Economic Dynamics Newsletter

Pierre-Olivier Gourinchas on Global Imbalances and Financial Factors

Ever since David Hume’s (1752) price-specie flow mechanism, understanding the dynamic process of adjustment of a country’s external balance is one of the most pressing –and vexing– question for international macroeconomists. The modern approach to this issue characterizes the dynamics of external debt as the result of forward-looking savings decisions by households, and investment decisions by firms, in market structures of varying degrees of complexity. As Obstfeld (2001) remarks, “[this approach] provides a conceptual framework appropriate for thinking about the important and interrelated policy issues of external balance, external sustainability and equilibrium real exchange rates”. Yet in most empirical studies, the theory falls short of explaining the dynamics of the current account. External adjustment has been the focus of much discussion recently, given the unprecedented build-up of US external imbalances. The current account deficits of the United States have steadily grown since the mid 1990s, reaching 6.4% of GDP in 2005. This represents the largest deficit in world history in dollar terms. Will such an imbalance be corrected, how and at what horizon?The research agenda I will discuss here today focuses on the historical role of financial variables in this adjustment process. My first line of research –with Hélène Rey from Princeton– shifts the focus of the analysis from the current account to the net and gross international investment positions and the role of valuation effects. My second line of research –with Ricardo Caballero and Emmanual Farhi from MIT– discusses the role of financial development and emphasizes the global supply of financial assets.

In the following discussion, I consider each in turn.

1. The importance of expected valuation effects

The recent wave of financial globalization came with a sharp increase in gross cross-holdings of foreign assets and liabilities (see Lane and Milesi- Ferretti (2006)). Hence, it is quite natural to shift the emphasis to the determinants of a country’s net international investment position (NIIP). Consider the US. Its NIIP is nothing but a leveraged portfolio, short in dollar denominated US assets (US equity, corporate and government debt, inward direct investment etc.) and long in foreign currency denominated foreign assets (Japanese equity, direct investment in China, UK gilts etc.) whose value is affected by fluctuations in assets and currency prices. The upsurge in cross border holdings has therefore opened the door to potentially large wealth transfers across countries, which may alter net foreign asset dynamics. These valuation effects are absent, not only from the standard theory, but also from official statistics since the National Income and Product Accounts and the Balance of Payment report most items in the current account at historical cost. Hence official data give a very approximate and potentially misleading reflection of the change in a country’s true NIIP.Here is a way to think about the orders of magnitude involved: at the end of 2004, the Bureau of Economic analysis reports US gross external assets and liabilities equal respectively to 85% and 107% of US GDP, implying a NIIP of -22% of GDP. That year, the trade deficit on goods and services reached 5.3% of GDP. The standard approach suggests that the US will need to run significant trade surpluses, at some point in the future, to stabilize its external debt. Part of the adjustment, however, may also come from lower returns on US assets held by foreigners, relative to the return on foreign assets held by the US, i.e. a wealth transfer to the US. Since most US liabilities are denominated in US dollars, and approximately 70% of US foreign assets are denominated in foreign currencies, this wealth transfer can take the form of a depreciation of the US dollar. For instance, consider an unexpected 10% depreciation of the US currency. It implies, ceteris paribus, a transfer of 5.9% (0.7*0.85*0.1) of GDP from the rest of the world to the US that would more than cover the trade deficit. Could it be, then, that movements in currency and asset prices contribute systematically to the adjustment process and if so, by how much?

One may be tempted to dismiss even the possibility of such predictable valuation effects. After all, usual interest parity considerations would rule them out: asset and currency prices should be expected to move in such direction as to deliver similar returns, when measured in a common currency. I will return to this important theoretical issue shortly, but I want to concentrate first on what the data have to say.

