A major focus of the recent literature on the determination of optimal portfolios in open-economy macroeconomic models has been on the role of currency movements in determining portfolio returns that may hedge various macroeconomic shocks. However, there is little empirical evidence on the foreign currency exposures that are embedded in international balance sheets. Using a new database, we provide stylized facts concerning the cross-country and time-series variation in aggregate foreign currency exposure and its various subcomponents. In panel estimation, we find that richer, more open economies take longer foreign-currency positions. In addition, we find that an increase in the propensity for a currency to depreciate during bad times is associated with a longer position in foreign currencies, providing a hedge against domestic output fluctuations. We view these new stylized facts as informative in their own right and also potentially useful to the burgeoning theoretical literature on the macroeconomics of international portfolios.
The rapid expansion of gross cross-border investment positions has stimulated a new wave of interest in the international balance sheet implications of currency movements. At the same time, recent advances in macroeconomic theory have provided a more nuanced consideration of the general equilibrium characteristics of the portfolio allocation problem than was attained in the earlier wave of “portfolio balance” models (see, amongst others, Devereux and Sutherland, 2009a, Devereux and Sutherland, 2009b, Tille and van Wincoop, 2007 and Engel and Matsumoto, 2009). A major concern of this new research programme has been to identify the appropriate currency exposure of optimal portfolios.
However, this literature has been constrained by a lack of empirical evidence concerning the currency exposures that are present in the international balance sheet. In a recent work (Lane and Shambaugh, 2009), we have compiled and described the currency composition of foreign asset and liability positions for a broad set of countries over 1990–2004. In that work, we established that the currency profiles of international portfolios show tremendous variation, both across countries and over time.
Accordingly, our goal in this paper is to synthesize two recent advances in the literature—the expansion of knowledge concerning the data on the currency composition of cross-border portfolios and the advances in theory regarding those positions—to study the cross-country and cross-time variation in aggregate foreign currency exposure. We pursue two broad lines of analysis. First, we provide a decomposition of aggregate foreign currency exposure into its constituent elements. This is important, since much of the theoretical literature has focused on particular dimensions of foreign-currency exposure, whereas the valuation impact of currency movements depends on the aggregate foreign currency position. Second, we conduct a panel analysis of variation in foreign currency exposure in order to identify which country characteristics help to explain the cross-sectional and time-series variation in the level of foreign currency exposure.
In the decomposition, we divide aggregate foreign-currency exposure into two primary subcomponents: the net foreign asset position and the level of foreign currency exposure embedded in a zero net foreign asset position. While some models focus on the latter component, the data suggest that the net foreign asset position is the most important determinant of aggregate foreign currency exposure. In addition, the decomposition shows that the structure of foreign liabilities (across portfolio equity, direct investment, local-currency debt and foreign-currency debt) is a key determinant of foreign currency exposure, with the equity share in liabilities more important than the currency composition of foreign debt liabilities. These findings point to the importance of analyzing the full set of foreign-currency assets and liabilities, rather than focusing on a particular subcomponent of the data.
We next analyze the panel variation in foreign currency exposures. We find that factors such as trade openness and the level of development help to explain the cross-sectional variation in foreign currency exposure: richer, more open economies take longer positions in foreign currency. This means these countries experience gains when their currency depreciates and losses when it appreciates. Once the cross-sectional variation is eliminated by including a set of country fixed effects in the estimation, we find support for a key general prediction of the theoretical literature: an increase in the propensity for a currency to depreciate during bad times is associated with a longer position in foreign currencies, which acts as a hedge against domestic output fluctuations. Our final contribution is to show that there is substantial heterogeneity in the roles of each regressor in explaining the variation in individual subcomponents of foreign-currency exposure: accordingly, it is important to take a broad perspective rather than examining individual components in isolation.
The structure of the rest of the paper is as follows. Section 2 lays out the conceptual framework for the study, while Section 3 briefly describes our dataset. The analysis of the decomposition of foreign-currency exposure into its constituent elements is presented in Section 4, with the main econometric analysis reported in Section 5. Section 6 provides a summary of the main stylized facts established by our analysis and final conclusions are offered in Section 7.
