves in our sample accoun for he same share of oal exernal asses as in 1982 (over one hird). Direc invesmen and porfolio equiy asses have also increased during he pas wo decades, and by 2002 represened around 12 percen of GDP and over 20 percen of oal exernal asses. Table 5 characerizes gross capial flows o and from some emerging economies during he period The paern reveals an ineresing dichoomy. For a number of counries, gross flows primarily reflec ineremporal borrowing or lending decisions, wih counries accumulaing ne asses or ne liabiliies eiher cumulaive inflows or cumulaive ouflows are clearly dominan (see also Table 3). Among counries ha accumulaed subsanial ne asses, a number of Eas Asian counries sand ou, paricularly Indonesia, Korea, Malaysia, and Thailand, ogeher wih oil-exporing counries such as Russia. For anoher group of counries, insead, gross inflows and gross ouflows have boh been large and roughly similar 7 See IMF (1993) for a descripion of balance-of-paymens ransacions classified as excepional financing.

8 - 6 - in magniude, reflecing increased financial inegraion wih he world economy. Examples include Chile and India. China has experienced large inflows and ouflows, bu also significan ne foreign asse accumulaion. Of course, similar aggregae levels of gross inflows and gross ouflows can conceal significan ne imbalances wihin specific asse caegories: for insance, China is a major ne recipien of FDI flows while simulaneously accumulaing a significan volume of foreign reserves. Having provided a broad characerizaion of he growh in inernaional balance shees in recen years for boh advanced and emerging economies, we nex urn o providing a simple framework for undersanding he underlying drivers. III. EXTERNAL ASSET DYNAMICS In his secion, we provide a simple accouning framework ha relaes he dynamics of ne foreign asses o rade flows, growh, raes of reurn, and real exchange raes. The goal is o lay ou he various channels by which exchange raes and oher macroeconomic fundamenals can affec he exernal adjusmen process. We hen decompose he facors underlying changes in ne foreign asses over he pas decade for a se of emerging markes. A. Accouning for exernal asse dynamics The change in ne foreign asses B can be wrien as he sum of ne capial ouflows and ne capial gains: B B 1 ( FX FA) + KG (1) where FX is ne accumulaion of foreign exchange reserves, FA is ne capial inflows (excluding reserves), and KG is he ne capial gain on he ne exernal posiion ousanding (change in sock minus underlying flow). Denoe by CA he curren accoun balance, KA he capial accoun balance, and EO ne errors and omissions. 8 Making use of he basic balance of paymens ideniy CA + KA + FA FX + EO 0, we can re-wrie (1) as follows: B B CA + KA + EO + KG (2) 1 In line wih saisical reporing pracices, all variables are expressed in US dollars. Equaion (2) can also be expressed as follows: B B BGST + ( KA + EO ) + ( i A i L + KG ) (3) A L In balance of paymens saisics (IMF, 1993) he so-called capial accoun measures cerain ransfers (such as deb forgiveness); capial flows are recorded in he financial accoun.

