Reducing large net foreign liabilities

• Author: Martin Schmitz,Céline Tcheng,Michael Fidora
• Published date: 01 May 2019
• Date: 01 May 2019
• DOI: http://doi.org/10.1111/roie.12388

Rev Int Econ. 2019;27:549–577. wileyonlinelibrary.com/journal/roie

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549

© 2019 John Wiley & Sons Ltd

DOI: 10.1111/roie.12388

ORIGINAL ARTICLE

Reducing large net foreign liabilities

MichaelFidora1

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MartinSchmitz1

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CélineTcheng2

1European Central Bank, Frankfurt, Germany

2Banque de France, Paris, France

Correspondence

Martin Schmitz, European Central Bank,

Kaiserstrasse 29, Frankfurt D‐60311,

Germany.

Email: Martin.Schmitz@ecb.int

Abstract

In light of persistently large net foreign liability (NFL) posi-

tions in several euro area countries, we analyze 138 episodes

of sizeable NFL reductions for a broad sample of advanced

and emerging economies. We provide stylized facts on the

channels through which NFLs were reduced and estimate

factors that make episodes “stable”, that is, sustained over

the medium term. Our findings show that while GDP growth

and valuation effects contribute most to NFL reductions

overall, stable reduction episodes also require positive trans-

action effects (i.e., current account surpluses), in particular

in advanced economies. Considering the different compo-

nents of a country's external balance sheet, we observe that

reduction episodes were almost exclusively driven by a de-

cline in gross external liabilities in emerging economies,

while in advanced economies also gross external asset ac-

cumulation contributed significantly, in particular in stable

episodes. Our econometric analysis shows that NFL reduc-

tions are more likely to be sustained if a country records

strong average real GDP growth during an episode and exits

the episode with a larger current account surplus that con-

sists of a combination of relatively high exports, low im-

ports and low net factor income payments. Moreover, we

find evidence that nominal effective exchange rate deprecia-

tion during an episode is helpful for achieving episode sta-

bility in the short run, while IMF programs and sovereign

debt restructurings also contribute to longer term stability.

JEL CLASSIFICATION

F21, F32, F34

550

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FIDORA ET AL.

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INTRODUCTION

In the context of global financial integration, countries have been increasingly lending and borrowing

across borders. The bulk of international financial integration occurred in advanced economies whose

foreign assets and liabilities, relative to GDP, increased eight‐fold since the 1970s and reached more

than 400% of GDP in the early 2000s.1 Nevertheless, emerging market economies (EMEs) were also

participating in the process of global financial integration as their total foreign assets and liabilities

(relative to GDP) doubled over the same period, albeit to only a quarter of the level observed for ad-

vanced economies.2

According to the neo‐classical growth model, increased financial integration ensures that capital is

allocated across countries to its most productive usage. This implies that being a net borrower, that is,

having more external liabilities than assets can be desirable. It also brings potential benefits in terms

of financial risk‐taking and international risk‐sharing (Obstfeld, 1994) as well as improved intertem-

poral consumption smoothing resulting, inter alia, in lower consumption volatility (Bekaert, Harvey,

& Lundblad, 2006).

However, persistent and large net foreign liabilities (NFLs), resulting from growing global current

account imbalances in the run‐up to the crisis and reflected in higher net foreign asset dispersion, also

entail increased external macroeconomic vulnerabilities. Indeed, large NFLs increase the risk of an

external crisis (e.g., Catao & Milesi‐Ferretti, 2014) and can lead to disruptive corrections and crises

when capital inflows suddenly stop. In such instances, domestic economic activity tends to drop se-

verely and defaults on external liabilities are likely.

In the euro area, vulnerabilities from large NFLs became particularly pressing in the decade fol-

lowing the Global Financial Crisis, even though most euro area countries with large pre‐crisis current

account deficits saw a significant correction of external flows subsequently. However, their external

stock positions—as reflected in NFL positions—remain large (Figure 1). In fact, nine euro area coun-

tries breached the European Commission's Macroeconomic Imbalances Procedure (MIP) threshold

of −35% of GDP (which the European Commission regards as an indication of possibly excessive

net foreign liabilities) at the end of 2016, with Ireland, Greece, Cyprus, and Portugal even recording

net foreign liabilities in excess of 100% of GDP. Such levels pose risks to external sustainability even

when taking into account that a substantial part reflects official funding—in the form of EU/IMF

program financing and TARGET2 liabilities—with low interest rates.

Against this background the contribution of our paper is twofold: first, it provides an overview of

the channels of sizeable NFL reduction episodes (in excess of 10 percentage points of GDP), using

different accounting decompositions of a country's external balance sheet, comprising gross external

assets and liabilities. Second, our paper analyzes econometrically which macroeconomic fundamen-

tals make episodes of NFL reductions more “stable,” that is, sustained over the medium‐term.

Our paper builds on several strands of literature. First, with external imbalances and vulnerabilities

having been on the radar of policy makers for a long time, the literature has mainly studied current

account imbalances and their reversals. Milesi‐Ferretti and Razin (2000), Edwards (2004), and Freund

(2005) identify episodes of current account reversals and investigate econometrically their macroeco-

nomic drivers. In addition, valuation effects constitute another channel of external adjustment in light

of increased financial integration (Gourinchas & Rey, 2007; Lane & Milesi‐Ferretti, 2005). Second,

our paper relates to the literature on the determinants of net external positions. Long‐term fundamen-

tals such as GDP per capita, the demographic structure, public debt and country size (Lane & Milesi‐

Ferretti, 2002) as well as geographic factors (Schmitz, 2014) help explain why countries are persistent

net creditors or net debtors. However, only one paper, to our knowledge, focuses—in a descriptive

way—on the determinants of net foreign liabilities reductions (Ding et al., 2014).3