Financial Globalization and Exchange Rates

Transcription

1 WP/05/3 Financial Globalizaion and Exchange Raes Philip R. Lane and Gian Maria Milesi-Ferrei

2 2005 Inernaional Moneary Fund WP/05/3 IMF Working Paper Research Deparmen Financial Globalizaion and Exchange Raes Prepared by Philip R. Lane and Gian Maria Milesi-Ferrei 1 January 2005 Absrac This Working Paper should no be repored as represening he views of he IMF. The views expressed in his Working Paper are hose of he auhor(s) and do no necessarily represen hose of he IMF or IMF policy. Working Papers describe research in progress by he auhor(s) and are published o elici commens and o furher debae. The founders of he Breon Woods Sysem 60 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 mean 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 inerconnecions 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 Auhor(s) Address: [email protected]; [email protected] 1 Philip R. Lane is professor of economics a Triniy College Dublin. This paper was 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 seminar paricipans a he Kiel Insiue for World Economics and Glasgow Srahclyde 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. 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 ).

3 - 2 - Conens Page I. Inroducion... 4 II. Trends in Inernaional Financial Inegraion... 5 A. Ne Flows and Ne Posiions, Indusrial Counries... 5 B. Gross Flows and Gross Posiions, Indusrial Counries... 6 C. Ne Flows and Ne Posiions, Emerging Markes... 7 D. Gross Flows and Gross Posiions, Emerging Markes... 8 III. Exernal Asse Dynamics...9 A. Accouning for Exernal Asse Dynamics... 9 B. The Evoluion of Ne Foreign Asses in Emerging Markes IV. Exchange Raes and The Adjusmen Process A. Exchange Raes, The Trade Balance and Real Oupu B. The Valuaion Channel: A Concepual Framework C. Case Sudies: The Unied Saes and Ausralia D. Regression Analysis, Indusrial Counries E. Exchange Raes and Raes of Reurn, Emerging Markes F. The Valuaion Channel in Inernaional Macroeconomic Models V. Policy Implicaions VI. Concluding Remarks References Appendix I Tables 1. Ne Capial Ouflows and Changes in Ne Exernal Posiion Indusrial Counries, Gross Capial Flows o and from Indusrial Counries ( ) Cumulaive Ne Capial Flows o Seleced Emerging Markes, Indicaors of Inernaional Financial Inegraion, Emerging Markes Gross Capial Flows o and from Seleced Emerging Markes, Decomposiion of Change in Foreign Asses for Seleced Emerging Markes, US: Relaive Conribuions of Flows, Marke Values and Exchange Raes o Dynamics of he Inernaional Balance Shee, Ausralia: Relaive Conribuions of Flows, Marke Values and Exchange Raes o Dynamics of he Inernaional Balance Shee, Exchange Raes and Raes of Reurn on Foreign Asses Exchange Raes and Raes of Reurn on Foreign Liabiliies...37

4 - 3 - Figures 1. Ne Foreign Asse Posiion (raio of GDP) and GDP per capia Indusrial Counries, Composiion of Inernaional Porfolio, Indusrial Counries (Sum of Asses and Liabiliies as a Raio of GDP, ) Average and Aggregae Curren Accoun o GDP Raio Emerging Markes Sample, Average and Aggregae Ne Exernal Posiion, Emerging Marke Sample, Ne Foreign Asses and GDP per capia Emerging Markes Sample, Indicaors of Inernaional Financial Inegraion, Emerging Markes Unied Saes: Componens of Change in Exernal Asses and Liabiliies, Ausralia: Componens of Change in Exernal Asses and Liabiliies, Real Rae or Reurn on Exernal Liabiliies and Changes in Real Exchange Rae Emerging Marke Sample,

5 - 4 - 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 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. 2 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. 2 Lane and Milesi-Ferrei (2004c) explain he consrucion of he daa.

6 - 5 - 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 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. 3 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. 4 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 3 Tille (2003) provides an ineresing analysis for he Unied Saes. 4 Lane and Milesi-Ferrei (2001b) analyze some of he deerminans of he composiion of he inernaional balance shee.

7 - 6 - Zealand and Iceland he larges debors in relaion o GDP. The posiive relaion beween ne 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 accumulaion of ne 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. 5 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.