9 - 7 - where BGST is he balance of rade in goods and services plus ne ransfers, A and L are exernal asses and liabiliies, respecively, and A L i, i are he nominal yields on hese asses and liabiliies. Taking raios of GDP and indicaing such raios wih lower-case leers, we can express (3) as follows: A L i A 1 i L 1+ KG γ b b 1 bgs + ( ka + eo) + b $ 1 (4) Y 1 + γ where γ is he growh rae of nominal GDP measured in US dollars. Anoher way o re-wrie he above expression is as follows: KG π d g b b 1 ca + + ( ka ) $ + eo b 1 b 1 (5) Y (1 + g)(1 + π ) 1+ g where g is he economy s real growh rae, π is he rae of inflaion (measured wih he GDP deflaor), and d is he rae of nominal exchange rae depreciaion vis-à-vis he US dollar. In oher words, changes in he ne exernal posiion can be due o several facors: 1. he curren accoun; 2. ne capial gains (measured in US dollars); 3. he capial accoun and ne errors and omissions; 4. he effec of exchange rae changes on he pas ne foreign asse posiion; 9 5. he effec of real GDP growh on he pas ne foreign asse posiion. An alernaive way o express equaion (5) is in erms of overall raes of reurn on exernal A L asses and liabiliies. Define k ( k ) as he rae of capial gain on exernal asses (liabiliies), A A A L A 1+ i + k measured in US dollars, so ha k A 1 k L 1 = KG, and le rˆ = be he real rae US 1+ π of reurn on foreign asses, measured in US dollars, wih an analogous definiion holding for he rae of reurn on foreign liabiliies r ˆL. In his case we can re-wrie (5) as follows: 9 If exernal asses and liabiliies are all denominaed in domesic currency, he capial gain effec will go exacly in he opposie direcion from he exchange rae change effec. Indeed, assume for simpliciy ha asse prices in domesic currency do no change. In his case, he capial gain expressed in domesic currency is zero, bu expressed in dollars i becomes KG d π d = b $ 1, similar (wih an opposie sign) o he erm b 1 in Y (1 + π )(1 + g) (1 + g)(1 + π ) equaion (5).

10 - 8 - rˆ g ε (1 + g ) rˆ rˆ b b bgs ka eo b a L A L 1 + ( + ) (1 + g)(1 + ε) (1 + g)(1 + ε) (6) Equaion (6) shows several facors ha can accoun for he dynamics of ne foreign asses: he adjused rade balance, he difference beween he real rae of reurn and he growh rae, adjused for he bilaeral real exchange rae vis-à-vis he US dollar, and differences in reurns beween foreign asses and liabiliies. A L If we express he real raes of reurn in domesic currency and denoe hem by r, r, equaion (6) akes he more familiar form: L A L r g r r b b 1 bgs + ( ka + eo) + b 1+ a 1 (7) 1+ g 1+ g This framework delivers several imporan insighs. Firs, he gap beween curren producion and curren absorpion (i.e. he rade balance) is only one facor in deermining he aggregae evoluion of he ne foreign asse posiion: i is vial o also keep rack of valuaion and denominaor effecs. Second, as is shown by he hird erm on he righ hand side (RHS) of equaion (6), he difference beween he rae of reurn and he growh rae, ineraced wih he inheried ne foreign asse posiion, exers a poenially powerful influence on is curren dynamics. Third, as capured by he las erm on he RHS in equaion (6), he gross scale of he inernaional balance shee maers in addiion o he ne posiion: even if he inheried ne foreign asse posiion is zero, he accumulaed levels of gross foreign asses and liabiliies will influence he overall dynamics o he exen ha he raes of reurn differ beween he wo sides of he inernaional balance shee. B. The evoluion of ne foreign asses in emerging markes In Table 6 we provide a simple decomposiion of changes in he raio of ne foreign asses o GDP beween end-1990 and end-2002 for a selecion of emerging markes in our sample. The breakdown follows equaion (4), so ha changes in ne foreign asses are given by he sum of he curren accoun (iself divided ino rade balance and invesmen income), capial accoun and errors and omissions, capial gains (including he effecs of exchange rae changes on he ne exernal posiion), and he effecs of growh on ne exernal asses. A number of feaures are worh highlighing: despie a cumulaive curren accoun in balance or surplus, counries such as Indonesia and Thailand experienced a deerioraion in he raio of ne foreign asses o GDP. For boh counries, his occurred because of capial losses linked o he real depreciaion of heir currencies during he period. On he oher side, he Czech Republic s and Mexico s exernal posiion deerioraed by much less han he large cumulaive curren accoun deficis would sugges, hanks

