Financial integration and external adjustment

Andreas Fischer, Henrike Leonie Groeger, Philip Sauré, Pınar Yeşin 09 December 2019

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Cross-border financial linkages have soared in the last three decades. According to Eurostat, there were more than 162,000 multinational enterprise groups in the EU in 2017.1 But balance of payments and national income accounting standards are residence-based and treat countries as if they were separate islands. Furthermore, for practical reasons, they make crude assumptions when compiling statistics. As a result, current account statistics based on existing standards cannot accurately measure the savings-investment balance of countries that are highly financially integrated.

There have been ongoing efforts to address the challenges that financial integration creates in the economically meaningful compilation of balance of payments statistics. Avdjiev et al. (2018) give a broad overview of measurement issues and call for additional macroeconomic indicators to measure the actual level of domestic and cross-border economic activities. On the practical side, a new EU pilot project is currently assessing the treatment of a small number of multinational enterprises in national accounts across Europe, which has repercussions for the consistency of balance of payments aggregates (Stapel-Weber et al. 2018).2 

Our recent research contributes to this growing discussion on measuring economic activity in a financially integrated world (Fischer et al. 2019). In particular, we study the role of balance of payments accounting standards regarding retained earnings on assessing external adjustment. Retained earnings (RE) are the part of companies’ profits which is reinvested and not distributed to shareholders as dividends. Surprisingly, balance of payments accounting standards do not prescribe the recording of RE on all types of cross-border investment homogeneously (IMF 2009). In particular, RE on portfolio equity investment are not recorded as investment income, and thus enter neither the current account nor the financial account. This implies that retained earnings are treated as the income and saving of the country where the company is located rather than of the countries where the cross-border investors are located. By contrast, RE that accrue from direct investments and investment funds are recorded as investment income in the current account and the financial account. RE on direct investment and investment funds are thus allocated correctly to the investors’ countries as savings. 

Growing financial integration

The missing RE on (portfolio) equity investment would distort current account statistics severely when countries have sizeable assets and/or liabilities in equity. In fact, following the rise in the number of multinational enterprise groups and the increasing demand for equity investment by cross-border investors, international investment positions in equity have increased considerably in the last two decades. Figures 1 and 2 exhibit countries with the largest net asset and net liability positions in equity investment relative to their GDP in a large sample of countries. Countries illustrated in Figure 1 had a sizeable net asset positon in portfolio equity investment in 2015, ranging from 17% of GDP in New Zealand to 137% of GDP in Norway. Similarly, countries illustrated in Figure 2 had a sizeable net liability position in portfolio equity investment in 2015, ranging from 16% of GDP in Spain to 146% of GDP in Ireland.

Figure 1 Countries with large net portfolio equity assets

Sources: IMF CPIS, IMF BOPS, own calculations

Figure 2 Countries with sizeable net portfolio equity liabilities

Sources: IMF CPIS, IMF BOPS, own calculations

For countries with sizeable equity investment positions, investment income on equity – in the form of dividends and retained earnings – would have undoubtedly become an increasingly important component of the current account. Yet, RE on these equity positions are not recorded in official current account statistics, as already mentioned above.3

Sizeable unrecorded RE on equity investment

Our study attempts to estimate RE on equity investment for a wide set of countries over time, and to allocate them as savings to the equity investors’ countries (Fischer et al. 2019). We develop a formal strategy to calculate corrected current accounts with RE by using country-specific payout ratios in national stock markets, and bilateral asset and liability positions in equity investment. Following this formal strategy, we estimate current accounts with RE for 44 countries from 2001 to 2015. The data coverage is extensive, it accounts for 82% of world GDP and 87% of the world’s total foreign assets in equity investment. The RE correction is computed for 627 country-year pairs. 

Figure 3 RE correction, official and corrected current account for Hong Kong

Source: IMF BOPS, own calculations
Note: Corrected current account (CA) balance is official current account plus the retained earnings correction.

Our study shows that the estimated RE on equity investment are time-varying and sizeable, especially for countries with large gross and net positions in equity investment. Figure 3 illustrates that RE on equity investment can be economically relevant for individual countries. For Hong Kong, the figure shows that net RE on equity investment that are not recorded in official statistics have ranged from +2% GDP to -5% GDP during 2001-2015. Our estimates suggest that the current account balance of Hong Kong has been increasingly overestimated since 2007, as RE on equity investment have steadily decreased after the Global Crisis. In contrast, the estimated RE are generally small for emerging market economies, because most of them do not have sizeable positions in equity investment.

External adjustment through financial linkages

We then provide empirical evidence that, after the Global Crisis, an external adjustment took place through financial linkages. In particular, countries with sizeable positions in portfolio equity experienced exceptionally large current account adjustments that remain concealed in official current account statistics. We show that official current account statistics cannot capture this type of external adjustment through financial linkages.

The intuition is the following. Before the Global Crisis, equity markets experienced large corporate profits and therefore large transfers in RE. As the crisis unfolded, however, corporate profits fell sharply and RE were small. This implied that economies that were highly financially integrated experienced adjustments in income flows in equity investment that remain concealed in official current account statistics. 

This type of external adjustment through financial linkages complements the narrative of Lane and Milesi-Ferretti (2012), who argue that the adjustment of global imbalances occurred through trade balances and that countries with exchange rate pegs were especially affected. Our findings raise new questions about the appropriate measurement of external balance adjustment of financially integrated economies.

References

Avdjiev, S, M Everett, P R Lane and H S Shin (2018), “Tracking the international footprints of global firms”, BIS Quarterly Review (March): 47-66.

Fischer, A, H Groeger, P Sauré and P Yeşin (2019), “Current account adjustment and retained earnings”, Journal of International Money and Finance 94 (June): 246-259.

Lane, P R and G M Milesi-Ferretti (2012), “External adjustment and the global crisis”, Journal of International Economics 88: 252-265.

Stapel-Weber, S, P Konijn, J Verrinder and H Nijmeijer (2018), “Meaningful information for domestic economies in the light of globalization – will additional macroeconomic indicators and different presentations shed light?”, NBER Working Paper 24859.

International Monetary Fund (2009), Balance of Payments and International Investment Position Manual, Washington, D.C., 6th edition.

Endnotes

[1] The EuroGroups Register defines as a multinational enterprise group in the EU a group that operates in two or more countries, at least one of them being an EU or European Free Trade Association (EFTA) country. These multinational enterprise groups employed 48 million people in the EU in 2017.

[2] Similarly, the Central Statistical Office of Ireland publishes a modified current account balance for Ireland in parallel to its official current account balance.

[3] Missing RE on portfolio equity also lead to valuation changes in the international investment position that cannot be explained by current account developments. When companies do not distribute their profits but instead reinvest, stock prices increase. When investors are non-residents, foreign liabilities increase. Thus, missing RE on portfolio equity investment lead to valuation changes in the international investment position due to asset price movements.

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Topics:  Global economy International finance

Tags:  External adjustment, financial integration, portfolio equity investment, Current account balance, retained earnings, balance of payments, Accounting

Economic Adviser at the International Research Unit of the Swiss National Bank and CEPR Research Fellow

PhD Researcher, European University Institute

University of Mainz

Economic Advisor, Swiss National Bank; Economics Lecturer, University of Zurich

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