8 - 7 - 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 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. 6 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 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 U.S. 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. 7 6 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. 7 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 (coninued )

9 - 8 - 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. 8 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 o 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, endowmens are oher variables ha may be imporan, especially in reference o he counries lised here. 8 See IMF (1993) for a descripion of balance-of-paymens ransacions classified as excepional financing.

10 - 9 - 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 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. 9 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 U.S. 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.

11 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: i A i L + KG γ b b bgs + ka + eo + b (4) + A L ( ) $ 1 Y 1 γ where γ is he growh rae of nominal GDP measured in U.S. 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 U.S. 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 U.S. dollars); 3. he capial accoun and ne errors and omissions; 4. he effec of exchange rae changes on he pas ne foreign asse posiion; 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 U.S. dollars, so ha k A 1 k L 1 = KG, and le rˆ = be he real US 1+ π rae of reurn on foreign asses, measured in U.S. dollars, wih an analogous definiion 10 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).

12 holding for he rae of reurn on foreign liabiliies r ˆL. In his case we can re-wrie (5) as follows: L A L rˆ (1 ) ˆ ˆ g ε + g r r b b 1 bgs + ( ka + eo) + b 1+ a 1 (1 + g )(1 + ε ) (1 + g )(1 + ε ) 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 U.S. dollar, and differences in reurns beween foreign asses and liabiliies. A L If we express real raes of reurn in domesic currency and denoe hem by r, r, equaion (6) akes he more familiar form: r g r r b b bgs ka eo b a L A L 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. (6) (7)

13 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 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 highligh 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 inerconnecion 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

14 goods become beer subsiues for domesic goods. In erms of financial globalizaion, wider rade imbalances are more feasible, he more diversified are inernaional porfolios. 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 U.S. 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 U.S. 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 Ne Foreign Asses (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. 11 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. 12 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. (coninued )

15 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 enails represens 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. 13 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. 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. 13 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.

16 More generally, he ne impac of exchange rae movemens on he value of holdings ha 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. 14 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: The 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 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): 14 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.

17 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 U.S. 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 U.S. 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 U.S. 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 1997.Q Q1 period of real depreciaion of he Ausralian dollar. Alhough, in conras o he U.S. 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.

18 We nex urn o regression-based analysis for a broader panel of counries. 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. 15 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. 16 We run an analogous equaion for he rae of reurn on foreign liabiliies. 17 Our primary ineres is jus in esablishing he direcion and magniude of he conemporaneous co-movemen beween he exchange rae and raes of reurn. 18 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. 16 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. 18 We could alernaively presen he simple correlaions beween reurns and exchange rae changes. See Lane and Milesi-Ferrei (2003). 19 We reurn o he issue of he predicabiliy of exchange raes in he discussion of resuls.

19 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. 21 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). 22 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 20 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. 21 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. 22 In he sample represened in his able, only he Neherlands and Ausralia record FDI a marke value. The Unied Saes repors posiions measured a boh book and marke value. For comparabiliy wih he counries ha only repor book values, he U.S. esimaes in hese ables refer only o he book value measure of FDI. However, for he Unied Saes, 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.

20 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 U.S. 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 Unied Saes, where he coefficien esimae is insignifican: again, a good candidae explanaion is ha a high proporion of is foreign lending is in U.S. 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 23 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 (coninued )

21 exchange rae appreciaion is associaed wih some deerioraion in domesic real reurns on foreign liabiliies. 24 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. 25 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. 26 Wih respec o oher liabiliies, a number of counries display 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. 24 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. 25 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. 26 Even for Canada and Ausralia, he paern of comovemen 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 (coninued )

