Control Variables

The first group of variables are the annual average changes of the real effect exchange rate with one year lag, following the same data and constructions as in Chapter 3. An

increase of the number indicates domestic currency appreciation against the world. As mentioned before, exchange rate fluctuations mainly generate two channels affecting the net investment incomes. On the one hand, an exchange rate would be associated with the long-run external borrowing/lending positions (the portfolio allocation equation

4.6) based upon the expected fundamentals of both domestic and foreign economies. A higher exchange rate position would imply a better lender position of foreign assets and hence higher income.

On the other hand, the valuation of the overall net position of the foreign currency asset (i.e. foreign currency exposure) would be altered by exchange rate shocks. As shown in the Appendix, given the fact that most of the external liabilities for develop- ing economies are denominated in foreign currency (FXE<0), depreciation of domestic currency tends to increase the outward interest payment in terms of domestic goods and hence deteriorates the net investment income. This implies a positive correla- tion between exchange rate and the dependent variable. Meanwhile, the Industrial economies on average tend to have a net positive position of foreign currency exposure and more than half of the external liabilities are denominated in terms of domestic currency. A depreciation of home currency then tends to generate higher investment income relative to the payments. A first order lag of the annual appreciation variable is introduced to capture the possible dynamics in the subsequent year.

The initial position of current account balance is measured in ratio to GDP from the WDI database. It would indicate the perceived net capital outflows. As mentioned before, the overall changes of the net foreign asset transactions will be approximated by the net capital outflows given the expected exchange rate adjustments. A negative initial position (implying a net capital inflow) is expected to be associated with an decrease in the net investment income during the subsequent periods and vice versa. Hence a positive coefficient is expected.

Country fixed effect dummies are included to capture the unobserved heterogeneities invariant for individual economies. Year fixed effect dummies are also included to cap- ture global shocks that are common within the groups.

4.3.3 Country Groups

Similarly to the previous chapter, the analyses are intended to assess the group- wise performances of countries. Data incompleteness of some variables restricts the disaggregation of country categories particularly for the Oil Exporting and Financial economies. Hence the results are mainly presented for all categories whenever data permits.

4.4 Empirical Results

4.4.1 Baseline Regression Results

Table 4-1 presents the baseline specification results for the annual changes of net investment income flows. As shown in the Appendix, the IMF data (upper panel) generally covers richer country-year observations, with 108 economies for the overall sample. The dependent variable from the WDI data (lower panel) tend to have larger variations, also reflected by the standard deviations of the regressions (RMSE). Simi- larly to the previous chapter, very few observations can be employed before 2000 for the Financial and Oil Exporting groups, which may undermine the fixed effect asymptotic assumptions.

It can be seen from Table 4-1that the initial position of current account rarely ex- hibit significance across the regressions. The coefficients for the overall sample (Column 1 & 2) are negative, suggesting a negative relationship between international capital outflows and the subsequent investment income improvements. By decomposing into country groups, only the Other Developing group tends to have negative correlation in both regressions shown in the upper and lower panel, though the coefficients are insignificant. The Oil Exporting tends to have ambiguous results under the two al- ternative measures. As mentioned before, this group suffers the most incomplete data coverage and the largest volatilities. The Industrial, Financial and Emerging Market economies tend to have positive coefficients, suggesting that larger net investment in-

Table 4-1. Baseline Regression on Annual Changes of NI as %GDP

Whole WholeExcl. Industrial Financial Oil EM OthrDev Fin&Oil

(1) (2) (3) (4) (5) (6) (7) 100d(NI/GDP): IMF Series

dlnREER 1.967 2.374 0.044 7.499 0.449 2.122 2.326 (3.98)*** (4.72)*** -0.03 (2.18)** (0.29) (3.37)*** (3.29)*** dlnREER(-1) 0.55 0.300 -1.361 -1.614 1.209 1.391 0.092 (1.36) (0.79) (-0.87) (-0.54) (0.93) (2.04)* (0.19) CApGDP(-1) -0.958 -2.258 0.829 1.496 -1.808 1.216 -3.262 (-0.90) (-1.39) (0.67) (0.72) (-0.88) (0.94) (-1.57) No. of Econ. 108 82 21 16 10 18 43 No. of Obs. 1367 1050 282 198 119 251 517 R2Overall 0.03 0.04 0.06 0.03 0.08 0.14 0.09 R2Within 0.04 0.07 0.04 0.06 0.10 0.16 0.10 R2_{Between 0.03 0.05 0.65 0.34 0.15 0.01 0.02} RMSE 1.273 1.093 0.725 1.793 1.716 0.636 1.385 100d(NI/GDP): WDI Series

