Valuation Effects and External Adjustment

Abstract

In the past two decades, cross country portfolio holdings of a large variety of assets have risen sharply. This has created an important role for changes in asset prices, or valuation effects". This dissertation examines the role of valuation effects in a country's external adjustment.

The dissertation is organized as follows: Chapter 1 is a brief introduction. Chapter 2 presents some facts about the U.S.'s valuation effects from stocks and bonds during 1994-2007. In particular, total valuation effects from stocks and bonds during this period were $1295 billions, offsetting about 22.8% the size of the U.S.'s total current account deficits. Much of the positive, stabilizing effects arose after 2002. Before 2002 the valuation effects were often negative and reinforcing the current account deficits.

Chapters 3, 4 and 5 present a two-country dynamic stochastic general equilibrium (DSGE) model to study valuation effects theoretically. Chapter 3 outlines the set up of the model, where output has a transitory and a trend component, both of which are subject to AR(1) shocks. Chapter 4 solves analytically a simplified version of the model that only considers transitory output shocks. It shows that valuation effects are stabilizing in response to transitory shocks. That is, valuation effects move in the opposite directions of the current account, and mitigate the impact of the current account on the NFA position. Chapter 4 also shows analytically that the size of valuation effects relative to the current account is positively related with the level of financial integration, which in turn increases with risk aversion, with output volatility, with output persistence, and decreases with the discount factor and with the cost of investing abroad. For the benchmark calibration, when domestic investors hold about 40% of their financial wealth in foreign equity, valuation effects will completely offset the current account.

Chapter 5 solves numerically for the full version of the model, where both transitory and trend output shocks are considered. It shows that valuation effects are not always stabilizing. Following trend shocks on output, valuation effects are amplifying: they move in the same direction as the current account and reinforce the impact of the current account on net foreign assets. The results are illustrated by the external imbalances between the U.S. and other industrialized countries since the 1990s. Chapter 6 concludes.