2.8 International Investment Position

A country’s international investment position (IIP)A measure of the difference between the total value of domestic holdings of foreign assets and the value of foreign assets held in the domestic country. is like a balance sheet in that it shows the total holdings of foreign assets by domestic residents and the total holdings of domestic assets by foreign residents at a point in time. In the International Monetary Fund’s (IMF) financial statistics, these are listed as domestic assets (foreign assets held by domestic residents) and domestic liabilities (domestic assets owned by foreign residents). The financial account balance, whose counterpart is the current account balance, is more like an income statement that shows the changes in asset holdings during the past year. In other words, the financial account balance consists of flow variables since it records changes in the country’s asset holdings during the year, while the international asset position of a country consists of stock variables since it records the total value of assets at a point in time.

A country’s net international asset position may be in surplus, deficit, or balance. If in surplus, then the value of foreign assets (debt and equity) held by domestic residents exceeds the value of domestic assets held by foreigners. Alternatively, we could say that domestic assets exceed domestic liabilities. This country would then be referred to as a creditor countryA country whose total domestic assets held abroad exceed total domestic liabilities held by foreigners.. If the reverse is true, so that domestic liabilities to foreigners exceed domestic assets, then the country would be called a debtor countryA country whose total domestic liabilities held by foreigners exceeds total domestic assets held abroad..

Asset holdings may consist of either debt obligations or equity claims. Debt consists of IOUs (i.e., I owe you) in which two parties sign a contract agreeing to an initial transfer of money from the lender to the borrower followed by a repayment according to an agreed schedule. The debt contract establishes an obligation for the borrower to repay principal and interest in the future. Equity claims represent ownership shares in potentially productive assets. Equity holdings do not establish obligations between parties, at least not in the form of guaranteed repayments. Once ownership in an asset is transferred from seller to buyer, all advantages and disadvantages of the asset are transferred as well.

Debt and equity obligations always pose several risks. The first risk with debt obligations is the risk of possible default (either total or partial). To the lender, default risk means that the IOU will not be repaid at all, that it will be repaid only in part, or that it is repaid over a much longer period of time than originally contracted. The risk of default to the borrower is that future borrowing will likely become unavailable. The advantage of default to the borrower, of course, is that not all the borrowed money is repaid. The second risk posed by debt is that the real value of the repayments may be different than expected. This can arise because of unexpected inflation or unexpected currency changes. Consider inflation first. If inflation is higher than expected, then the real value of debt repayment (if the nominal interest rate is fixed) will be lower than originally expected. This will be an advantage to the borrower, who repays less in real terms, and a disadvantage to the lender, who receives less in real terms. If inflation turns out to be less than expected, then the advantages are reversed. Next, consider currency fluctuations. Suppose a domestic resident, who receives income in the domestic currency, borrows foreign currency in the international market. If the domestic currency depreciates, then the value of the repayments in domestic currency terms will rise even though the foreign currency repayment value remains the same. Thus currency depreciations can be harmful to borrowers of foreign currency. A similar problem can arise for a lender. Suppose a domestic resident purchases foreign currency and then lends it to a foreign resident (note that this is the equivalent of saving money abroad). If the domestic currency appreciates, then foreign savings, once cashed in, will purchase fewer domestic goods and the lender will lose.

The risk of equity purchases arises whenever the asset’s rate of return is less than expected. This can happen for a number of different reasons. First, if the equity purchases are direct investment in a business, then the return on that investment will depend on how well the business performs. If the market is vibrant and management is good, then the investment will be profitable. Otherwise, the rate of return on the investment could be negative. All the risk, however, is borne by the investor. The same holds true for stock purchases. Returns on stocks may be positive or negative, but it is the purchaser who bears full responsibility for the return on the investment. Equity purchases can suffer from exchange rate risk as well. When foreign equities are purchased, their rate of return in terms of domestic currency will depend on the currency value. If the foreign currency in which assets are denominated falls substantially in value, then the value of those assets falls along with it.