The surge in financial globalisation constitutes one of the major developments in the world economy since the mid-1990s, with Lane and Milesi-Ferretti (2007) documenting a large rise in most countries’ holdings of external assets and liabilities. This pattern is observed even for the world’s major economies, and financial globalisation opens new channels of international adjustment that complement the standard ones operating through trade flows (Gourinchas and Rey 2007). For the United States, for instance, data from the Bureau of Economic Analysis show that external assets and liabilities increased as a share of GDP by factors of five and seven, respectively, between 1982 and 2007.
A consequence is that financial factors, such as movements in asset prices and interest rates, play a growing role for international transactions. Should we then be concerned about economic actors being exposed to far-off foreign developments, with the losses of UBS on the US subprime mortgage market being one of many examples?
The rising role of earning streams
In recent research, we show that financial factors play a growing role in the US current account (Hellerstein and Tille 2008). At first glance, the earning streams (interest and dividends) on cross-border assets and liabilities seem trivial. Over the past four decades, the US current account balance has moved in close step with the trade balance, with the net asset income contributing very little to the overall current account.
A very different picture emerges, however, if we look to the gross flows. The nation’s gross income from the rest of the world consists of exports plus earnings on foreign assets (the dividends and interest earned by US investors on their assets abroad). These earnings represent a growing share of US gross income, roughly doubling from 1970 to 2007, as illustrated in Figure 1 below. A similar pattern is observed for gross payments to the rest of the world, consisting of imports and earnings by foreign investors on their US assets.
Figure 1. Earnings on assets as a share of gross flows
Current account volatility due to financial factors
The pattern documented above has made the current account more sensitive to fluctuations in international financial yields and interest rates. This reflects the higher volatility of financial variables (such as earnings streams) compared to real variables (such as trade flows).
The heightened sensitivity of the current account to movements in yields is strikingly illustrated by the Bureau of Economic Analysis’ June 2007 revisions to the balance of payments, which reduced the current account deficits for 2004 – 2006 by amounts between 0.22% and 0.34% of GDP compared to preliminary data. These reductions were driven solely by net asset income, with only minimal revisions to the trade balance. The revisions to net asset income in turn reflected primarily an upward adjustments to the yield earned on US assets abroad, with revisions to the asset holdings themselves playing a marginal role. This is illustrated in Figure 2, which decomposes the revision in the net asset income into these two aspects.
Figure 2. Decomposition of the revision to net asset income
Is this a cause for concern?
Should we be concerned about the heightened exposure of the current account to movements in financial yields?
Usually we think of volatility as being detrimental. The key question here is not whether the current account has become more volatile, but rather how that volatility is associated with volatility in overall US income, as measured by GDP. If US assets abroad deliver a high yield in times when US GDP is low, they provide a valuable hedge and the volatility of the current account is nothing more than risk sharing at work.
We show that the yield differential between US international assets and liabilities is negatively correlated with US growth (Table 1). The US earns a higher yield on its assets than it pays on its liabilities precisely when it faces a recession.
Table 1. Determinants of income volatility
|Standard deviation (percent)|
|Real GDP growth||1.6||1.1|
|Minimizing asset holdings (percentage of GDP)a||58||141|
Sources: US Bureau of Economic Analysis; authors' calculations
Notes: a The ratio of foreign assets to GDP that minimizes the variance of national income, assuming zero net foreign assets.
Our analysis further indicates that this “insurance” benefit from financial globalisation has become stronger over the last ten years. A simple “back of the envelope” calculation shows that minimising the volatility of national income would require large offsetting holdings of assets and liabilities that are in line with their current levels.
Financial globalisation translates into a growing role of financial earnings in the current account, making it more volatile. This need not be a cause for concern, however, as spreading the business cycle risk across countries leads to that exact pattern.
Of course, our work should not be viewed as a definitive look at these questions. We focused on the yields on assets and liabilities – the part of the return that take the form of cash flow streams that enter the balance of payment. The overall return also includes capital gains (with some measurement issues), and we are currently looking at this dimension. In addition, the benefit of sharing “normal” business cycle risk through financial integration can come at the cost of an exposure to large so-called “extreme events”.
Gourinchas, Pierre-Olivier, and Hélène Rey. 2007. “From World Banker to World Venture Capitalist: US External Adjustment and the Exorbitant Privilege.” In Richard H. Clarida, ed., G7 Current Account Imbalances: Sustainability and Adjustment. NBER Conference Report. Chicago: University of Chicago Press.
Hellerstein, Rebecca, and Cédric Tille. 2008. “The Changing Nature of the US Balance of Payments.” Federal Reserve Bank of New York Current Issues in Economics and Finance, vol 14(4).
Lane, Philip, and Gian Maria Milesi-Ferretti. 2007. “A Global Perspective on External Positions.” In Richard H. Clarida, ed., G7 Current Account Imbalances: Sustainability and Adjustment. NBER Conference Report. Chicago: University of Chicago Press.