DP4923 International Financial Adjustment

Author(s): Pierre-Olivier Gourinchas , Hélène Rey

Publication Date: February 2005

Keyword(s): exchange rates , external adjustment , MeeseRogoff , net foreign assets , valuation

JEL(s): F31 , F32 , F37

Programme Areas: Financial Economics , International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP4923.asp

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.