22 significanly negaive coefficiens, wih he esimaes far above uniy for Ausralia and Spain. For his pair, he paern is akin o ha experienced by emerging markes: real depreciaion is associaed wih an increase in he foreign-currency reurn paid o foreign invesors. In summary, he regression analysis in Tables 9 and 10 delivers a number of ineresing lessons. Firs, especially on he foreign asses side, exchange rae movemens are an imporan covariae of raes of reurn, consisen wih he operaion of a powerful valuaion channel. Second, real appreciaion is ypically associaed no only wih lower real reurns on foreign asses, bu also lower real reurns on foreign liabiliies: a leas for small ne posiions, his implies ha he ne valuaion impac of exchange rae movemens on he ne foreign asse posiion has been limied. Third, he sensiiviy of reurns o exchange raes does vary across invesmen caegories: he composiion of he inernaional balance shee is an imporan deerminan of he aggregae valuaion effec. Fourh, he Unied Saes behaves from quie differenly oher counries in ha he raes of reurn on is liabiliies (in all invesmen caegories) are unaffeced by currency movemens. Since dollar depreciaion raises he reurn on is foreign asses, his means ha he valuaion channel in he U.S. case may indeed be a powerful adjusmen mechanism in correcing is large exernal liabiliy posiion. We reurn o he feasibiliy of his opion laer in his paper. E. Exchange Raes and Raes of Reurn, Emerging Markes In general, we would expec he relaion beween domesic-currency raes of reurn and changes in he real exchange rae o be even sronger for emerging markes, which in general have less scope for borrowing or lending in domesic currency. Careful empirical work has o face he severe difficulies in measuring such raes of reurn: among hese, he lack of precise hisorical daa on inernaional invesmen posiions; sock-flow discrepancies; deb reducion and deb forgiveness agreemens, and defaul episodes. While aware of hese limiaions, we have consruced rough esimaes of raes of reurn on exernal asses and liabiliies for our emerging-marke sample. The mehodology is based on esimaing he sock of exernal asses and liabiliies (Lane and Milesi-Ferrei, 2004c), and using daa on ineres paymens and capial flows o back ou raes of reurn. A simple panel regression wih fixed effecs of real domesic-currency raes of reurn on exernal liabiliies on changes in he real effecive exchange rae gives a coefficien of 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.

23 wih a -saisic of As Figure 9 shows, his relaion holds no only along he ime-series dimension, bu also in he cross-secion. The Figure shows a srong negaive relaion (ploed for he year 1997, a year of large exchange rae depreciaions in he Asian counries of our sample) beween he domesic currency rae of reurn on exernal liabiliies and he real effecive exchange rae. F. The Valuaion Channel in Inernaional Macroeconomic Models The preceding empirical analysis has indicaed ha revaluaions are an imporan conribuor o ne foreign asse dynamics. However, i has been sandard in boh he radiional Mundell-Fleming approach and conemporary new open economy macroeconomics o consider scenarios in which he iniial ne foreign asse posiion is zero and he gross scale of inernaional balance shees is ignored. This rules ou any consideraion of he valuaion channel in erms of macroeconomic behavior and he analysis of alernaive policies. However, wo imporan recen excepions are provided by Benigno (2001) and Tille (2004). In a wo-counry model, Benigno (2001) shows ha moneary shocks have much larger real effecs if he iniial global seady sae is characerized by imbalances in ne exernal posiions, since exchange rae movemens generae a ne valuaion effec ha has asymmeric effecs on home and foreign counries. One implicaion is ha counries will disagree abou he opimal moneary policy, since he valuaion channel acs o ransfer wealh beween home and foreign ciizens. Tille (2004) considers he case of iniially-balanced ne foreign posiions bu allows for differen levels of scale in erms of gross holdings of foreign asses and liabiliies. Maching he U.S. daa, he shows ha an increase in gross cross-holdings of domesic-currency and foreign-currency bonds means ha he welfare impac of a surprise moneary expansion is grealy magnified in he case ha he foreign-currency share of foreign asses is larger han he foreign-currency share of foreign liabiliies. Indeed, his calibraion suggess ha he welfare impac of he valuaion channel is 350 percen more powerful han he radiional channel, since devaluaion confers a sizeable capial gain on he home counry in his seup. Clearly, much remains o be done o improve he heoreical reamen of he valuaion channel in macroeconomic models. For insance, i would be highly desirable (albei exremely challenging) o incorporae a realisic profile of he inernaional balance shee (wih is mix of FDI, porfolio equiy and deb insrumens) and joinly deermine he equilibrium response of real variables, asse prices and exchange raes o various shocks and policies. In his regard, Hau and Rey (2003) and Pavlova and Rigobon (2003) have made ineresing recen aemps o joinly model financial reurns and exchange raes. Finally, anoher imporan research quesion is o assess he conribuion of he valuaion 27 A similar regression for asses gives a coefficien of -1, consisen wih he fac ha overseas asses are enirely denominaed in foreign currency.

