International Financial AdjustmentPierre-Olivier Gourinchas∗Berk eley, CEPR and NBERandH´el`ene Rey∗∗Princeton, CEPR and NBERFebruary 2004First draft: April 2002AbstractThe paper proposes a uniÞed framework to understand the dynamics of net foreign assetsand exchange rate movements. Focusing on the Þnancial account and its determinants,we show that coun tries’ capital gains and losses on net foreign assets constitute a keychannel for external adjustment. For example, a depreciation of the domestic currencyor a drop in the domestic stoc k market index improves the sustainability of a country’sexternal position by decreasing the value of its liabilities to foreigners. Our theory impliesthat deviations from trend of the ratio of net exports to net foreign assets contain infor-mation about future portfolio returns and, possibly, future exchange rate changes. Usingquarterly data on U.S. gross foreign positions and returns, we Þnd that adjustments inthe country’s external position occur indeed mostly at short to medium horizons throughportfolio revaluations, not through future changes in net exports. We also Þnd evidenceof predictability of net foreign asset portfolio returns at horizons between one quarter tothree years. These results cast a new light on the sustainability of US current accountdeÞcits.Alejandro Justiniano provided outstanding research assistance. A draft of this paper was present ed at the May2002 5th CEPR Conference of the Analysis of International Capital Markets Researc h Training Network (Gerzensee)under the title ‘The Intertemporal Approach to the Financial account’. We thank our discusssants Bartosz Mackowiakand Philip Lane for their comments as well as Mike Devereux, Gene Grossman, Maury Obstfeld, Chris Sims, LarsSvensson, Mark Watson, Mike Woodford and seminar participants at Princeton, Harvard, the IMF and at the 2003Hong Kong Monetary Authority Conference. This paper is part of a researc h network on ‘The Analysis of InternationalCapital Markets: Understanding Europe’s Role in the G lobal Economy’, funded by the European Commission under theResearc h Training Net work Program (Contract No. HPRNŒCTŒ 1999Œ00067) and is part of the project “ExchangeRates, Internationa l Relative Prices, and Macroeconomic Models”, funded by the ESRC (grant no.L138 25 1043).∗Department of Economics, University of California at Berkeley, Berkeley, CA, USA. Telephone: (1) 510 643 0720.E-mail: [email protected]. Web page: www.princeton.edu/˜pog∗∗Department of Economics and Woodro w Wilson School, Princeton University, Princeton, NY , USA. Telephone:(1)-609 258 6726. E-mail: [email protected]. Web page: www.princeton.edu/˜hrey1IntroductionUnderstanding the dynamic process of adjustmen t of a country’s external balance is one of the mostimportant questions for international economists. ‘To what extent should surplus countries expand;to what extent should deÞcit countries contract?’ asked Mundell (1968). These questions remain asimportant today as then.The modern theory which focuses on those issues is the ‘intertemporal approach to the currentaccount’. It views the current account balance as the result of forward-looking intertemporal savingdecisions by households and investment decisions by Þrms, under incomplete markets. As Obstfeld(2001)[p11] remarks, ‘it provides a conceptual framework appropriate for thinking about the im-portant and interrelated policy issues of external balance, external sustainability, and equilibriumreal exchange rates’ together with a rigorous, solidly microfounded, analysis of w elfare issues forinternational problems.This approach has yielded major insigh ts into the current account patterns that followed the twomajor oil price shocks of the seventies, or the large U.S. Þscal deÞcits of the early eighties. Yet,in many instances and for most countries, its key empirical predictions are easily rejected by thedata. Our paper suggests that this approac h falls short of explaining much of the dynamics of thecurrent account because it usually assumes that the only asset traded internationally is a one-periodriskfree bond.1In reality, international Þnancial markets have become increasingly sophisticated andoffer a rich menu of assets (equity, FDI, corporate and government bonds for example). Traditionalmodels therefore ignore a central aspect of the adjustment of countries’ external balances, namely,predictable changes in the valuation of foreign assets and liabilities. Fluctuations in the rate ofreturns of Þnancial assets and in the exchange rate affect in an important way the dynamics ofexternal balances. This link between asset prices, exchange rate and current account dynamicshas been ignored in the intertemporal approach to the current account and may explain much ofits failure. According to our approach, balance of payments adjustments may occur through thisrebalancing of assets and liabilities. Consider the case of the US. It currently has a very negativeforeign asset position. The intertemporal budget constraint of the coun try implies that it will haveto reduce this imbalance. The intertemporal approach to the current account suggests that the USwill need to run trade surpluses. In this paper, we show that this rebalancing can also take place1There are exceptions: i) Kray and Ventura (2000) and Ventura (2001) allow for investment in risky foreign capital;ii) the international real busine ss cycle literature usually assumes that markets are complete but this implies that thecurren t accoun t is merely an accounting device and has counterfactual implications; iii) more recently, speciÞcformsof endogeneous mark e t incompleteness have been studied (see for example Kehoe and Perri (2002)).1through a change in the returns on US assets held by foreigners relative to the return on foreignassets held by the US. Importantly, this rebalancing may occur via a depreciation of the dollar. Withlarge gross asset positions, as is the case in the data, a given change in the dollar can transfer largeamounts of wealth from the rest of the world to the US and vice versa.2Our framework gives therefore novel insigh ts into the dynamics of adjustment of countries’ exter-nal account and ties the dynamics of the exc hange rate to net exports and net foreign assets, therebyreconciling the ‘asset market view’ and the ‘goods mark et view’ of exchange rate determination. Itrecognizes the central