The debate on the sustainability, or lack thereof, of global imbalances has kept policymakers and international economists busy for several years. One of the many elements in the discussion is the role of return differentials across assets in different countries, with a particular emphasis on the “valuation effects” through which exchange rate and asset price movements alter the value of international financial holdings. Such effects are a substantial driver of international holdings, as shown by Lane and Milesi-Ferretti (2005). Gourinchas and Rey (2007) argue that return differentials play a substantial role, with about one-third of U.S. external imbalances being offset through a higher return on U.S. assets, relative to the return on U.S. liabilities. The sustainability of such differentials remains nonetheless debated (Curcuru et al. 2008).
Assessing the sustainability of a current account balance is ultimately a statement on its long-run value. Getting a sense of the long-run current account is then an important (albeit not a straightforward) exercise. It has long been recognised that a growing country can keep its external debt stable as a share of GDP while still running a current account deficit. Such an inference focuses on the level of a country external debt. However, it overlooks the composition of external assets and liabilities, which plays a substantial role because of valuation effects.
The long-run current account and a country’s external position
Under the standard inference described above, the current account along a balanced growth path is proportional to the country’s net foreign asset position, with the ratio between the two simply reflecting the growth rate of GDP. Intuitively, a debtor country can run a current account deficit and add to the absolute value of its net debt, while maintaining a constant debt-to-GDP ratio. The current account deficit is the combination of a surplus in the trade balance that is more than offset by the interest payments on the debt.
An implicit assumption behind this argument is that the return on external liabilities takes the form of an interest payment that enters the current account. However, such earning streams play a small role for several categories of assets, such as equity and foreign direct investment, for which most of the returns takes the form of capital gains. As such gains entail no income flow, they do not enter the balance of payments. But these capital gains cannot be ignored, as they drive the large valuation effects identified in the literature.
The presence of capital gains implies that the composition of a country’s external assets and liabilities, in addition to their levels, matters for an assessment of its long-run current account. This is because the role of capital gains substantially differs across assets, being more relevant for equity and FDI than for bonds. Consider the case of a country with liabilities in bonds and assets in equity that exactly offset each other. This country can run a current account deficit and keeps its external position balanced. Intuitively the interest payments on liabilities, which enter the current account, are offset by capital gains on assets, which do not. Notice that this occurs despite all assets earning the same rate of return.
In a recent contribution (Tille 2008), I show that this dimension can be included through standard balance of payment accounting. Such accounting also points to the need for caution when gauging long-run sustainability by looking at the current account, as it is affected by the composition of international holdings. By contrast, the trade balance is not affected and thus offers a more reliable indicator.
How much do capital gains matter?
The empirical relevance of the composition of external holdings can be assessed by relying on the External Wealth of Nations dataset of Lane and Milesi-Ferretti (2005) which contains the holdings across various categories of assets for a broad range of industrialised and emerging countries. To focus on the impact of the composition of holdings, I combine these data with a calibration of the rate of returns on different assets. The analysis thus answers the following question: “Given a country’s external assets and liabilities in a particular year, what is the long-run current account that it could run to keep its overall net position unchanged?”
The exercise shows three main points. First, taking the composition into account has a sizable effect on the value of the current account along a stable growth path. Based on the most recent position data (2006), the effect exceeds 1% of GDP for one-third of the countries in the sample and ranges between 0.5 and 1% for another third.
Second, there is a clear contrast between industrialised and emerging countries. The former tend to be net creditors of equity and FDI, the two categories of assets for which capital gains are the most relevant. This increases the estimated long-run current account deficit for the industrialised group by 0.23% of GDP based on 2006 positions. The situation is mirrored for emerging markets, where the estimated surplus is increased by 0.70% of GDP.
Third, the relevance of the composition of holdings has substantially increased in recent years. This is illustrated by Figure 1, which shows the cross-sectional standard deviation of the current account gap (the difference between the estimate including the composition of holdings and the ones ignoring it). Looking across all countries in the sample (red line), there is a clear upward trend in the dispersion of the gap, with the composition of holdings pushing some countries towards a current account surplus and others towards a deficit. The situation is even more striking if we limit ourselves to the countries for which the data are available since 1970 (blue line, 22 countries out of 61).
Figure 1. Standard deviation of current account gap, percentage of GDP
Implications for the future
The exercise presented above is of course limited, as the world’s economies are not on a steady growth path in any particular year. I therefore complete it by considering a scenario analysis from 2006 to 2020. I rely on the IMF World Economic Outlook forecasts for GDP and the current account and combine them with assumptions on the rates of returns. I do not consider any return differential and instead assume that all assets earn the same return, albeit in different ways. Under this scenario, industrialised economies benefit from capital gains that offset about one third of their current account deficits from 2006 to 2020. Conversely, emerging markets see a quarter of their surpluses being offset by capital losses.
Capital gains on international assets and liabilities are an important ingredient in any assessment of the sustainability of global imbalances. Ignoring them can lead to inaccurate inferences on the long-run current account, a problem that has become more acute with recent financial globalisation. Capital gains are likely to play a substantial role in the near future, and a finer assessment than the one presented here, tailored to the specific situation of individual countries, is a relevant, if tedious, exercise.
Curcuru, Stéphanie, Tomas Dvorak, and Francis Warnock (2008), “Cross-Border Returns Differentials”, Quarterly Journal of Economics.
Gourinchas, Pierre Olivier and Helene Rey (2007), “International Financial Adjustment”, Journal of Political Economy, 115(4), pp. 665-703.
Lane, Philip and Gian Maria Milesi-Ferretti (2005), “A Global Perspective on External Positions”, CEPR Discussion Paper 5234
Tille, Cédric, (2008), “Composition of International Assets and the Long Run Current Account,” Economic Notes, forthcoming.