24 channel o persisen shifs in ne foreign asses. Tha is, he valuaion effecs induced by currency and asse price movemens can generae volailiy in he value of exernal asses and liabiliies bu i is an open quesion as o how imporan are valuaion effecs versus curren accoun imbalances in driving he lower-frequency componen of ne foreign asse dynamics. On he agenda for fuure research is a beer characerizaion of he relaion beween exchange rae movemens and ne foreign asse posiions over ime: for insance, he impac effec may primarily operae hrough he valuaion channel, wih a longer-erm conribuion via gradual adjusmen in he curren accoun o a susained real exchange rae movemen. V. POLICY IMPLICATIONS As was emphasized in discussing equaion (6) above, financial globalizaion increases he empirical relevance of he valuaion channel for exchange rae movemens. Improving quaniaive undersanding of he valuaion channel is obviously desirable, in order o keep beer rack of he dynamics of ne foreign asses and inernaional wealh effecs. One helpful innovaion would be for he relevan naional saisical agencies o collec more informaion on he role played by currency movemens in deermining raes of reurn on foreign asses and liabiliies. From a policy perspecive, does he valuaion channel offer a reliable mehod o address an excessive ne exernal liabiliy posiion? Gourinchas and Rey (2004) provide some evidence for he Unied Saes ha hisorical adjusmen in is ne foreign asse posiion has indeed in par relied on he valuaion channel, wih he exchange rae responding in a predicable, sysemaic manner during phases when is exernal posiion was unsusainable. However, here is good reason o be skepical ha he valuaion channel can be relied upon o solve adjusmen problems. Even for hose counries for which a one-ime surprise devaluaion may indeed generae a posiive valuaion effec ha improves he ne foreign asse posiion, such a move would involve a repuaional cos: fuure invesors would require a larger premium in order o compensae for he risk of subsequen devaluaions. Indeed, such manipulaion of he exchange rae creaes a classic ime-consisency problem, wih he sandard recommendaion ha policymakers ake seps o commi o no using he devaluaion opion as a form of capial levy. While he severiy of his problem is one of he underlying facors behind he prevalence of liabiliy dollarizaion and shor-mauriy deb among he emerging marke naions, i may ye have an increasing bie for major debors among he advanced naions Alberola (2003) discuss he impac of liabiliy dollarizaion on he pah of exchange-rae adjusmen in emerging markes. He argues ha he real exchange rae will end o overshoo is equilibrium level, due o he need o foser higher curren accoun surpluses in he afermah of depreciaion o make up for o he increase in liabiliies.

25 Moreover, as has been highlighed repeaedly in his paper, i is imporan o recognize ha he Unied Saes is a special case, in view of is abiliy o issue a large proporion of is liabiliies in dollars. This capaciy is relaed o he dollar s saus as he defaul reserve currency and safe haven. In urn, he dollar saus helps explain he sysemaic posiive difference beween he rae of reurn gained on U.S. exernal asses and he one paid ou on is liabiliies. Neverheless, furher subsanial increases in he U.S. ne debor posiion would raise he prospec of a subsanial U.S. dollar depreciaion, wih he associaed capial losses infliced on U.S. crediors. In urn, his may hreaen he special saus of he dollar, also in ligh of he emergence of he euro as an alernaive inernaional reserve currency, and raise he rae of reurn required by foreign invesors on dollar insrumens. I is ineresing o speculae on he rend implicaions of financial globalizaion for exchange rae volailiy. Along one dimension, if financial globalizaion improves inernaional risk sharing, hen more similar wealh dynamics could lead o more correlaed aggregae demand paerns and hereby reduce he need for exchange rae shifs. However, as has been recenly emphasized by Kalemli-Ozcan e al (2003) and Heahcoe and Perri (2004), greaer crossborder risk-sharing could also permi increased specializaion in producion, wih secoral shocks under ha scenario ranslaing ino greaer real exchange rae variabiliy. Along anoher dimension, he diversificaion of risks afforded by financial globalizaion may also permi greaer dispersion in ne foreign asse posiions, hrough a weakening of he associaion beween exernal imbalances and counry risk premia. If ha is he case and he pace of real globalizaion (i.e. he inernaional inegraion of produc markes) does no proceed sufficienly quickly, hen large-scale real exchange rae movemens may increase in frequency, as par of he adjusmen process in coping wih enlarged global imbalances. In ligh of hese opposing forces, i is difficul o make a firm predicion abou he ne impac of ongoing financial globalizaion on exchange rae volailiy. In urn, while financial globalizaion shifs he erms of he debae abou he relaive meris of alernaive exchange rae sysems, i does no obviously il he balance in one direcion or he oher in deciding beween floaing and fixed regimes. Of course, he acceleraion of financial globalizaion in he 1990s also had a large impac on exchange raes, by arguably increasing he prevalence and severiy of currency and financial crises. The policy response o he 1990s series of crises has been o emphasize he imporance of adequae domesic financial regulaion, he fragiliy of pegged exchange raes and robus fiscal conrol. However, our emphasis on he roles played by exchange raes and raes of reurn in driving ne foreign asse dynamics also raises he quesion of wheher naional governmens should seek o mold he inernaional balance shee in some fashion, eiher direcly or by providing incenives o he privae secor o insure agains paricular financial vulnerabiliies. The rapid growh in official exernal reserves in many counries in recen years can be inerpreed as one response o he risks associaed wih financial globalizaion. In addiion, increased direc invesmen and porfolio equiy flows can in principle improve risk-sharing by ying raes of reurn on exernal liabiliies o domesic

