Ebook Financial Integration and the Wealth Effect of Exchange Rate Fluctuations
A striking recent development in the U.S. economy is the apparent disconnect between its foreign debt and international borrowing. Over the last 20 years, the U.S. Net International Investment Position (hereinafter NIIP, the difference between foreign assets held by U.S. investors and U.S. liabilities to foreign investors) has regularly moved towards ever higher indebtedness, with the U.S. owing 22 percent of its GDP to the rest of the world at the end of 2004 (Nguyen 2005). While this is hardly surprising given the growing current account deficit of the U.S., the connection between the deficit and the NIIP is looser than one may expect. Figure 1 shows the NIIP (solid line, left scale) and the current account balance (dotted line, right scale). Over the last three years, the NIIP has remained steady despite the U.S. running a large current account deficit.
This apparent puzzle is explained by the direct impact of exchange rate movements on the NIIP. As detailed below, the U.S. owns a large amount of assets denominated in foreign currencies. The dollar value of these assets mechanically increases when the dollar depreciates. This so'called valuation effect of exchange rate movements is receiving a growing attention in the literature (Gourinchas and Rey 2005a,b, Lane and Milesi'Ferretti 2005a,b, 2003, Obstfeld 2004, Tille 2003).
The purpose of this paper is twofold. We first present a detailed description of the U.S. balance sheet, stressing the leverage across currencies and asset categories. We then consider a standard open economy model and extend it to include international financial integration, with an emphasis on the valuation effect of exchange rate movements. We use the model to assess how financial integration affects the international transmission of monetary shocks.
A detailed breakdown of the composition of the U.S. assets and liabilities shows that the U.S. international portfolio is highly leveraged along several dimensions. In terms of currencies, the U.S. is a large net creditor in assets denominated in foreign currencies, which amount to 50 percent of GDP at the end of 2004. This is more than offset by net liabilities in dollar, that represent 72 percent of GDP, for a net overall debt of 22 percent of GDP.
As a result of this leverage a depreciation of the dollar leads to a substantial transfer to the U.S., with a 10 percent movement transferring 5 percent of U.S. GDP. We also document a substantial leverage across various types of assets. The U.S. is a net creditor in FDI and equity, to the tune of 10 percent of GDP, while it owes the equivalent of 32 percent of GDP in debt and banking assets, a feature also documented in Gourinchas and Rey (2005b). Combining the two dimensions, we show that the currency leverage is concentrated in FDI and equity positions, with holdings of debt and banking positions being essentially in U.S. dollar.
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