International Financial Integration*

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B. Data Issues on Rates of Return

In previous work (Lane and Milesi-Ferretti 2002a, 2002b) we documented the importance
of differences in rates of return for explaining the dynamics of net external positions.
Three basic stylized facts emerged from the analysis: first, rates of return on both assets
and liabilities tended to be high, easily exceeding countries’ growth rates; second, cross-
country differences in rates of return were substantial, and third, some countries exhibited
substantial differences between returns on external assets and liabilities. One classical
example is the United States, which according to IIP data has been a debtor country since
1989, but its investment income position turned negative only in 1998.

In this section, we attempt to explain the behavior of the rates of return on foreign assets
and liabilities. We use IMF balance of payments statistics data on interest earnings and
payments on external holdings, together with data on international investment positions
and on capital flows, to construct measures of yields and rates of return on external assets
and liabilities as well as, where possible, on their sub-components. We then assess the
degree to which these yields and returns can be explained by ‘market’ rates of return,
which we construct using information on the composition and geographical allocation of
external assets and liabilities.

external factors. The mechanics are most direct in the case of an unindexed nominal asset,
where the impact of exchange rate movements on ex-post returns depends on whether it is
denominated in domestic currency or foreign currency. Similarly, the domestic currency
return on an unhedged foreign currency nominal asset or liability is negatively related to
real appreciation. For positions denominated in domestic currency, there is no mechanical
relation. On the one side, real appreciation may proxy for good fundamentals (if not
captured elsewhere in the regression) and so be associated with high domestic currency
returns; real appreciation also boosts profits by lowering the costs of imported inputs if
these are priced in foreign currency. On the other hand, real appreciation may reduce
returns by a loss of competitiveness, or by lowering the terms of trade if local currency
pricing in good markets prevails.

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