11 - 9 - o subsanial capial gains on heir ne exernal posiion linked o he real appreciaion of heir currencies beween end-1990 and end More generally, he Tables highlighs he need o focus no only on he curren accoun (which includes he yield on exernal asses and liabiliies), bu also on economic growh and he overall raes of reurn on he exernal porfolio in order o undersand he evoluion of ne foreign asses. Indeed, growh and especially valuaion effecs can have an impac on he evoluion of he exernal posiion ha is of he same order of magniude as rade imbalances. IV. EXCHANGE RATES AND THE ADJUSTMENT PROCESS The framework summarized in equaion (6) highlighs he poenial conribuion of shifs in exchange raes in deermining he dynamics of exernal asse posiions. In his secion, we firs briefly review he radiional channels by which exchange raes influence he adjusmen process, before focusing on he valuaion channel (i.e. he impac of he exchange rae on he raes of reurn earned on holdings of foreign asses and liabiliies). A. Exchange Raes, he Trade Balance and Real Oupu The iner-connecion beween he exchange rae and he rade balance is among he mos-sudied quesions in inernaional economics, in boh academic and policy circles. From a long-run perspecive, he classical ransfer problem posulaes ha persisen credior naions should have more appreciaed real exchange raes. The mechanism underlying he ransfer problem hypohesis is ha he posiive inernaional invesmen reurns earned by long-run crediors have heir counerpar in rade deficis and aendan real appreciaion. Lane and Milesi-Ferrei (2002b, 2004b) find considerable empirical suppor for he ransfer problem, for boh indusrial and developing counries. However, hey find he magniude of he effec differs wih counry characerisics such as openness, size and he level of developmen. In relaion o financial globalizaion, imporan findings are ha he ransfer problem is smaller in he absence of curren and capial accoun resricions and ha equiy financing reduces he size of he ransfer effec relaive o deb financing. A a shorer horizon, he inerplay beween he exchange rae and he rade balance is complex and less well undersood. In paricular, he cyclical correlaion beween he variables will depend on he naure of he shocks hiing he economy, wih nominal, fiscal and real shocks generaing differen co-movemen paerns beween he variables. However, in policy erms, here is a broad consensus ha exchange rae depreciaion is ypically required if he objecive is o engineer an improvemen in he rade balance. Empirical sudies of he elasiciies of rade volumes o exchange raes and income levels provide exensive suppor for his proposiion (Hooper e al 2000). Again, he pace of financial globalizaion and real globalizaion (in erms of produc marke inegraion) will influence hese key elasiciies. For insance, he scale of exchange rae adjusmen is eased, as foreign goods become beer subsiues for domesic goods. In erms of financial globalizaion, wider rade imbalances are more feasible, he more diversified are inernaional porfolios.

12 In racking he dynamics of he raio of ne foreign asses o GDP, real exchange raes also operae by deermining he real value of domesic oupu in erms of inernaional price comparisons. For insance, if variables are measured in US dollars, a foreign asse ha is consan in real dollar erms will shrink relaive o he consan-dollar value of GDP if real appreciaion vis-à-vis he US dollar occurs. This denominaor effec is highlighed in equaion (8) in he previous secion and is powerful channel by which he real exchange rae may influence he dynamics of he NFA/GDP raio. However, in addiion o hese well-known channels, exchange raes also poenially influence he dynamics of inernaional asse holdings hrough influencing he raes of reurn on foreign asses and liabiliies. 10 We focus on his valuaion channel in he res of his secion. B. The Valuaion Channel: A Concepual Framework As oulined earlier in he paper, he dynamics of ne foreign asses depend no only on he rade balance bu also on he raes of reurn earned on accumulaed foreign asses and paid ou on foreign liabiliies. In domesic-currency real erms, he ne impac is given by NETRET = r A r L (8) A L 1 1 where he socks of foreign asses and liabiliies A and L are now expressed in domesic currency. Since hese posiions are predeermined from a ime- perspecive, he ne valuaion impac of a change in he real exchange rae is given by NETRET r r RER RER RER A L = A 1 L 1 (9) I is clear from his expression ha exchange rae changes can have a non-zero valuaion impac even if he iniial ne foreign asse posiion is balanced, so long as he raes of reurn on foreign asses and liabiliies are differenially affeced by a shif in he exchange rae Clearly, in racking a raio, here is some discreion in erms of aribuing he impac of an exchange rae change o he numeraor or he denominaor via he choice of he reference currency. In he nex subsecion, we look a he levels of foreign asses and liabiliies in erms of real domesic currency. 11 Sricly speaking, he impac on he reurns on foreign asses and liabiliies is no he only valuaion effec of exchange rae changes. As highlighed by he debae over he Marshall- Lerner condiion and re-emphasized by he curren debae abou limied exchange rae passhrough, exchange rae movemens also exer a pure valuaion effec on he rade balance o he exen ha impor and expor volumes are unresponsive o exchange rae changes.

