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Philip R. Lane is professor of economics at Trinity College Dublin. This paper was prepared for the “Dollars, Debt, and Deficits — 60 Years After Bretton Woods” conference co-organized by the Banco de España and the IMF, Madrid, June 14–15 2004. The authors thank their discussant Daniel Cohen, conference participants in Madrid and Budapest, and seminar participants at the Kiel Institute for World Economics and Glasgow Strathclyde for useful comments, and Abdel Senhadji and Cédric Tille for data on Australia and the United States. Marco Arena, Charles Larkin, and Vahagn Galstyan provided excellent research assistance. Part of this paper was written while Lane was a visiting scholar at the International Monetary Fund. Lane also gratefully acknowledges the financial support of the Irish Research Council on Humanities and Social Sciences (IRCHSS) and the HEAPRTLI grant to the IIIS. This paper is also part of a research network on “The Analysis of International Capital Markets: Understanding Europe’s Role in the Global Economy,” funded by the European Commission under the Research Training Network Programme (Contract No. HPRN–CT–1999–00067).
Lane and Milesi-Ferretti (2001b) analyze some of the determinants of the composition of the international balance sheet.
Only a few countries in our sample (including the United States) measure FDI at market value: hence, stock market fluctuations have a less dramatic impact on FDI stocks compared to portfolio equity holdings. Of course, the fall in foreign portfolio equity assets and liabilities relative to GDP does not imply a decline relative to total domestic equity holdings.
The difference in stock market performance between the United States and world markets is entirely accounted for by the year 2003, during which the sharp depreciation of the U.S. dollar raised foreign stock returns measured in dollars. Between end-1998 and end-2002 the decline in stock market valuations in the United States and world markets was similar.
In addition to the standard macroeconomic drivers of net foreign asset positions that were emphasized by Lane and Milesi-Ferretti (2002a), political risk and natural resource endowments are other variables that may be important, especially in reference to the countries listed here.
See IMF (1993) for a description of balance-of-payments transactions classified as exceptional financing.
In balance of payments statistics (IMF, 1993) the so-called ‘capital account’ measures certain transfers (such as debt forgiveness); capital flows are recorded in the financial account.
If external assets and liabilities are all denominated in domestic currency, the capital gain effect will go exactly in the opposite direction from the exchange rate change effect. Indeed, assume for simplicity that asset prices in domestic currency do not change. In this case, the capital gain expressed in domestic currency is zero, but expressed in dollars it becomes
Clearly, in tracking a ratio, there is some discretion in terms of attributing the impact of an exchange rate change to the numerator or the denominator via the choice of the reference currency. In the next subsection, we look at the levels of foreign assets and liabilities in terms of real domestic currency.
Strictly speaking, the impact on the returns on foreign assets and liabilities is not the only “valuation” effect of exchange rate changes. As highlighted by the debate over the Marshall- Lerner condition and re-emphasized by the current debate about limited exchange rate pass-through, exchange rate movements also exert a “pure” valuation effect on the trade balance to the extent that import and export volumes are unresponsive to exchange rate changes. There are also potential valuation effects even on domestically owned assets, but we restrict attention to the cross-border positions through which valuation effects have asymmetric redistribution effects on home and foreign investors.
Cross-border hedging could automatically generate such a positive comovement. However, the extent to which hedging takes place is unclear: much hedging activity occurs between counterparties of the same nationality, with no net impact on the national risk profile.
A further complication is that exchange rate movements may also affect the international tax planning of multinational corporations that may affect the distribution of reported earnings in different locations. See Sullivan (2004) on the trend increase in the shifting of reported profits by U.S. multinationals to overseas affiliates.
While the most appropriate real exchange rate measure would be a “finance-weighted” index, reflecting the relative importance of host or source countries in external holdings, the strong correlation between the geographical pattern of trade and financial flows ensures that a trade-weighted exchange rate is a reasonable proxy.
The rate of return on foreign assets in year t is measured as the sum of investment income and capital gains earned in that year, divided by foreign assets at the end of year t − 1.
