Ebook International Financial Adjustment
Understanding the dynamic process of adjustment of a country’s external balance is one of the most important questions for international economists. ‘To what extent should surplus countries expand; to what extent should deficit countries contract?’ asked Mundell (1968). These questions remain as important today as then.
The modern theory which focuses on those issues is the ‘intertemporal approach to the current account’. It views the current account balance as the result of forward-looking intertemporal saving decisions by households and investment decisions by firms, under incomplete markets. As Obstfeld (2001)[p11] remarks, ‘it provides a conceptual framework appropriate for thinking about the important and interrelated policy issues of external balance, external sustainability, and equilibrium real exchange rates’ together with a rigorous, solidly microfounded, analysis of welfare issues for international problems.
This approach has yielded major insights into the current account patterns that followed the two major oil price shocks of the seventies, or the large U.S. fiscal deficits of the early eighties. Yet, in many instances and for most countries, its key empirical predictions are easily rejected by the data. Our paper suggests that this approach falls short of explaining much of the dynamics of the current account because it usually assumes that the only asset traded internationally is a one-period riskfree bond. In reality, international financial markets have become increasingly sophisticated and offer a rich menu of assets (equity, FDI, corporate and government bonds for example). Traditional models therefore ignore a central aspect of the adjustment of countries’ external balances, namely, predictable changes in the valuation of foreign assets and liabilities. Fluctuations in the rate of returns of financial assets and in the exchange rate affect in an important way the dynamics of external balances.
This link between asset prices, exchange rate and current account dynamics has been ignored in the intertemporal approach to the current account and may explain much of its failure. According to our approach, balance of payments adjustments may occur through this revaluation of assets and liabilities. Consider the case of the US. It currently has a very negative foreign asset position. The intertemporal budget constraint of the country implies that it will have to reduce this imbalance. The intertemporal approach to the current account suggests that the US will need to run trade surpluses. In this paper, we show that this rebalancing can also take place through a change in the returns on US assets held by foreigners relative to the return on foreign assets held by the US. Importantly, this rebalancing may occur via a depreciation of the dollar. With large gross asset positions, as is the case in the data, a given change in the dollar can transfer large amounts of wealth from the rest of the world to the US and vice versa.
Our framework therefore gives novel insights into the dynamics of adjustment of countries’ external account and ties the dynamics of the exchange rate to net exports and net foreign assets, thereby reconciling the ‘asset market view’ and the ‘goods market view’ of exchange rate determination. It recognizes the central importance of intertemporal budget constraints and transversality conditions for the external adjustment process. But it departs from the literature by allowing for a sophisticated array of internationally traded financial assets. Consequently, this paper shifts the emphasis from the current account to the financial account and its components. Most importantly, the dynamics of the exchange rate plays a major role in our set up by affecting the differential in rates of return between assets and liabilities. We show in particular in section 4 that the ratio of net exports to net foreign assets contains significant information about future exchange rate changes, even at relatively short horizons.
Lane and Milesi-Ferretti have documented the importance of valuation effects in the process of international adjustment in several papers. In Lane and Milesi-Ferretti (2001), they point out that the correlation between the change in net foreign asset position at market value and the current account is low or even negative. Lane and Milesi-Ferretti (2002b) note that rates of return on the net foreign asset position and the trade balance tend to comove negatively, suggesting that wealth transfers affect the trade balance. Similarly, introducing variable interest rates and exchange rates in traditional models of the current account, as done by Bergin and Sheffrin (2000) helps to model the volatility of net foreign asset positions. And Kray and Ventura (2000) demonstrate the importance of allowing for risky domestic investment opportunities to account for realistic current account dynamics. Mercereau (2003) and Mercereau (2004) introduce a stock market in a model of the current account with a CARA utility and show that the current account may help predict future stock market performance. More recently Tille (2003) discusses the effect of the currency composition of US assets on the dynamics of its external debt, while Corsetti and Konstantinou (2003) provide an empirical analysis of the responses of US net foreign debt to permanent and transitory shocks.
The remainder of the paper is structured as follows. In section 2 we briefly review the intertemporal approach to the current account. We then lay down the building blocks of our theory of international financial adjustment in section 3 and present the construction of our dataset in section 4. In section 5, we show that there are substantial valuation effects which contribute to the dynamics of financial adjustment in the short to medium-run. Adjustment of net exports operates at longer horizons. We also find evidence of net foreign portfolio returns and of exchange rate movements both in and out-of-sample. Section 6 concludes.
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