13 The magniude of he valuaion channel is direcly increasing in he gross scale of he inernaional balance shee: he relevance of his channel for aggregae ne foreign asse dynamics is growing in line wih he specacular accumulaion of gross foreign asse and liabiliy holdings in recen years. Relaedly, he valuaion channel also depends on he composiion of he inernaional balance shee, since he sensiiviy of reurns o exchange raes will vary across invesmen caegories and will also depend on he currency composiion of foreign asses and liabiliies (and on he exen of hedging). Of course, even if he exchange rae does indeed have a valuaion impac, i does no mean ha he ne foreign asse posiion will move one-for-one. Firs, exchange rae changes also have a direc impac on he rade balance. Second, a valuaion gain enailsrepresens a posiive wealh effec ha will plausibly raise consumpion and invesmen, leading o a negaive co-movemen beween he ne reurns erm and he rade balance (Lane and Milesi- Ferrei 2002a, 2002b). Third, from anoher angle, a sufficienly- large negaive valuaion effec may lead o a sudden sop in capial flows ha forces he rade balance o move ino surplus. Finally, i is imporan o remember ha i is he ne valuaion effec ha maers: a capial gain on foreign asses may be fully offse by a capial gain on foreign liabiliies. 12 In addiion, equaion (9) only capures he conemporaneous impac of a change in he exchange rae. Some reurns may respond o he exchange rae only wih a lag (for insance, he fuure profiabiliy of FDI posiions may be affeced by curren exchange rae movemens). In addiion, curren exchange rae movemens may lead o a revision of expecaions abou fuure exchange rae changes, which in urn feed ino he ex-ane reurns required o hold paricular foreign asse and liabiliy posiions. As was discussed earlier in he paper, here are polar cases in which he impac of exchange rae movemens on raes of reurn is sraighforward. For insance, he domesic rae of reurn on an unhedged foreign asse ha offers a fixed foreign-currency reurn will fall one-for-one wih he rae of real appreciaion: a given foreign-currency reurn will be diminished by he fall in he real domesic value of foreign currency. Conversely, he domesic rae of reurn on a foreign liabiliy ha offers a fixed domesic-currency reurn will be unaffeced by a shif in he real exchange rae. However, he domesic rae of reurn on a foreign liabiliy ha offers a fixed foreign-currency reurn (e.g. foreign currency deb or domesic deb ha offers a dollar-linked rae of reurn) will also fall in proporion o he rae of real appreciaion. More generally, he ne impac of exchange rae movemens on he value of holdings ha There are also poenial valuaion effecs even on domesically-owned asses, bu we resric aenion o he cross-border posiions hrough which valuaion effecs have asymmeric redisribuion effecs on home and foreign invesors. 12 Cross-border hedging could auomaically generae such a posiive comovemen. However, he exen o which hedging akes place is unclear: much hedging aciviy occurs beween counerparies of he same naionaliy, wih no ne impac on he naional risk profile.

