International Financial Adjustment

Abstract

The paper proposes a unified framework to study the dynamics of net foreign assets and exchange rate movements. We show that deteriorations in a country's net exports or net foreign asset position have to be matched either by future net export growth (trade adjustment channel) or by future increases in the returns of the net foreign asset portfolio (hitherto unexplored financial adjustment channel). Using a newly constructed data set on US gross foreign positions, we find that stabilizing valuation effects contribute as much as 31% of the external adjustment. Our theory also has asset pricing implications. Deviations from trend of the ratio of net exports to net foreign assets predict net foreign asset portfolio returns one quarter to two years ahead and net exports at longer horizons. The exchange rate affects the trade balance and the valuation of net foreign assets. It is forecastable in and out of sample at one quarter and beyond. A one standard deviation decrease of the ratio of net exports to net foreign assets predicts an annualized 4% depreciation of the exchange rate over the next quarter.

Exchange rates in the modern floating era: what do we really know?

“…Very recently, there has developed a literature claiming somewhat more positive results, notably in West (2005, 2006), Engel et al (2007), , and Gourinchas and Rey (2007). These and a number of other papers are critically surveyed in Rogoff and Stavrakeva (2008).…”

“…Obstfeld and Rogoff (1996) introduce a model that simultaneously determines the current account and the exchange rate, as do Ferrero et al (2008), who supply a dynamic general equilibrium version of the model developed in Obstfeld and Rogoff (2001). Most recently, Gourinchas and Rey (2007) argue that a simple function of cumulated current account variables has out-of-sample predictive power for the US dollar trade-weighted exchange rate.…”

“…An important recent paper on the relationship between the current account and the real exchange rate is by Gourinchas and Rey (2007). They use a simple accounting framework to develop a measure of the cumulated current account normalized by income.…”

“…They develop a simple diagrammatic approach to testing forecasting sensitivity to small perturbations in the sample (see also Rossi 2006). Of all the models tested, the only one that appears robust to the forecast sample is the current account model of Gourinchas and Rey (2007) (albeit, as already noted, it remains to be seen how well the model works after the dramatic late-2008 rise in the dollar). Although only one of the two weighted nominal exchange rate models performs reasonably well over all sample periods, both the trade-and FDI-weighted specifications outperform the driftless random walk over part of the past two decades.…”

The Swedish external position and the krona

“…See alsoTille (2003) andGourinchas and Rey (2007)-these papers especially focus on the role of valuation effects for the external position of the USA.…”