Working Paper: NBER ID: w22741
Authors: Kristin Forbes; Ida Hjortsoe; Tsvetelina Nenova
Abstract: Large current account deficits, and the corresponding reliance on capital flows from abroad, can increase a country’s vulnerability to periods of heightened risk and uncertainty. This paper develops a framework to evaluate such vulnerabilities. It highlights the central importance of two financial factors: income on international investments and changes in the valuations of those investments. We show how the characteristics of a country’s international investment portfolio – the size of its international asset and liability holdings, their currency denominations, their split between equity and debt, and their return characteristics – affect the dynamics of these financial factors. Then we decompose those dynamics into their drivers, explore how they are affected by domestic and global risk shocks, and apply this framework to 10 OECD economies. These examples, including a more detailed assessment for the UK, show that a substantial degree of international risk sharing can occur through current accounts and international portfolios. Our flexible framework clarifies which characteristics of a country’s international portfolio determine whether a current account deficit is “menacing” or “mitigating”.
Keywords: current account deficits; risk; international investment; vulnerability; financial factors
JEL Codes: F21; F32; F36; F42
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| large current account deficits (F32) | increase vulnerability to heightened risk and uncertainty (D81) |
| certain characteristics of a country's international investment portfolio (F21) | influence vulnerability to risk shocks (E71) |
| high share of liabilities in domestic currency (F65) | mitigate adverse effects during heightened domestic risk (H84) |
| reliance on debt rather than equity (G32) | provides less automatic risk sharing (F65) |
| negative net international investment position and riskier liabilities (F34) | greater international risk sharing during heightened global risk (F65) |
| current account deficits under certain circumstances (F32) | provide a form of automatic international risk sharing (F30) |
| interactions of the UK's international investment portfolio with currency movements (F32) | lead to improvements in NIIP and current account during heightened risk (F32) |