The first task is to construct accurate measures of a country’s NIIP at market value. In Gourinchas and Rey (2006a), we assemble a quarterly dataset of the US gross foreign asset and liability positions at market value since 1952 disaggregated into four broad asset categories (direct investment, equity, debt and other –mostly bank loans and trade credit), and compute capital gains and total returns on these global portfolios components. This exercise delivers a number of important “stylized facts.” First, it is well known that the investment income balance –the balance of interest, dividends and earnings on direct investment paid to and by the US– has remained positive despite mounting net liabilities. What is less well-known is that the evidence on total return on US external assets and liabilities is consistent with the evidence on yields: since 1952, the US enjoyed an average annual excess return on its gross assets of 2.11%. Moreover, this excess return has increased to 3.32% since the collapse of the Bretton Woods system of fixed exchange rates. About one third of this excess return reflects the role of the US as a world financial intermediary, borrowing mostly in the form of low yield-low risk assets (loans and debt), and investing in high yield-high risks assets (equity and FDI). The remaining two thirds arise from return differentials within asset classes. This reflects mostly the ability of the US to borrow at very low interest rates, a fact sometimes interpreted as evidence of the “exorbitant priviledge” that the US enjoys from its unique position in the international monetary order, as the issuer of the world’s reserve currency.

Gourinchas and Rey (2005) turn to the question of the international adjustment process. We cast the analysis in very general terms, relying simply on a country’s intertemporal external constraint and a no-Ponzi condition, and characterize two adjustment channels. The traditional “trade channel” links current imbalances to future trade surpluses. The novel “valuation channel” shows that expected future excess returns on the NIIP can also potentially contribute to the process of adjustment. Formally, our empirical approach builds on Campbell and Shiller (1988), who look at the adjustment process of the dividend price ratio, or more recently Lettau and Ludvigson (2001), who look at movements in the consumption-wealth ratio. Like these papers, we construct a measure of cyclical external imbalances –akin to the deviation from trend of the ratio of the trade deficit (the flow) to the NIIP (the stock)– and relate it to future expected net exports growth and excess returns. In contrast with these papers, we allow for slow moving structural changes in the data, capturing increasing trade and financial integration. The empirical results indicates that up to 27% of cyclical external imbalances are eliminated via predictable adjustments in future returns, and 64% are eliminated via future improvements in the trade balance, accounting for 91% of the fluctuations in external imbalances. We then turn the argument on its head: if the valuation channel is operative, current cyclical imbalances, properly measured, should predict future excess returns, and possibly future currency movements. There again, we obtain very strong predictability results, from 1 to 16 quarters ahead, both in and out of sample. A global imbalance today strongly predicts future positive excess return on US external assets and a future depreciation of the U.S. dollar. This last result is especially striking: the classic paper of Meese and Rogoff (1983), established that no exchange rate model could significantly outperform the random walk at short to medium horizons. Our results decisively overturn their conclusion.

2. Valuation effects: some elements of theory

It is now time to return to the theory. As mentioned above, the empirical evidence in favor of strong predictable valuation effects is quite puzzling: why would the rest of the world agree to buy US assets (i.e. finance the US current account deficit) if these assets are expected to under-perform?A successful theory will need two critical ingredients: consumption and portfolio home biases. The former implies that a stabilization of the current account must be accompanied by relative price and real exchange rate movements. The latter requires that domestic and foreign assets are imperfect substitute and implies that wealth transfers are accompanied by predictable and partially offsetting exchange rate movements (see Obstfeld (2004)). The connection between consumption and portfolio home biases is an active topic of research (see Obstfeld and Rogoff (2000), Coeurdacier (2005) and Heathcote and Perri (2005)). Under some conditions, home portfolio bias can emerge as a consequence of the tilt in preferences toward the home good.

Gourinchas and Rey (2006b) build on this literature. We consider a two-country Lucas tree economy with complete markets and preferences for the home good (see Kollmann (2006) for a related model). Preliminary results indicate that, in models with perfect risk sharing, external adjustment operates via strong and unexpected valuation effects, but no predictable valuation effects. The intuition for that result is the following: in an endowment economy, efficient risk sharing requires that a country runs a trade deficit when domestic output is relatively low. To do this, the planner’s allocation generates an unexpected valuation gain that offsets current and expected future trade deficits. One way to implement this allocation is for foreigners to hold claims to the domestic tree and vice versa: under reasonable preference assumptions, the negative domestic shock lowers the value of domestic equity relative to foreign equity and generates an unexpected capital loss for foreigners, which turns the domestic country into a net creditor. In the meantime, the decline in the relative supply of the home good requires an instant real appreciation, followed by a subsequent depreciation. Crucially, this expected real depreciation is offset by expected adjustments in asset returns. Therefore it does not generate predictable excess returns nor contributes to the adjustment process.

