GLOBE

The International Investment Position

by Steven Suranovic ©1997-2004

Chapter 5    

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A country's international investment position is like a balance sheet in that it shows the total holdings of foreign assets by domestic residents and the total holdings of domestic assets by foreign residents at a point in time. In the IMF's financial statistics, these are listed as domestic assets (foreign assets held by domestic residents) and domestic liabilities (domestic assets owned by foreign residents). The financial account balance, whose counterpart is the current account balance, is more like an income statement which shows the changes in asset holdings during the past year. In other words, the financial account balance consists of flow variables since it records changes in the country's asset holdings during the year, while the international asset position of a country consists of stock variables since it records the total value of assets at a point in time.

A country's net international asset position may either be in surplus, deficit or balance. If in surplus then the value of foreign assets (debt and equity) held by domestic residents exceeds the value of domestic assets held by foreigners. Alternatively we could say that domestic assets exceeds domestic liabilities. This country would then be referred to as a creditor nation. If the reverse is true, so that domestic liabilities to foreigners exceed domestic assets, then the country would be called a debtor nation.

Asset holdings may consist of either debt obligations or equity claims. Debt consists of IOUs in which two parties sign a contract agreeing to an initial transfer of money from the lender to the borrower followed by a repayment according to an agreed schedule. The debt contract establishes an obligation for the borrower to repay principle and interest in the future. Equity claims represent ownership shares in potentially productive assets. Equity holdings do not establish obligations between parties, at least not in the form of guaranteed repayments. Once ownership in an asset is transferred from seller to buyer, all advantages and disadvantages of the asset are transferred as well.

Debt and equity obligations always pose several risks. The first risk with debt obligations is the risk of possible default (either total or partial). To the lender, default risk means that the IOU will not be repaid at all, that it will be repaid only in part, or, that it is repaid over a much longer period of time than originally contracted. The risk of default to the borrower is that future borrowing will likely become unavailable. The advantage of default to the borrower, of course, is that all of the borrowed money is not repaid. The second risk posed by debt is that the real value of the repayments may be different than expected. This can arise because of unexpected inflation or unexpected currency changes. Consider inflation first. If inflation is higher than expected, then the real value of debt repayment (if the nominal interest rate is fixed) will be lower than originally expected. This will be an advantage to the borrower, who repays less in real terms, and a disadvantage to the lender who receives less in real terms. If inflation turns out to be less than expected, then the advantages are reversed. Next consider currency fluctuations. Suppose a domestic resident, who receives income in the domestic currency, borrows foreign currency in the international market. If the domestic currency depreciates then the value of the repayments in domestic currency terms will rise even though the foreign currency repayment value remains the same. Thus, currency depreciations can be harmful to borrowers of foreign currency. A similar problem can arise for a lender. Suppose a domestic resident purchases foreign currency and then lends it to a foreign resident ( note this is the equivalent of saving money abroad). If the domestic currency appreciates then foreign savings, once cashed in, will purchase fewer domestic goods and the lender will lose.

The risk of equity purchases arises whenever the asset's rate of return is less than expected. This can happen for a number of different reasons. First, if the equity purchases are direct investment in a business then the return on that investment will depend on how well the business performs. If the market is vibrant and management is good then the investment will be profitable. Otherwise the rate of return on the investment could be negative. All of the risk, however, is borne by the investor. The same holds for stock purchases. Returns on stocks may be positive or negative but it is the purchaser who bears full responsibility for the return on the investment. Equity purchases can suffer from exchange rate risk as well. When foreign equities are purchased, their rate of return in terms of domestic currency will depend on the currency value. If the foreign currency in which assets are denominated, falls substantially in value then the value of those assets fall along with it.

The US International Investment Position

The data for the US international investment position is available from the Bureau of Economic Analysis at http://www.bea.doc.gov/bea/di/home/iip.htm. You can access a recent version in Excel spreadsheet form by clicking HERE. (To access, right-click and save to your desktop).