26 macroeconomic condiions. Alhough he lieraure is expanding rapidly, more research on his quesion is clearly needed. VI. CONCLUDING REMARKS This paper has been concerned wih he macroeconomic implicaions of financial globalizaion. Having esablished recen paerns in erms of gross and ne inernaional asse rade for boh advanced and emerging marke economies, we have shown ha he dynamics of ne foreign asse posiions crucially depend on an array of facors beyond he value of he rade balance: socks maer, as well as flows. In paricular, we have focused on he imporance of he valuaion channel of exchange rae adjusmen: currency flucuaions influence he raes of reurn on he inheried socks of foreign asses and liabiliies, in addiion o operaing hrough he radiional rade balance channel. In urn, his raises a se of subsanive policy quesions abou he opimal exernal capial srucure and he exploiabiliy of he valuaion channel as an adjusmen mechanism. An open quesion is how much furher he financial globalizaion process will go: is he end poin he idealized scenario of perfec marke inegraion, or will barriers such as rade coss and imperfec informaion place a limi on he exen of inegraion? The impac of financial globalizaion on exchange rae behavior and he inernaional adjusmen mechanism is likely o remain near he op of he research and policy agendas. We hope ha much clearer answers can be given a he 100 Years Afer Breon Woods conference in 2044.

27 References Alberola, Enrique, 2003, Misalignmen, Liabiliies Dollarizaion, and Exchange-Rae Adjusmen in Lain America, Documeno de Trabajo 0309, (Madrid: Banco de España). Benigno, Pierpaolo, 2001, Price Sabiliy wih Imperfec Financial Inegraion, (unpublished; New York: New York Universiy). Chen, Yu-Chin, and Kenneh Rogoff, 2003, Commodiy Currencies, Journal of Inernaional Economics, Vol. 60, pp Gourinchas, Pierre-Olivier, and Helene Rey, 2004, Inernaional Financial Adjusmen, (unpublished; Berkeley: Universiy of California and Princeon: Princeon Universiy). Hau, Harald, and Helene Rey, 2003, Exchange Raes, Equiy Prices and Capial Flows, (unpublished; Paris: INSEAD and Princeon: Princeon Universiy). Heahcoe, Jonahan, and Fabrizio Perri, 2004, Financial Globalizaion and Real Regionalizaion, Journal of Economic Theory, Vol. 119, pp Hooper, Peer, Karen Johnson, and Jaime Marquez, 2000, Trade Elasiciies for G-7 Counries, Princeon Sudies in Inernaional Economics No. 87, (Princeon: Princeon Universiy). Inernaional Moneary Fund, 1993, Balance of Paymens Manual, 5 h Ediion, Washingon. Kalemli-Ozcan, Sebnem, Ben Sorensen, and Oved Yosha, 2003, Risk Sharing and Indusrial Specializaion: Regional and Inernaional Evidence, American Economic Review, Vol. 93 (June), pp Lane, Philip R., and Gian Maria Milesi-Ferrei, 2001a, The Exernal Wealh of Naions: Measures of Foreign Asses and Liabiliies for Indusrial and Developing Counries, Journal of Inernaional Economics, Vol. 55, pp , 2001b, Exernal Capial Srucure: Theory and Evidence, in The World's New Financial Landscape: Challenges for Economic Policy, edi by H. Sieber, (Berlin- Heidelberg: Springer-Verlag), pp , 2002a, Long-Term Capial Movemens, NBER Macroeconomics Annual, Vol. 16, pp , 2002b, Exernal Wealh, he Trade Balance and he Real Exchange Rae, European Economic Review, Vol. 46, pp