Looking ahead, the next obvious step is to build general equilibrium models of international portfolio allocation with incomplete markets. I see this as a major task that will close a much needed gap in the literature between effectively complete markets models and the special cases that assume away predictable return or eliminate current account fluctuations (see, inter alia, Baxter and Crucini (1995), Corsetti and Pesenti (2001), Heathcote and Perri (2005), Pavlova and Rigobon (2003), Tille (2005)). One interesting step in that direction is Evans and Hnatkovska (2005).

Along the way, we are witnessing a renewal of interest in the old partial-equilibrium portfolio balance literature of Kouri (1982), and more recently Blanchard Giavazzi and Sa (2005), that generate predictable valuation effects. In these models interest rates are constant and the exchange rate performs the dual role of allocating global portfolios between imperfectly substitutable domestic and foreign assets, and affecting the trade balance through traditional expenditure switching effects. Whether the insights from that literature survive in a modern dynamic global portfolio model is a question of great interest.

3. The global supply of financial assets

Despite extensive debates on the factors behind the current “global imbalances,” few formal structures analyze the joint determination of capital flows and asset returns. In my view, any successful theory should address three stylized facts. The first is the well known increase in current account deficits in the US, offset by surpluses in Europe, Japan and since 1997, emerging and oil producing countries. The second fact, oft cited in recent months, is the stubborn decline in long run world real interest rates. The third fact is the sharp increase in the share of US assets in the financial portfolio of the rest of the world.Caballero, Farhi and Gourinchas (2006) develop a stylized model to account for these three observations. Its key feature is a focus on the ability of different regions to supply tradable financial assets, and how this impacts equilibrium world interest rates and global capital flows.

The model is quite standard, except for two features. First, it assumes that only a fraction of current and future domestic output can be capitalized into tradable financial claims. The present value of the remaining share of output constitutes a non-tradable financial asset. Second, the model is non-ricardian: as in Blanchard (1985) or Weil (1987), current households do not have full rights over the non-tradable asset: some of these rights might belong to future unborn generations. In a ricardian setting, the relative supply of tradable and non-tradable financial assets is irrelevant: an increase in the share of income capitalized into tradable assets increases the supply of those assets but decreases the supply of non-tradable financial assets by the same amount, and hence raises the demand for tradable financial assets one for one. This leaves equilibrium allocations and interest rates unchanged. By contrast, in a non-ricardian setting, an increase in the share of income capitalized into tradable assets increases the total supply of financial assets and affects equilibrium allocations.

The fraction of output that can be attached to tradable financial assets might differ across countries, reflecting different levels of financial development, of protection of property rights, of intermediation capital or of any financial friction.

The model considers what happens when regions that are good asset suppliers experience a sustained growth slowdown (continental Western Europe and Japan in the early 1990s), or when the quality, or acceptance of financial assets deteriorates (emerging Asia and Russia after the Asian crisis). In both cases, the global supply of financial assets declines. This depresses global interest rates, generates persistent capital flows into the US and an offsetting current account deficit. From the good’s market perspective, global declines in the supply of financial assets abroad increases the value of US financial assets, hence US wealth when portfolio are not perfectly diversified. This increases consumption and leads to a trade deficit.

We extend the basic structure along two dimensions. First we allow for domestic and foreign direct investment. Direct investment generates intermediation rents for the US (as documented in Gourinchas and Rey (2006a)) that further relax the US external constraint and finances permanent trade deficits. Second, we introduce heterogeneous goods to discuss real exchange rate determination. The exchange rate patterns generated by the expanded model are consistent with the data, while leaving the broader pattern of capital flows and global returns largely unchanged. In the short run, under the assumption of home consumption bias, the increase in US wealth translates into higher relative demand for US goods and a real exchange rate appreciation. In the long run, we find that the real exchange rate depreciates only moderately.

This line of research highlights the role of financial factors for current imbalances. It indicates that the current configuration of asymmetries is likely to continue until the conditions for the initial imbalances are reversed (higher growth among asset suppliers, Europe and Japan, or financial development among asset demanders, emerging Asia). Along that path, the US may build large net external liabilities. Of course, such leverage is risky. Our framework emphasizes that these risks do not arise unavoidably from the current situation.

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