From the attached spreadsheet we can see that the US investment position is evaluated in two separate ways. Line 1 in the Table shows the position evaluated at current cost, Line 2 shows the position evaluated at market value. Current costs measures asset values based on the prices that prevailed when the assets were purchased. Thus if a US resident purchased 100 shares of stock in a British company in 1998 for $2000, and if he continues to hold that stock, then the valuation today, based on current cost methods would still be $2000. However, if the value of that stock on the market has since risen to $3000, then using market value measures, the stock would be recorded at the higher value.

Between the two methods, current cost valuations are much easier to account for since they are simple additions of annual financial account flows. However, market valuation is a much better estimation of the true value of outstanding assets. Market value is a preferred method with some reservations included for increased difficulty in measuring changes in aggregate assets values.

The US is currently (2004) the largest debtor nation in the world. This means that it's international investment position is in deficit and the money value of that deficit is larger than any other country in the world. At market values the preliminary estimate for 2002 is that the US was in debt to the rest of the world in the amount of $2.605 trillion. (refer to cell AC10 in spreadsheet). Evaluated at current cost the debt was not significantly different at $2.387 trillion.

Note that this valuation is the US "net" investment position, meaning that it is the difference between the sum total value of Foreign assets owned by US residents (US assets abroad) minus US assets owned by foreigners (foreign-owned assets in the US). The first of these, US assets abroad, represents our purchases of foreign equities and money we have lent to foreigners. The total value stood at $6.473 trillion in 2002 using market value methods. The second, foreign-owned assets in the US, represents foreign purchases of US equities and money they have lent to us, or equivalently, that we have borrowed. The total in 2002 stood at $9.078 trillion.

The size of the US debt position is cause for some worry. Noting the changes over the past 20 years, one can see that the US had a sizable creditor position back in 1982. As a result of trade deficits run throughout the 1980s and 1990s, the US quickly turned from a net creditor to a net debtor. The changeover occurred in 1989 using market valuation. In the early 1990s the size of this debt position was not too large compared to the size of the economy, however, by the late 1990s and early 2000s the debt ballooned. In 2002, the US debt position stood at 24.9% of GDP. Given the large US current account deficit expected in 2003, we can expect the debt position to grow even further during the next year or more.

For several reasons the debt is not a cause for great worry. First, despite its large numerical size, the US international debt position is still less than 25% of it's annual GDP. Although this is large enough to be worrisome, especially with a trend towards a future increase, it is not nearly as large as some other countries have experienced in the past. In Argentina and Brazil, international debt positions exceeded 60% of GDP. For some less developed countries, international debt has at times exceeded 100% of their annual GDP.

A second important point is that much of our international obligations are denominated in our own home currency. This means that when international debts (principal + interest) are paid to foreigners they will be paid in US currency rather than foreign currency. This relieves the US from the requirement to sell products abroad to acquire sufficient foreign currency to repay its debts. Many other countries who have experienced international debt crises, have had great problems financing interest and principal repayments especially when bad economic times make it difficult to maintain foreign sales.

Finally, it is worth noting that, despite the name applied to it, our international "debt" position does not correspond entirely to "debt" in the terms' common usage. Recall that debt commonly refers to obligations that must be repaid with interest in the future. Although a sizable share of our outstanding obligations is in the form of debt, another component is in equities. That means some of the money "owed" to foreigners is simply the value of their shares of stock in US companies. These equities will either make money or not based on the success of the business, but they do not require a formal obligation for repayment in the future.

However, doing a rough, back-of-the-hand calculation with the numbers for 2002, to separate debt from equities, reveals that the equity holdings both abroad and domestically almost balance out. That is, foreign ownership of US equities is about equal to US ownership of foreign equities. That implies that the net debt position in the US, at 25% of GDP, does approximately reflect the net debt balance as well. In other words, the US does owe an extra 25% of GDP to the rest of the world after subtracting what foreigners owe to the US.

 


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©2004 Steven M. Suranovic, ALL RIGHTS RESERVED
Last Updated on 6/3/04