28 - 27 -, 2003, Inernaional Financial Inegraion, Saff Papers, Vol. 50 (Special Issue), pp , 2004a, Inernaional Invesmen Paerns, IMF Working Paper 04/134, (Washingon: IMF)., 2004b, The Transfer Problem Revisied: Ne Foreign Asses and Real Exchange Raes, Review of Economics and Saisics, (forhcoming)., 2004c, The Exernal Wealh of Naions Mark II: Revised and Exended Esimaes of Foreign Asses and Liabiliies, , in progress. Obsfeld, Maurice, and Alan Taylor, 2004, Global Capial Markes: Inegraion, Crisis, and Growh (Cambridge, England: Cambridge Universiy Press). Pavlova, Anna, and Robero Rigobon, 2003, Asse Prices and Exchange Raes (unpublished; Cambridge, Massachuses: MIT). Sullivan, Marin A., 2004, Shifing of Profis Offshore Coss US Treasury $10 Billion or More, Tax Noes, Vol. 104, pp Tille, Cédric, (2003), The Impac of Exchange Rae Movemens on U.S. Foreign Deb, Curren Issues in Economics and Finance, Vol. 9, No. 1, pp. 1 8 (New York: Federal Reserve Bank)., 2004, Financial Inegraion and he Wealh Effec of Exchange Rae Flucuaions, (unpublished; New York: Federal Reserve Bank).

29 APPENDIX I Indusrial counries sample: Ausralia, Ausria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Ialy, Japan, Neherlands, New Zealand, Norway, Porugal, Spain, Sweden, Swizerland, Unied Kingdom, Unied Saes. Emerging markes sample: Argenina, Brazil, Chile, Colombia, Mexico, Venezuela, China, India, Indonesia, Korea, Malaysia, Philippines, Taiwan province of China, Thailand, Czech Republic, Hungary, Poland, Russia, Israel, Souh Africa, Turkey.

30 Table 1. Ne Capial Ouflows and Changes in Ne Exernal Posiion Indusrial Counries, Ne ouflows Change in ne foreign asses Billions US$ Pc. of 2003 GDP Billions US$ Pc. of 2003 GDP Japan Swizerland Norway Canada Euro Area* Sweden Denmark New Zealand Ausralia Unied Kingdom Unied Saes * Change in he ne foreign asse posiion calculaed as he sum of he change in he ne posiions of Ausria, Belgium, Finland, France, Germany, Greece, Ialy, Neherlands, Porugal, and Spain. Source: IMF, Balance of Paymens Saisics, and Lane and Milesi-Ferrei (2004c).

31 Table 2. Gross Capial Flows o and from Indusrial Counries ( ) Capial Inflows Capial Ouflows Change in Foreign Liabiliies billions US$ percen of 2003 GDP billions US$ percen of 2003 GDP billions US$ percen of 2003 GDP Change in Foreign Asses billions US$ percen of 2003 GDP Unied Saes Euro Area Unied Kingdom Swizerland Canada Ausralia Sweden Denmark Norway Japan New Zealand Source: IMF, Balance of Paymens Saisics and Lane and Milesi-Ferrei (2004c).

32 Table 3. Cumulaive Ne Capial Flows o Seleced Emerging Markes, Toal Excluding IMF and Excepional Financing billions US$ Percen of 2003 GDP billions US$ Percen of 2003 GDP "Borrowers" Brazil Mexico Poland Hungary Czech Republic Turkey Argenina "Lenders" China Russia Taiwan Prov. of China Korea Thailand Indonesia Malaysia Source: auhors calculaions based on IMF, Balance of Paymens Saisics.

33 Table 4. Indicaors of Inernaional Financial Inegraion, Emerging Markes (percen of GDP) Average ne exernal posiion Average exernal asses of which: foreign exchange reserves FDI + porfolio equiy Average exernal liabiliies of which: FDI + porfolio equiy Source: auhors calculaions based on Lane and Milesi-Ferrei (2004c) and IMF, Balance of Paymens Saisics.

34 Table 5. Gross Capial Flows o and from Seleced Emerging Markes, billions US$ Capial inflows Capial ouflows Toal Excluding IMF and excep. fin. Toal FX reserves Percenage of 2003 GDP billions US$ Percenage of 2003 GDP billions US$ Percenage of 2003 GDP billions US$ Percenage of 2003 GDP China Taiwan Prov. of China Korea Philippines Brazil Mexico Poland India Chile Indonesia Thailand Source: auhors' calculaions based on IMF, Balance of Paymens Saisics and naional sources.