dlnREER 3.08 3.146 0.353 5.502 1.605 1.522 3.508 (3.83)*** (3.91)*** (0.23) (1.06) (0.94) (1.91)* (3.17)*** dlnREER(-1) 0.567 0.491 -0.908 -7.608 2.163 3.764 0.000 (0.88) (0.80) (-0.44) (-0.90) (1.28) (2.76)** (0.000) CApGDP(-1) -3.871 -2.991 0.632 -8.638 1.775 0.499 -4.419 (-1.59) (-0.89) -0.46 (-1.95)* (0.40) (0.15) (-0.96) No. of Econ. 98 77 20 14 7 16 41 No. of Obs. 1144 893 279 180 71 194 420 R2_{Overall 0.01 0.02 0.04 0.04 0.22 0.17 0.04} R2Within 0.05 0.06 0.03 0.09 0.21 0.19 0.08 R2_{Between 0.14 0.27 0.52 0.02 0.84 0.16 0.24} RMSE 1.743 1.415 0.817 2.734 2.381 0.97 1.833 Country Dum. Yes Yes Yes Yes Yes Yes Yes Year Dum. Yes Yes Yes Yes Yes Yes Yes

1_{Robust t-statistics (clustering at individual economy level) are presented in the parentheses.} 2_{RMSE is the root mean square error of the regression.}

3_{Asterisks, ***, **, *, denote the significance level at 1%, 5% and 10% respectively.}

come improvement tends to be associated with larger current account surplus, though the effects are insignificant.

The contemporaneous changes of the real effective exchange rate tend to be posi- tively correlated with net investment income flows. In the overall sample regressions (Column 1 & 2), the coefficient for the contemporaneous appreciation variable is pos- itively significant with the magnitude between 2-3. As discussed before, the positive coefficient suggests significant valuation effects from the foreign currency exposures. Quantitatively, an economy with 10 percent annual average appreciation tends to be associated with about 0.3 percent improvements in its net investment income flows in terms of GDP.

By comparing among the groups8_{, one can see that the Emerging Market and Other}

8_{Those results remain similar if the regressions are conducting on the subsamples consistent with}

Developing economies both have significantly positive coefficients, with the magnitude of the former group slightly smaller than the latter. This suggests the tendency that de- preciations tend to worsen their substantial proportion of foreign currency denominated liabilities that dominate the valuation changes in external asset positions. Specifically, summary statistics from Chapter 3 suggest that a representative Emerging Market economy exhibits a small annual average appreciation (0.4 percent) during the sample period while a representative Other Developing economy shows an overall depreciation (1.5 percent). This suggests that the net investment income flows for the former group tends to have a small improvements from appreciations, i.e. about 0.8 percent in ratio to GDP using the IMF series (0.004*2.12=0.008), while the latter group tends to suffer about 3 percent (-0.015*2.24=0.03) loss on the NI flows.

The Financial group tends to have the largest coefficient but the significance level tends to be ambiguous under the two alternative measures. Given the group average depreciation at about 0.3 percent over the sample period, the results from the upper panel then suggest 2 percent (-0.003*7.50=0.02) annual deterioration on net investment incomes relative to GDP. The coefficient for the Oil Exporting group is positive but insignificant. Given the group average annual appreciation at about 0.2 percent, the result suggest a small improvements (0.002*0.45=0.0009) at about 0.09 percent per year.

The coefficient for the Industrial economies is insignificant, suggesting smaller and less significant valuation effects than within developing economy groups that on aver- age have larger unbalanced positions of external assets and liabilities. Given the group average annual appreciation is about 0.3 percent over the sample period, the positive coefficient suggests an improvement in net external capital income flows. However, when the regressions are conditioned on a smaller sample to be used in later sections, the coefficient turns to be insignificantly negative (see Table 4-20 in Appendix), sug- gesting that within the subsample, depreciation tends to reduce the outward interest payments or improve the incomes. This may particularly reflect both their positive FXE but negative NFA positions, in contrast to most developing economies with neg-

ative positions in both, thus gains from the foreign currency exposure channels are resulting in the similar long-run deterioration effects on their negative NFA positions. Similarly to the contemporaneous variable, the first order lag of exchange rate ap- preciation variable exhibit positive sign for the overall sample regressions but insignif- icant, suggesting the adjustments in the subsequent year may not be substantial. By decomposing into groups, the positive coefficient can be observed for the Oil Exporting, Other Developing and Emerging Market groups. Only the last category exhibits sig- nificant result, suggesting more persistent valuation effects than the other groups. The Industrial and Financial economies tend to have insignificantly negative coefficients, suggesting that depreciation tends to improve the net investment income flows to a limited extent one year later.