Some Further Complications

The analysis of trade imbalances is further complicated by the fact that not all financial flows are IOUs or debt obligations. In the previous stories we assumed that all financial account transactions corresponded to international lending or borrowing. In actuality, many international asset transactions involve sales or purchases of productive assets. For example, if a foreigner purchases shares of Microsoft stock in the US market, the transaction would be recorded as a credit entry on the financial account and would add to a financial account surplus. However, in this case we could not claim that someone in the US borrowed money from the rest of the world because there is no obligation to repay principal and interest in the future. Instead the foreign purchaser of the US asset has purchased an ownership claim in a US corporation which entitles him to the future stream of dividends plus capital gains if he sells the stock later at a higher price. If the company is profitable in the future then the investors will earn a positive return. However, if the company suffers economic losses in the future then the dividends may be discontinued and the stock's price may fall. Alternatively the US dollar could experience a significant depreciation. The end result could be losses for the foreign investor and a negative rate of return. In either case the foreign investor is not entitled to a return of his original investment or any additional return beyond. This same type of relationship arises for international real estate transactions and for foreign direct investment, which occurs when a foreign firm substantially owns and operates a company in another country.

To the extent that financial account flows correspond to asset purchases without repayment obligations, the stories above change somewhat. For example suppose a country runs a trade deficit in period one and that the resulting financial account surplus corresponds to foreign purchases of US real estate and businesses. In the first period, a country's standard of living could be raised above that possible with balanced trade, not by borrowing money, but, by selling ownership claims on productive assets. In the second period, the country's standard of living need not be reduced since there is no repayment obligation.

This case is analogous to an individual who sells his watch at a pawn shop. In that period he is able to buy more than his income because he has divested of some of his previously accumulated wealth. In the following period he can once again make purchases equal to his income and thus need not suffer a reduction in his living standards.

The implication here is that non-debt asset flows may be less problematic than international loans because they may not require a reduction in living standards in the future. Of course, in this case there is an additional concern that the country which sells off its assets may also be losing control of its productive assets and thus its citizens will not be the ones to earn positive returns on these domestic activities. This concern should be tempered for a few reasons. First, foreign owned firms remain subject to the laws of the domestic country. Countries can prevent exorbitant profit taking by applying profit taxes. What's more, the foreign owners do not enjoy voting privileges and thus have less say over laws that might affect them. Second, foreign owned firms generate employment opportunities for domestic citizens which serves to benefit the country. Finally, owners of firms, whether foreign or domestic, are generally motivated by the same desire, namely to make the business successful, and successful businesses generally benefit the owners the employees and the consumers of the product.

As an example consider the purchase in the 1980s of Rockefeller Center in New York City by a group of Japanese investors. Rockefeller Center is a centrally located building in NYC whose owners lease office space to businesses that wish to locate their offices there. Any owner of the building must compete with other businesses leasing office space throughout the city and thus must provide as high a quality and as low a price as is possible. If the owners manage the property well and provide quality services then they will have lots of tenants and they will make a profit. If they provide poor services then businesses will move out and the owners will lose money. Thus, it really shouldn't matter to the tenants whether the owners are American or Japanese, only whether they are good managers of the office space. Similarly, the owners, regardless of nationality, will hire workers to maintain the facilities. These workers will benefit if the management is good and will suffer if it is poor, regardless of the owner's nationality. Finally, if the owners of the building are successful then they deserve to earn a profit or return on their investment. If they provide poor services at high prices then they will deserve to make a loss. Indeed, it shouldn't matter to anyone whether the owners are American or Japanese nationals.

International Finance Theory and Policy - Chapter 6-2: Last Updated on 6/3/04