35 Table 6. Decomposiion of Change in Foreign Asses for Seleced Emerging Markes, (percen of GDP) Change in ne foreign asses Cumulaive rade balance b2002 b1990 Cumulaive curren accoun bgs Cumulaive invesm. Income i A i L $ Y A L 1 1 Cumul. capial Oher facors acc + errors & omissions Growh K-gains ec effec ( ka + eo ) g + g b KG Y π d (1 + g )(1 + π ) b Perc. change in real eff. exchange rae Brazil Czech Republic Indonesia Mexico Thailand Turkey Noe: he breakdown of changes in he ne foreign asse posiion reflecs equaion (5) in he ex. Source: IMF, Inernaional Financial Saisics, and Lane and Milesi-Ferrei (2004c). $ 1

36 Table 7. US: Relaive Conribuions of Flows, Marke Values and Exchange Raes o Dynamics of he Inernaional Balance Shee, Mean Sandard Deviaion CON FLOW _FA CON FLOW _FL CON_MV _FA CON_MV _FL CON_ER _FA CON_ER _FL Source: US Bureau of Economic Analysis (BEA). We hank Cedric Tille for kindly sharing in elecronic form his hisory of he BEA daa releases. Table 8. Ausralia: Relaive Conribuions of Flows, Marke Values and Exchange Raes o Dynamics of he Inernaional Balance Shee, Q Q Q Q1 Mean 1997.Q Q1 Sandard deviaion 2001.Q Q Q Q2 CON FLOW _FA CON FLOW _FL CON_MV _FA CON_MV _FL CON_ER _FA CON_ER _FL Source: Auhors calculaions based on daa from he Ausralian Bureau of Saisics.

37 Table 9. Exchange Raes and Raes of Reurn on Foreign Asses (1) (2) (3) (4) (5) Toal FDI Por_Eq Por_Deb Oher USA -0.37*** -0.57*** *** UK -1.01*** -0.83*** *** -0.96*** Ausria -1.34** -3.85** France Germany -0.88*** -1.04*** -2.49*** -1.16*** -0.45*** Ialy -1.08*** -1.17*** Neherlands Sweden -0.74* -0.63** Swizerland -1.07*** -0.62** -2.43*** -0.8** -0.93*** Canada -0.66*** -0.46* -0.97*** -0.86*** Finland -1.09*** -1.07** Iceland Spain -0.69*** -1.62*** *** -0.61** Ausralia -0.57*** -0.65** -0.55* -0.89*** -0.41* Panel -0.78*** -0.76*** -0.97*** -0.89*** -0.63*** Noe: Bea coefficiens from regression of rae of reurn on real appreciaion. ***,**,* denoe significance a he 1,5 and 10 percen levels respecively. OLS wih robus sandard errors. Panel esimaion includes counry fixed effecs (no repored). Full regression resuls available from he auhors upon reques. Daa availabiliy varies by counry, wihin span. Source: auhors calculaions based on IMF, Balance of Paymens Saisics, and Lane and Milesi-Ferrei (2004c).

38 Table 10. Exchange Raes and Raes of Reurn on Foreign Liabiliies (1) (2) (3) (4) (5) Toal FDI Por_Eq Por_Deb Oher USA UK -0.92*** * -0.78*** Ausria France 0.85 Germany -0.49** ** Ialy -0.71*** Neherlands * Sweden -0.77*** Swizerland -0.73*** *** Canada -0.52*** *** -0.67*** Finland -1.79* 0.91 Iceland -1.33*** Spain -0.69*** ** Ausralia -0.31*** *** -1.68*** Panel -0.68*** * -0.60** -0.79*** Noe: Bea coefficiens from regression of rae of reurn on real appreciaion. ***,**,* denoe significance a he 1, 5 and 10 percen levels respecively. OLS wih robus sandard errors. Panel esimaion includes counry fixed effecs (no repored). Full regression resuls available from he auhors upon reques. Daa availabiliy varies by counry, wihin span. Source: auhors calculaions based on IMF, Balance of Paymens Saisics, and Lane and Milesi-Ferrei (2004c).