14 carry a variable marke reurn depends on he naure of he co-movemens beween exchange raes, asse prices and profiabiliy (in he case of non-marke asses such as FDI posiions and some bank claims). In some cases, he iner-connecions beween exchange raes and he deerminans of marke reurns can be quie suble and complex and may also depend on he underlying source of an exchange rae shock. For insance, devaluaion may be associaed wih an increase in he rae of reurn on foreign liabiliies if i is associaed wih an increase in he profiabiliy of foreign affiliaes operaing in he domesic marke or, alernaively, if i engenders an increase in he counry risk premium. On he oher hand, a devaluaion may be generaed by a negaive domesic produciviy shock ha also lowers he reurn earned by foreign invesors. Wih respec o foreign asses, domesic real depreciaion may be he resul of superior overseas economic performance ha raises he overseas rae of reurn. However, a negaive domesic produciviy shock may also reduce he overseas earnings of domesic mulinaionals, such ha devaluaion is accompanied by a decline in he overseas rae of reurn. 13 In view of he range of possible heoreical scenarios, he srengh of he valuaion channel is ulimaely an empirical issue. We firs consider some case sudy evidence, before urning o cross-counry quaniaive exploraion in he subsequen subsecion. C. Case Sudies: he Unied Saes and Ausralia I is possible o gain some insigh ino he quaniaive imporance of he valuaion impac of exchange rae movemens for hose counries ha calculae he accouning decomposiion abou he relaive imporance of capial flows, marke value capial gains and exchange rae capial gains in deermining he dynamics of foreign asse and liabiliy posiions. This is possible o for wo counries in our sample (he Unied Saes and Ausralia). Of course, an accouning decomposiion does no reveal he complee conribuion of he exchange rae valuaion channel, since i does no ake ino accoun he poenial indirec impac of he exchange rae on marke values or on he revaluaion of invesmen income flows. Tables 7 and 8 presen he decomposiions for he Unied Saes and Ausralia respecively, showing he average annual relaive conribuions of each componen in proporion o he inheried socks of foreign asses (liabiliies): 13 A furher complicaion is ha exchange rae movemens may also affec he inernaional ax planning of mulinaional corporaions ha may affec he disribuion of repored earnings in differen locaions. See Sullivan (2004) on he rend increase in he shifing of repored profis by U.S. mulinaionals o overseas affiliaes.

15 CON _ FLOW CON _ MV CON _ ER FA FA FA CAPFLOW = FA KG _ MV = FA KG _ ER = FA FA FA FA In addiion, he ables display he sandard deviaions for hese componens. Figure 7 and Figure 8 presen similar daa, bu scale he size of capial flows and valuaion changes by GDP, so as o provide a ready reckoning of heir macroeconomic impac. Table 7 and Figure 7 show he saisics for he Unied Saes over While financial flows have radiionally been he dominan source of balance shee growh, he period saw a much greaer role for capial gains. Indeed, he conribuion of marke-value capial gains exceeded ha of financial flows in he growh of he foreign asse holdings of he Unied Saes during he global sock marke boom of , wih a similar conribuion o he growh in he value of foreign liabiliies. Conversely, and consisenly wih he evidence in Tables 1 and 2, he global correcion in asse prices during saw a decline in he marke value of boh foreign asses and liabiliies. Table 7 highlighs he role of he exchange rae valuaion channel. The 5.1 percen average annual dollar appreciaion during was associaed wih an annual average 1.7 percen fall in he value of US foreign asses. In conras, he sharp dollar depreciaion during was associaed wih an annual average 5.5 percen increase in is foreign asse posiion. This gain helped o offse he impac of he growing curren accoun defici on he U.S. ne exernal posiion. (Throughou, in line wih expecaions, he exchange rae channel had a near-zero impac on he sock of US foreign liabiliies.) In erms of relaive sabiliy, capial flows have been much less volaile han eiher of he capial gain componens. Turning now o he Ausralian evidence, Table 8 and Figure 8 show ha he exchange rae valuaion channel has been more imporan han in he US case. For insance, he exchange rae valuaion erm was a bigger conribuor han eiher financial flows or marke-value capial gains in he growh of foreign asses during he period of real depreciaion of he Ausralian dollar. Alhough, in conras o he US case, Ausralian foreign liabiliies are also sensiive o he exchange rae, his side of he inernaional balance shee is only abou half as sensiive as he foreign asse posiion. This is consisen wih a larger role for holdings denominaed in domesic currency in foreign liabiliies han in foreign asses. These case sudies of he Unied Saes and Ausralia provide suggesive evidence abou he imporance of he valuaion channel in driving flucuaions in inernaional asse holdings. We nex urn o regression-based analysis for a broader panel of counries.

