The integration of international financial markets has been one of the defining features of the past twenty years. Across industrialized countries, total foreign assets and liabilities have tripled as a share of Gross Domestic Product (GDP), with foreign-equity assets and liabilities increasing six-fold. This pattern has generally been mirrored in emerging markets, although they have experienced a more cyclical trend, especially during financial crises. Given the substantial increase in cross-border flows of capital, what role do exchange rate movements play?

The traditional view suggests that a country’s net foreign asset position (NFAP) is intertwined with its trade balance; exchange rates affect the NFAP just as they affect the trade balance. A currency depreciation, by making exports cheaper and imports more expensive, tends to improve the trade balance, and with it the NFAP. But this “trade balance channel” view may overlook the effect of exchange rates on existing foreign assets and liabilities. Suppose a country has an initially balanced NFAP, with assets and liabilities denominated in different currencies. Following a currency depreciation, the domestic-currency value of foreign assets increases, while the foreign-currency value of domestic liabilities falls. Through this “valuation channel”, an exchange rate movement can have a significantly larger effect on a country’s NFAP than that suggested by the “trade balance channel”.

This study seeks to address the issue by developing an accounting framework in which exchange rate movements affect the NFAP through both the trade balance and existing stocks of foreign assets and liabilities. The model shows how a country’s NFAP may be affected by changes in the trade balance and in net capital gains, by the impact of exchange rate changes on the stock of foreign assets, and by economic growth. The striking result of this analysis is that both the initial NFAP and the gross scale of the country’s financial position do matter. For example, if two countries with balanced NFAPs depreciate, the net result will differ if one country has greater foreign assets.

The outcomes of the model are tested by examining the sensitivity of foreign asset returns to movements in exchange rates across a range of countries between 1999 and 2002, using data from the International Monetary Fund. The authors estimate the magnitude and direction of the relationship between the domestic-currency return on a foreign asset and that country’s (trade-weighted) exchange rate.

Across all types of assets, the estimated correlation is negative, implying that an appreciation of the domestic currency coincides with reduced foreign asset returns. Suppose a UK investor holds a German bond paying a 5% return in euros. The results of this study indicate that if the British pound appreciates against the euro, the return on the bond will be worth less in pounds. This result highlights the importance of the “valuation channel”, since both the return and NFAP of an existing stock of foreign assets will be affected by a currency appreciation.

In no cases is the estimated relationship between a currency appreciation and the domestic-currency return on foreign liabilities positive. A positive relationship would imply that a productivity shock at home, raising the value of the domestic currency, would cause the subsidiaries of foreign companies to increase profits. Strikingly, the authors find no instances of this kind of productivity transfer across borders.

While the results on this study hold across nearly all countries in the sample, there is one exception to the rule: the United States. The dollar-denominated returns on US-owned foreign assets are the least sensitive to changes in the value of the dollar. In fact, when looking only at foreign liabilities, changes in the dollar’s value do not appear to have any effect. The authors believe that this is because the majority of foreign assets and liabilities held by the United States are denominated in dollars. As such, changes in the value of the dollar do not have any effect on US returns. Another interesting result is that the sensitivity of a country’s NFAP to currency appreciations varies across investment categories; equity returns are more sensitive to exchange rate changes than debt returns are.

This paper yields several broad implications. Previous studies have shown that monetary shocks such as sudden interest rate changes have a larger effect if a country’s NFAP is initially unbalanced. Since the “valuation channel” can lead to greater imbalances, monetary shocks may actually have a larger effect than productivity shocks. Second, as the “valuation channel” grows in importance, a country may have an opportunity to improve its NFAP by devaluing its currency. But this type of policy is only likely to be effective once since it would result in a loss of reputation. After this devaluation, investors would require a larger return to compensate them for bearing the risk of additional devaluations, as occurred during the Asian financial crisis. Despite this, however, a one-time adjustment may still be a powerful policy tool.

Given the sensitivity of the “valuation channel” across investment categories, the results suggest that governments may want to mold the composition of the international portfolio to alter the sensitivity of net foreign asset position to exchange rate movements.

Report Source:
"Financial Globalization and Exchange Rates", a Working Paper by: Philip R. Lane (IIIS, Trinity College, Dublin), Gian Maria Milesi-Ferretti (International Monetary Fund).
IMF Working Paper No.05/3, January 2005, pp.46