39 % Figure 1. Ne Foreign Asse Posiion (raio of GDP) and GDP per capia Indusrial Counries, 2003 SWI 100% Raio of ne foreign asses o GDP 50% 0% ITA JPN BEL FRA GER SWE UK NET CAN AUT FIN US DEN y = 0.039x R 2 = 0.39 NOR SPA -50% GRE PRT AUS ICE NZE -100% GDP per capia (housands of US$) Sources: IMF, World Economic Oulook (GDP per capia) and Lane and Milesi-Ferrei (2004c) (ne foreign asses).

40 Figure 2. Composiion of Inernaional Porfolio, Indusrial Counries (Sum of Asses and Liabiliies as a Raio of GDP, ) Equiy FDI Deb Noe: Char plos he sum of aggregae equiy, FDI, and deb asses and liabiliies as a share of aggregae GDP for a sample of indusrial counries including: Ausralia, Ausria, Belgium, Canada, Denmark, Finland, France, Germany, Iceland, Ialy, Japan, Neherlands, Norway, Spain, Sweden, Swizerland, Unied Kingdom, Unied Saes. The sample choice is dicaed by daa availabiliy. Source: Lane and Milesi-Ferrei (2004c).

41 - 40-3% Figure 3. Average and Aggregae Curren Accoun o GDP Raio Emerging Markes Sample, % 1% 0% Average raio -1% -2% -3% Aggregae raio -4% -5% -6% Figure 4. Average and Aggregae Ne Exernal Posiion, Emerging Marke Sample, * -20% Aggregae raio -25% Average raio -30% -35% -40% Source: auhors calculaions based on IMF, Balance of Paymens Saisics and Lane and Milesi-Ferrei (2004c).

42 Figure 5. Ne Foreign Asses and GDP per capia Emerging Markes Sample, % 80% TAI 60% Ne foreign asses/gdp 40% 20% 0% -20% -40% -60% RUS CHN SAF IND COL THA ARG PHI BRA TUR IDN VEN MAL POL CHI MEX CZE HUN KOR ISR -80% GDP per capia, curren US$ Sources: IMF, World Economic Oulook (GDP per capia), and Lane and Milesi-Ferrei (2004c) (ne foreign asses).

43 Figure 6. Indicaors of Inernaional Financial Inegraion, Emerging Markes 90% 80% Average raio of exernal asses and liabiliies o GDP 70% 60% 50% Gross liabiliies 40% 30% Gross asses 20% 10% % Average raio of exernal asses and liabiliies o expors 300% 250% Gross liabiliies 200% 150% 100% Gross asses 50% Source: Auhors calculaions based on Lane and Milesi-Ferrei (2004c).

44 Figure 7. Unied Saes: Componens of Change in Exernal Asses and Liabiliies, Change in US exernal asses (percen of GDP) Exchange-rae effecs Price effecs Capial flows Change in US exernal liabiliies (percen of GDP) Exchange-rae effecs Price effecs Capial flows Source: Auhors' calculaions based on Tille (2003) and updaed daa provided by Cédric Tille.

45 Figure 8. Ausralia: Componens of Change in Exernal Asses and Liabiliies, Change in exernal asses (percen of GDP) exchange rae effecs price effecs flows Change in exernal liabiliies (percen of GDP) exchange rae effecs price effecs flows Source: auhors' calculaions based on Ausralian Naional Saisics

46 Figure 9. Real Rae of Reurn on Exernal Liabiliies and Changes in Real Exchange Rae Emerging Marke Sample, % Real dom. curr. rae of reurn on ex. liabs. 80% 60% 40% 20% 0% KOR IDN THA MAL PHI COL TAI BRA HUN ISR ARG INDCHN CHITUR CZE POL MEX VEN SAF -20% -50% -40% -30% -20% -10% 0% 10% 20% 30% 40% Perc. change in real eff. exch. rae Noe: he real domesic currency rae of reurn on exernal liabiliies is consruced as he sum of he yield (ineres paymens in 1997 divided by he sock of liabiliies a end-1996) and he capial gain rae (change in sock of exernal liabiliies beween 1997 and 1996 minus flow, divided by sock of exernal liabiliies a end-1996). The change in he real exchange rae is he percenage change in he CPI-based real effecive exchange rae beween end-1997 and end Source: auhors calculaions based on IMF, Balance of Paymens Saisics, Inernaional Financial Saisics, and Lane and Milesi-Ferrei (2004c).