16 D. Regression Analysis, Indusrial Counries In his secion, we analyze he sensiiviy of raes of reurn on foreign asses and liabiliies o movemens in rade-weighed mulilaeral exchange raes. 14 In addiion o he aggregae posiions, we also examine reurns for he separae invesmen caegories (FDI; porfolio equiy; porfolio deb; and oher (deb)), since he relaion beween exchange rae movemens and raes of reurn should depend on he specific characerisics of each invesmen class. Our specificaion is given by A r = α + β log( rer ) + u (10) i i i where he dependen variable is he real domesic-currency reurn on foreign asses in invesmen caegory i and he regressor is he log change in he rade-weighed real effecive exchange rae. 15 We run an analogous equaion for he rae of reurn on foreign liabiliies. 16 Our primary ineres is jus in esablishing he direcion and magniude of he conemporaneous co-movemen beween he exchange rae and raes of reurn. 17 We do no aemp o disinguish beween anicipaed and unanicipaed changes in he real exchange rae: however, real exchange raes are largely unpredicable a an annual horizon (a leas for our sample of advanced counries), such ha his may be a fairly-innocuous assumpion While he mos appropriae real exchange rae measure would be a finance-weighed index, reflecing he relaive imporance of hos or source counries in exernal holdings, he srong correlaion beween he geographical paern of rade and financial flows ensures ha a rade-weighed exchange rae is a reasonable proxy. 15 The rae of reurn on foreign asses in year is measured as he sum of invesmen income and capial gains earned in ha year, divided by foreign asses a he end of year Clearly, his is a very parsimonious seup. However, in addiion o being suied o our shor daa span, capuring he simple bivariae relaion is an obvious firs sep, even if i does no rule ou he possibiliy ha any impac of he exchange rae on he rae of reurn may jus be proxying for he role played by some omied variable ha commonly influences boh he rae of reurn and he exchange rae or may jus reflec endogeneiy bias. 17 We could alernaively presen he simple correlaions beween reurns and exchange rae changes. See Lane and Milesi-Ferrei (2003). 18 We reurn o he issue of he predicabiliy of exchange raes in he discussion of resuls.