Clearly, this is a very parsimonious setup. However, in addition to being suited to our short data span, capturing the simple bivariate relation is an obvious first step, even if it does not rule out the possibility that any impact of the exchange rate on the rate of return may just be proxying for the role played by some omitted variable that commonly influences both the rate of return and the exchange rate or may just reflect endogeneity bias.
We could alternatively present the simple correlations between returns and exchange rate changes. See Lane and Milesi-Ferretti (2003).
We return to the issue of the predictability of exchange rates in the discussion of results.
In terms of country selection for the regressions, we only include those with at least thirteen years of data on rates of return. In addition, we rule out observations that may be contaminated by factors such as revisions in methodology and other corrections.
In some cases, we observe a coefficient above unity, which means that real appreciation is associated with a fall in foreign-currency returns on foreign assets: the domestic investor “loses twice” by suffering both a low foreign-currency return and an unfavorable conversion rate back into domestic real terms. Such a pattern could be generated, for instance, if the domestic business cycle is asymmetric with respect to the international business cycle: the domestic currency appreciates when international partners are doing badly (as proxied by poor foreign-currency rates of return). This, of course, is a risk-leveraging pattern of comovement between foreign-currency returns and the domestic real exchange rate.
In the sample represented in this table, only the Netherlands and Australia record FDI at market value. The United States reports positions measured at both book and market value. For comparability with the countries that only report book values, the U.S. estimates in these tables refer only to the book value measure of FDI. However, for the United States, if we use the rate of return based on FDI at market value then the exchange rate coefficient in the FDI asset equation is -0.71 (t-stat 1.38) and it is 0.15 (t-stat 0.37) in the FDI liability equation.
Albeit significant only at the 10 percent level. Although a pattern of high real returns plus exchange rate depreciation is also evident in the early 1990s, the most striking period for Finland is the post-EMU 1999–2002 period: in 1999 the return on its foreign liabilities was large (driven by gains in Nokia’s share price during the equity market boom), while its real exchange rate depreciated (on account of the fall in the external value of the euro). In contrast, the stock market reversals of 2001–2002 were accompanied by an appreciating real exchange rate (as the euro’s external value recovered). This case is a vivid illustration of the importance of co-movements between exchange rates and asset prices. It also underlines that exchange rates need not always move in a “risk-sharing” manner, which applies a fortiori for members of a currency union that have little influence on the external value of the currency.
In no case is the estimated coefficient significantly positive. This is quite surprising, since some of the mechanisms discussed earlier in order to explain a negative relation between exchange rate appreciation and the rate of return on foreign assets should symmetrically imply a positive association between exchange rate appreciation and the rate of return on foreign liabilities. For instance, a positive domestic productivity shock might raise profitability of foreign affiliates operating in the domestic market and generally boost domestic asset prices, while at the same time generating real appreciation.
Indeed, there is only one significant country coefficient (Germany), but it is negative and large (-2.9) negative. This means that declines in the German stock market are typically associated with real appreciation. Since the point coefficient is fairly similar for both assets and liabilities, this implies that German real appreciation tends to occur during phases of disappointing global stock returns, since the returns on German overseas assets fall in addition to the returns paid out on domestic stocks owned by foreign investors.
Even for Canada and Australia, the pattern of comovement is negative: real appreciation is associated with low domestic rates of return on their foreign bond liabilities. In part, this may suggest that exchange rate movements for these countries have a substantial predictable component, since foreign investors would be prepared to accept a low domestic-currency return if real appreciation were anticipated. The predictability hypothesis receives some support from the empirical work of Chen and Rogoff (2003), who show that “commodity” currencies (such as the Australian and Canadian dollars) are more predictable than other currencies. Of course, another potential contributory factor is the extent to which these countries issue bond liabilities in foreign currency.
A similar regression for assets gives a coefficient of -1, consistent with the fact that overseas assets are entirely denominated in foreign currency.
Alberola (2003) discuss the impact of liability dollarization on the path of exchange-rate adjustment in emerging markets. He argues that the real exchange rate will tend to overshoot its equilibrium level, due to the need to foster higher current account surpluses in the aftermath of depreciation to make up for to the increase in liabilities.