The Federal Reserve Bank of New York today released The Changing Nature of the U.S. Balance of Payments, the latest article in its series Current Issues in Economics and Finance.
Authors Rebecca Hellerstein and Cédric Tille show that earnings on cross-border investments represent an increasingly large share of the gross flows between the United States and other nations. These earnings streams, the authors observe, fluctuate much more sharply than export and import flows, and thus will almost certainly heighten the volatility of the U.S. current account going forward. Nevertheless, while forecasting the current account will become more difficult, the cross-border financial linkages that create current account volatility bring significant economic benefits: they distribute risk across countries and provide insurance against the uncertainties of the domestic business cycle.
As the authors explain, the value of cross-border financial holdings has soared with the increased integration of world financial markets. Between 1982 and 2006, the value of foreign assets held by U.S. investors tripled from 32 percent of GDP to 106 percent. Similarly, the value of assets held by foreign investors in the United States increased sixfold from 22 percent of GDP to 123 percent.
This rise in cross-border financial holdings has entailed significant increases in dividend and interest earnings. As a share of gross income from the rest of the world, U.S. earnings on foreign assets virtually doubled between 1970 and 2007, rising from 17 percent to 32 percent. Over the same period, earnings by foreign investors in the United States claimed an increasing share of U.S. gross payments to other nations, advancing from 9 percent to 23 percent.
Hellerstein and Tille argue that as earnings streams on international assets have assumed a larger role in gross flows to and from the United States, the current account has become more sensitive to fluctuations in international financial yields. As evidence of this heightened sensitivity, the authors point to a recent revision of the balance of payments data by the U.S. Bureau of Economic Analysis. An upward adjustment in U.S. net income on international assets and liabilities—driven largely by an adjustment to yields, combined with large underlying holdings—led to a sizable reduction in the current account deficit after 2001. The reduction was especially marked for the years 2004-06, with the amended data lowering the deficit by 0.22 percent to 0.34 percent of GDP.
While the heightened exposure of the current account to movements in financial yields can be expected to create greater current account volatility, Hellerstein and Tille do not see grounds for concern. “The question is not whether U.S. international transactions have become more volatile,” they remark, “but rather how they are linked to overall U.S. income, as measured by GDP.” The authors show that although the yield differential between U.S. international assets and liabilities is volatile, it is negatively correlated with U.S. growth. As a result, the United States earns a higher return on its assets than it pays on its liabilities during downturns in the economy.
Noting that this “insurance benefit” from financial globalization has strengthened over the last ten years, the authors conclude, “The greater volatility of the current account going forward does not imply lower economic welfare. To the contrary, it is the channel through which business cycle risk is shared across countries.”