17 We begin by examining he raes of reurn on foreign asses in Table The resuls for oal foreign asses are given in column (1). In all cases, he esimaed coefficien is negaive: real appreciaion is associaed wih a fall in he domesic-currency rae of reurn earned on foreign asses. For a number of counries, he esimaed coefficien is in fac very close o -1: his one-o-one mapping is consisen wih a process by which he foreign-currency real reurn on foreign asses is orhogonally deermined and he exchange rae jus acs o conver he foreign-currency reurn ino domesic erms. 20 The smalles esimaed coefficien (in absolue value) in he sample is for he U.S. a This admis a number of inerpreaions. Firs, some proporion of U.S. foreign asses is denominaed in dollars and hence heir value is no direcly affeced by exchange rae movemens. Second, dollar appreciaion could be associaed wih an increase in reurns on foreign-currency foreign asses. One example would be a posiive produciviy shock in he U.S. ha boh appreciaes he dollar and raises reurns in U.S. financial markes. If foreign financial markes posiively co-move wih he U.S., foreign-currency asse reurns would also rise a he same ime. A posiive U.S. produciviy shock could also raise he profis earned overseas by U.S. mulinaionals, such ha foreign-currency reurn rises in ha case as well. The resuls for FDI asses are given in column (2). 21 For mos counries, FDI posiions are sill measured a book value, raher han marke value, and herefore he valuaion channel is ypically undersaed. However, currency movemens should sill maer, since hese would affec facors such as he curren replacemen cos of capial goods and fixures, boh domesically and overseas. In column (2), he fixed-effecs panel esimae of he impac of 19 In erms of counry selecion for he regressions, we only include hose wih a leas hireen years of daa on raes of reurn. In addiion, we rule ou observaions ha may be conaminaed by facors such as revisions in mehodology and oher correcions. 20 In some cases, we observe a coefficien above uniy, which means ha real appreciaion is associaed wih a fall in foreign-currency reurns on foreign asses: he domesic invesor loses wice by suffering boh a low foreign-currency reurn and an unfavorable conversion rae back ino domesic real erms. Such a paern could be generaed, for insance, if he domesic business cycle is asymmeric wih respec o he inernaional business cycle: he domesic currency appreciaes when inernaional parners are doing badly (as proxied by poor foreign-currency raes of reurn). This, of course, is a risk-leveraging paern of comovemen beween foreign-currency reurns and he domesic real exchange rae. 21 In he sample represened in his able, only he Neherlands and Ausralia record FDI a marke value. The US repors posiions measured a boh book and marke value. For comparabiliy wih he counries ha only repor book values, he US esimaes in hese ables refer only o he book value measure of FDI. However, for he US, if we use he rae of reurn based on FDI a marke value hen he exchange rae coefficien in he FDI asse equaion is (-sa 1.38) and i is 0.15 (-sa 0.37) in he FDI liabiliy equaion.

18 real appreciaion on he real reurn on FDI foreign asses is However, here are some cases in which he coefficien is subsanially above uniy: for hese counries, real appreciaion ends o be associaed wih low foreign-currency real reurns on FDI asses. We nex examine he reurns on porfolio equiy asses in column (3). The fixed-effecs panel esimae is very close o -1, which is consisen wih orhogonal conribuions of exchange rae movemens and foreign-currency raes of reurn o he domesic-currency real rae of reurn. Two excepions o his rule are Germany and Swizerland: for hese counries, real appreciaions have coincided on average wih periods of srongly negaive world sock marke reurns, and hence disappoining foreign-currency reurns on heir equiy porfolios. Column (4) displays he resuls for foreign asses in he porfolio deb caegory. There is srong covariaion beween he exchange rae and domesic-currency reurns is ypically quie good and he esimaed coefficiens are consisen wih he foreign-currency reurns on foreign porfolio deb asses being exogenously deermined wih respec o he domesic real exchange rae. However, he Unied Saes coefficien is only -0.65, consisen wih he fac ha a considerable proporion of is foreign bond holdings are denominaed in US dollars. Finally, we urn o he oher invesmen caegory in column (5). This caegory largely comprises bank lending. Since banks do no mark o marke all asses and liabiliies bu raher carry a high proporion a book value, he raes of reurns in his caegory will be dominaed by he yield componen, wih capial gains and losses undersaed. However, on he asses side, he broad picure is quie similar o ha for porfolio deb. Again, an imporan excepion is he US, where he coefficien esimae is insignifican: again, a good candidae explanaion is ha a high proporion of is foreign lending is in US dollars. We urn o he raes of reurn on foreign liabiliies in Table 10. In erms of he resuls for oal foreign liabiliies in column (1), we see quie a mixed paern in erms of he esimaed exchange rae coefficiens across counries. As was shown also in Table 7, For he Unied Saes, he rae of reurn paid ou on foreign liabiliies is oally unaffeced by movemens in he real exchange rae consisen wih he fac ha foreign liabiliies are almos enirely dollar-denominaed and offer reurns ha no linked o exchange rae flucuaions (e.g. bank deposis or fixed-ineres deb insrumens). A he oher exreme, he esimaed coefficien for Finland is The fixed-effecs panel esimae is -0.68: his generally indicaes ha 22 Albei significan only a he 10 percen level. Alhough a paern of high real reurns plus exchange rae depreciaion is also eviden in he early 1990s, he mos sriking period for Finland is he pos-emu period: in 1999 he reurn on is foreign liabiliies was large (driven by gains in Nokia s share price during he equiy marke boom), while is real exchange rae depreciaed (on accoun of he fall in he exernal value of he euro). In conras, he sock marke reversals of were accompanied by an appreciaing real exchange rae (as he euro s exernal value recovered). This case is a vivid illusraion of he imporance of co-movemens beween exchange raes and asse prices. I also underlines ha exchange raes need no always move in a risk-sharing manner, which applies a foriori for members of a currency union ha have lile influence on he exernal value of he currency.

