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A Appendix: Robustness of Empirical Results
The paper benefited from comments and feedback from Luis Cubeddu, Thomas Elkjaer, Pierre-Olivier Gourinchas, Manos Kitsios, Signe Krogstrup, Bernardo Lischinsky, Yun Liu, Gian-Maria Milesi-Ferretti, Jose Manuel Montero, Maurice Obstfeld, Jonathan Ostry and Anne-Charlotte Paret-Onorato. Hongrui Zhang provided excellent research assistance.
It can also shed light on the potential costs of mercantilistic policies, which may increase trade balances, but at the expense of experiencing offsetting low financial returns, as discussed further below.
Throughout the paper, the terms net foreign asset (NFA) and international investment position (IIP) are used indistinctly.
A further refinement entails disaggregating the income balance into investment and other income. In most cases, investment income is the largest component of the income balance.
A few countries (about one sixth of our overall sample of country-years) provided data, on a confidential basis, on the decomposition of valuation changes into different components, including the reconciliation residual. For most countries within this reduced sample, average reconciliation residuals are not statistically different from zero.
An alternative (“direct”) approach for estimating valuation changes with data on IIP structure and prices is also feasible for a few countries. This entails using information on the currency and security structure of assets and liabilities, along with proxies of key prices (e.g., debt, stocks and exchange rates) in order to estimate valuation changes by type of securities and sum them to obtain an aggregate measure of valuation changes. See Curcuru et al. (2013) for a comparison of the residual and direct approaches for the US. The paper build on the residual approach as data on these components are scarce for most countries.
Valuation changes and financial returns more broadly can be computed in US dollars or in local currency. While these two measures can differ considerably in nominal terms, differences are small in real terms. The paper’s main results are robust to using either approach (see Appendix A.2).
Throughout the paper, ‘income balance’ refers to net investment income. Other components of the income balance (secondary income and non-investment primary income) are normally small.
The exact decomposition is given by
The focus is on currency positions in USD, EUR, GBP, CHF, JPY and a category of other foreign currencies, based on data availability. For the latter category, the nominal effective exchange rate of the US (against the rest of the world) is used.
The sample includes all economies covered by the IMF’s External Balance Assessment (International Monetary Fund (2017a)), plus Saudi Arabia, Hong Kong SAR and Singapore.
This is partly due to the highly synchronized movement of asset prices in the post-GFC period.
Results on the decomposition of valuation changes into exchange rate and asset price changes rely on estimated currency exposures from Bénétrix et al. (2015).
The US estimate is broadly consistent with those found by Obstfeld and Rogoff (2005) and Lane and Milesi-Ferretti (2009), while somewhat larger than those of Gourinchas and Rey (2007) and Curcuru et al. (2008). Sample periods vary somewhat across studies, however. Data from the Bureau of Economic Analysis (available for 2003-15), which disaggregates the stock-flow reconciliation residual, leads to similar results, with a slightly lower NFA return (about 0.9 percent) and return differential (3.1 percent).
The offsetting nature of the yield differential and the remaining return differential is partly due to Switzerland’s relatively low inflation and large portfolio equity retained earnings liabilities (which, unlike FDI retained earnings, are not recorded in the income balance). Both factors generate both an inflated income balance and compensating valuation losses.
Results for the euro area should also be interpreted more cautiously given the shorter time span of the data.
This seems to be primarily explained by asset price differentials, with additional (but not primary) contributions from both yield and exchange rate differentials.
Specifically, a steady state exists if −1 < β < 0, and it is given by nfass = −κc/β (for the baseline case δ = 0). The underlying assumption is that, while persistent drivers of the NFA can be different in magnitude across countries, the speed of convergence to steady steady is similar across them. This is relaxed later, as different country groups are studied.
As a robustness check, Appendix (A.2) presents an alternative approach that imposes a linear constraint on the coefficients consistent with the BOP identity ∆nfa = tb + rNFA + gNFA. Specifically, the following system of four (seemingly unrelated) equations is estimated:
subject to β = βTB + βNF Aret + βg.
Ireland is an outlier, reflecting significant, well-known, mismeasurement issues related to the presence of large multinational corporations. See, for example, International Monetary Fund (2017b) and Lane et al. (2017).
We find no evidence of a change in the regression coefficients after the GFC (result not reported).
As discussed in Lane et al. (2017), profit shifting towards low tax rate jurisdictions tends to boost the trade balance of the latter economies, with an offsetting effect on the income balance (i.e., the current account balance remains broadly unchanged). In such cases, the measured NFA returns could be distorted, and the breakdown between trade and NFA return channels could be less informative.
As noted by Gourinchas and Rey (2014), this posed a significant challenge to the profession in terms of modeling a process of external adjustment with expected valuation changes.
This result is consistent with the notion that most individual economies are too small to affect global returns (i.e., their own returns on foreign assets). Different results may arise if credit countries are assessed collectively.
This results from running regression (7) treating the set of reserve countries as a single country, and allowing it to have a different slope coefficient. Regression results are not reported.