19 exchange rae appreciaion is associaed wih some deerioraion in domesic real reurns on foreign liabiliies. 23 Wih respec o FDI liabiliies, column (2) of Table 10 suggess ha here is lile covariaion beween exchange rae flucuaions and real domesic reurns. In par, his may be aribued o he fac ha FDI posiions are mosly measured a book value bu he insignificance of he exchange rae also suggess ha he earnings of foreign affiliaes in he domesic marke are no (conemporaneously) affeced by exchange rae swings. This paern is worh exploring furher bu would require he availabiliy of higher-qualiy daa. Similar o he case for FDI liabiliies, mos of he esimaed counry coefficiens for porfolio equiy liabiliies are insignificanly differen from zero: he domesic-currency real reurn offered by porfolio equiy liabiliies is no sysemaically affeced by he exchange rae. Again, his is somewha surprising o he exen ha we migh expec domesic sock marke booms o be associaed wih real appreciaion. 24 Only Canada and Ausralia show a significan connecion beween exchange rae movemens and he rae of reurn paid ou on foreign bond liabiliies. For he ohers, he resuls suppor he caricaure of bond liabiliies ha offer a domesic rae of reurn ha is invarian o exchange rae flucuaions. 25 Wih respec o oher liabiliies, a number of counries display 23 In no case is he esimaed coefficien significanly posiive. This is quie surprising, since some of he mechanisms discussed earlier in order o explain a negaive relaion beween exchange rae appreciaion and he rae of reurn on foreign asses should symmerically imply a posiive associaion beween exchange rae appreciaion and he rae of reurn on foreign liabiliies. For insance, a posiive domesic produciviy shock migh raise profiabiliy of foreign affiliaes operaing in he domesic marke and generally boos domesic asse prices, while a he same ime generaing real appreciaion. 24 Indeed, here is only one significan counry coefficien (Germany), bu i is negaive and large (-2.9) negaive. This means ha declines in he German sock marke are ypically associaed wih real appreciaion. Since he poin coefficien is fairly similar for boh asses and liabiliies, his implies ha German real appreciaion ends o occur during phases of disappoining global sock reurns, since he reurns on German overseas asses fall in addiion o he reurns paid ou on domesic socks owned by foreign invesors. 25 Even for Canada and Ausralia, he paern of co movemen is negaive: real appreciaion is associaed wih low domesic raes of reurn on heir foreign bond liabiliies. In par, his may sugges ha exchange rae movemens for hese counries have a subsanial predicable componen, since foreign invesors would be prepared o accep a low domesic-currency reurn if real appreciaion were anicipaed. The predicabiliy hypohesis receives some suppor from he empirical work of Chen and Rogoff (2003), who show ha commodiy currencies (such as he Ausralian and Canadian dollars) are more predicable han oher currencies. Of course, anoher poenial conribuory facor is he exen o which hese counries issue bond liabiliies in foreign currency.